Been researching the derivatives industry a bit. It's pretty hard to find real deal professionals amongst all the get-rich-quick schemes online, but on a hunch I went hunting for some history on Jimmy Wales, one of the founders of Wikipedia and its primary early funding source. I ended up finding out that he was a prolific poster on the newsgroups from 1996-1998 and spent a ton of time in the objectivism newsgroups, which maybe is a little suspect, and strangely, in misc.invest.financial-plan, as opposed to the more esoteric newsgroups related to mathematical finance.
Here's one of the few posts related to his former career. It's not particularly new to me, as I did know a fair bit about the advantage market makers and pros have in the derivatives market, with their minuscule transactional costs. I think if more people knew that, the less willing they'd be to subscribe to seminars and schemes, aside from all the other equipment and know-how that people employ. That said, options trading is the ultimate in model-based, quantitative, theoretical trading, and so it still feels a little weird to me. Going in with my limited means, buying or selling a few puts or calls here at random -- am I a David versus Goliaths? It's hard to say, and it depends a lot on whether you think 1. the market is biased towards professionals and member firms and institutions and 2. that prognostication can be done mathematically -- something I'm still very doubtful of, not because of the math, but because of the prognostication. So knowing that prognostication is not possible, the only wait to defend against unexpected events is to be less exposed, as a portion of your portfolio. Cash management, bla bla.
(For interesting reference, here is one of the few derivatives related things that Wales recommends reading on the newsgroups, Don M. Chance's Derivatives 'R Us postings.)
I think another interesting thing that I took away from all this is that options trading firms typically seem to be this maverick organizations, since the equity requirements to be a member of the Chicago Board is 200 grand. Well, and a lot of other paperwork I think, but overall there isn't that kind of regulation that you see in stocks and bonds, and I think options trading houses tend to be even more out there than hedge funds, which tend to service clients and less inclined to the actions of the proprietary trading houses since they're dealing with client money. Or maybe it's the other way around?
Thursday, November 09, 2006
Sunday, November 05, 2006
CAPM illusions
Here's a succinct statement, attribute it to E. Derman:
Notice that assumption: "if you can diversify over a large enough..." Not only is the rationalist methodology employed to derive this a little shaky, there's still that additional caveat that you have to diversify over a "large enough...portfolio". I'm sure there's some bit I don't know, where at a certain level of diversification you decrease the "risk" to a certain livable amount, so you don't have to be perfectly diversified, but yeah, still seems like a lot of conditionals.
It's a tough thing, trying to make money this way. It's even tougher with the overlay of being conscious of the possibility of pure randomness, and the possibility that skill doesn't exist. The hedge fund rebuttal guy described here doesn't seem to really know that, though, he'll tell you that the top hedge fund guys are just goddamn masters of their game. Modern celebrity kind of hews to the weird logic of hedge funds, too, with certain specific people taking off -- would hedge fund guy claim that Britney Spears was a skillful singer that didn't somehow get swept along in the fickle interest of the public? How would we know? The idea that luck (in the form of randomness) outruns skill every day of the week is something that more people have to be aware of.
If you can diversify over a large
enough M-neutral portfolio of stocks so
that their accumulated unavoidable risk
cancels, then this M-neutral portfolio of
zero volatility must earn the risk-free rate
r. The same must therefore be true of each
M-neutral element of the portfolio. This
leads to the result that:
(u - r) = β(uM - r)
This is the result of the capital asset
pricing model or arbitrage pricing theory:
in a world of rational investors, the excess
return you can expect from buying
a stock is its β times the expected return
of its hedgeable factor. Put differently, you
can only expect to be rewarded for the
unavoidable factor risk of each stock,
since all other risk can be eliminated by
diversification.
Notice that assumption: "if you can diversify over a large enough..." Not only is the rationalist methodology employed to derive this a little shaky, there's still that additional caveat that you have to diversify over a "large enough...portfolio". I'm sure there's some bit I don't know, where at a certain level of diversification you decrease the "risk" to a certain livable amount, so you don't have to be perfectly diversified, but yeah, still seems like a lot of conditionals.
It's a tough thing, trying to make money this way. It's even tougher with the overlay of being conscious of the possibility of pure randomness, and the possibility that skill doesn't exist. The hedge fund rebuttal guy described here doesn't seem to really know that, though, he'll tell you that the top hedge fund guys are just goddamn masters of their game. Modern celebrity kind of hews to the weird logic of hedge funds, too, with certain specific people taking off -- would hedge fund guy claim that Britney Spears was a skillful singer that didn't somehow get swept along in the fickle interest of the public? How would we know? The idea that luck (in the form of randomness) outruns skill every day of the week is something that more people have to be aware of.
