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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!

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

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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!

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

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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.

And the Crowd Goes Wild…

Mar, 09/19/2017 - 12:55
On the Wisdom and Madness of CrowdsPhoto: PixabayWhen the markets fall and the streets run red, the lone wolf survives, but the pack dies.

In 1906, the British scientist Francis Galton made a discovery that would forever change our knowledge about group decision making. Before his revelation, Galton was of the opinion that the future of society could not be trusted to the less educated masses. He believed that a few select individuals were far better for the job. In order to test his hypothesis, Galton had people from all walks of life guess the weight of an ox at a country fair. After collecting 787 guesses and calculating the average, he realized the masses weren’t so dumb after all. Their collective guess was within 1 pound of the true weight. The Wisdom of Crowds by James Surowiecki shares Galton’s reaction to this discovery:

The result seems more creditable to the trustworthiness of a democratic judgment than might have been expected.

Ever since Galton’s realization, the evidence has been building for the wisdom of the crowd. This is especially true in investing, where markets behave in an efficient manner most of the time. Therefore, it is usually in your best interest to follow the crowd (i.e. accept market prices as fairly accurate). And why wouldn’t you? Social proof, as Robert Cialdini refers to it, is one of the most powerful psychological influences. This elevator prank and the Asch conformity experiments illustrate this well. However, though following the crowd will benefit you most of your life, it can also lead to financial ruin in particular moments. And that is what I want to talk about today.

When Crowds Get it Wrong

Despite the overwhelming evidence that the market is usually correct, there have been a handful of cases where the market consensus was grossly inaccurate. These errors typically occur during moments of high emotion (i.e. fear or greed) and they defy logic. As Edward Chancellor wrote in Devil Take the Hindmost (emphasis mine):

In his Theory of Cognitive Dissonance, Leon Festinger argued that people will tolerate increasing degrees of dissonance if they are motivated by a sufficiently enticing reward…A description of speculators in William Fowler’s circle during the 1860s provides an illustration of this behavior. They were engaged, wrote Fowler, “in bolstering each other up, not for money, for we thought ourselves impregnable in that respect, but by argument in favor of another rise. We knew we were wrong, but tried to convince ourselves that we were right.”

These kinds of errors occur when individual beliefs are lost in favor of the group’s beliefs. Gustav Le Bon summarized this idea beautifully in The Crowd: A Study of the Popular Mind:

The most striking peculiarity presented by a psychological crowd is the following: Whoever be the individuals that compose it, however like or unlike be their mode of life, their occupations, their character, or their intelligence, the fact that they have been transformed into a crowd puts them in possession of a sort of collective mind which makes them feel, think, and act in a manner quite different from that in which each individual of them would feel, think, and act were he in a state of isolation.

When the crowd starts to behave erratically and you start seeing behavior that you haven’t seen before, look out. See exhibit A:

LOL

For another example of crowd madness, let’s consider the tech bubble of the late 1990s. When looking at sentiment readings from the American Association of Individual Investors (AAII), bullishness hit a peak in early 2000, shortly before the bubble began to burst:

The mistaken bullishness on the part of the market is completely explained by the high expectations (i.e. hope/greed) of that era. However, the crowd can also get it wrong in the other direction as well. For example, the market bottom during the Great Recession in March 2009 coincides with some of the highest bearish sentiment on record:

This doesn’t imply that you can look at sentiment alone and figure out what the stock market is going to do next, however, sentiment may provide insight as to when markets are not behaving normally. As Cliff Asness from AQR capital stated:

I kinda get excited these days at the 150th percentile…to me [this represents] something that we’ve never seen before. I made this up, but it’s 150% of the prior 100th percentile.

When you are seeing multiple indicators at their extremes, you should take notice. I am not implying that you should change your actions, but realize that this is the same herd behavior that has dominated markets for centuries. Why is this important? Because when you can recognize that the crowd is mad, you can prevent yourself from following along and making large investment errors (i.e. selling during a panic). I don’t consider buying during a bubble to be an investment error because bubbles can take years to form. The foregone gains by waiting on the sidelines could be worse than the losses during the subsequent decline.

How to Resist the Crowd During Times of Panic

So how do you resist the madness of the crowd? Don’t deviate from your investment philosophy. My investment philosophy is more or less just keep buying and avoid risky assets that are not equities (i.e. gold, commodities, cryptocurrency). Don’t get me wrong, it can be hard to follow this when the social pressures start to mount. For example, I have a friend who invested 5% of his net worth in Bitcoin years ago. In the last few months his Bitcoin has grown to over 50% of his net worth. He is beating me. Maybe he is lucky. Maybe he is smarter than me. I don’t know, but I am not going to change what I do based on what the crowd is doing. Or, as a re-imagined Game of Thrones quote:

When the markets fall and the streets run red, the lone wolf survives, but the pack dies.

