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The Patterns That Weren’t There

Mar, 01/09/2018 - 12:56
Why Signals Are Hard to Identify and What to Do About ItOil Spill in Skagway, Alaska (Photo: Wikimedia Commons)

It was the beginning of 1959 and something was not quite right with John Nash. The famed mathematician, who would eventually go on to win the Nobel Prize in Economics for his work on game theory, was having a mental breakdown.

What started with innocent jokes about finding patterns in licenses plates progressed into a full-fledged belief that extraterrestrials were sending him decoded messages through the New York Times. At one point, Nash also became convinced that more men around Boston were wearing red neckties to get him to notice them. He was seeing patterns that weren’t there.

Though no one knows why approximately 1 percent of the population in all countries develop schizophrenia, seeing patterns between non-related things (the technical term is Apophenia) is a common symptom. You may already know Nash’s story from A Beautiful Mind, but understanding why Nash believed what he did provides an important lesson for investors.

In late 1995, following his recovery from schizophrenia, Nash was asked why he believed so many illogical things in his past. Nash’s answer revealed a core truth about how humans perceive patterns:

The ideas I had about the supernatural beings came to me the same way that my mathematical ideas did. So I took them seriously.

This is the problem that you, I, and every other human on Earth are born with — we have no faulty pattern detector. Just like John Nash couldn’t discern between reality and the spurious patterns he saw, we cannot easily tell the difference between a signal and noise. This limitation did not hinder us in a world of small sample sizes and no need for probabilistic thinking, however, the modern world has changed all of that.

For example, in ancient times, if you spotted a tiger in the same cave three times, you probably wouldn’t go near that cave in the future. Today, if a mutual fund has outperformed for three years in a row, you might send them all your money. Different times, but similar thinking.

This matters for you as an investor, because you may end up making investment decisions based on seeing patterns that are nothing more than random chance. Many investors tend to chase performance by investing in those funds/sectors with the best recent track record. However, there is plenty of evidence that doing so typically leads to worse performance in the long run (see here, here, here, and here).

The thing that many investors tend to forget is that randomness will always exhibit some patterns. In fact, the British mathematician Frank P. Ramsey proved mathematically that no matter how complicated you make a system, as it grows in size it will have to show some substructure. This is known as Ramsey’s theorem and illustrates why patterns exist within randomness.

To make this idea clearer, consider the following two sequences of 10 coin flips:

  1. HHHHHHHHHH
  2. THTTHTHHTH

Which sequence is more likely?

If you have ever studied statistics you will know that this is a trick question — both sequences are equally likely. I know that this answer doesn’t feel right, but that is the point of this post. It seems rational to assume that sequence 2 is more random than sequence 1 because it exhibits less of a pattern. After all, if someone came up to you and flipped 10 heads in a row, you would start to question whether their coin was rigged, right? However, sequence 2 has the same probability of occurring as sequence 1 (1 in 1,024).

If we imagined flipping a coin 400 times and plotting it on a 20x20 grid, you might see some smaller patterns though the sequence is completely random (Note: red = tails, black = heads):

My point is that many of the financial decisions you make throughout the rest of your life will be dominated by small sample sizes where randomness will likely play a role. If you combine this with the recency bias (i.e. the tendency to overweight the most recent information), you can see how short term patterns could affect your financial decision making. Therefore, before you make a financial decision, consider how chance could be influencing your decision.

The Disguise of Randomness

One of my professors in college used to do a wonderful exercise that beautifully illustrated the nature of randomness. He would give someone a coin and a sheet of paper and then ask them to do two things in private:

  1. Write down what they thought a sequence of 20 coin flips would look like.
  2. After doing step 1, flip the real coin 20 times and write down the actual sequence of flips elsewhere.

Within seconds of being shown the two sequences, my professor could always tell which came from the real coin and which was simulated. How did he do this?

My professor realized that people tend to switch back and forth between heads and tails too quickly in their simulations, while the real coin typically wouldn’t. Most people think that seeing 4 or more heads (or tails) in a row seems un-random so they balance their simulated sequence out with more tails (or heads). Ironically, this behavior makes their sequence less random and easier to identify when compared to the real coin sequence.

I loved this exercise because it demonstrated how randomness likes to disguise itself with patterns. While it will always be a challenge to identify this disguise, it doesn’t mean we shouldn’t try. Thank you for reading!

➤ You can follow Of Dollars And Data via Email (1 weekly newsletter), Twitter, Facebook, or Medium.

This is post 54. Any code I have related to this post can be found here with the same numbering: https://github.com/nmaggiulli/of-dollars-and-data

Disclaimer

The above references an opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice. The postings on this site are my own and do not necessarily reflect the views of my employer. Please read my “About” page for more information.

OfDollarsAndData.com is a participant in the Amazon Services LLC Associates Program, an affiliate advertising program designed to provide a means for sites to earn advertising fees by advertising and linking to Amazon.com and affiliated sites.

The Patterns That Weren’t There was originally published in Of Dollars And Data on Medium, where people are continuing the conversation by highlighting and responding to this story.

Seven Things I Learned From One Year of Blogging (Yes, This is Clickbait)

Mar, 01/02/2018 - 12:53
Of Dollars And Data Celebrates One Year!

This week Of Dollars And Data celebrates its one year anniversary and I thought it would be fitting to talk about seven things I learned over the past year about blogging and side hustles in general. So, if you have ever thought about doing a side project, or are doing one now, this is for you.

1. It Will Take More Time Than You Think

It was April 2015 when I first imagined starting a personal finance blog and came up with a list of post ideas. However, I didn’t write a single word until January 1, 2017. Below is a picture of that original list of post ideas with selected posts crossed off over time:

If you look closely in the center, you will see my most popular post yet “Just keep buying” as one such post idea.

The point is that it is okay if you haven’t started yet. Maybe the time isn’t right, but I can tell you that at some point it will be. In my case, one day I realized that I had the skills to do something compelling (finance + data visualizations in R) and I could use the excuse of my 2017 New Year’s resolution to motivate me. To this day it is the only New Year’s resolution I have ever kept. So, if you are struggling to get something going, that’s okay. It will take more time than you think.

2. You Will Fear Failure and Will Want to Give Up

When I started Of Dollars And Data I had a constant fear of failure. It was so bad that I originally started the blog anonymously because I was unsure whether I was any good. Even after I started, I cannot tell you how many times I thought about giving up. The negativity spiral would start as follows:

Maybe I’m not a good writer. Maybe my visualizations suck. Maybe I have nothing interesting or novel to say. Maybe I don’t have enough experience (I’m NOT in this industry after all). Maybe I am not smart enough.

All these thoughts would swirl around in my mind, but I kept pushing on week after week. Today most of these fears have subsided as I have gained enough confidence to know that I can succeed if I keep putting in the work.

If you ever fear failure or want to give up, it’s normal to feel that way. Fight through it and keep moving forward. If you don’t believe me, consider the empowering truth told in The Drunkard’s Walk: How Randomness Rules Our Lives (emphasis mine):

That’s why successful people in every field are almost universally members of a certain set — the set of people who don’t give up.

So don’t give up.

3. Not Everyone Will Believe In You…But Some People Will

The hardest part of starting a side project is that most people will not believe in you or remotely care about what you are doing. Sometimes even the people closest to you won’t be supportive. Sadly, for me this feeling is all too familiar.

In July 2016 I moved from San Francisco to Boston to support my girlfriend of 4 years who was entering graduate school. After starting the blog six months later, I realized that she really wasn’t supportive of my goals and dreams. I can’t tell you how demoralizing it is to know that the person you changed your life for doesn’t care about something you are working hard on. I had no real choice but to leave. It was the hardest decision I ever made, but I had to make it. Sometimes you have to sacrifice a lot for the things you believe in.

Though many people won’t believe in you, some people will. I have lots of family and friends who have supported me throughout the past year and I cannot thank them enough for it. However, my biggest support has been my father who has been there since Day 1 and has acted as the “Chief Editor” for Of Dollars And Data. This one is for him:

Dad, though you are 3,000 miles away, I have never felt closer to you. Thank you for being there through the tough times and believing in me every single week.

Lastly, you will find that some people who have the least to gain from helping you will go out of there way to provide support and motivation. For example, I was very lucky that Jason Zweig retweeted me only a few weeks into my blog after I sent him an email about this post:

The tweet that changed everything

Without this tweet, Michael Batnick (who was one of my first 20 Twitter followers and earliest supporters) never would have found me and I wouldn’t be where I am today. I have to thank both of them and the many others in FinTwit (Finance Twitter) who have shared my work and motivated me along the way.

4. Luck Plays A Big Role In Your Success

While I wish I could say that my first year of success is attributable solely to my hard work, I would be telling a big lie. The fact is that much of my life has been lucky breaks and the same goes for my blog. Being born in a developed country, growing up with supportive parents, and having an above average intelligence has given me advantages in society that I did nothing to earn. Yes, luck didn’t make me write my posts or create my visualizations, but a lot of the upside came from chance events.

I already discussed above how Jason Zweig handed me a dose of good fortune early on in my blogging journey, but it didn’t stop there. This tweet from Josh Brown got me 800 Twitter followers in a single day. Considering I only had ~1,000 followers at the time of his tweet, you can see the impact of such a rare event:

When it comes to the outcome of your side projects, realize that luck will play a big role. Don’t be afraid to reach out to people and ask for help. You may be surprised with the result. Either way, I am reminded of what Samuel Goldwyn once said, “The harder I work, the luckier I get.”

5. Consistently Good Beats Sometimes Great

Morgan Housel once said:

The best way to build a powerful brand is to be good all the time rather than great some of the time.

I cannot tell you how true this is after a year of blogging. When I first started, I was so obsessed with always putting out great content that I worried that my first “okay” post would be my undoing. However, this hasn’t been the case at all, as most of my posts seem to be good with some being great and some being “not so great.”

As an example of this, check out the distribution of my post views over my first year. As you can see, the bulk of my posts get a little less than 5,000 total views, with a small handful getting over 10,000 views:

The point is that, it is okay when everything you do is not a home run. Just keep producing good quality and let the chips fall where they may.

6. To Become a Better Writer, Read More

The best way to become a better writer is to read more and not just about a single subject matter. Why? Reading is the best way to generate new ideas. Every person has a different perspective on life. This comes from different experiences, cultural ideas, values, etc. You know things I don’t know. You can make connections I can’t make. By reading, you are allowing these unique connections to flourish, which can make you a better writer.

I have seen my own writing improve immensely due to my increased reading habit this past year. Remember, if you start to run out of ideas to write about, read some more and add fuel to your writing fire. Your brain is made for making connections, finding patterns, and discovering new insights, so feed it regularly by reading.

7. You Will Make Lots of New Friends (aka FinTwit is the best!)

The best part about blogging over the last year is all of the amazing people I have met because of it, both online and in person. The FinTwit community has been the most supportive community I have ever been apart of and I could not be happier. I wholeheartedly agree with The Financial Bodyguard when she said that FinTwit might be possibly the best Twitter community in the world. Thank you everyone in FinTwit for a great 2017. Looking forward to an even better 2018!

Next week I will be back to my usual investing posts (I promise). Thank you for reading!

➤ You can follow Of Dollars And Data via Email (1 weekly newsletter), Twitter, Facebook, or Medium.

This is post 53. Any code I have related to this post can be found here with the same numbering: https://github.com/nmaggiulli/of-dollars-and-data

Disclaimer

The above references an opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice. The postings on this site are my own and do not necessarily reflect the views of my employer. Please read my “About” page for more information.

OfDollarsAndData.com is a participant in the Amazon Services LLC Associates Program, an affiliate advertising program designed to provide a means for sites to earn advertising fees by advertising and linking to Amazon.com and affiliated sites.

Seven Things I Learned From One Year of Blogging (Yes, This is Clickbait) was originally published in Of Dollars And Data on Medium, where people are continuing the conversation by highlighting and responding to this story.