Saturday, November 04, 2006
Things I've been thinking about
"Liquid" is essentially synonymous with "popular" -- possibly why I'm sure there exist secretive, quant-run hedge funds that focus on using their models for liquid securities on the markets for illiquid versions (cf. Emanuel Derman). They can get a "fair value" and determine what kind of arbitrage exists in markets that are unpopular, where there are not enough people to guarantee that every instrument is fairly priced in an un-tradable time frame.
Starting to curry to Nassim Nicholas Taleb's writing again. I had skimmed his book something like six or eight months back but failed to appreciate how closely aligned his world view is with mine. Or the fact that so many other historical figures have come to the same conclusion: you can't predict the future using the past. It just occurred to me wonder what NNT thinks about Santayana: "Those who cannot remember the past are condemned to repeat it." Of course, history is never perfectly repeated, but we can develop lore and instinct from these past interactions, which is something I think NNT does agree with -- empirical (experiential) observations are where we should be looking. So I guess instead of simply "you can't predict the future using the past," we should add to that "but we can keep an eye on it." Predictability implies future knowledge and that is something we don't have, but certainly there are particular arrangements of preceding factors that may (BUT NOT DEFINITIVELY) give rise to similar future results.
I like quantitative finance for the admission that probability is a huge factor in markets, which is something completely missing from the "campfire story" tenets of "technical" trading. I do have to heed NNT's view that the Gaussian probability distribution probably is not the best way to understand a market that has numerous blow-ups (and if the Mandelbrotian fractal power law distribution or whatever is more applicable, what does that say about the size of some possible future blow-up? We ain't seen nothing yet...?). Is there any way to realistically account for these kinds of things? Taleb would buy huge numbers of OTM options (calls I think? Maybe both sides) with the idea that the view rare events that put him in the money were less rare than people thought, although it's not clear to me how that strategy worked out -- talk of that is conspicuously hard to find.
Starting to curry to Nassim Nicholas Taleb's writing again. I had skimmed his book something like six or eight months back but failed to appreciate how closely aligned his world view is with mine. Or the fact that so many other historical figures have come to the same conclusion: you can't predict the future using the past. It just occurred to me wonder what NNT thinks about Santayana: "Those who cannot remember the past are condemned to repeat it." Of course, history is never perfectly repeated, but we can develop lore and instinct from these past interactions, which is something I think NNT does agree with -- empirical (experiential) observations are where we should be looking. So I guess instead of simply "you can't predict the future using the past," we should add to that "but we can keep an eye on it." Predictability implies future knowledge and that is something we don't have, but certainly there are particular arrangements of preceding factors that may (BUT NOT DEFINITIVELY) give rise to similar future results.
I like quantitative finance for the admission that probability is a huge factor in markets, which is something completely missing from the "campfire story" tenets of "technical" trading. I do have to heed NNT's view that the Gaussian probability distribution probably is not the best way to understand a market that has numerous blow-ups (and if the Mandelbrotian fractal power law distribution or whatever is more applicable, what does that say about the size of some possible future blow-up? We ain't seen nothing yet...?). Is there any way to realistically account for these kinds of things? Taleb would buy huge numbers of OTM options (calls I think? Maybe both sides) with the idea that the view rare events that put him in the money were less rare than people thought, although it's not clear to me how that strategy worked out -- talk of that is conspicuously hard to find.
Wednesday, October 11, 2006
'Fighting tomorrow's battles with yesterday's weapons."
A terrifically succinct overview of the year by one of my favourite business columnists, David Olive. Also the source of that pithy title.
Saturday, October 07, 2006
The accidental investor
An observant reader wrote in to point out the fact that, in my initial post on this site, I lamented the two analytical methodologies that most people chose to follow when trading in the stock market, but neglected to address what he felt was a third path -- that most lovingly tread by Burton Malkiel in A Random Walk Down Wall Street -- where any attempt at analysis would fail due to the randomness of the markets and the fact that at all times all available information is priced into the stock. Malkiel concluded that the investor in the stock market could not hope to beat the action of the markets themselves in the long run.
Now, the fact of the matter is that he could very well be right. For the investor who is not at all interested in finance or stock markets or researching companies or thinking about market trends and human and consumer psychology, then Malkiel gives a solid, if not infallible, argument for why that investor should stick their money in index funds and not worry too much about capturing the larger gains seen by more active investors (as well as the occasionally -- or often -- larger losses). But for those of us who are interested in those things, I think it's still quite possible to apply certain tenets of common sense, to imagine that an overheated market or a completely hated market might return to in a time of relative economic peace. True, in future economic and political turbulence could invalidate the stock markets as a real method of earning money (although it seems that perhaps those times are often the best to make money, too! Turbulence does not affect all areas equally, much like that William Gibson quote: "The future is here, it's just not evenly distributed."