Be the lone wolf. 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 39. 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.

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

Know Thy Investing Self

Mar, 09/12/2017 - 12:49
Why I Sold All of My Gold and Won’t Look Back

There is a great line that comes from Adam Smith’s The Money Game:

The first thing you have to know is yourself. A man who knows himself can step outside himself and watch his own reactions like an observer.

Knowing yourself as an investor will be far more important for your long term results than even the most perfect portfolio. Why? Investing is primarily a behavioral exercise, not an analytical one. Despite all of the “data” that Of Dollars And Data prides itself on displaying, behavior beats analytics in the investment world. To demonstrate the importance of this, I am going to tell you a personal story about my history with one asset in particular: gold.

I used to hold 5% of my net worth in gold, but after examining the data and questioning myself, I realized I had to get out. Why was I in gold to begin with? There is some evidence that gold can play an important role in a portfolio due to its lower correlation with equities and bonds. When the S&P 500 goes zig, gold generally goes zag. As a result, there is a small rebalancing bonus that you could have earned, historically, by holding some gold. I have written about this previously here, and Jake from EconomPicData described the idea of the rebalancing bonus with volatile assets beautifully here.

However, though it plays well in a portfolio, gold is a very volatile asset by itself. For example, consider it’s real returns by year:

The highest one year real return for gold since 1976 is 120% and the lowest is -41%. More importantly, you will notice that gold can have long stretches of negative returns. To be exact, from 1981 it took ~32 years before gold was back at its all time high, adjusted for inflation:

And that is why I had to get out of gold as a long term investment. I saw this chart and said, “Nope.” Can you imagine having 5% of your net worth in an asset while watching it drop by 75% in value over the course of multiple decades? I realized I could not and I sold last week, thankfully, at a profit. The fact that I have gone back and forth on gold a few times over the last few years illustrates why I shouldn’t own anything this volatile. I have accepted my nature as an investor and will ignore gold as a long term investment for the rest of my life — rebalancing bonus be damned.

Ironically, Michael Batnick, my favorite investment writer, recently put 10% of his net worth into gold as short term investment based on pricing trends. Gold is currently down ~25% from its 2013 high. Will it recover to its 2013 high and beyond, or will the drawdown continue for another few decades? I have no idea, however, I don’t have the same investing discipline as Michael and I know this. My decision to abandon gold could either work out in my favor, or be an expensive mistake. But, I’m okay with that.

How to Know Your Investing Self Better

The problem with trying to know your investing self is that you have so few data points to go on. Large market drawdowns happen rarely, and some investors, myself included, have never experienced anything of this magnitude. Despite the difficulty in determining how you will react to a 30%, 40%, or 50%+ decline in equity markets, there are likely clues in your behavior. For example, consider the following questions:

  • Do comments about the stock market from your friends/colleagues make you want to check my portfolio?
  • If you lost $X (where X is 50% of your equity allocation), would you feel okay still owning stocks? Note this has to be done in actual $ terms not in percentage terms. Losing 50% sounds bad, but losing $500,000 sounds far worse. Always convert to dollars when thinking about losses.
  • What kind of event would have to occur for you to sell (i.e. full fledged nuclear war, super volcano eruption, etc.)? This sounds extreme, but it may get you thinking about how you would feel so you can admit if you have a selling point.
  • Are there any assets that you could never own based on their volatility?

Despite all of the questions above, it will still be difficult to know your investing self. Or, as Fred Schwed once said:

Like all of life’s rich emotional experiences, the full flavor of losing money cannot be conveyed by literature.

While investing with real money may be the only way to actually understand your investment nature, I don’t recommend doing anything that could ruin you financially. However, taking a small percentage of your portfolio and putting it into more volatile assets may be worth the investment, even if you incur small losses. The knowledge you gain from this exercise could save you far more in the future. Best of luck in finding your true investment self and thank you for reading!

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

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This is post 38. 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.

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

The Cobra Effect

Mar, 09/05/2017 - 12:50
The Law of Unintended Consequences and the Risk of Owning BondsPhoto: Pixabay

When the British occupied India under colonial rule in the mid to late nineteenth century, they had a problem — Cobras. These venomous snakes were numerous in India and, unsurprisingly, the British were not fond of them. As a result, the British government set up a program by which they would pay anyone to bring them a dead cobra. Initially, this worked wonders as dead cobras started flooding in. However, after some time, the British discovered that some of the Indians had played a trick on them.

Indians looking to cash in on the cobra buyback program setup cobra farms to breed cobras. These cobras were killed and given to the British for the bounty. As soon as the British discovered this cobra farming scheme, they ended the buyback program. Indian cobra farmers, with no other use for the cobras, abandoned their operations and set the cobras free. As a result, the number of cobras in India increased.