My Favorite Investment Writing of 2017

Mar, 12/26/2017 - 15:29
Plus My Favorite Books I Read in 2017Photo: Pixabay

Outside of Twitter and my email list, I rarely discuss other writers’ work on Of Dollars And Data. However, without these individuals I wouldn’t be even half as good of an investment writer as I am today. Reading the work of others is the most helpful way to learn about investing and it can also improve your writing. So, where credit is due, my favorite investment pieces of 2017:

Morgan always writes great stuff, but this post is so good that it completely changed the way I write. I’d actually argue it’s a little too good, because Morgan gave away one of his secrets. I won’t tell you what the secret is, but I will say this: good writers imitate, great writers steal from Morgan Housel.

If you are unconvinced of the value that an active manager can provide, this is the post to read. Corey does an incredible job of explaining the behavioral reasons why certain active strategies can outperform in the long run.

Well researched. Incredible charts. This is primetime Batnick. It is also probably the best summary of the Bessembinder paper, which made a splash in the finance community earlier this year. Looking forward to Michael’s book in 2018.

This guy doesn’t post often, but when he does, I listen. This one completely changed how I view rising equity valuations and future expected returns. Seeing higher P/Es might me justified merely because it is easier and cheaper to invest with less risk (i.e. more diversification) than in previous decades. I can’t say with certainty this is correct, but it makes a lot of sense to me.

They say an image is worth a thousand words, and Ben uses that to his advantage in this post better than anyone. His writing is simple, yet profound. I know few writers that can say so much by saying so little.

Always funny, entertaining, and informative, this piece is no exception. Josh probably knows every trick in the finance industry and he regularly exposes them all. Mad props for leading the way in integrity. Josh sets an example for the rest of us.

Never forget the master. Jason Zweig has been writing about investing longer than anyone on this list and he always delivers. This post is particularly insightful because of the history of the main character (Karl G. Karsten) who called into question forecasting and discovered smart beta before either were a thing.

My Favorite Books I Read in 2017

I read 45 books in 2017 which is 15 books short of what the average CEO reads, so now you know why I’m not a CEO. Either way, here are my 10 favorites (in no particular order):

This book inspired one of my most popular posts of 2017 and covers the physical and psychological aspects of survival in a unique way. Gonzales focuses on accidents and how to mentally survive incredibly difficult situations. If you are interested in adventure, perseverance, or psychology, then this book is for you.

Sapiens takes a deep dive into truly understanding humans and how they live and organize themselves. One of his main arguments is how humans use stories to define themselves and the world around them. Harari’s unique perspective on these issues presents insightful research that is also entertaining.

How do animals have sex? It’s not as simple as the birds and the bees. In this book, Olivia Judson digs into the many and varied reproductive strategies that have evolved in species across the globe. From spiders performing bondage to slime molds with over 500 different sexes, this book will open your eyes to the driving force behind life itself. If you need more convincing, Meb Faber said it was one of his favorite books.

Howard Marks, cofounder of Oaktree Capital, is known for his annual letters that educate and inspire. In The Most Important Thing, Marks summarizes the many tenets of his investment philosophy into one simple work. I enjoyed the book because it was so profound and entertaining at the same time. Just consider this story Marks used to explain how worst case scenario projections may not be negative enough:

I tell my father’s story of the gambler who lost regularly. One day he hears about a race with only one horse in it, so he bet the rent money. Halfway around the track, the horse jumped over the fence and ran away.

I still think the jury is out on a lot of nutrition science because the problem is so difficult, but Nina Teicholz does an incredible job showcasing the scientific evidence for including more fat in the diet. In fact, the book is quite boring at times because of how many studies Tiecholz is able to cite in support of her argument. Seriously, Tiechnolz cites study after study after study on saturated fat consumption, and the weight of the evidence (no pun intended) is impressive. So, if you are still convinced that bacon and butter are bad for you, read this book.

Glass, cold, sound, clean, time, and light. Six things that we all take for granted, but all have intriguing histories. Steven Johnson does a wonderful job of telling the narratives behind a handful of the life changing technologies we use on a daily basis. One funny story that stuck with me was how wrong many inventors were about how their inventions would ultimately be used. Ironically, Alexander Graham Bell thought the telephone would be used to listen to music, while Thomas Edison thought the phonograph would be used to communicate via recorded audio.

Peter Bernstein maybe one of the best investment thinkers of all time, and Against the Gods has no shortage of his brilliance. I wrote an entire post based on Bernstein’s work and highly recommend the book if you want a more in-depth view of risk and its history in human society.

This book changed the way I viewed my future career and other life decisions. Taleb’s premise is that you should follow life strategies that make you antifragile. In other words, find ways to follow strategies with infrequent, large non-linear gains and small linear losses. Careers that include blogging/writing are of this nature as the costs are small, but the upside can be massive. If you want to discover how antifragility might be able to help you, read this book.

I love Jocko Willink’s ability to inspire others to put in the work and get things done. His Twitter/Instagram feed consists of his daily 4:30 AM wakeup and workout routines. This book is on theme and does not disappoint. I still am the top review for this book on Amazon if you want to get my full thoughts. Either way, I will leave you with a quote from the book that I hope speaks to you as it did for me:

We are defeated one tiny, seemingly insignificant surrender at a time that chips away at who we should really be. It isn’t that you wake up one day and decide that’s it: I am going to be weak. No. It is a slow incremental process. It chips away at our will-it chips away at our discipline.

Last, but not least, this book brings up a lot of controversial issues on intelligence and its increasing importance in modern society. Many people throw this book out because of its discussion of race. Personally, I don’t find the race and intelligence ideas that interesting. The more important question to me is: as careers evolve to require ever higher amounts of intellectual ability, what will happen to those individuals that don’t have such intellectual gifts? What should we do (if anything) to give those with unequal ability a fair shot in a world where they are genetically disadvantaged? If these questions interest you, then look past the controversy and read this book.

I hope you found something useful in this list. Enjoy the rest of your holidays and I will see you all in 2018! Thank you for reading.

➤ You can follow Of Dollars And Data via Email (1 weekly newsletter), Twitter, Facebook, or Medium.

This is post 52. Any code I have related to this post can be found here with the same numbering: https://github.com/nmaggiulli/of-dollars-and-data

Disclaimer

The above references an opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice. The postings on this site are my own and do not necessarily reflect the views of my employer. Please read my “About” page for more information.

OfDollarsAndData.com is a participant in the Amazon Services LLC Associates Program, an affiliate advertising program designed to provide a means for sites to earn advertising fees by advertising and linking to Amazon.com and affiliated sites.

My Favorite Investment Writing of 2017 was originally published in Of Dollars And Data on Medium, where people are continuing the conversation by highlighting and responding to this story.

When Do You Sell?

Mar, 12/19/2017 - 15:53
The Most Challenging Question in Investing

Before you buy your next investment, consider the following question:

When do you sell?

The question seems easy enough, but I’d argue its the most challenging question for investors. Why? Because it forces you to face off against two of the strongest behavioral forces in investing: fear of missing out on the upside and the fear of losing money on the downside. Let’s go through a few examples to explain my thinking:

Imagine you are putting money into your 401(k) every 2 weeks and buying a diversified portfolio of cheap index funds/ETFs. When do you sell?

Excluding rebalancing, you might say, “I will only start to sell in retirement.” That was my gut response as well.

However, what if there is a melt up and valuations start to rise to extreme levels? If the CAPE kept rising from 30 to 40 to 50 … all the way to 100, would you sell then and move to cash? The only time we have ever seen valuations that high was Japan in the late 1980s when the CAPE rose to ~94, and you know what happened afterward:

So, do you cash out as the market heats up, or let is play itself out? We must also consider the flip side of this.

As you near retirement, the market starts drawing down significantly. In dollar terms you are down $100,000, then $200,000, then $300,000 and it is outside of your control. The decades you spent saving, investing, and making the right financial choices are being wiped out in a matter of months. So, do you sell?

It is easy to talk about buy and hold, but very different in a moment of crisis. I haven’t personally experienced anything more than a 10–15% drawdown across my portfolio since I have started investing in 2012, but based on what I have read, it doesn’t sound pleasant. Large dollar drawdowns are known to be gut wrenching with many people reporting feeling physically sick. So before you talk the talk of not selling in a panic, consider whether you can actually walk the walk.

Now let’s propose a different scenario:

Instead of buying broadly diversified index funds/ETFs in your retirement account, you decide to do some individual stock picking in your brokerage account. Once again, when do you sell?

You might be tempted by Buffett’s wisdom from his 1988 letter to shareholders (emphasis mine):

When we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever.

However, remember that of all the stocks in the Dow Jones Industrial Average in 1901, only General Electric is still in the Dow today. Forever is a lot shorter than it seems.

Assuming you don’t want to hold forever, let’s say you bought two stocks, one of which doubled in a year and the other is down 25% after a year. If you are a typical investor, you will sell your winner to lock in a gain and hold onto your loser so it can recover in price. This is known as the disposition effect and it is a well documented investor behavior.

However, the evidence suggests that selling your winners and holding your losers would (on average) be the wrong move. Why? Stocks that do well over the previous year tend to do well over the next year and stocks that did poorly over the previous year tend to do poorly over the next year. This is known as momentum factor and it is also one of the most well documented investment results we see across different markets and time periods. This factor combined with the disposition effect provides evidence for how typical investors sell at precisely the wrong time.

The examples above are just two of many different scenarios you will face as an investor. Considering whether to sell an underperforming asset class, or thinking about the tax consequences of your actions will also effect if/when you sell. Nevertheless, being cognizant of the behavioral forces at play in every scenario can make a big difference in your investment results.

The Importance of When to Sell

The question of when to sell is important because it forces you as an investor to put a range on the downside and upside for when you should sell a given investment. It seems obvious after the fact, but I have gotten into many positions previously where I didn’t have a set price range (or selling methodology) in mind.

I thought about this idea while talking with some coworkers about the crypto market. One of them said, “I wish I had gotten into Bitcoin while it was $100.” I responded, “Okay, but when would you have sold?” He didn’t have an answer, and I don’t blame him. It is hard to conceptualize Bitcoin at $15,000+ before the fact. It is far more likely that he, like me, would have sold out before it got anywhere near $15,000.

I can say with certainty that if I had bought Bitcoin at $100, as soon as it hit $300, or maybe $500, I would have sold. Why? A 3x-5x return is incredible in such a short time frame. Those are the kind of returns I expect over decades in equity markets, so why would I not lock those returns in if I received them in far less time? Yes, my decision looks silly when Bitcoin hits $15,000 after the fact, but at the time, making 3x-5x in a short time frame is amazing.

So, before you go buy your next investment, ask yourself:

When do you sell?

Thank you for reading!

➤ You can follow Of Dollars And Data via Email (1 weekly newsletter), Twitter, Facebook, or Medium.

This is post 51. Any code I have related to this post can be found here with the same numbering: https://github.com/nmaggiulli/of-dollars-and-data

Disclaimer

The above references an opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice. The postings on this site are my own and do not necessarily reflect the views of my employer. Please read my “About” page for more information.

OfDollarsAndData.com is a participant in the Amazon Services LLC Associates Program, an affiliate advertising program designed to provide a means for sites to earn advertising fees by advertising and linking to Amazon.com and affiliated sites.

When Do You Sell? was originally published in Of Dollars And Data on Medium, where people are continuing the conversation by highlighting and responding to this story.

The Double-Edged Sword

Mar, 12/12/2017 - 12:58
Why Some Strategies Can Lead to Both Success and FailureStavanger, Norway (2017)

Take a deep breath. The air filling your lungs is 78% nitrogen and 21% oxygen. A Swedish pharmaceutical chemist by the name of Carl Wilhelm Scheele first discovered both of these elements in the mid 1770s, but he didn’t get any credit for it. However, this never stopped Scheele, because he was obsessed with chemicals. Scheele’s obsession drove him to discover 6 additional elements on the periodic table all without using advanced scientific equipment given his lack of money.

However, his love of chemicals had a dark side. Scheele was known to have a habit of tasting whatever chemical he was working with. Bill Bryson’s A Short History of Nearly Everything tells the unfortunate side effect of Scheele’s peculiar “tastes”:

Scheele’s rashness eventually caught up with him. In 1786, aged just forty-three, he was found dead at his workbench surrounded by an array of toxic chemicals, any of which could have accounted for the stunned and terminal look on his face.