Some of the things that are common sense, at least to me, are:
1. Companies that have earnings, and particularly those that have records of earnings for a number of years, are usually better investments in the long run than growth companies -- trying to guess which growth company will be able to transition to an earnings company is much closer to gambling than choosing companies that have already made that transition.
2. Things that have been popular for a long time are closer to being unpopular than things that are only recently starting to get popular, due to people's love of novelty. This is a way of finding "growth" in a company that may already be an earnings company.
3. Valuation is arbitrary, depending on your perspective, but cheapness can still be measured against what people have paid in the past. That said, buying anything cheaply is no guarantee that it'll retain its value.
4. Your lifetime (or your investing horizon) may not be "a long time", even if you think it is.
As you can see, there's enough qualification in there, which is part and parcel of my philosophy that you should never assume you know what you're doing. You can be 99% sure of something, but that margin of error should never be forgotten when investing. Doubt, but just enough.
I should also clarify for my readers that in my previous post I was saying that I was not interested in investing in oil -- a reader of mine assumed that I was pointing out a dissimilarity between the energy boom and the Internet stock boom in that the former was supposedly based on educated speculation whereas the latter was not. I don't buy that, but I won't say I'm negative on oil, just that I'm not interested in it, or its obvious volatility. As well, I'm starting to think telecom and particularly companies in the VoIP arena are getting a bit of that hype machine action that pushed energy. There's still something there that's making my spidey sense tingle.
Now, the fact of the matter is that he could very well be right. For the investor who is not at all interested in finance or stock markets or researching companies or thinking about market trends and human and consumer psychology, then Malkiel gives a solid, if not infallible, argument for why that investor should stick their money in index funds and not worry too much about capturing the larger gains seen by more active investors (as well as the occasionally -- or often -- larger losses). But for those of us who are interested in those things, I think it's still quite possible to apply certain tenets of common sense, to imagine that an overheated market or a completely hated market might return to in a time of relative economic peace. True, in future economic and political turbulence could invalidate the stock markets as a real method of earning money (although it seems that perhaps those times are often the best to make money, too! Turbulence does not affect all areas equally, much like that William Gibson quote: "The future is here, it's just not evenly distributed."
Some of the things that are common sense, at least to me, are:
1. Companies that have earnings, and particularly those that have records of earnings for a number of years, are usually better investments in the long run than growth companies -- trying to guess which growth company will be able to transition to an earnings company is much closer to gambling than choosing companies that have already made that transition.
2. Things that have been popular for a long time are closer to being unpopular than things that are only recently starting to get popular, due to people's love of novelty. This is a way of finding "growth" in a company that may already be an earnings company.
3. Valuation is arbitrary, depending on your perspective, but cheapness can still be measured against what people have paid in the past. That said, buying anything cheaply is no guarantee that it'll retain its value.
4. Your lifetime (or your investing horizon) may not be "a long time", even if you think it is.
As you can see, there's enough qualification in there, which is part and parcel of my philosophy that you should never assume you know what you're doing. You can be 99% sure of something, but that margin of error should never be forgotten when investing. Doubt, but just enough.
I should also clarify for my readers that in my previous post I was saying that I was not interested in investing in oil -- a reader of mine assumed that I was pointing out a dissimilarity between the energy boom and the Internet stock boom in that the former was supposedly based on educated speculation whereas the latter was not. I don't buy that, but I won't say I'm negative on oil, just that I'm not interested in it, or its obvious volatility. As well, I'm starting to think telecom and particularly companies in the VoIP arena are getting a bit of that hype machine action that pushed energy. There's still something there that's making my spidey sense tingle.
Tuesday, September 26, 2006
Hold up, wait a second
A friend of mine sent me an interesting article today, regarding a fellow who's managed to quit his job at the age of 34, not after making millions, but by living frugally and making some savvy if not spectacular investment choices. Of course, he's also written a book to explain how he's done it, because if there's anything people who've made money like to do, it's to share all their wisdom with others for the nominal cost of a book purchase -- "Lesson 1: Write a book about how to make money."
One of the things that struck me about this article is his terrifically mediocre advice about investing in the markets. It's not that he hasn't made money -- anyone who does and beats the indices as well as fixed income returns + inflation is already a leg up on the general population; it's that his strategy contains one of the major fallacies of investing (to me) that I think should be pointed out:
Secondly, in that quote, Foster is clearly showing the symptoms of "missed opportunity regret" -- where a stock you once owned, and made a little money on (or lost a little money on, or maybe a lot of money on) suddenly skyrockets without a seat for you. I suffer from it, as does any other average person, but it's certainly not a reason to hold a stock forever. What Foster is forgetting is that he actually made a decent return (30%) and he's focussed on the could-have-been. In another scenario, which he conveniently forgets, he makes a 30% return, and then coming back a few years later, finds the stock no longer exists, the company shut down. Should he have then held forever? Obviously, the idea with holding less hyped companies in solid, stolid industries, is to avoid that ruinous scenario, but to me the concept of "forever" is naive.