This is called the cobra effect and perfectly illustrates the law of unintended consequences. While no one knows if this story is true, there are plenty of examples that mirror its result, namely, individuals making decisions to cause one outcome to occur can accidentally cause the opposite. The cobra effect is hard to foresee before hand and appears quite often in the investing world. And that is what I am here to talk about today.

If we took a high level tour of the greatest investing blunders of all time, I would argue that they all suffered from the cobra effect. Given that the strict objective of investing is to get wealthier, I cannot imagine a more unintended outcome than losing vast sums of money. However, I don’t want to talk about get rich quick schemes or penny stocks. The cobra I want to talk about today is bonds.

What words come to your mind when I say “bonds”? Safety? Low risk? Principal preservation? These are all generally true…in the short run. Over longer periods of time, bonds have simply been ineffective at building wealth. And with today’s very low yields, your return on bonds after inflation and taxes is essentially 0%. So, unless you require 0% returns going forward (i.e. you have more money than you could ever need), you need to hold ample amount of equities. For example, the average real return on 10-year U.S. bonds from 1928–2016 was 2%:

While this isn’t 0%, this 2% is being heavily skewed by the higher bond returns starting in the early 1980s. If we look at the returns by decade you can see that for 4 decades, starting in 1940 and ending in the late 1970s, annualized bond returns were negative or close to 0%!

As you can see, besides the 1980s where bond yields were through the roof, the long term record for bonds is quite unimpressive. Therefore, all of your long term capital preservation and growth will need to come via equities or equity-like investments (i.e. REITs, etc.).

So how does the cobra effect occur with bonds? Retirees, scared of losing principal, might shift all of their assets into CDs and Treasuries for “safety.” For the first decade or so 100% in bonds works fine, but, as the retiree ages, the scourge of inflation and taxes slowly dwindle away their nest age and the probability of running out of money starts to sky rocket. The decision to provide safety has made the retiree less safe in the long run. Nick Murray puts it best in his book Simple Wealth, Inevitable Wealth:

You can have blissful emotional and financial security on this end of your remaining lifetime — right here, right now. We’ll get you some money market funds, a six-month CD, Treasury bills, and maybe some very high grade corporate bonds maturing in the next five years. The number of currency units you’ve got will hardly fluctuate at all. You’ll get a little current income, and you will sleep like a baby. Of course, one day — and that day may not come for twenty years or more — you’ll run out of money. Perfect security on this end of your investing lifetime; total insecurity (indeed, disaster) on the other end.

He continues (emphasis his):

There is no such thing as no risk. There’s only this choice of what to risk, and when to risk it.

The risk of owning bonds shows up later in your investment life, while the risk of owning equities can show up much earlier. And why should we expect anything different? As someone who wants to build and keep wealth, you should expect to go through a handful of periods where you might be down 40%+. This is the nature of investing. If you don’t want the volatility, then you deserve the meager result you will surely obtain. In the case of a 100% bond portfolio, we could re-imagine a famous Benjamin Franklin quote:

Those who give up return for security deserve neither return nor security.

How To Use Bonds Effectively

For the record, I am not against holding bonds in a portfolio. I am just against holding 100% bonds, unless you have sufficient capital such that your returns don’t matter. I also can’t tell you what % of your portfolio should be in bonds, as this would require me to know your goals, temperament, and individual circumstances. However, I can say with some level of certainty that bonds will not be a builder of wealth going forward.

Despite the bad rap I have given to bonds, I do think there are effective ways of using them. For example, I currently hold ~20% of my net worth in bonds though I am only 27. Some might say that is stupid given the amount of time I have for equity compounding, but I hold bonds for 2 reasons:

  1. To dampen volatility during downturns.
  2. As a form of liquidity to rebalance back into stocks during these downturns.

Since investing is primarily a behavioral exercise, not an analytical one, bonds can act as a form of insurance against panicking when there is blood in the streets. The fact is that I don’t know how I will react during a 30%+ drawdown, since I haven’t experienced one yet. Therefore, I am using my bonds as an experiment on myself to see how I will react when a larger drawdown does eventually occur. If I play it cool, I will likely reduce my bond exposure in the future. The key is to know yourself as an investor. 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 37. 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 Cobra Effect was originally published in Of Dollars And Data on Medium, where people are continuing the conversation by highlighting and responding to this story.

Falling Fast and Rising Slow

Mar, 08/29/2017 - 12:59
On the Nature of Equity Price Declines and RecoveriesPhoto: Pixabay

This week’s post concerns something that is well known to many investors: stock prices fall quickly and recover slowly. However, my real question is: how long, on average, does it take for the decline and subsequent recovery to occur?