Scheele’s insatiable drive to understand the mysteries of chemistry led to his ultimate demise. His strength became his greatest weakness. It was his double-edged sword.

This idea is most relevant for “investors” (I actually mean speculators) who take extremely risky bets and keep winning. Their initial success boosts their confidence and they continue their risky investment behavior. While some of them will wise up and diversify after getting rich, many won’t and will pay the price as a result. The very thing that made them rich (i.e. taking big risks) leads to their downfall.

History is riddled with examples of this phenomenon. Consider the famous speculator Jacob Little, who made and lost his fortunes a record nine times, dying without a cent to his name in 1865. Or the story of Jesse Livermore, who got rich and then saw his wealth disappear on at least four occasions while trading on Wall Street in the first few decades of the 1900s. The point is that speculation is an inherently risky game that usually ruins most people financially…if they don’t stop playing.

To imagine this visually, I have run 20 simulations of a strategy with an 80% chance of gaining ~20% and a 20% chance of losing ~90% in each period. This strategy has an expected return of -2%, so it should lose money in the long run. However, it can perform well in the short run by chance alone (i.e. some of the simulations haven’t lost any money even after 10 periods):

As you can see, most of the simulations experience a 90% loss within the first 10 periods. In expectation, a 90% loss should occur once every five periods, however, three of the simulations didn’t experience a loss within 10 periods! This is akin to a gambler going on a hot streak. However, the streak doesn’t last forever. If we extend out the number of periods, the double-edged sword will present itself and slice away the gains:

The three “surviving” lines from the first chart finally realize losses, but only after the 10th period. This is because, on average, a strategy will trend toward its mean return over time. Or as I like to think about it: luck can only disguise skill for so long.

From this idea, there are a few key takeaways for you as an investor:

  • If you find yourself getting rich quickly with an investment, this is usually a sign of luck. I’d recommend realizing your winnings and getting out so you can diversify your wealth. If you still have a fear of missing further gains, try selling a portion of your assets as they appreciate. This is a kind of hedge where you can realize some gains while reducing your FOMO at the same time. If done correctly, you will have realized some profit even if your risky asset eventually goes to $0.
  • Sometimes others will beat you even when they are following the absolute worst strategies. Don’t feel bad, just stick to your sound investment plan. If their strategies are really that toxic, the double-edged sword will cut them down in the long run.
  • Stay humble and rational. Losing strategies sometimes win and winning strategies sometimes lose. Nothing will ever change this, but you can change how you react to such events.

Is Crypto the New Double-Edged Sword?

I see many parallels today between historical speculators and the overnight millionaires in the cryptocurrency market. I am not saying that those people who got rich in crypto are guaranteed to lose their wealth in crypto, but that there will be some individuals whose crypto success makes them keep pushing their luck elsewhere. The crypto market reminds me of a lottery where there are a few big winners (i.e. 40% of all Bitcoin is owned by less than 1,000 people). Yes, some of these individuals will stay rich, but some of them will go broke because of their double-edged sword.

Either way, this is one of the most exciting times to be following the investing world and I am excited to see how it will all play out. Until next week, thank you for reading!

➤ You can follow Of Dollars And Data via Email (1 weekly newsletter), Twitter, Facebook, or Medium.

This is post 50. Any code I have related to this post can be found here with the same numbering: https://github.com/nmaggiulli/of-dollars-and-data

Disclaimer

The above references an opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice. The postings on this site are my own and do not necessarily reflect the views of my employer. Please read my “About” page for more information.

OfDollarsAndData.com is a participant in the Amazon Services LLC Associates Program, an affiliate advertising program designed to provide a means for sites to earn advertising fees by advertising and linking to Amazon.com and affiliated sites.

The Double-Edged Sword was originally published in Of Dollars And Data on Medium, where people are continuing the conversation by highlighting and responding to this story.

Beyond All Expectations

Mar, 12/05/2017 - 13:02
When Old Patterns Break and How to Think About Financial Data

It had been nine days since Volkert Evertszoon and his fellow shipmates had consumed anything other than their own urine. The men were on death’s door as their longboat floated helplessly throughout the western part of the Indian Ocean. Then…a miracle occurred. After washing ashore a remote islet on the north eastern side of Mauritius, they spotted the answer to their prayers. Enter the dodo:

The Dodo (Photo: Wikimedia Commons)

Though the dodo was first spotted in the 1590s, and subsequently hunted to extinction throughout Mauritius, these flightless birds still roamed free on the island where Evertszoon and his men had landed. However, this wouldn’t last long.

The dodo had no fear of humans and approached Evertszoon and his shipmates as soon as they arrived. Evertszoon describes the interaction, which was the beginning of the end for the dodo:

We could catch them with our hands…[and after catching one flock, another flock] came running as fast as they could to its assistance, and by which they were caught and made prisoners also.

The men feasted on the birds for months during the spring of 1662 in what became the last recorded sighting of the dodo before it went extinct.

The story of the dodo’s last stand is told in When Hitler Took Cocaine and Lenin Lost His Brain: History’s Unknown Chapters by Giles Milton, and provides an important lesson on the power of expectations. From the perspective of the dodo, the arrival of humans (or any other large predator) was outside the realm of its evolutionary grasp. Anything the dodo had approached previously had not tried to eat it. However, the arrival of humans broke the old pattern. It was beyond all expectations.

This idea is directly relevant to how investors use historical financial data to make decisions about the future. We assume that history is a great guide for what is to come, which is only sometimes true. We rely heavily on previous patterns…until they break. This is the classic black swan problem explained by Nassim Taleb, and highlights the difficulty with relying on financial history to make predictions.

For example, let’s consider one piece of financial data that is thrown around a lot and seems unhelpful most of the time: cyclically adjusted price-to-earnings ratio or CAPE. The CAPE for U.S. stocks as of early December 2017 stands at ~32. Many investors assume this means that the market must be overvalued. The old pattern is: high CAPE = bubble. I understand the logic. I have shown previously that there is a negative relationship between the current valuation (i.e. CAPE) of U.S. stocks and their real returns for the next 5 years:

However, when we look over longer time periods, this relationship breaks down. Below is the same chart as the one above, but for real returns over the next 30 years:

Yet, we can take this idea one step further and show U.S. stock prices with regards to CAPE since 1900. Below I plotted the real price + dividends of U.S. stocks (index is on a log scale) with a heatmap in the background that corresponds to the current CAPE value during that month. Note that higher CAPE values are red and lower CAPE values are blue:

As you can see, a higher CAPE ratio is typically correlated with stock market peaks, but this is not always true. The problem with these charts is that the conclusions we could draw from them are limited. Why? Nearly all of the months with a CAPE > 30 occurred in just two time periods: the Great Depression (1929) and the DotCom Crash (1999). So as “predictive” as they might seem, we simply don’t have enough U.S. market history to examine.

So does the current CAPE > 30 = bubble? I don’t know, but there doesn’t seem to be enough data to justify it with a high degree of certainty. In addition, how CAPE is defined has technically changed over time. Jeremy Schwartz, Director of Research at Wisdom Tree, recently discussed how changing earnings definitions could affect the measurement of CAPE. Therefore, the jury is still out. Personally, when it comes to CAPE or other financial data, I take Cliff Asness’ view of only getting excited around the 150th percentile (i.e. 150% of the prior 100th percentile, or something we’ve never experienced before).

What does this mean for you as an investor? It means to expect the unexpected. Who thought Trump would be the President? Who thought the Patriots would come back to win Super Bowl 51? Who thought Bitcoin would hit $10,000? Very few. So why should CAPE > 30 be any different? As Josh Brown (or Morgan Housel) famously said:

Not only is this time different, every time is different.

The False Sense of Security

Despite my arguments against the helpfulness of some financial data, I don’t think financial data is useless (this is of Dollars and Data after all). However, I do think financial history gives us a false sense of security. Humans excel at pattern recognition, which is the very thing that has led to many of the biggest blunders in investment history. Consider a few of the more famous failures of pattern recognition:

  • Housing prices can’t fall across the U.S. at the same time…until they do.
  • Long Term Capital Management (LTCM) couldn’t lose more than $35 million in a single day…until they lost $553 million on a Friday in August 1998. This was based on their expectations about interest rate spreads.
  • When the internet was first available for public commercial use in mid-1989, I would bet that over 99% of DCF valuation models did not include it in their calculations. The internet broke the old pattern of valuation and then broke it again when the dotcom bubble burst.

This reminds me of a joke Howard Marks told in The Most Important Thing:

I tell my father’s story of the gambler who lost regularly. One day he hears about a race with only one horse in it, so he bet the rent money. Halfway around the track, the horse jumped over the fence and ran away.

This is the pattern breaking that has come to define our world. Just like the dodo, investors are on their own island of financial history with no clue what will wash ashore from the seas of tomorrow. We feel safe on our island, but the ocean will continue to bring chaos. We learn from the past though our returns come from a future that is inherently uncertain. We can hold onto our old beliefs…until something comes along and makes them go the way of the dodo. Thank you for reading!

➤ You can follow Of Dollars And Data via Email (1 weekly newsletter), Twitter, Facebook, or Medium.

This is post 49. Any code I have related to this post can be found here with the same numbering: https://github.com/nmaggiulli/of-dollars-and-data

Disclaimer

The above references an opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice. The postings on this site are my own and do not necessarily reflect the views of my employer. Please read my “About” page for more information.

OfDollarsAndData.com is a participant in the Amazon Services LLC Associates Program, an affiliate advertising program designed to provide a means for sites to earn advertising fees by advertising and linking to Amazon.com and affiliated sites.

Beyond All Expectations was originally published in Of Dollars And Data on Medium, where people are continuing the conversation by highlighting and responding to this story.

There Are Many Ways to Win

Mar, 11/28/2017 - 12:51
Why A Few Simple Rules Are More Important than Specific Strategies

In every laboratory experiment ever conducted between the fire ant (Solenopsis invicta) and the woodland ant (Pheidole dentata), fire ants have overwhelmed and eaten their woodland counterparts. Because fire ant colonies are typically 100 times larger than woodland colonies, the woodland ants never stand a chance. This puzzled the myrmecologist (ant researcher) Edward O. Wilson who noticed that both species were found within close proximity of each other in their natural habitat throughout the southern United States. So how does the woodland ant survive despite being vastly outnumbered by its fiery opponents?

Wilson discovered that the woodland ant had evolved a unique strategy to keep its enemies at bay. Unlike most other ants, the woodland ant has two classes of workers — a “minor” class (i.e. a typical worker found in most ant species) and a larger “soldier” class with sharp, powerful mandibles. The soldier class represents about 10% of the woodland ant population and spend most of their time idle…until they detect a fire ant.

Upon detecting a fire ant, the woodland soldiers go into hunt mode, ripping to shreds every foe they come across. After their initial response, the soldiers patrol the area over the next few hours to eliminate any other fire ants they find. Wilson provides the punchline in the book Journey to the Ants:

The result of this zeal is that fire-ant scouts seldom make it home. And without dispatches from the front, their colonies are blinded…The hair trigger reaction of the defenders [woodland ants], renders them undetectable most of the time.

What’s fascinating about this survival strategy is that it is only one of hundreds employed by the 9,500+ different ant species across the globe. For example, consider the army ant (Eciton burchellii) which is constantly on the move and uses overwhelming force to devour all insects and even small birds they come across. When not moving, army ants make temporary nests out of their own bodies (called bivouacs) where they can control the internal temperature and humidity level:

Photo: Wikimedia Commons

Or how about the leafcutter ant (Atta texana) which lives off of fungus it cultivates underground:

Photo: Flickr

Or the African weaver ant (Oecophylla smaragdina) which constructs nests by gluing together leaves with silk produced from their ant larvae:

Photo: Wikimedia Commons

My point is that there are many different strategies that ants employ to survive and thrive — there are many ways to win. But, despite these many winning strategies, all ant species follow a few simple rules:

  • They all communicate mostly via scent/taste.
  • They all rely exclusively on female workers and a queen for the colony (i.e. you have probably never seen a male ant in your life, as they have wings and only live during the mating season).
  • They all constantly sacrifice workers for the good of the colony. For example, it is estimated that roughly 6% of some ant colonies die every hour while they are foraging.