Which reminds me of the saw that people bring out about now, that over a period of the last hundred years or so, common stock has on average given the highest return of all investments. This is pushed as the reason why you should buy and hold, and maybe so for the casual investor who doesn't want to think too much about what he or she's buying (which has its own problems, obviously). That's all well and good until you think about the fact that a hundred years is not really that long a period of time. What happened yesterday is no indication of what will happen tomorrow, even though this is a prime tenet of technical trading and prognostication, and it's also impossible to know where we are on the scale of things. It's quite possible we're at the beginning of a long, hundred-year long trend of underperforming or negatively performing stocks but who would know? How would you determine this were the case until after it happened?
Furthermore, the example of the ever-increasing stock market, I believe fails to account for the fact that companies that failed don't contribute, so there's a built-in confirmation bias to the numbers where it's only companies that continue as going concerns into the present day (already a test for a company's fitness) that factor into the stock market returns. I'm not sure about that, and will have to do some more research on it to be sure, but I think there's certainly room for doubt about the sure-fire methodology of buying and holding.
I do find it funny how coy the article is about his investment successes, carefully revealing only the "wins" he's made to make it seem like he's invested smartly -- it almost feels like he's paid off the newspaper! But what I find funnier is that even the positive investments he's made aren't particularly good: 30%, 33%, 25%. I don't know about you, but if the best stock investment I made returned 33%, I wouldn't be so quick to advertise my ability in stock picking, especially in a national newspaper. If, on the other hand, his entire portfolio was up 33% on the year, that would be something to crow about -- especially in this market.
One of the things that struck me about this article is his terrifically mediocre advice about investing in the markets. It's not that he hasn't made money -- anyone who does and beats the indices as well as fixed income returns + inflation is already a leg up on the general population; it's that his strategy contains one of the major fallacies of investing (to me) that I think should be pointed out:
While living in Vancouver, for instance, he noticed a coffee chain called Starbucks that was popping up on every street corner. After studying the annual report, he bought the stock. It soared about 30 per cent in a matter of weeks. Then he sold -- a decision he regrets to this day.One, the concept of "holding a stock forever" that is espoused by Buffett isn't borne up by Buffett's own actions. Buffett sells stock and keeps alert to the environment for equities and debt instruments much more so than he lets on. He speculated against the US currency in the past few years by selling it, and has been known to participate in somewhat exotic bond investments. So I often find the attempt to model oneself after Buffett, by buying "recession proof, value-oriented" businesses kind of funny. I don't think it's a bad attitude, but clearly this Derek Foster guy feels he has absorbed the key lessons from Buffett, or something."That was stupid. I should have just held on to it forever. It would have been worth about eight times as much now", he says.
Secondly, in that quote, Foster is clearly showing the symptoms of "missed opportunity regret" -- where a stock you once owned, and made a little money on (or lost a little money on, or maybe a lot of money on) suddenly skyrockets without a seat for you. I suffer from it, as does any other average person, but it's certainly not a reason to hold a stock forever. What Foster is forgetting is that he actually made a decent return (30%) and he's focussed on the could-have-been. In another scenario, which he conveniently forgets, he makes a 30% return, and then coming back a few years later, finds the stock no longer exists, the company shut down. Should he have then held forever? Obviously, the idea with holding less hyped companies in solid, stolid industries, is to avoid that ruinous scenario, but to me the concept of "forever" is naive.
Which reminds me of the saw that people bring out about now, that over a period of the last hundred years or so, common stock has on average given the highest return of all investments. This is pushed as the reason why you should buy and hold, and maybe so for the casual investor who doesn't want to think too much about what he or she's buying (which has its own problems, obviously). That's all well and good until you think about the fact that a hundred years is not really that long a period of time. What happened yesterday is no indication of what will happen tomorrow, even though this is a prime tenet of technical trading and prognostication, and it's also impossible to know where we are on the scale of things. It's quite possible we're at the beginning of a long, hundred-year long trend of underperforming or negatively performing stocks but who would know? How would you determine this were the case until after it happened?
Furthermore, the example of the ever-increasing stock market, I believe fails to account for the fact that companies that failed don't contribute, so there's a built-in confirmation bias to the numbers where it's only companies that continue as going concerns into the present day (already a test for a company's fitness) that factor into the stock market returns. I'm not sure about that, and will have to do some more research on it to be sure, but I think there's certainly room for doubt about the sure-fire methodology of buying and holding.