To begin, let’s consider the following thought experiment:

Imagine you are magically transported to some month between 1920 and 2016 where the U.S. stock market just hit an all time high and we know with certainty that the market is going to drop 20% (i.e. a 20% drawdown) in the very near future. My question is:How long, on average, would it take before you were down 20%?And the more important follow-up question: Once you are down 20%, how long will it take to recover (i.e. reach a new all time high)?

I used Shiller’s U.S. stock market data and found that it would take, on average, 7 months before you declined 20% or more and 6 years to recover from that decline. The asymmetry in the results might surprise you, but you need to remember that once you have experienced a 20% drawdown, the market can always fall further. The nasty can always get nastier. [Side note: I use the Shiller U.S. stock market data a lot, but the more I torture the data, the more it seems to confess different financial insights!]

To provide more statistics on this, below you will find a table that shows, for various drawdown levels, the median number of years it would take to fall from a peak (column [A]) and to recover from that fall (column [B]). I used the median instead of the average to reduce the skew from outliers. Lastly, please ignore column [C] for now, as I will address it shortly.

As you can see, when we know in advance that a certain drawdown will occur, the amount of time to experience such an event (column [A]) is usually quite short. While a 20% drawdown would take 6 months (0.5 years), a 50% drawdown takes about 2 years to unfold. However, given how small our sample size is (i.e. there are only three 50%+ drawdowns in the data), these statistics will likely not be helpful for understanding future market behavior.

If you focus your attention on column [B] you will notice that the time to recover once you have experienced a particular drawdown is much larger than the fall time (column [A]). This is true because many smaller drawdowns can become larger as markets get more chaotic. In other words, every 50% drawdown was once a 5% drawdown.

Though this data suggests that once you are at a peak that drawdowns happen quickly, I will admit there is some selection bias going on with column [A]. I stated that the drawdown had to be known beforehand. However, this is never the case. Many times, when you are at a peak, in the next few months you will likely hit an even higher peak. Therefore, I need to correct for this selection bias.

In order to do this, I created column [C] to allay any fears. Column [C] provides the median number of years from any peak to a specific drawdown level. So, given you have hit a random all time high, it would take roughly 5 years before you experienced a 20% drawdown. This time period is much longer than the one in column [A]. Why? Drawdowns, especially larger ones, have been historically rare.

To provide a better visual aid to this, let’s look at a log plot of the S&P 500 real price + dividends from 1920 to 2016. I have shaded this plot red whenever the market falls 20% and green from the moment after it falls 20% until its next all time high. Therefore, the red bars represent declines and the green bars represent recoveries.

As you can see, there is far more green then red in this chart, which illustrates the point of this post. You may also notice that some of the declines happened so quickly that the red bars don’t plot well on the chart. For a clearer visual, consider the same plot with 40% drawdowns:

The most interesting thing about this plot to me is that the recovery from the dotcom bubble in 2000 was the longest in U.S. stock market history, after adjusting for inflation. From the peak, it took roughly 13 years before the highs of the dotcom bubble were reached again.

The Stock Market is Like a Ladder

Some of you may be wondering why I had a picture of a ladder at the beginning of this post, and the reason is that it seems to be a decent, though imperfect, analogy for equity price behavior. Prices go up slowly, like someone climbing a ladder. However, once in a while, people slip and the subsequent fall occurs much faster than the climb up. Unfortunately, depending on the damage suffered from the fall, some investors decide to never get on that ladder again.

This was a fun exercise to do, but may not provide much value in the future if market behavior differs from its own history. For example, in modern markets, individuals and machines better understand the concept that the U.S. stock market has, historically, always recovered. As a result, future recoveries may happen more quickly or larger drawdowns may be prevented altogether.

Lastly, the impact of peaks and drawdowns will not be as extreme for the investor that is dollar cost averaging. All of the recovery times above assume that you bought in at the peak. However, if you are using just keep buying or a similar strategy, your cost basis will be lower and your recoveries relative to this cost basis will be shorter. With that being said, remember to enjoy the slow ride up and don’t fear the roller coaster like drops when they occur. 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 36. 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.

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

When There is Blood in the Streets

Mar, 08/22/2017 - 12:53
Why Following Advice During a Financial Panic is Not as Easy as it SoundsPhoto: Wikimedia Commons

There is a famous quote by the 18th century banker Baron Rothschild:

The time to buy is when there’s blood in the streets.

Rothschild made a lot of money in the panic that followed the Battle of Waterloo using this exact motto. However, his advice is far easier said than done. I’ve noticed this problem within the personal finance/investing community that seems to suggest that a few common rules can solve almost all of your financial problems. The issue is that it is far easier to memorize a simple catch phrase that looks good retrospectively, than to act on the same advice in the moment. I will expand on this point later, but first…some data.