Without these rules, most ants would not be able to survive regardless of their specific evolutionary strategies.

This idea is relevant to investing, because as investors, we spend a lot of time thinking about our specific investment strategy (i.e. how much should I put in value stocks?, should I avoid emerging markets?, etc.) despite the fact that a few behavioral rules will likely drive most of our investment success. I would argue that 70–80% of your investment success will come from these few rules, while the remaining 20–30% has to do with the specific asset allocation strategy you select. Let me explain.

After looking at a variety of investment portfolios over the 40 year period of 1976–2016, I found that the average annual real returns ranged from 6%–9%. The 6% return portfolio (“Equal Wt”) was an equal weighted portfolio of six assets (U.S.10-Year Treasuries, U.S. 3m T-bills, U.S. Corporate Bonds, S&P 500, Int. Stocks, and REITs) while the 9% return portfolio was 100% U.S. stocks (“S&P 500”). You can compare their annual performance, along with some other portfolios here:

As you can see, the differences are not that drastic between the portfolios. If we compare the “Equal Wt” portfolio to the “All Stocks” portfolio (which contains 50% S&P 500 and 50% Int. Stocks) we would see a performance difference of about 2% a year. Don’t get me wrong, having 8% versus 6% annually over 40 years doubles the amount of money you have at the end, all else equal. However, by following a few simple rules you can easily make up for this difference. Some good rules include:

  • Saving money. Your returns won’t matter much if you can’t save money. It is far easier to double your savings rate from 5% to 10% (or 10% to 20%) than to increase your risk adjusted returns. If you were saving 10% on a $50,000 salary, in order to save 20% (all else equal), you would need to raise your post-tax income by $5,000. So you can either attempt to increase your returns from 6% to 8% annually, or double your savings rate. One is unknowable beforehand, the other is completely in your control. You decide.
  • Knowing your investment self. Understanding your investor behavior will play a far larger role in your long run investment success than a marginal amount of additional return. Why? All it takes is one bad decision to wipe out decades of good decision making. Your 2%+ premium can be lost in an instant if you don’t understand your risk tolerance.
  • Keeping your fees low. Your future returns are not guaranteed, but your future fees are, so keep them in check.
  • Using diversification. Don’t get me wrong, every person who has gotten very rich has likely done this through concentrated holdings, however, this strategy is also a surefire way to go broke. Diversification doesn’t necessarily improve returns directly, but it can transform the risk you take, which can indirectly increase your returns through better investment decisions (i.e. you may be less likely to panic). Just remember that underperformance for some asset classes is to be expected when diversifying.

My point is that while asset allocation is incredibly important, the difference in return between different allocation strategies can be mitigated by following the right investment rules.

A Rules Based Approach

One of the most amazing things about ants is how rules based they are. For example, most ants identify a dead ant by the scent of oleic acid. Their definition is so precise that if you put a living ant inside an ant colony after coating it with oleic acid, the other ants will throw it out because they believe that it is dead. While we might think of this rules based approach as too rigid or possibly “stupid”, rules have enabled ants to succeed in varied environments across the globe.

This same idea is true in investing. Sticking to a decent investment approach has been shown to have incredible long term success. I recently heard about the Fidelity study where they realized that the investors with the best performance were the ones that forgot they had a Fidelity account! It’s hard to deviate from an investment strategy when you don’t know you have one. So find a strategy that you like and stick with it. Remember, there are many ways to win…if you follow the right rules.

Lastly, if you are interested in learning much more about ant biology, I highly, highly recommend Journey to the Ants. It is an incredible read with even more amazing photographs. Until next week…thank you for reading!

➤ You can follow Of Dollars And Data via Email (1 weekly newsletter), Twitter, Facebook, or Medium.

This is post 48. Any code I have related to this post can be found here with the same numbering: https://github.com/nmaggiulli/of-dollars-and-data

Disclaimer

The above references an opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice. The postings on this site are my own and do not necessarily reflect the views of my employer. Please read my “About” page for more information.

OfDollarsAndData.com is a participant in the Amazon Services LLC Associates Program, an affiliate advertising program designed to provide a means for sites to earn advertising fees by advertising and linking to Amazon.com and affiliated sites.

There Are Many Ways to Win was originally published in Of Dollars And Data on Medium, where people are continuing the conversation by highlighting and responding to this story.

It’s Not About the Money

Mar, 11/21/2017 - 13:32
On Lifestyle Diversification in RetirementPhoto: Flickr

The task was simple. Each team was given an envelope and one specific goal:

Start a business and earn as much money as possible within two hours using only the money inside the envelope.

The problem? Each envelope only contained $5.

It was a Wednesday afternoon and each team had until Sunday night to finish the challenge. They could plan as much as they wanted, but as soon as they split open their envelope containing the $5, their two hour window would begin. If that wasn’t hard enough, each team would have to create a single slide summary of what they did and present it to their fellow students the following Monday.

What would you do if you were given this task? How would you maximize your earnings in two hours with only $5 to start?

This was the assignment given to students at Stanford’s Graduate School of Business. So how did they approach this problem? Professor Tina Seelig, the creator of the $5 challenge, recalls her experience:

When I ask this question to most groups, someone usually shouts out, “Go to Las Vegas,” or “Buy a lottery ticket.” This gets a big laugh. These folks would take a significant risk in return for a small chance at earning a big reward. The next most common suggestion is to set up a car wash or lemonade stand, using the five dollars to purchase the starting materials. This is a fine option for those interested in earning a few extra dollars of spending money in two hours. But most of my students eventually found a way to move far beyond the standard responses. They took seriously the challenge to question traditional assumptions — exposing a wealth of possibilities — in order to create as much value as possible.

In fact, the average team earned $200 in profit (a 4000% ROI). How did they do this? They realized that the $5 was a complete distraction. The money was irrelevant to the task. With this in mind, the question became what can you do with nothing to earn the most money? Professor Seeling elaborates:

All of the teams were remarkably inventive. One group identified a problem common in a lot of college towns — the frustratingly long lines at popular restaurants on Saturday night. The team decided to help those people who didn’t want to wait in line. They paired off and booked reservations at several restaurants. As the times for their reservations approached, they sold each reservation for up to $20 to customers who were happy to avoid a long wait.

Other teams also used their free time/labor to earn money successfully. However, the winning team did the most genius thing of all. Remember that “presentation” that each team had to give to their classmates on the following Monday? The winners sold their presentation slot to a company looking to hire Stanford Business School Graduates, earning them $650. After all, how often do you get the undivided attention of some of the best and brightest business school students in the country? It was a win-win for both sides.

The results of the $5 challenge demonstrates that sometimes, focusing on the money can lead us astray. This idea is directly applicable to one of the biggest topics in all of investing — retirement. When you hear the word retirement the first word that pops into your head might be “money” or “savings” or “401(k)”, but while money is important for your retirement, it matters far less for your overall well being than you might imagine at the outset. Let me explain.

In the process of doing research on retirement, I found no shortage of resources discussing personal finances. Michael Kitces has written an overwhelming number of detailed articles on the topic and Bill Sharpe, the Nobel Prize winning economist, has stated that retirement is the “nastiest, hardest problem in finance.” As you can see, my entire view of retirement was shaped by financial matters. This all changed when I came across a book that shattered my reality on the topic.

The book was How to Retire Happy, Wild, and Free and it contains no sections on money. Yes, it is a retirement book that excludes any talk of optimal withdrawal rates, taxes, or required minimum distributions. Why does it exclude these? Because the author’s research found that things like “physical well-being, mental well-being, and solid social support play bigger roles than financial status for most retirees.” In other words, it’s not about the money. Ernie Zelinski, the book’s author, states:

Regardless of how talented you are and how successful you are in the workplace, there is some danger that you will not be as happy and satisfied as you hope to be in retirement…What may be missing is a sense of purpose and some meaning to your life. Put another way, you will want to keep growing as an individual instead of remaining stagnant.

The premise of the book is that it is not a financial crisis you need to worry about in retirement, but an existential one. The fact is, once you stop working for 40+ hours a week, what are you going to do with all of your time? It is easy to say “vacation”, but even if you did that for an entire year, then what? Don’t believe me? Consider what Kevin O’Leary, aka “Mr. Wonderful” from Shark Tank, stated about his attempts at early retirement after selling one of his companies:

I could never be retired right now; I tried it, very boring. I’ve been on every beach on the planet.

Or, consider what John Osborne, a retired educational psychology professor who teaches a course on how to retire happy, said in the book (emphasis mine):

The more your life revolves around work, the more of a shock retirement will be. It’s like having a portfolio that’s not diversified, and it’s not until your job is gone that you confront reality. It can be like falling into space.

So, let’s confront one reality. I know that, statistically, the readers of this blog (i.e. you) are more likely to be reading this post while at work (thanks Alexa):

So, years from now in your retirement, you may end up craving the very thing that you are distracting yourself from right now. Ironic, right?

So what’s the solution to this future dilemma? As Osborne suggests: diversify your life interests. It is easier said than done, but finding other purposeful things to do with your time will likely lead to more life satisfaction than the marginal amount of money you will earn from working more hours in your primary career. This is probably not true for everyone, but you should consider it.

It’s Really Not About the Money

I understand the skepticism you may have listening to a 27 year old financial blogger tell you that retirement isn’t only about the money. However, the fact remains that once you have some base level of financial security, your day to day happiness in retirement will be more heavily impacted by your relationships, your hobbies, and your sense of purpose than your financial assets. I completely relate to this as my day to day happiness is effected far more by my dating life and blogging life than what is happening with the S&P 500.

However, let’s say you don’t listen to me and decide to focus on the money. Once you are rich you are still likely to worry about your wealth, as this recent New York Times article seems to suggest. So even when you do get the financial status you crave, you will probably get anxious about losing it. In other words, you are screwed on both ends. Either you feel too poor, or you feel wealthy and you worry about being poor again. You never win. It’s far better to not focus on the money and enjoy life for what it brings.

My advice is to find what you do, but don’t be afraid to try something new once in a while. Diversify your life interests and you may be surprised with the returns. Thank you for reading!

➤ You can follow Of Dollars And Data via Email (1 weekly newsletter), Twitter, Facebook, or Medium.

This is post 47. Any code I have related to this post can be found here with the same numbering: https://github.com/nmaggiulli/of-dollars-and-data

Disclaimer

The above references an opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice. The postings on this site are my own and do not necessarily reflect the views of my employer. Please read my “About” page for more information.

OfDollarsAndData.com is a participant in the Amazon Services LLC Associates Program, an affiliate advertising program designed to provide a means for sites to earn advertising fees by advertising and linking to Amazon.com and affiliated sites.

It’s Not About the Money was originally published in Of Dollars And Data on Medium, where people are continuing the conversation by highlighting and responding to this story.

A Little Knowledge is Dangerous

Mar, 11/14/2017 - 12:52
How to Deal with Overconfidence in Financial Markets

It had been a little over a week since anyone had seen Karina Chikitova. The forest she had walked into nine days prior was known for being overrun with bears and wolves. Luckily, she was with her dog and it was summer in the Siberian Taiga, a time when the night time temperature only dropped to 42 degrees (6 Celsius). However, there was still one major problem — Karina was just 4 years old.

Despite the odds against her survival, Karina was found two days later after her dog wandered back to town and a search party retraced the dog’s trail. You might consider Karina’s 11 day survival story a miracle, but there is a hidden lesson beneath the surface.

In his book Deep Survival: Who Lives, Who Dies, and Why, Laurence Gonzales interviews Kenneth Hill, a teacher and psychologist who manages search and rescue operations in Nova Scotia. When Gonzales asks Hill about those who survive versus those who don’t, Hill’s response is surprising (emphasis mine):

It’s not who you’d predict, either. Sometimes the one who survives is an inexperienced female hiker, while the experienced hunter gives up and dies one night, even when it’s not that cold. The category that has one of the highest survival rates is children six and under…And yet one of the groups with the lowest survival rates is children ages seven to twelve.