I do find it funny how coy the article is about his investment successes, carefully revealing only the "wins" he's made to make it seem like he's invested smartly -- it almost feels like he's paid off the newspaper! But what I find funnier is that even the positive investments he's made aren't particularly good: 30%, 33%, 25%. I don't know about you, but if the best stock investment I made returned 33%, I wouldn't be so quick to advertise my ability in stock picking, especially in a national newspaper. If, on the other hand, his entire portfolio was up 33% on the year, that would be something to crow about -- especially in this market.
Friday, September 22, 2006
A time for recuperating
As many of you have likely experienced this year, the equity markets have not been a kind and placid presence this year. Although most of the indices, including the DJIA and the TSX, are up a moderate percentage, it's not clear that investing in the markets was any better than socking your entire portfolio into a high interest savings account. In fact, for all the vaunted housing bubble talk, at least in the Canadian market there have been no major price declines and in some markets, including Vancouver, it still would have made a good momentum-style investment to be in real estate. However, real estate being a much longer term investment, with lower liquidity than stocks, I don't know how feasible it would have been to try to capture that move, when US markets have begun to feel the pinch and the possibility exists that the malaise will shift to Canada.
For me, it's been a lull year in total. Although I saw some fair early gains, I'm now considering this year a wash in my mind. One of the major stories this year was energy. Obviously the big news in energy investing is the giant dive the Amaranth hedge fund took based on big futures bets on natural gas -- the losses are purportedly around six billion, larger even than the LTCM meltdown. That said, energy in general has retreated significantly in the past month and it's become clear to me that energy stocks were this year's version of "Internet stocks". I avoided internet plays even during the boom year of 1999 when I started really paying attention to the market, because they never quite seemed legitimate. Somehow, oil stocks and their attendant hype did not ring the same BS sensors, and I've lost a fair chunk of money trying to engage in oil investments this year, after the hype had reached monster levels and it's clear that most of the investors are speculators now. It pains me all the more considering I was invested in oil in 2000 -- Chesapeake Energy to be exact, at 7 dollars a share. Once again, I was in too soon, and sold before the huge spike in oil prices that precipitated this frenzy.
Now, there's a claim that the oil discovery in the Gulf of Mexico is huge and some even talk about it reconfiguring scenarios about the future and the decline of our oil stocks now that a giant surplus has been discovered. There's still debate about how big that surplus really is, but what the market's reaction has shown me is that even if oil is a legitimately scarce resource, it's incredibly volatile (duh) and even beginning to view it as a stably-priced commodity is pure and simple naivete. The talk of oil prices remaining at a certain, $60-plus level smacks of "the new economy" philosophy that was used to justify extravagant price jumps in Internet stocks -- another similarity. All hype markets start to look the same.
So, more fool me for engaging in a hype market. Although I'm typically very skeptical about markets like that, the overall stagnancy of the market and non-directionality made it very difficult to find stocks that were clear winners and so I suppose I succumbed to the hype, the "quick and easy pickings" of gold and oil, none of which netted me a thing. In fact, the one holding that served me very well this year was Falconbridge (ex. Noranda), that was eventually purchased by Xstrata. A nickel and copper mining play that I got into before those markets heated up, before it was on anyone's radar. And that's what successful stock investing is all about to me -- finding markets that are off people's radar, or that are hated, and getting in early. It's difficult now to find a pure information edge on anyone else, but this is kind of a secondary edge, one that involves making use of people's behavioural tendencies to negate the supposedly free information. Information is much more readily available, but that has not improved people's interpretations of it, and that's why I'm still more willing to side with Warren Buffett than Efficient Markets proponents when philosophizing about the equity markets.
For me, it's been a lull year in total. Although I saw some fair early gains, I'm now considering this year a wash in my mind. One of the major stories this year was energy. Obviously the big news in energy investing is the giant dive the Amaranth hedge fund took based on big futures bets on natural gas -- the losses are purportedly around six billion, larger even than the LTCM meltdown. That said, energy in general has retreated significantly in the past month and it's become clear to me that energy stocks were this year's version of "Internet stocks". I avoided internet plays even during the boom year of 1999 when I started really paying attention to the market, because they never quite seemed legitimate. Somehow, oil stocks and their attendant hype did not ring the same BS sensors, and I've lost a fair chunk of money trying to engage in oil investments this year, after the hype had reached monster levels and it's clear that most of the investors are speculators now. It pains me all the more considering I was invested in oil in 2000 -- Chesapeake Energy to be exact, at 7 dollars a share. Once again, I was in too soon, and sold before the huge spike in oil prices that precipitated this frenzy.
Now, there's a claim that the oil discovery in the Gulf of Mexico is huge and some even talk about it reconfiguring scenarios about the future and the decline of our oil stocks now that a giant surplus has been discovered. There's still debate about how big that surplus really is, but what the market's reaction has shown me is that even if oil is a legitimately scarce resource, it's incredibly volatile (duh) and even beginning to view it as a stably-priced commodity is pure and simple naivete. The talk of oil prices remaining at a certain, $60-plus level smacks of "the new economy" philosophy that was used to justify extravagant price jumps in Internet stocks -- another similarity. All hype markets start to look the same.