Let’s consider the drawdowns on the S&P 500 since the late 1920s. For a short refresher, a drawdown is any decline from an all time-high. Therefore, if a stock is at 100 and falls, that stock is in a drawdown until its price is above 100. More importantly, I want to focus on times when there is “blood in the streets” as Rothschild’s quote suggests. Though there is no formal definition for this, I am going to propose that any drawdown greater than 30% can be considered a “blood in the streets” moment. As you can see below, the S&P 500 has had 6 initial drawdowns of greater than 30% since the late 1920s (the dark points represent the month where the drawdown first exceeded 30%):

In addition to these 6 drawdowns of over 30%, there were 4 occasions where the S&P 500 had a drawdown of over 40%, and 3 occasions where it had a drawdown of over 50%. While we cannot predict the frequency of future drawdowns or their magnitude, if history is any guide you should plan for four 30%+ drawdowns and two 50%+ drawdowns in equity markets over a 50 year investment life. I don’t know when (or if) they will happen, but this is a fair expectation given market history.

So what’s it like when there is blood in the streets? To imagine this, I have gone back through the data and aligned and indexed every market peak for the most famous U.S. stock market crashes. This means that from each all time high, we can see the crash play out. It will allow us to easily compare the 1929 crash to the crashes in 1974 (peak was in 1973), 1987, 2000, and 2008 (peak was in 2007). Below are the 5 peaks aligned to start at 100 and play out over time. You can see which line corresponds to which peak using the year showing up on the far right side of the plot:

As you can see, each market crash behaves different especially as time goes on. For example, the Great Depression and the Dotcom bubble both didn’t see the bottom until ~3 years after their respective peaks, while the crash of 1987 quickly resolved itself and was above its old peak within 2 years.

If we expand our time horizon to look out over a a 10 year period, we see a few very interesting things about these same stock market crashes:

The most important thing I learned from this data was that the Dotcom bubble combined with the Great Recession of 2008 placed the U.S. stock market in a similar place to the Great Depression 10 years after its beginning. Now I am not saying that both events exhibited the same level of financial chaos, because they didn’t. Looking at the Great Depression you can see that the green line is far lower for far longer than the black line (Dotcom bubble). This exemplifies how the experience of the Great Depression was far worse than the Dotcom bubble + Great Recession, despite the real price changes ending up around the same place 10 years later. This is intriguing even though it is likely pure coincidence.

Now this is where the “blood in the streets” quote will fail you. Imagine being 1 year into the Great Depression. By our definition, there was “blood in the streets” as there had already been a 30% drawdown in the U.S. stock market. However, the market would continue to decline for another 2 years, with a 64% decline in the last year! Though you might start buying when there is blood in the streets, you may soon realize that a lot of that blood is your own.

This is the fundamental problem with buying big during a crash. It’s incredibly difficult to call the bottom. So if you try to wait it out you will either miss it completely (i.e. staying in cash for too long), or you will buy before the true bottom and could lose money if you sell at lower prices. Either way, the best action is no action at all…

Don’t React When the Streets Run Red

If there is any advice I would follow during a panic, it would be to not react to it. By reacting you are far more likely to make a decision that loses you money than one that will help you. Assuming you have a sufficient level of liquidity in an emergency fund, I would continue buying assets at the same rate during a financial panic as you did before the panic. Yes, just keep buying is here again.

If you don’t believe me, consider the words of Charlie Munger, Warren Buffett’s acclaimed business partner. Munger stated the following at the beginning of an interview with the BBC:

If you’re not willing to react with equanimity to a market price decline of 50% two or three times a century, you’re not fit to be a common shareholder and you deserve the mediocre result you’re going to get.

Munger and Buffett are known for buying when prices are depressed, but I still do not advise this course of action for an average investor. The problem is that they have the extra capital to buy cheaper assets, but you probably don’t. Your extra capital may be needed for liquidity purposes during an emergency (i.e. job loss, etc.), but this is something that only you would know. While you may commit now to not act during the next panic, I doubt it will be easy when the time comes. 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), Facebook, Twitter, or Medium.

This is post 35. 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 There is Blood in the Streets was originally published in Of Dollars And Data on Medium, where people are continuing the conversation by highlighting and responding to this story.

Cooperation in the Age of Anger

Mar, 08/15/2017 - 12:58
Why We Need Understanding And Support For Others Now More Than EverPhoto: Pixabay

I have finally cracked. After writing for Of Dollars And Data for 33 weeks without discussing politics in the slightest, I have had enough. I really thought I could keep this website strictly to personal finance/investing, but I don’t have the will to write about tax loss harvesting while nuclear war threatens our very existence and the political divide in this country grows wider. I want to talk about both of these topics today and why we need to have more understanding and support for those that hold worldviews different from our own.