So why do younger children fare better in survival situations than their slightly older counterparts? Gonzales attributes this to their lack of brain development:

For example, small children do not create the same mental maps adults do. They don’t understand traveling to a particular place, so they don’t run to get somewhere beyond their field of vision. They also follow their instincts. If it gets cold, they crawl into a hollow tree to get warm. If they’re tired, they rest, so they don’t get fatigued. If they’re thirsty, they drink. They try to make themselves comfortable, and staying comfortable helps keep them alive.

Karina displayed these exact behaviors when she became lost. She hid in tall grasses away from animals, she curled up with her dog to stay warm, and she found berries to eat when she was hungry. Contrast this with Gonzales’ description of Karina’s slightly older counterparts (emphasis mine):

Children between the ages of seven and twelve, on the other hand, have some adult characteristics, such as mental mapping, but they don’t have adult judgment. They don’t ordinarily have the strong ability to control emotional responses and to reason through their situation. They panic and run. They look for shortcuts. If a trail peters out, they keep going, ignoring thirst, hunger, and cold, until they fall over. In learning to think more like adults, it seems, they have suppressed the very instincts that might have helped them…a little knowledge is dangerous.

This idea is incredibly powerful because there is evidence that having a little knowledge on a particular topic can lead to vast amounts of overconfidence. This overconfidence, in turn, can lead to bad decision making. In psychology, this is known as the Dunning-Kruger effect, or the cognitive bias in which individuals with low ability perceive themselves as having high ability.

Dunning and Kruger found that after gaining a small amount of knowledge in a particular domain, an individual’s confidence soared. However, when that individual was provided with further training, they were better able to asses their skills and their confidence dropped. It was only once their experience approached that of an expert did their confidence rise again.

If we had to imagine an investor’s confidence as they gained experience, it might look something like this:

I can tell you that I am sitting comfortably in the “God, I hope this works” category. All jokes aside, overconfidence is the most dangerous investment bias out there because it is so prevalent and hard to recognize in your own behavior. Don’t believe me? Consider Jason Zweig’s question from Your Money and Your Brain:

Just ask yourself: Am I better looking than the average person?You didn’t say no, did you?

I could ask you hundreds of other questions assessing your abilities in various domains and you are likely to believe you are above average in many of them. In fact, Zweig’s research found that roughly 75% of people believe they’re above average regardless of the skill that is being assessed. Driving? ~75% believe they are above average. Telling jokes? ~75% above average. Intelligence tests? You guessed it. This was true despite the mathematical fact that only 50% of people can be above average.

Why does this matter to you as an investor? Because almost every epic investment blunder in history was the direct result of overconfidence. Long Term Capital Management were confident that bond spreads couldn’t widen beyond a certain point for a prolonged period of time. Investors during the Dot Com Bubble thought that the internet was the future of the economy (Marc Andreessen argues that these investors were right, just too confident too early). When the treasurer of Orange County’s investment fund was asked how he knew interest rates wouldn’t rise, he replied:

I am one of the largest investors in America. I know these things.

His fund filed for bankruptcy within a year.

However, don’t let the pros take all the credit, overconfidence can hit closer to home as well. I remember years ago spending an hour or two reading financial statements on an individual stock before buying it. That’s all it took. One hour and I put a few grand into a single stock that ended up underperforming the S&P 500. I’ve honestly spent more time shopping for the right pair of dress shoes.

At this point, if you haven’t admitted that you have fallen victim to overconfidence, I am telling you that one day you will. You won’t even realize it either. However, there are a few things you can do to prevent this.

How To Spot Your Own Overconfidence

So, you’ve made a decision and want to know whether you are being overconfident? Here are a few suggestions:

  1. Ask yourself how long you have thought about the decision. If you were exposed to a topic relatively recently, the data suggests you are more likely to be overconfident. Do more research first.
  2. Get opinions from other sources with opposing viewpoints. If your decision is reasonable, it should be able to stand up to a fair amount of scrutiny.
  3. Question everything, just like a small child would. This recommendation comes from Your Money and Your Brain and it closely relates to the survival stories I told earlier. If you keep asking yourself “Why?” you may realize that your logic has many holes in it.
  4. Diversify. No one ever went broke by being underconfident and allocating less capital to a position. No one ever got filthy rich doing this either, but that conversation is for another time. Side note: The word “underconfident” isn’t recognized by Medium’s spell check. See my point?

While these ideas are not guaranteed to eliminate overconfidence, they can help you recognize when a little bit of knowledge might be dangerous. Lastly, if you are interested in other behavioral biases that affect investors, in addition to Zweig’s book, I also recommend James Montier’s The Little Book of Behavioral Investing. Thank you for reading!

➤ You can follow Of Dollars And Data via Email (1 weekly newsletter), Twitter, Facebook, or Medium.

This is post 46. Any code I have related to this post can be found here with the same numbering: https://github.com/nmaggiulli/of-dollars-and-data

Disclaimer

The above references an opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice. The postings on this site are my own and do not necessarily reflect the views of my employer. Please read my “About” page for more information.

OfDollarsAndData.com is a participant in the Amazon Services LLC Associates Program, an affiliate advertising program designed to provide a means for sites to earn advertising fees by advertising and linking to Amazon.com and affiliated sites.

A Little Knowledge is Dangerous was originally published in Of Dollars And Data on Medium, where people are continuing the conversation by highlighting and responding to this story.

The Constant Reminder

Mar, 11/07/2017 - 12:51
How The Right Decisions And Compounding Can Lead to Huge Results

Every 175 years something remarkable happens — Jupiter, Saturn, Uranus, and Neptune come into close alignment. An American aerospace engineer by the name of Gary Flandro discovered this while working at NASA’s Jet Propulsion Laboratory in the summer of 1964. More importantly, Flandro realized that the next time this alignment would occur was in the late 1970s, a little more than a decade away.

As a result of his finding, Flandro devised a Grand Planetary Tour that would allow a probe to fly by all 4 gas giants much faster and cheaper than previously estimated. The physics behind the tour was to use the planets as slingshots (gravity assists) in order to cut down on energy costs and the time needed to visit them. The end result was NASA’s Voyager program. After considering 10,000 possible trajectories, NASA decided upon two of them and launched Voyager 2 followed by Voyager 1 in the late summer of 1977.

Two things stand out about the Voyager program:

  1. Decisions made by NASA scientists 40 years ago have had a profound effect on the mission and its success through today. For example, despite launching after Voyager 2, Voyager 1 is currently the furthest man made object from the Earth at a distance of ~13.1 billion miles or 20 light hours (as of this writing). Every second Voyager 1 moves 10 miles further away from us. Tick. Tick. Ti — Voyager 1 just completed a marathon. The decision to have Voyager 1 start on a faster and shorter trajectory and then let nature run its course made this possible. All it took was some great decision making, the rest was physics.
  2. Once a successful process is put in place, the end results can be surprising. What started as a mission to check out the gas giants and their respective moons became a study of the edge of our solar system and deep space. Voyager 1 and 2 have continually sent useful data back to NASA and will continue to do so until 2020, when their ability to transmit information will finally fade. The goals achieved by the probes were not necessarily all imagined at the outset.

These two ideas from the Voyager program are highly relevant to investing and your personal finances. Just like NASA had to choose from thousands of trajectories for Voyager 1 and 2, you will need to choose from a seemingly endless supply of investment advice. And the decisions you make today will have compounded effects decades later. These small decisions are hard to notice in the short run, but impossible to ignore in the long run. The simplest example of this is your savings rate. Imagine increasing your savings rate from 5% to 10% (or 15%) of your income. For the first few years, the benefits of this will be almost non-existent:

I purposefully made the y-axis this large because this visually represents the psychological attention you place on smaller amounts of money. The difference between saving $2,500 and saving $5,000 for a few years won’t change your life in any significant way, so its easy to mentally ignore the difference. However, if we allow this difference to compound year after year, the true impact of this decision emerges:

I know what you might be thinking: “Wow Nick. So you’re telling me saving more money leads to me having more money in the future? That’s so original.” I agree with you. The point of this visual isn’t to convince you to save more. You already know that. The point is to show you that making the right choices and letting things run their course can lead to incredible results. Whether this means continual buying and holding (i.e. do nothing on most days), staying the course during rough times, or focusing on the right part of your finances, the right choices, when compounded, can help you succeed as an investor.

This idea is even more striking outside of investing where it can be difficult to measure smaller changes and their eventual impact. For example, it’s easy to see how a higher savings rate leads to more money because you can do the math and see how this would compound over time. However, it is not necessarily easy to see how running for 20 minutes a day is going to help you get fitter. You can’t just run the numbers and imagine what your health/body would look like.

This is what makes consistent actions and the power of compounding so amazing. When I think about creating a new habit in my life, I like to imagine all of the future benefits from that habit discounted back to the moment when the habit is formed. That’s what it’s like. When you increase your savings rate from 5% to 10%, you don’t get 5% more money at the end, you double the amount of money you have. The first day you form your exercise habit is the day you lose the weight. The first day you form your writing habit is the day you wrote your best work. It all compounds back to the moment when the habit is formed.

This is the constant reminder. The reminder that the little things you do, the actions you perform, the habits you build day in and day out will form your life. Remember, you are a fractal of yourself. What you do on one day you likely do on most days. You may not notice these actions on a daily basis just like you probably don’t notice yourself getting fitter and you don’t notice Voyager 1 moving away from us at 10 miles a second, every second. However, these effects are still there, compounding away.

The beauty of this is that by forming good habits, you can hit escape velocity from your former self to become an improved you. Just like Voyager 1 left Earth and went into space, that probe is now pushing the limits (literally) of where humans have gone. And by making the right decisions and letting natural processes take over, you can get some surprising results…

An Unexpected Surprise

As Voyager 1 was exiting our Solar System in early 1990, the noteworthy astronomer and author Carl Sagan asked NASA to turn the probe’s camera toward Earth to take a final picture. The resulting image, known as the Pale Blue Dot, is one of the most famous in all of astronomy. It is not easy to see, but if you look down the orange streak on the right side of the image you will notice a small blue blip halfway down. That blip is Earth:

Pale Blue Dot (February 14, 1990)

If this image doesn’t make you realize how small we are, I don’t know what will. The edge of the known universe is 13.7 billion light years away from us, yet the furthest we have ventured is 20 light hours with Voyager 1. If each light year we moved toward the edge of the universe earned us $1, we wouldn’t even have a 1/3 of a penny yet of the $13.7 billion available. But despite our smallness, we have produced incredible things. If this idea interests you, I highly recommend the video below based on Carl Sagan’s book Pale Blue Dot. Until next week, thank you for reading!

https://medium.com/media/73c45a01cf856757b62bf6544889ff7b/href

➤ You can follow Of Dollars And Data via Email (1 weekly newsletter), Twitter, Facebook, or Medium.

This is post 45. Any code I have related to this post can be found here with the same numbering: https://github.com/nmaggiulli/of-dollars-and-data

Disclaimer

The above references an opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice. The postings on this site are my own and do not necessarily reflect the views of my employer. Please read my “About” page for more information.

OfDollarsAndData.com is a participant in the Amazon Services LLC Associates Program, an affiliate advertising program designed to provide a means for sites to earn advertising fees by advertising and linking to Amazon.com and affiliated sites.

The Constant Reminder was originally published in Of Dollars And Data on Medium, where people are continuing the conversation by highlighting and responding to this story.

The War Between Fear and Evidence

Mar, 10/31/2017 - 11:51
On Evidence-Based Investing and How You Can Profit From It

A war is currently being fought every day throughout the world. This war was here before you were born and will be around long after you are gone. I am talking about the war between fear and evidence. While humanity has access to more information today than any point in human history, facts continue to fall flat in the face of compelling narratives that rely on emotional appeal, especially fear. As The Science of Fear summarized so well:

Fear sells. Fear makes money. The countless companies and consultants in the business of protecting the fearful from whatever they may fear know it only too well. The more fear, the better the sales.