So, more fool me for engaging in a hype market. Although I'm typically very skeptical about markets like that, the overall stagnancy of the market and non-directionality made it very difficult to find stocks that were clear winners and so I suppose I succumbed to the hype, the "quick and easy pickings" of gold and oil, none of which netted me a thing. In fact, the one holding that served me very well this year was Falconbridge (ex. Noranda), that was eventually purchased by Xstrata. A nickel and copper mining play that I got into before those markets heated up, before it was on anyone's radar. And that's what successful stock investing is all about to me -- finding markets that are off people's radar, or that are hated, and getting in early. It's difficult now to find a pure information edge on anyone else, but this is kind of a secondary edge, one that involves making use of people's behavioural tendencies to negate the supposedly free information. Information is much more readily available, but that has not improved people's interpretations of it, and that's why I'm still more willing to side with Warren Buffett than Efficient Markets proponents when philosophizing about the equity markets.
Tuesday, August 22, 2006
LEAPS and Bounds
I've been trading options occasionally for several years, and it's a tricky market. The small investor is preyed on by a slew of options trading seminars and "educational websites" that teach complicated and (due to commissions) expensive strategies -- with some of the more exotic strategies, like condors and butterflies, you could be trying to yoke four different options together. And anyone who has traded options knows how illiquid they can be compared to equities, making those multi-option trades very difficult to pull off effectively.
In my opinion, LEAPS (Long Term Equity AnticiPation Security) are about the only derivative that I feel worth using. When you first start option trading, the front-month options with their bargain basement prices seem like the way to go -- buy a stack of them ahead of an earnings call and wait for the surprise to make the option pop. In fact, that strategy -- essentially, of buying very out of the money options, letting most expire worthless and occasionally winning big enough to compensate and profit on the few -- is the strategy that a primary proponent of the inability to know anything about the future action of the markets, Nassim Nicholas Taleb, uses in his options trading. It's not necessarily a bad strategy, but one that I find takes an incredibly strong stomach and one that can often see you losing a lot of money and doubting yourself when you haven't made the big score. Sounds like gambling.
With LEAPS, there is still the possibility of losing the entire investment, like in any option that might expire worthless at expiration. But what I like about LEAPS is that you are able to make time more of an ally -- for most equities these days, a year or two is enough to see significant change in market value (unless, and this is quite possible, you choose an underlying stock that remains stagnant -- there's no perfect strategy in investing), and there is a definite exit time for the strategy. Although you won't lose your investment in a stock, it's quite possible that you will see the same loss and yet continue to hold on to that position while you wait for it to return to breakeven. Unless you specifically invested in that stock with the intention to hold it indefinitely, I view that as a bad trait of an active investor -- being anchored to a position when that capital that is locked up can be deployed elsewhere. The freer your capital, the better off you are.
In my opinion, LEAPS (Long Term Equity AnticiPation Security) are about the only derivative that I feel worth using. When you first start option trading, the front-month options with their bargain basement prices seem like the way to go -- buy a stack of them ahead of an earnings call and wait for the surprise to make the option pop. In fact, that strategy -- essentially, of buying very out of the money options, letting most expire worthless and occasionally winning big enough to compensate and profit on the few -- is the strategy that a primary proponent of the inability to know anything about the future action of the markets, Nassim Nicholas Taleb, uses in his options trading. It's not necessarily a bad strategy, but one that I find takes an incredibly strong stomach and one that can often see you losing a lot of money and doubting yourself when you haven't made the big score. Sounds like gambling.
With LEAPS, there is still the possibility of losing the entire investment, like in any option that might expire worthless at expiration. But what I like about LEAPS is that you are able to make time more of an ally -- for most equities these days, a year or two is enough to see significant change in market value (unless, and this is quite possible, you choose an underlying stock that remains stagnant -- there's no perfect strategy in investing), and there is a definite exit time for the strategy. Although you won't lose your investment in a stock, it's quite possible that you will see the same loss and yet continue to hold on to that position while you wait for it to return to breakeven. Unless you specifically invested in that stock with the intention to hold it indefinitely, I view that as a bad trait of an active investor -- being anchored to a position when that capital that is locked up can be deployed elsewhere. The freer your capital, the better off you are.