1. The Most Important Data Series

To start, I want to talk about arguably the most important data series that the world has ever known:

This is it. 2 data points in 1945 during World War II and zero ever since. Keeping that line at zero is the most important thing that we can do to ensure the future of our species in the near term. Don’t get me wrong, we still need to fix other problems (i.e. the environment, inequality, etc.), but none of those present the short term existential crisis that nuclear war does. It has been over half a century since the world was at such a crossroads. The Cuban Missile Crisis of 1962 was the closest we ever got to full blown nuclear war. Though I don’t think North Korea presents the same existential threat today that the USSR did in 1962, any nuclear attack would be devastating. Even one bomb is too many.

So why does North Korea have such a troubled relationship with the U.S.? It is a complex answer, but it all goes back to the Korean war. Did you know that the U.S. dropped 100,000 more tons of bombs on North Korea from during the Korean War than they did in the Pacific during all of World War II? How about that approximately 20% of the North Korean population was killed in the Korean war? I am not saying that these facts excuse the behavior of the North Korean regime, but this context matters a lot.

I don’t know enough about the U.S. relationship with North Korea to say anything noteworthy, but I am for any solution that will prevent the loss of life, especially from a nuclear attack. I can only hope those in both governments feel the same way.

2. Befriend Your Enemy

Whether the nuclear threat ever materializes, there is still a growing political and ideological divide across America. All political discourse seems to have lost its civility. Yelling has taken the place of finding common ground to build a productive relationship. I do not know much about politics, but I can say this with certainty: The more forceful an opposing point is presented to an individual, the more likely that individual will reaffirm their original belief. This means that the argumentative nature of today’s political discourse is actually making things worse and there are plenty of psychological studies about confirmation bias to support this.

So what can you and I do about it? Stop the yelling, try to seek understanding, and support your fellow Americans as people. Yes, all of them. Even the white supremacists out in Charlottesville, as much as you might hate them, deserve to be treated fairly as people. I don’t agree with their views, but I would seek to understand why they have those views. You might think they hold these views because they are “bad” people, but thinking like this is both inaccurate and unhelpful for making progress.

Understanding individuals as people and befriending them is a far more useful tactic for reducing hate than any form of argument or violence. If you don’t believe me, consider the story of Daryl Davis, an African-American blues musician who befriended over 200 members of the KKK and got them to disavow the Klan. Davis never pressured any of these men to leave the KKK, but they left nonetheless. Davis simply asked them, “How can you hate me when you don’t even know me?” The fact is that Daryl Davis figured it out:

Hate needs to be hugged, not choked, out of existence.The Story of Humanity is the Story of Cooperation

Despite the grim picture I have painted about human cooperation, the world has gotten more, not less, cooperative over the last few hundred years. To illustrate this, I will leave you with one of my favorite ideas in all of economics that exemplifies the power of human cooperation through the free market.

There is an essay called, “I, Pencil” by Leonard Read that Milton Friedman summarizes incredibly in this video. Friedman discusses how something as simple as a pencil could not be created without lots of human cooperation. The amount of things that need to be accomplished to create a pencil (i.e. chop down a tree, grow rubber, mine brass, etc.) are far too vast for any one person. He expands on this idea eloquently:

Literally thousands of people cooperated to make this pencil. People who don’t speak the same language, who practice different religions, who might hate one another if they ever met! When you go down to the store and buy this pencil, you are in effect trading a few minutes of your time, for a few seconds of the time of all those thousands of people. What brought them together and enduced them to cooperate to make this pencil? There was no Commissar sending out orders from some central office. It was the magic of the price system. The impersonal operation of prices that brought them together and got them to cooperate to make this pencil so that you could have it for a trifling sum. That is why the operation of the free market is so essential, not only to promote productive efficiency, but even more, to foster harmony and peace among the people of the world.

Free markets are not perfect, but they are the best thing we have tried to encourage massive levels of cooperation across the world. So don’t fret. We are moving in the right direction despite the occasional speed bump along the way. As Josh Brown explained so well recently, this is just a counter-trend.

Call to Action

Instead of asking you to share this story, I want you to actually do something that helps you and increases the amount of cooperation in the world. Find someone that you had a falling out with and reach out to them. Estranged relative? An old friend? I don’t care who it is, but please find it in your heart to forgive this person or to apologize to them if you did something wrong. Try and mend some old wounds. I am asking you this favor as a brother, a son, a friend, and, most importantly, as a human on this planet. The world is so filled with hate and anger right now that I just want to know, “Where is the love?”

Thank you for reading!

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

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

This is post 34. 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.

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

Retiring Off Dividends: What Are the Odds?