I completely agree. Humans are wired to respond to stories that rely on emotions, not cold, abstract numbers. The fact remains that it is far easier to relate to the death of a celebrity than it is to the deaths of thousands of people from a natural disaster on the other side of the planet. You don’t feel like you know those thousands like you “know” that celebrity. Or as Joseph Stalin so infamously said:

The death of one man is a tragedy, the death of millions is a statistic.

Despite our hard-wired tendency to react to emotional appeal, we can fight back. How? Evidence. Though fear is winning the war, everyday a small group of people win a few more battles using evidence. As I stated last week in Phil Huber’s post about evidence-based investing:

Fear is loud. Evidence is quiet. Listen to the evidence.

For example, consider the following “quiet” evidence:

And these are just a few examples of the overwhelming evidence that our biggest fears are not as bad as they seem and that human life is generally improving around the world. If you need more convincing, read Morgan Housel’s What A Time To Be Alive.

So, how is this related to investing? This is the primary goal of evidence-based investing (EBI) — to purse investment strategies backed by data and facts rather than narratives and emotion. EBI is about favoring history over uncertainty. Or, as my favorite investing quote of all time states:

Fear has a greater grasp on human action than does the impressive weight of historical evidence.-Jeremy Siegel

Read that quote again. Seriously. Let it sink in. Now, consider what Warren Buffett said regarding a similar subject:

In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.

Do you feel the impressive weight of evidence crushing your fear? You should. If not, I can probably guess your counter argument. What about the Black Swan? The nuclear war? The apocalypse? What if Taleb is right? He might be, but it wouldn’t matter anyways. If the apocalypse happens, your financial assets are irrelevant. So, who cares? Anything else though, our society and financial markets will survive. Terrorist attack? Hurricanes? Pandemics? These are all awful, but we’ll be fine.

So What Does the Evidence Say?

This week I will attend the 2nd Annual Evidence-Based Investing Conference (EBI East) in New York where some of the best investment thinkers in the world will discuss the evidence surrounding a variety of investment topics. With this in mind, I wanted to share just a few of the key points from evidence-based investing that you can use to improve your investment outcomes:

  • Keep your fees low. It’s not about active vs. passive, it’s about high fee vs. low fee. Future returns are not guaranteed, but your future fees will be, so keep them lower.
  • Diversify adequately (even within equities). During financial panics riskier assets tend to fall together, but this can be mitigated by having some portion of your portfolio in much safer assets (i.e. U.S. Treasuries or cash). However, during normal times you will notice that global equity markets display a wide range of outcomes. This implies you should diversify across these markets as well (Many thanks to Jake from EconomPic for helping me get this data. Follow him on Twitter):
  • Some strategies can beat the market, but they are difficult to stick with. For example, there is plenty of historical evidence for factor investing (smart beta) strategies that beat the market. However, these strategies will regularly experience bouts of underperformance, making them difficult to stay invested in. Remember, even Warren Buffett underperforms for shorter periods of time quite regularly. If you decide to invest some money using a smart beta strategy, set your expectations accordingly.
  • Investor behavior matters more than investment analysis. Your ability to (1) not sell during a panic and (2) acquire income producing assets on a fairly regular basis (i.e. consistent savings), will do far more for your investment success than your attempt to find the next Amazon. Investing is a highly emotional game, so I would argue that knowing your investing self is just as important as knowing your investment portfolio.

We Are Trying to Get the Message To You

Despite the barrage of gloom and doom that comes from parts of the financial media, there is a group of people trying to turn the tide so that this:

Fear > Evidence

becomes this:

Fear < Evidence

And this group will keep fighting the war between fear and evidence. Day in. Day out. One blog post. One podcast. One book. One chart at a time. We are out there and we are spreading the word. Or, as Metallica so boldly said in their debut album in 1983:

We are trying to get the message to you

Thank you for reading!

➤ You can follow Of Dollars And Data via Email (1 weekly newsletter), Twitter, Facebook, or Medium.

This is post 44. Any code I have related to this post can be found here with the same numbering: https://github.com/nmaggiulli/of-dollars-and-data

Disclaimer

The above references an opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice. The postings on this site are my own and do not necessarily reflect the views of my employer. Please read my “About” page for more information.

OfDollarsAndData.com is a participant in the Amazon Services LLC Associates Program, an affiliate advertising program designed to provide a means for sites to earn advertising fees by advertising and linking to Amazon.com and affiliated sites.

The War Between Fear and Evidence was originally published in Of Dollars And Data on Medium, where people are continuing the conversation by highlighting and responding to this story.

Is Bitcoin in the Optimal Portfolio?

Sáb, 10/21/2017 - 17:43
How A Little Bitcoin Goes a Long Way

The age of cryptocurrency is upon us and Bitcoin is leading the pack. If you don’t know what Bitcoin is, please explain your whereabouts over the last 6 months, or tell me where you keep your cryogenic sleep chamber. My friends, my friends’ friends, and all of the FinTwit (finance Twitter) universe have been ensnared in the jaws of cryptocurrency. As a result, I have decided to do some digging beyond my original Bitcoin post.

However, rather than explain Bitcoin or the blockchain, which Patrick O’ Shaughnessy’s Hash Power podcast has done beautifully, I want to discuss Bitcoin’s investment performance and the role it can play in your portfolio. To start, think about how you would answer the following question:

Does Bitcoin belong in an optimal portfolio?

Yes? No? If so, how much? If not, why not? It’s not easy to answer because you probably haven’t run the numbers. Well, thankfully, I have. Before I give you the punchline, let’s consider what the optimal portfolio actually is in this case:

Imagine it is September 2010. Bitcoin is just budding onto the scene and you have the next 7 years over which to invest. What asset class mix at that time would lead to the highest risk-adjusted return for the next 7 years?

Obviously, no one can know in advance what the optimal portfolio will be, but given we have historical data we can figure out what it would have been in hindsight. So, let’s look at asset class returns over the previous 7 years. To do this, consider the 1-month nominal returns on the following asset classes:

What you will notice is that Bitcoin is by far the most volatile asset class of those listed. What is even more striking is that for aesthetic reasons I had to exclude 13 observations for Bitcoin that had a monthly return greater than 50%. Please read that again. A monthly return greater than 50%. This is unheard of for an asset class.

In fact, Bitcoin had an average monthly return of 25% from September 2010 to September 2017 (highest among all assets listed). I understand that this is being heavily skewed by outliers, but its median monthly return is still 7% over this time period. This is crazy when you compare it to the 1.4% median monthly return of the S&P 500 over this same period. I understand that these two returns are not necessarily comparable for a host of reasons, however, the difference is striking.

But the question remains: with its volatility and high average returns, does Bitcoin offer value in the optimal portfolio? The answer is yes. Bitcoin does add value to a portfolio, but only when held in small doses. In other words, a little Bitcoin goes a long way. Specifically, I found that the optimal portfolio over September 2010 — September 2017 contained:

  • 54% U.S. Equities (Ticker = SPY)
  • 44% U.S. Long-Term Bonds (Ticker = VBLTX)
  • 2% Bitcoin

If we were to plot the efficient frontier (monthly return on y-axis and risk on x-axis) we would see Bitcoin is far from the optimal portfolio and unlike all other assets:

When I first saw this I thought I had made a programming error, but no. As I mentioned earlier, Bitcoin has averaged a 25% monthly return since inception. Even if we subset to 2015 and beyond, Bitcoin has had an average monthly return of 10% (or a 8% median monthly return) compared to ~1% for the S&P 500. Additionally, I included the “Gold Only” portfolio in the chart above to illustrate how differently Bitcoin has behaved when compared to Gold. Bitcoin is not the new Gold. It is some other beast entirely.

This chart leads to a bigger question though: why does the optimizer recommend holding such a small amount of Bitcoin in the optimal portfolio? It seems to me like Bitcoin’s volatility has a large negative impact on its inclusion in a portfolio. Therefore, the solver optimizes to include a little bit of Bitcoin for its highly positive returns, without adding much risk to the portfolio. Remember, Bitcoin has grown over 6000x since September 2010, compared with a little over 2x for the S&P 500. Who had the ability to buy and hold Bitcoin over this time period is a mystery to me.

Some Caveats About “Optimal” Portfolios

Before concluding I want to note some caveats about my optimal portfolio analysis.

  • Firstly, we only have 7 years of data. This is far from enough to draw any true long term conclusions about an asset’s behavior. While it is true that the distribution of asset class returns shift over time, I would argue that you need over a decade (and ideally 2+ decades) to start to understand the nature of an asset class. This is what makes Bitcoin so wild and intriguing right now.
  • Secondly, remember that the optimizer is only as good as its inputs. If we had more data or a different set of assets, the optimizer could give us a completely different solution. This is what makes optimizers so effective and so useless at the same time. It gives us the perfect solution to a problem we aren’t solving for anymore. Or, as Marshall McLuhan famously stated:
We look at the present through a rear-view mirror. We march backwards into the future.

Bitcoin for the the Next 7 Years?

I would be a fool to tell you that I knew where Bitcoin (or any other cryptocurrency was headed). Maybe it is a big bubble and I am analyzing something as useless as a tulip, or maybe this is the future of permission-less transactions that overthrows entire industries. Either way, I now have some evidence that Bitcoin might be worthy for investors, though in small doses. Remember, this is not me recommending you to go buy Bitcoin or any other cryptocurrency. Do plenty of research and think for yourself before you enter into any position.

Lastly, will we still be talking about cryptocurrencies 7 years from now? I have no idea, but I am excited to see how it plays out. Thank you for reading!

➤ You can follow Of Dollars And Data via Email (1 weekly newsletter), Twitter, Facebook, or Medium.

This is post 43. Any code I have related to this post can be found here with the same numbering: https://github.com/nmaggiulli/of-dollars-and-data

Disclaimer

The above references an opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice. The postings on this site are my own and do not necessarily reflect the views of my employer. Please read my “About” page for more information.

OfDollarsAndData.com is a participant in the Amazon Services LLC Associates Program, an affiliate advertising program designed to provide a means for sites to earn advertising fees by advertising and linking to Amazon.com and affiliated sites.

Is Bitcoin in the Optimal Portfolio? was originally published in Of Dollars And Data on Medium, where people are continuing the conversation by highlighting and responding to this story.

Shaking the Hourglass

Mar, 10/17/2017 - 11:31
On Time’s Role in InvestingPhoto: The Persistence of Memory (Salvador Dali)

Recently I finished an incredible book by Alan Lightman called Einstein’s Dreams. The book describes a series of short thought experiments about worlds in which time behaves differently from our own. Naturally, I thought it would be fun to imagine how investing might work in some of these alternate realities as well. I doubt any of my conclusions are “right”, so I ask you to think about what might happen in these worlds. Feel free to leave comments below. Enjoy!

The Immortals

A woman celebrates her 212th birthday, yet she is one of the younger members in society. A man says “I do” for the 36th time, but he isn’t even half way to his final marriage. Two friends meetup after having not talked in centuries. Ideas come and go, but people have not. Because, in this world:

Suppose that people live forever. (Lightman p. 91)

With the benefits of eternal life, the average investor invests more like a college endowment than a modern day retail investor. An infinite time horizon should have that effect. For example, how much of your portfolio (if any) would you put in bonds given that equities have always outperformed bonds historically? As a reminder, consider this chart from this post:

When you have all the time in the world, would you own anything other than “riskier” assets? Even if you lose money on them, you can make this up over decades (or centuries). I understand that there are liquidity arguments to be made here, but outside of that, the case for bonds seems weak.

However, it also seems possible that the historical relationship between stocks and bonds would break down in this new world. For example, I would guess that returns on riskier assets would fall somewhat. With more time to make up losses, investors should be willing to accept reduced returns as a result. This effect shouldn’t be particularly large, but it probably matters to some extent.

So where does this leave our hypothetical investors of eternity? They should experience lower aggregate returns on risky assets, and investors wanting higher returns would need to take on far more risk to get it (i.e. private equity, leverage, etc.). However, there might be other unanticipated effects of infinite life. For example, some individuals might give up investing altogether and live off of their labor for eternity (i.e. no need for retirement). Some may try get rich quick schemes until one finally worked. Some may become so rich that they are forced to redistribute their wealth if they pass some threshold. Who knows?