Technically, Fallacies
There's a division in stock market philosophies that gets played up repeatedly: technical versus fundamental analysis. Fundamental analysis, though having its own problems, tries to ground itself in some basic qualities of a business -- how much money it has in its coffers (although the example of Enron and its ilk show that even accounting sometimes can't be trusted). Technical analysis, with its candlesticks, Bollinger Bands, flags and head-and-shoulders, spends a great deal of time looking at graphs, backtesting theories against old data and generally doing a good job at imitating empiricism. Ironically, it appeals to people who believe themselves rational... or maybe scientific?
There's a casino game called baccarat, one that isn't too often played but has a relatively small house edge (blackjack being one of the few that has a lower house edge). There are two sets of cards that come out for every round of the game, and although initially seeming complex, the play boils down to betting on which of those sets is higher or if they are equal. That's fine and dandy, but one of the things that casinos do is produce a baccarat scoresheet, which is essentially just a long rectangular grid of squares. Gamblers take that sheet and through their own systems, attempt to track the results of previous rounds and predict the results of future rounds. Since baccarat boils down to a sort of coin-toss, and anyone with a basic knowledge of odds knows that a series of coin tosses are completely independent (each toss has a 50% chance of being heads or tails), it's obvious that the only thing those meticulously recorded histories are doing is giving people the illusion of control. In fact, it's been proven mathematically that betting solely on the banker for every hand is the optimum baccarat strategy -- but people hate that, because... it's boring. So we discover the crux of gambling -- entertainment. This same urge is what drives investors and traders to develop theories that they feel might assist them. Essentially, they're all gamblers, but with longer timelines and more sophisticated systems.
One might argue that the stock market, being influenced by the actions of other players, means that paying attention to historical trends has a strong basis. After all, in poker games with players that you see consistently and learn to distinguish, knowing their previous play matters tremendously. Why doesn't the same apply to markets? Simple. Markets are composed of a group of people making decisions that are 1. too numerous to easily account for; 2. follow any infinite variety of systems; 3. interact with themselves (when people look at what the market is doing to determine what to do in the market -- they are the market). Computationally, even the idea of trying to model that behaviour is beyond our means. And still, in both cases, poker and the markets, we can only think about future actions as probability -- the passive, fish-like poker player of the past could suddenly turn aggressive, with no prior warning. Even if we had the computational horsepower, it would be pointless.
Ultimately, the investor or trader who forgets that they are making bets on future changes in the stock market and not on history is more naive, in my opinion, than one who admits that very little can be predicted. On the flipside, super-investors like Warren Buffett claim that paying attention to "intrinsic value" of a company and its stock, and ignoring the action of the market until it wakes up and realizing it was paying the wrong price, is the most effective means to make money. I have problems with that argument, too, but I'll address those another day.
There's a casino game called baccarat, one that isn't too often played but has a relatively small house edge (blackjack being one of the few that has a lower house edge). There are two sets of cards that come out for every round of the game, and although initially seeming complex, the play boils down to betting on which of those sets is higher or if they are equal. That's fine and dandy, but one of the things that casinos do is produce a baccarat scoresheet, which is essentially just a long rectangular grid of squares. Gamblers take that sheet and through their own systems, attempt to track the results of previous rounds and predict the results of future rounds. Since baccarat boils down to a sort of coin-toss, and anyone with a basic knowledge of odds knows that a series of coin tosses are completely independent (each toss has a 50% chance of being heads or tails), it's obvious that the only thing those meticulously recorded histories are doing is giving people the illusion of control. In fact, it's been proven mathematically that betting solely on the banker for every hand is the optimum baccarat strategy -- but people hate that, because... it's boring. So we discover the crux of gambling -- entertainment. This same urge is what drives investors and traders to develop theories that they feel might assist them. Essentially, they're all gamblers, but with longer timelines and more sophisticated systems.
One might argue that the stock market, being influenced by the actions of other players, means that paying attention to historical trends has a strong basis. After all, in poker games with players that you see consistently and learn to distinguish, knowing their previous play matters tremendously. Why doesn't the same apply to markets? Simple. Markets are composed of a group of people making decisions that are 1. too numerous to easily account for; 2. follow any infinite variety of systems; 3. interact with themselves (when people look at what the market is doing to determine what to do in the market -- they are the market). Computationally, even the idea of trying to model that behaviour is beyond our means. And still, in both cases, poker and the markets, we can only think about future actions as probability -- the passive, fish-like poker player of the past could suddenly turn aggressive, with no prior warning. Even if we had the computational horsepower, it would be pointless.
Ultimately, the investor or trader who forgets that they are making bets on future changes in the stock market and not on history is more naive, in my opinion, than one who admits that very little can be predicted. On the flipside, super-investors like Warren Buffett claim that paying attention to "intrinsic value" of a company and its stock, and ignoring the action of the market until it wakes up and realizing it was paying the wrong price, is the most effective means to make money. I have problems with that argument, too, but I'll address those another day.