Mar, 08/08/2017 - 12:59
A Simulation of Retirement Dividend Income Using Varying Savings Rates and Time HorizonsPhoto: Pixabay

This is a guest contribution by Nick McCullum from Sure Dividend. Sure Dividend uses The 8 Rules of Dividend Investing to systematically identify high-quality dividend stocks suitable for long-term investment.

Investing in the stock market has historically been one of the best ways to build long-term wealth.

We can take this a step further — instead of just growing wealth, dividend stocks are one of the best ways to generate income.

In fact, the end goal of many dividend growth investors is to create a dividend stock portfolio (composed of ETFs or even individual stocks) that generates enough income to cover their retirement expenses.

With that in mind, this article investigates your chances of retiring off of dividend income using different savings rates and time horizons.

Some Benchmark Parameters & Assumptions

If you are investing in broad-based index ETFs (which is a great choice for the vast majority of investors), then the two most important factors in your long-term investment success are:

  1. Your savings rate
  2. Your time horizon

Because of the importance of these two metrics, they are the two main variables that I will tweak in this analysis.

More specifically, I will consider savings rates from 10%-50% (using incremental of 10%) and time horizons ranging from 45 year to 15 years (using 5 year increments). Using the traditional retirement age of 65, this implies a starting investment age of 20 to 50.

This analysis will estimate future investment returns by fitting a normal distribution through the historical returns of the S&P 500 Index ETF, which trades under the ticker SPY on the New York Stock Exchange.

SPY is a great investment option for long-term investors seeking broad-based equity exposure. In fact, Warren Buffett recommends a portfolio containing 90% SPY and 10% in short-term government bonds for the average U.S. investor with no financial experience.

Since 1993, SPY has had an average daily total return of 0.042% and an average daily total return standard deviation of 1.163%. I use daily returns (rather than monthly returns or annual returns) because this increases the sample size under consideration.

In reality, stock market returns do not perfectly fit the normal distribution; but it is a close enough proxy for the purpose of this analysis.

R was used to run a 1000-trial Monte Carlo simulation for each time horizon-savings rate pair. The R script that I’ve used to create the simulation is a variation of the Sure Dividend Retirement Calculator. You can see the modified script here.

I’ll also be assuming — for simplicity’s sake — that the person who is doing the investing has an annual income of $70,000 per year. This analysis would yield the same results for any other assumed income; but some level of income must be selected to compute the dollar value of invested capital given a particular savings rate.

The last assumption I’ll make is about dividend yield. The S&P 500 Index ETF currently has a dividend yield of about 1.9%.

This is certain to change over time; however, I have about as much information on what the S&P 500 yield will be in 15–45 years as I do about the weather in 15–45 years. In other words, I’m clueless.

One thing is certain: the S&P 500’s dividend yield is currently much lower than its normal historical levels:

Source: Multpl

This means that using its current 1.9% dividend yield as a proxy for future dividend income is conservative. Thus, 1.9% will be the rate used to determine dividend income once final portfolio values are computed using the Monte Carlo simulator.

The Simulation Results

Here are the retirement portfolio value after investing in the S&P 500 over various time horizons and savings rates using a $70,000 income for simplicity’s sake.

While this table is interesting, we do not care so much about portfolio size.

What we are really concerned about is our portfolio’s ability to generate retirement income.

The following table shows the retirement income generated from each of the portfolio sizes in the previous table, using the S&P 500’s current dividend yield of 1.9%. Cells highlighted in green are sufficient to replicate the investor’s annual employment income using dividends alone.

To generalize this, we can show — as a percent — the individual’s ability to replicate their day job income using dividend payments:

The retiree was unable to cover their retirement expenses using dividend payments in more than half of the situations I investigated. Importantly, there was no time horizon where a 10% savings rate was sufficient to retire on dividends alone.

So how can we make this easier?

There are a number of ways an investor can improve their chances. Aside from the obvious (starting earlier or increasing their savings rate), the retired investor can also invest in a high-yield dividend ETF (rather than the S&P 500 ETF).

One notable example is the Vanguard High Dividend Yield ETF, which trades under the ticker VYM. The ETF has a current dividend yield of 2.9%, significantly highly than SPY’s.

If an investor held SPY until retirement and then switched to VYM, the percentage of their employment income covered by dividend payments becomes far superior:

Under this scenario, an investor with a 30% savings rate and 30 year time horizon now has the potential to cover their living expenses with dividend payments. Moreover, a very long-term investor (45 year time horizon) with a 10% savings rate can now retire on dividends.

Importantly, there doesn’t appear to be any additional risks in this strategy; VYM has had almost exactly the same volatility as SPY since the inception of each ETF.

Investors who need even more yield can look for other investment options that offer the prospect of higher dividend income.