Flashforward

“AMZN $4,000” lit up the screen as the television host announced Amazon’s largest acquisition of 2020: Vanguard. The king of cheap had bought the king of cheap. Yet, before another word can be spoken, darkness ensues and the trader’s vision comes to an end.

This is a world of changed plans, sudden opportunities, of unexpected visions. For in this world, time flows not evenly, but fitfully and, as a consequence, people receive fitful glimpses of the future. (Lightman, p. 66)

Despite people experiencing random visions of the future, investing in this world would likely be very similar to our own. In our world, investors with inside information can trade on it (illegally) and they would be tough to notice unless they were a larger player in the market. How is this any different from trading based on a “vision” of the future? For example, it would be near impossible to tell insider trading from “vision” trades without a smoking gun, so markets would try to find these vision traders and capitalize on their signals, if possible.

Unfortunately, there are 2 elements that limit the financial success of visions. Firstly, not all visions are related to financial information, so most glimpses of the future would be irrelevant for making money. Secondly, some financially related visions would not be worth all that much.

For example, if I told you in October 2017 that the Dow Jones would be at 22,000 as of December 2018, how much money could you make off of that? Yes, you could buy put options today with the DJIA at ~22,800, but you have no idea when those options would be most valuable. Maybe you would get returns in the lower double digits off of this. I wouldn’t be complaining if I knew this, but this information is unlikely to make me filthy rich either.

Some of the best future financial information you could get, on the long side, would be the price of some currently small, publicly traded company. You could buy call options and wait it out. Without hyperinflation or some insane reverse stock split scheme, this would likely work well. The only thing better might be a vision of the winning lottery numbers. Good luck with that.

Concentric Dilation

They all stood frozen around the grand clock. Not a heart seemed to be beating, but they were beating…very…slowly. If you averted your gaze outward from the clock, you would see people moving at increasingly faster speeds. At the furthest points away from the clock, people would seem to move like a flash of light.

From this place, time travels outward in concentric circles — at rest at the center, slowly picking up speed at greater diameters. (Lightman, p. 54)

What does this world of concentric time mean for our average investor? This should depend on their goals. Younger investors may decide to take advantage of the time dilation present in this world by investing in a portfolio at the outskirts then traveling toward the center. Since time passes more slowly in the center, these young investors will age very little while their portfolios experience centuries of growth. Genius, right?

Wrong. The only problem with this idea is that everyone else would be trying this as well. If everyone is running around through time trying to get rich, who is actually doing the work to grow the economy at the outskirts? It is obviously a logical flaw. I tried to imagine the steady state scenario of this world, but, frankly, it is beyond me. I have no idea how society would organize itself with the ability to travel forward (but not backward) in time very quickly. What do you think?

This “Time” is Different

Investing and time will forever be linked together. What is investing but the sacrifice of current consumption in expectation of increased future consumption? Investors who want to get rich quickly tend to forget this truism and the importance of being patient. I understand this, but even I am surprised by the time horizons over which some of the greatest investors tend to think.

For example, I recently asked a question on Twitter about 20 year returns for a variety of asset classes and Corey Hoffstein, a quantitatively focused investor, replied:

20-years is a short period.

I was shocked by his response. How so? 20 years is at least a third of my investing life. How can this be short? But…he is right. This is the kind of thinking that I have seen time and time again by the wisest investors. Jason Zweig once spoke about how he measures his investment time horizon “in centuries” and Benjamin Franklin left money in his will to the cities of Boston and Philadelphia with a stipulation that it compound for 100 years before first being drawn upon. When you think about time over longer periods, investing seems much simpler and the payoff much more obvious.

I hope you enjoyed these thought experiments. If you want to read more about, I highly recommend Einstein’s Dreams by Alan Lightman. I will be back to my usual charting self next week. Thank you for reading!

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➤ You can follow Of Dollars And Data via Email (1 weekly newsletter), Twitter, Facebook, or Medium.

This is post 42. Any code I have related to this post can be found here with the same numbering: https://github.com/nmaggiulli/of-dollars-and-data

Disclaimer

The above references an opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice. The postings on this site are my own and do not necessarily reflect the views of my employer. Please read my “About” page for more information.

OfDollarsAndData.com is a participant in the Amazon Services LLC Associates Program, an affiliate advertising program designed to provide a means for sites to earn advertising fees by advertising and linking to Amazon.com and affiliated sites.

Shaking the Hourglass was originally published in Of Dollars And Data on Medium, where people are continuing the conversation by highlighting and responding to this story.

Losing With a Winning Hand

Mar, 10/10/2017 - 12:47
The Nature of Underperformance and Why it Pays to WaitPhoto: Pixabay

It was late 1999 and Warren Buffett had experienced his worst year in a decade. While the S&P 500 was up over 20%, Berkshire Hathaway’s stock price was down 20%. Some started to believe that Buffett had lost his magic touch. An article titled “What’s Wrong, Warren?” from late 1999 captures this sentiment:

Indeed, Buffett has even started taking flak on Internet message boards. One contributor called Berkshire a “middlebrow insurance company studded with a bizarre melange of assets, including candy stores,hamburger stands, jewelry shops, a shoemaker and a third-rate encyclopedia company [the World Book].”

Some had begun to feel that Warren Buffett was an old man who was out of touch with the internet economy of the late 1990s. But you already know how this story ends. In the 3 years that followed, Berkshire’s stock increased in value by 29% while the S&P 500 lost 37% by the end of 2002. The Oracle of Omaha had the last laugh.

This story illustrates how, despite being one of the best money managers of all time, Warren Buffett still has periods of underperformance. Ben Carlson summarized this idea well with a table showing Berkshire’s largest price declines since 1980:

As you can see, Berkshire has temporary declined in value 30–50% multiple times in the last few decades. The question is: If Warren Buffett has periods of underperformance, why would you expect anything differently for your personal portfolio?

This question is important because if you understand the nature of underperformance, you are more likely to hold onto asset classes that perform poorly in the short run. Let me illustrate this using some data.

Back in January of this year I wrote a post about asset allocation that computed the optimal portfolio using data on 9 different asset classes over the period of 1976–2016. I found that the portfolio with the highest risk-adjusted return over this time period contained:

  • 34% U.S. Treasury 10 year Bonds
  • 29% S&P 500
  • 24% REIT (real estate investment trust)
  • 10% Gold
  • 3% International Stocks (developed markets)

You might think that after “data mining” this portfolio you would have incredible performance and few losses, but you would be wrong. While this portfolio has real returns of 7% a year with a 9% standard deviation, it still loses money in 25% of all years. For comparison, the S&P 500 had a 9% real return with a 16% standard deviation over this period:

Though this portfolio underperforms the S&P 500 by 2% each year, it has far less risk as illustrated by its smaller annual losses and lower standard deviation. What is even more intriguing is that while this portfolio only contains 5 asset classes, in any given year 2 of them are likely to lose money. Think about what this means. Even when we cheat and mathematically compute the optimal portfolio using historical data, we will still have assets that underperform regularly. In fact, this optimal portfolio has at least 1 asset class that loses money in 75% of all years and 2 or more asset classes that lose money in half of all years.

Why does this matter to you? Because if we see this level of individual underperformance when we know the future, imagine what might happen to your portfolio given we don’t know the future. Knowing that some of your assets will underperform can help you to stay the course. If you still are skeptical, I am going to take this idea one level deeper by having us play a coin flipping game.

Demonstrating Underperformance via Coin Flips

Imagine I have a rigged coin that comes up heads 60% of the time and tails 40% of the time. I will say that this coin has a 10% “edge” for heads, where “edge” is defined any percentage above 50%. Let’s also imagine that you are going to place bets based on the outcome of the coin flip, and I will pay you even odds on the outcome (i.e. if you bet $1 and win you get $2 back, if you bet $1 and lose you get $0 back). Given you will always bet heads (trust me on this), what is the optimal bet size to maximize your return over many rounds of this game?

Rather than getting into the complexity of the math, which you can read about here, the optimal bet in this game will be 2 * your edge. So with an edge of 10% for heads, you should always bet 20% of your bankroll on heads. For example, if you start with $100, you would bet $20 on your first flip. If the first flip comes up heads, you win $20 and now have $120. You would then bet $24 (20% * $120) on heads in the next round, etc.

At the extremes this strategy makes sense. For example, with a 0% edge (i.e. a fair coin with a 50% chance of heads) you should not play since 2 * your edge = 0. With a 50% edge (i.e. the coin always lands heads), you should always bet 100% of your bankroll on heads for every flip since 2 * your edge = 100%.

Despite following the optimal betting strategy I outlined above, we can still underperform over shorter periods of time due to chance alone. For example, let’s imagine doing 100 coin flips of the 60% heads coin and betting different amounts (10% to 50%) on heads for each flip. As you can see, in this particular simulation, betting 10% of your bankroll in each flip outperforms betting 20% for the first 100 flips:

But, we know mathematically that 10% is not the optimal bet size, 20% is the optimal bet size. By chance, we had a lot of tails early on in this simulation and lost out. However, if we extend the number of flips, the optimal strategy emerges:

As you can see, over longer periods, the betting 20% of your bankroll strategy is ideal. For those of you that are wondering why the 50% strategy goes to 0, this is because we assume that your bankroll rounds to $0 if you only have $0.01 left and lose. Betting 50% of your bankroll is too aggressive for this particular coin as too many tails in a short period will bankrupt you. However, betting too little (<20%) is also sub-optimal as you don’t take full advantage of your edge.

Underperformance Should Be Expected

I hope that the coin flip example was useful in demonstrating that even when we know we are behaving optimally, we may not always get the best results. This is especially true with investing where a diversified portfolio of broad asset classes with low fees can have periods of underperformance. Some of your individual asset classes are likely to lose money in every year, but you should expect this. If everything you own is moving up all of the time, maybe your assets are too correlated and the next crash will be particularly ugly.

I wanted to reiterate this point because I know the psychological feeling of seeing an asset underperform. Back in 2013, before I knew much about investing, I sold all of my bonds and was 100% stock because bonds had lost money while the S&P 500 was up 32% that year. I knew the value of having bonds for diversification, but I still made this decision because I hated the feeling of underperforming. I got lucky that stocks didn’t crash before I added bonds back into my portfolio, but I have since learned to accept underperformance as a necessary part of a well-built portfolio. I hope you can realize that bouts of poor performance will happen to you, and everyone else, as well.

Lastly, if you enjoyed the coin flipping/betting ideas and want to read about a pioneer in investing and betting, I highly recommend Ed Thorpe’s A Man for All Markets. Thank you for reading!

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This is post 41. Any code I have related to this post can be found here with the same numbering: https://github.com/nmaggiulli/of-dollars-and-data

Disclaimer

The above references an opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice. The postings on this site are my own and do not necessarily reflect the views of my employer. Please read my “About” page for more information.

OfDollarsAndData.com is a participant in the Amazon Services LLC Associates Program, an affiliate advertising program designed to provide a means for sites to earn advertising fees by advertising and linking to Amazon.com and affiliated sites.

Losing With a Winning Hand was originally published in Of Dollars And Data on Medium, where people are continuing the conversation by highlighting and responding to this story.

Find What You Do

Mar, 10/03/2017 - 12:41
On Finding Your Purpose and the Beauty in InvestingPhoto: Pixabay

Mark Zuckerberg was once asked what he thought of The Social Network, the film that tells the beginnings of Facebook. Mark laughed and said he was amazed at how many little things the filmmakers got perfectly right, while also getting the major plot points completely wrong. For example, Mark recalled how every piece of clothing in the film was an exact replica of clothing he actually owned, yet his motivation for starting Facebook had nothing to do with chasing a girl. For the record, Mark met his current wife Priscilla before he started FB. Mark elaborates on this point (emphasis mine):

They frame it as if the whole reason for making Facebook and building something was because I wanted to get girls or because I wanted to get into some kind of social institution…They just can’t wrap their head around the idea that someone might build something because they like building things.

I like this quote because it embodies Mark and everything he stands for. He builds things with computers. That is what he does. He did it at Harvard and he did it at Facebook. Everyday he continues to build the largest community in human history with the help of dedicated employees, lines of computer code, and large metal servers. But, I’m not here to talk about Facebook or Mark Zuckerberg.