Sunday, August 20, 2006
Fool's Paradise
I have a two-fold reason for starting this site: one, I'm tired of the America-centrism that exists in most investment blogs, since most of them are based in the United States. And two, I'm a natural cynic and anti-evangelist and I feel this perspective on investing is not as present as it should be online (or even in the real world). Everyone thinks that there's an effective system out there that just needs to be discovered, often through "technical" or "fundamental" means, as if these two terms can bring some form of empiricism to what at heart is a slowed-down form of intelligent gambling. The first trucks in colourful graphs and arbitrary rule-systems, while the second ascribes implicit value to companies, when value is solely the agreed upon price of a populace. Gold investors never seem to remember this, or fall back on the old "humans have always valued gold." Always? Really?
Anyhow, as you can plainly tell already, I'm not much of a believer. Why do I invest? For various reasons: a chance to make money, a gambling arena that has no real house edge, an intellectual pursuit with no real solution. Maybe it just tickles my fancy when the numbers go up -- entertainment? After a good seven years market-watching and reading and thinking about companies, I'm as willing to go with an experienced hunch and an adaptable attitude toward my investments (Rule No. 1, which I will continue to expound in the days ahead: Learn to Sell) as I am with some carefully calculated strategy that ultimately fails when some factor remains unaccounted for. It's busywork, and can only help you so far before you just have to open your eyes and survey the scene.
With that said, my intention here is not to recommend companies' stocks or educate the newbie investor. I will write about companies that I am thinking about and perhaps write about larger macroeconomic trends (although I'm not much of a macro-ist, frankly -- I think of investing in this way as much like burning down a forest to kill a tree. Hmm, think I'll need a better analogy than that!). I doubt I will describe my portfolio or its results, mainly because I think that if you do begin to do that, unless you are completely transparent about your results, that it is easy to become a shill for yourself -- letting people know your best trades, or just the percentage but not the sizing. It's natural for a lot of people to want to shine their shiniest shoes when they go out. I take the opposite tack, and usually obsess over my mistakes, but in either case, it's never an accurate reflection of a person's investing ability and tends to turn most investment blogs into de facto newsletters. So I will endeavour to be as objective as I can be and admit when I can't be.
I will also admit to not being an expert on any stock, even the ones that fall into my career of technology. No one can be, even many of the employees of the company. Everyone who buys and sells stocks curries to certain favourite elements of a stock, and neglects other parts, so while I don't have a complete and detailed view of GM, I do have an opinion on it and have acted on that opinion in the past -- I don't think anyone who really thinks about it can believe there are people who are experts on a stock. There are just people with more or less information, and in a strange twist, I think sometimes too much information can cause problems, too. There's a delicate balance there, one which makes me think that investing still falls closer to the realm of art, ultimately.
So, dear reader, watch this space!
Anyhow, as you can plainly tell already, I'm not much of a believer. Why do I invest? For various reasons: a chance to make money, a gambling arena that has no real house edge, an intellectual pursuit with no real solution. Maybe it just tickles my fancy when the numbers go up -- entertainment? After a good seven years market-watching and reading and thinking about companies, I'm as willing to go with an experienced hunch and an adaptable attitude toward my investments (Rule No. 1, which I will continue to expound in the days ahead: Learn to Sell) as I am with some carefully calculated strategy that ultimately fails when some factor remains unaccounted for. It's busywork, and can only help you so far before you just have to open your eyes and survey the scene.
With that said, my intention here is not to recommend companies' stocks or educate the newbie investor. I will write about companies that I am thinking about and perhaps write about larger macroeconomic trends (although I'm not much of a macro-ist, frankly -- I think of investing in this way as much like burning down a forest to kill a tree. Hmm, think I'll need a better analogy than that!). I doubt I will describe my portfolio or its results, mainly because I think that if you do begin to do that, unless you are completely transparent about your results, that it is easy to become a shill for yourself -- letting people know your best trades, or just the percentage but not the sizing. It's natural for a lot of people to want to shine their shiniest shoes when they go out. I take the opposite tack, and usually obsess over my mistakes, but in either case, it's never an accurate reflection of a person's investing ability and tends to turn most investment blogs into de facto newsletters. So I will endeavour to be as objective as I can be and admit when I can't be.
I will also admit to not being an expert on any stock, even the ones that fall into my career of technology. No one can be, even many of the employees of the company. Everyone who buys and sells stocks curries to certain favourite elements of a stock, and neglects other parts, so while I don't have a complete and detailed view of GM, I do have an opinion on it and have acted on that opinion in the past -- I don't think anyone who really thinks about it can believe there are people who are experts on a stock. There are just people with more or less information, and in a strange twist, I think sometimes too much information can cause problems, too. There's a delicate balance there, one which makes me think that investing still falls closer to the realm of art, ultimately.
So, dear reader, watch this space!
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