Final Thoughts

This article showed the impressive power of dividend growth stocks for long-term wealth creation.

With a sufficient savings rate and time horizon, investors stand a good chance of covering their entire living expenses on dividend payments alone.

For the scenarios where dividends were not sufficient, the outlook is not necessarily bleak. It is alright to draw down some principal during retirement if you do not intend to pass on your full wealth to your heirs. Many people enjoy long and prosperous retirements by periodically selling some of their stock holdings.

With that said, the best case scenario is to retire on dividends alone. This article showed that this is a distinct possibility using a long-term dividend growth investing strategy.

Retiring Off Dividends: What Are the Odds? was originally published in Of Dollars And Data on Medium, where people are continuing the conversation by highlighting and responding to this story.

Turn Off, Tune Out, Get Rich

Mar, 08/01/2017 - 13:01
Why Ignoring Financial Noise is Crucial For Investment SuccessPhoto: Flickr

This week I want to talk about the amount of noise that exists in the financial media and how you would be far better off as an investor if you ignored it. The idea here is that by consuming financial media you are going to be more susceptible to psychological changes that harm your long term investment returns. In others words, you will panic and you will sell.

To start this discussion, I am going to bring forth the analogy of Mr. Market, a metaphorical figure created by the legendary value investor Benjamin Graham. Paraphrased from Graham’s book, The Intelligent Investor:

Imagine that in some private business you own a share that cost you $1,000. One of your partners, named Mr. Market, tells you what he thinks your share is worth and furthermore offers either to buy out or to sell you an additional share on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or fears run away with him, and the value he proposes seems to you a little short of silly.Will you let Mr. Market’s daily communication determine your view of the value of your $1,000 share in the enterprise?

You face the same predicament as the one above EVERY. SINGLE. DAY. while you are invested in the stock market. Throughout the week you are constantly being presented with a price and have to decide whether to buy shares, sell shares, or hold on to what you have.

The problem with the market, and financial media generally, is the amount of noise that comes out on a daily basis. I cannot tell you how many times I have seen a headline like, “Stocks up/down after [insert event here].” Almost all of these events will have little to no impact on the trends underlying the stock market’s long term growth, yet long term growth prospects are nowhere to be found in the reporting. It gets even more entertaining when a news outlet explains why stocks are “up” in the morning to then later point out why they are “down” in the afternoon. And sometimes these market shifts are explained using the same event.

What I have come to realize is that the financial media isn’t really for investors, but for traders. The financial outlets won’t tell you that though. Noise means something to a trader, but to an investor it should be promptly ignored. It is understandable why the financial media behaves this way though. They need to create this sense of dread for their viewers to keep reading and watching. It is better for their business model. More eyeballs = more ad $$.

If I had my own investing show it would last all of 20 minutes one time. In those 20 minutes I could provide the core principles that would guide you through most of your investment life. For everything else more personal/complex, see a financial planner.

With that being said, rather than just talking about noise in the financial markets, let’s look at some data. Using 1-year real U.S. stock and bond returns, the noise in the market looks something like this:

Over 1 year periods, markets can be very chaotic for both U.S. bonds and U.S. stocks. This is also true over shorter time horizons (i.e. monthly, daily, intra-day, etc.). However, the chaos fades as the time horizon increases. Below is an animation I created that shows the S&P 500 and U.S. 10-year Bond returns as they vary from a 1-year horizon to a 30-year horizon. What you will notice is that over longer time horizons, the trends of society play out and all of the noise falls away. Start watching at the “1-Year Period” chart and you will see this process in action:

As the return period increases, we are witnessing changes in productivity, technology, business organization, and much more. These are the true drivers of wealth creation and the things that one should focus on as an investor. As I have stated previously, there are always many reasons to sell. There will always be noise implying that you should get out, that this time it’s different, and that the world will really end. However, it probably won’t.

Escape the Quicksand

Watching financial news is akin to being caught in quicksand. The more you watch, the more likely you are to react to short term events and do something that could lose you money. Remember, you only lose money when you sell. And you are more likely to sell during a panic when a news outlet is flashing turmoil across your screen. This is not an analytical argument, but a psychological one. Even Sir Isaac Newton lost a small fortune in the South Sea Bubble of 1720, despite being one of the smartest people to ever live. Newton later remarked something along the lines of:

I can calculate the motion of heavenly bodies, but not the madness of men.

So turn off, tune out, and get rich. Don’t consume too much financial media (including this blog). When it comes to investing, Jack Bogle, the founder of Vanguard, gave some of the best advice I have ever heard:

Don’t just do something, stand there!

Thank you for reading!

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This is post 33. 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

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Turn Off, Tune Out, Get Rich was originally published in Of Dollars And Data on Medium, where people are continuing the conversation by highlighting and responding to this story.