I am here to ask YOU to find what you do. This isn’t an easy task, and it may take years before you find it, but I promise that it is out there. And no I don’t want you to think of this as solely “finding your passion.” That phrase, which I have used many times previously, is so overused that the “passion” feels all but extinguished at this point. I am talking about finding what you do. This is a far more aggressive form of discovering your purpose on this planet. I can’t tell you exactly how to do it, but I can try to illustrate what it feels like when you find it. How? By telling you about what I do.

So what do I do?

I make financial data come to life using visualizations. I turn cold, hard facts into vibrant, flowing charts. I do all of this in the hopes of explaining a complex financial topic in a much simpler manner. My goal is to make you see something you hadn’t seen before. While I don’t always accomplish this goal every week for every reader, I do hope that, occasionally, you come away amazed.

For example, consider the 1 year real returns for 9 different asset classes from 1976–2016. I could make you a table with the average return and standard deviation for each asset class.

Or, I could show you this:

Which one do you think is more effective in allowing you to compare asset classes and get an understanding for their risk and reward? Don’t get me wrong, the point estimates are useful, but distributions are far more intuitive.

And this is just the beginning. What if I wanted to use this same data to ask a bigger question? What if I wanted to know what the long term returns of these assets looked like? If we plot the 20 year annualized real returns for these same asset classes, a different picture emerges:

With this level of aggregation we can draw many more useful conclusions. For example, we can clearly see that commodities have had negative real returns over longer periods of time and that the return on U.S. housing is close to 0%. So much for the American dream, right?

And this is just the tip of the iceberg. I could take this one chart and run with it in different ways. I could ask why the bond-like instruments have a bell shaped distribution while the equities do not. Or, I could ponder why REITs have performed so well or why gold has the widest distribution of returns.

And, just for fun, I can do something like this:

This animation doesn’t necessarily have a big point (i.e. things move toward their average return as the holding period increases), but it looks sick.

So why am I telling you this? Because, when you look at something differently than the rest of the world, that is when you have found your purpose. When you see beauty in what others may see as mundane, pay attention. That’s your calling. I don’t know whether it will be finance or art or comedy or music or whatever, but YOU will know.

In my case, while most of the world may see investing as all about money and greed, I could not disagree more. Investing is the grand equalizer of the world. It does not care about your gender, race, religion, sexual orientation, or any other aspect of your identity. Market returns do not discriminate. Gains and losses are shared without prejudice. And, no matter how smart you are, you cannot outsmart the market consistently. This fact is humbling and showcases the incredible power of the market. It is amazing to me how the market acts more like a biological system than almost anything humans have ever created. The market has fractal properties and it’s always evolving. Morgan Housel calls it the unsolvable puzzle.

But, more than just that, investing and the markets reflect stories that encompass all of modern history. Consider this chart of the U.S. stock market that displays the real returns with dividends for the 20th century and for the 21st century (thus far). Note the y-axis is a log scale:

Each line with its many peaks and valleys contains the influence of hundreds of millions of individuals making trillions upon trillions of collective decisions. War, peace, life, death, innovation, destruction, division, and cooperation. They all exist in the chaotic lines above. Despite all of that chaos, there is incredible beauty. Why? Because the story of markets over the last few hundred years is a story of massive human cooperation. I have discussed this idea before here, but I cannot restate its importance enough. By investing, you are participating in the very act that is bringing about increased human cooperation and improved well being around the globe. You are helping businesses to employ individuals and, hopefully, make their employees’ lives better. While the system is far from perfect, especially at distributing the gains, things will get better with time.

You may not see it like I see it, but that’s okay. Either way, I want you to go out and find that thing that you see differently. Find the thing that you want to show the world. If you really think about it, there is nothing stopping you. Find what you do. Thank you for reading!

➤ If you liked this post, please consider sharing on Twitter, Facebook, or LinkedIn.

➤ You can follow Of Dollars And Data via Email (1 weekly newsletter), Twitter, Facebook, or Medium.

This is post 40. Any code I have related to this post can be found here with the same numbering: https://github.com/nmaggiulli/of-dollars-and-data

Disclaimer

The above references an opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice. The postings on this site are my own and do not necessarily reflect the views of my employer. Please read my “About” page for more information.

OfDollarsAndData.com is a participant in the Amazon Services LLC Associates Program, an affiliate advertising program designed to provide a means for sites to earn advertising fees by advertising and linking to Amazon.com and affiliated sites.

Find What You Do was originally published in Of Dollars And Data on Medium, where people are continuing the conversation by highlighting and responding to this story.

Alaska’s Crude Truth about Growing Dividends

Mar, 09/26/2017 - 13:00

What happens if you treat your stake of the oil wealth — through the Alaska Permanent Fund Dividend — as a long-term resource?

At this time of year in Alaska, the light is slipping away as the long winter sets in. However, a bright spot comes on October 5th when every man, woman, and child in Alaska receives $1,100 dollars from the Alaska government. Why? The Alaska Permanent Fund Dividend (PFD). The PFD provides an annual distribution of earnings derived from state oil revenues that have been reinvested in global markets.

The western Alaska city of Bethel, pictured in January 2017, is a hub for people who live in small communities without many jobs and depend on the Permanent Fund Dividend to keep their homes warm. Photo by Ben Matheson.

The fund owns an incredibly broad global portfolio of assets worth about $60 billion. This includes stocks, shopping malls in suburban Washington D.C., Israeli private equity, venture capital (we own a small portion of Snapchat), infrastructure, and complex financial products like mezzanine debt.

Each year, the dividend is calculated based on a five-year rolling average of realized earnings. The highest dividend on record was $2,072 in 2015. Thanks to the billions of barrels of oil on state lands, Alaskans enjoy the annual dividend and are exempt from a state income tax. However, after oil prices cratered in 2014, the state found itself digging deep into saving accounts and setting the groundwork for systematic withdrawals from the PFD. The governor vetoed half the dividend last year, and the legislature reached a compromise of value of $1,100 per resident this year.

A common nugget that makes the rounds in Alaska each fall is the total amount of money paid out by the fund since inception. As of 2016, if you had received every dividend since 1982, you would have a total of $40,121. While this isn’t chump change, it dramatically understates the true value of the dividend and serves as a powerful and relevant example of the time value of money.

What if you were fortunate enough to have squirreled away each dividend in the stock market, specifically a generic, low-cost S&P 500 index fund and then never touched it?

I built a simulation to show the growth of an Alaskan’s capital if they had invested the annual dividends in a simple S&P 500 index fund and left it alone to grow.

The results are impressive. A 35-year-old today, who was just an infant in 1982, would have grown their money to a tidy sum of $220,136 by 2016. This late Millennial had the benefit of the bull market of the late 90s.

A ten-year-old born in 2007 experienced a far different set of market conditions. Though they were born just as the housing market overheated and plunged financial markets into the Great Recession, they would still have $25,089 if they had bought and held:

Those without the benefit of the Alaska Permanent Fund Dividend still have the option to approach an unexpected windfall like a bonus, inheritance, or surprising tax return in a way that creates future value without impacting their standard of living. We may not all receive oil money, but we all have a chance to turn a nonrenewable resource into a renewable one.

This annual massive influx of around $700 million (or nearly double that in the highest dividend years) into Alaska’s small economy is well-anticipated by businesses eager to score a chunk of the pie. Alaska Airlines rolls out a sale for tickets to Hawaii, while snowmobile dealers entice people to put their check into a down payment and ride off in a new rig. A local event known as the PFD Travel Fair (put on by the travel industry) celebrates the dividend and volunteers for helping you spend your dividend on the right tickets: “our job is to help you make the most of your PFD Travel budget.” While Alaskans have pushed back even on the concept of studying the PFD in recent decades, there is a growing body of literature and media attention dedicated to exploring how Alaskans spend, save or otherwise use the dividend.

A bush pilot approaches the Kuskokwim village of Tuluksak. Rural Alaskans live in a region with an extremely high cost of living and limited economic opportunity. The PFD plays an outsized role in many families’ annual budgets.

40 percent of Alaskans reported planning to spend all of their PFD, according to a survey by Northern Economics, though more than two thirds of the spenders said it would be going towards bills. 20 percent claimed to be planning to save the full value of their dividend.

Emeritus Professor Scott Goldsmith of the University of Alaska Anchorage has studied the PFD as long as anyone and points to conflicting data on how the dividend is spent and saved. However, any observer of the Alaska economy knows that retailers capture a significant piece of Alaskans’ checks.

“There is no evidence that the cumulative saving of dividends has resulted in a significant accumulation of wealth or provided a base of assets, or ‘grubstake’ as we say in Alaska, leading to private sector investments generating economic development,” wrote Goldsmith.

Studies using hard data are beginning to emerge: Lorenz Kueng of Northwestern leveraged data from a personal finance website that tracks individual spending through credit card records and bank accounts (think a Mint-style site) and found that the average households breaks from the expected pattern of regular, normalized spending and burns about a third of the dividend on non-durable items in the three months after the dividend arrives. Curiously, he found that higher income households are more likely to spend than lower income households, although lower income households with little liquid wealth (low bank account balances) are more likely to spend than those with liquidity. Still, high income households strongly respond to the dividend payments each October.

Knowing that the oil will one day run out (the pipeline is running at one-quarter capacity and may be shut down in future decades if engineers can’t keep the oil flowing at lower rates), many believe that converting a nonrenewable resource (oil) into a renewable one (financial assets) is prudent to share the wealth across multiple generations. Others hold the dividend as intended to be a citizens’ check on government spending. But the social impacts are part of the debate: in rural areas reachable only by small plane, the injection of cash is critical for families largely surviving off foods they harvest from the land: moose, caribou, berries, and even seals and whales. It buys heating oil, snowmobile parts, and tools essential for the traditional lifestyle.

Alaskans often see the dividend as a simple payment due to members of the “owner state.” Just as oil companies pay a North Dakota farmer a royalty for each barrel of oil extracted, the drillers pay the state government for oil pulled directly from state lands before sending it down the Trans-Alaska pipeline. A quarter of this royalty is constitutionally protected in the Permanent Fund. After the money grows in the market, the royalty payment goes to the actual owners: Alaska residents. But others are eyeing the PFD as a model for an uncertain economic future.

As part of his journey to visit all 50 states, Faceboook founder Mark Zuckerberg visited Alaska and highlighted how similar the PFD is to a system of universal basic income(UBI). That is, a regular, unconditional amount of money that each person receives no matter their economic status.

As sophisticated algorithms, artificial intelligence, and robots replace work once thought to be the exclusive domain of people, economists and technologists anticipate a future in which millions of able-bodied people are out of jobs and the profits are funneled to a narrow set of tech companies. Taxing robots or wealth to deliver a basic standard of living is an idea for maintaining a stable society — one that has reached the forefront of politics. In Hillary Clinton’s new book, the former Democratic nominee reveals that she explored extending Alaska’s system nationally to tax financial transactions and ultimately name a basic income program after the state.

For those living on the lowest incomes, the difference of $1,000 — $2,000 a year can be huge, especially as a family with children receives dividends for each child. University of Alaska Anchorage economists Matthew Berman and Random Reamey showed that the dividend has lifted 15,000 to 25,000 Alaskans out of poverty each year and estimate that getting rid of the PFD would boost the number children living in poverty by a third.

The societal-level benefits and costs of large-scale UBI-style programs will be determined in years to come. At an individual level, those with the ability to save and invest their annual checks (or other significant influxes of money) have a tremendous opportunity to grow a modest one-time sum into a much larger amount of capital.

The Alaska experiment may be ongoing, but the evidence for powerful personal investment growth is stretching towards four decades as Alaskans have a chance to turn non-renewable oil wealth into diversified and arguably more renewable assets.

Notes:

The code for the PFD investment calculator is built in JavaScript (React) and is available here, along with additional analysis and plotting done in R.

https://github.com/benmatheson/PFD_invest_simulation

Alaska’s Crude Truth about Growing Dividends was originally published in Of Dollars And Data on Medium, where people are continuing the conversation by highlighting and responding to this story.