Monday, June 25, 2012

Savage, The Flaw of Averages

I missed Sam L. Savage’s The Flaw of Averages: Why We Underestimate Risk in the Face of Uncertainty when it was published in hard cover in 2009, so I was delighted to see that it had been reissued in paperback (Wiley, 2012). There’s something in this book for almost everyone—well, at least for almost everyone who thinks about how to make decisions in an uncertain world. Its potential audience encompasses the statistically savvy as well as those who never cracked open a statistics book. The left-brained analyst might be attracted to it, but he’ll be challenged to be a right-brained thinker.

The recurring theme throughout the book is that using single, average numbers to plan for uncertain outcomes leads to systematic errors. Or, as Harry Markowitz writes in his foreword, “plans based on average assumptions are wrong on average.”

Take, for instance, a diversified portfolio of mortgages spread across various housing markets. “Suppose that property values are expected to rise in some of these markets but fall in others, remaining the same on average. What do you suppose the profit graph looks like with respect to property values? In locations where values increase, defaults drop slightly, increasing profit slightly. But where values fall, defaults go up. In some cases values will fall to the extent that the equity in the houses drops below the amount owed. At that point defaults increase dramatically, with owners just dropping off the house keys at the bank and moving into Motel 6.” Savage uses some hypothetical numbers to illustrate his point. “In this example, an 8 percent increase in value in one location improves profit by less than 5 percent, whereas an 8 percent devaluation in another location decreases profit by a whopping 40 percent. Thus the profit of a mortgage portfolio based on what are expected to be average property values will overestimate average profit.” (p. 95)

Savage, whose father wrote the groundbreaking The Foundations of Statistics in 1954, eschews the “Steam Era” anachronistic vocabulary of statistics in favor of plain English and computer simulations. But he can’t quite break with the past; he briefly describes key statistical “red words” and then suggests that we forget them. For example, in place of “hypothesis testing,” we should use “Did it happen by chance?” Similarly, we should forget about correlation and covariance and use scatter plots instead.

Statisticians will not, of course, be persuaded to abandon their formulas. Nor should they. But someone has to be on hand to ask the right kinds of questions and to understand the pitfalls inherent in certain ways of thinking. Black boxes should not be allowed to rule the world unchecked.

Savage writes in an entertaining style, as some of the chapter titles indicate: “When Fischer and Myron Met Bob: Option Theory,” “Some Gratuitous Inflammatory Remarks on the Accounting Industry,” and “Sex and the Central Limit Theorem.” He clearly explains such issues as how much a person should pay for information to reduce uncertainty and why the common corporate practice of sandbagging can be costly for the company.

The Flaw of Averages will not replace Statistics 101, but it’s a lot more fun.

Tuesday, June 19, 2012

Frush, The Strategic ETF Investor

As ETFs proliferate so do books on using ETFs as investing vehicles. Scott Paul Frush, who earlier wrote All About Exchange-Traded Funds, is back with a second volume on the subject—The Strategic ETF Investor: How to Make Money with Exchange-Traded Funds (McGraw-Hill, 2012).

Frush describes the ins and outs of ETFs in some detail—from the creation and redemption process to the known (and not-so-known) costs of ETFs. He outlines some of the nuances of how ETFs are taxed. For those not wanting to go it alone, Frush explains how to vet and work with a financial professional.

The main thrust of the book is how to design a high-performance ETF portfolio. Each investor should devise and tend to his own “perfect” portfolio, which is (for those who could ever be expected to find the mnemonic useful) personalized, economical, reoptimized, filtered, empirical, comprehensive, and timeless. By the way, “timeless” doesn’t mean “eternal” but regime neutral. That is, the portfolio should be optimized to “work in multiple market environments, not just in rising markets.” (p. 107)

The key to investment performance is “al-location, al-location, al-location.” Frush drives home the importance of asset allocation with an analogy to hockey. “Employing asset allocation is like a hockey player choosing to wear protective equipment: helmet, shoulder pads, hip pads, kneepads, and so on. If the hockey player were to take off his protective equipment, he could probably skate faster, cut easier, and pass the puck better. As a result, he could become a dominant player. But it doesn’t take a rocket scientist to recognize that by not wearing the proper hockey protective equipment, he is being very unwise and foolish. One hit into the boards from an opponent and he could be out of the game for a very long time, if not forever. No more domination.” (p. 131)

Frush offers some simple model ETF portfolios. First, three asset allocation models using (almost) the same ETFs but weighting them differently according to the portfolio’s risk level. Although the author believes that “for the most part, the asset allocation models should be sufficient for investors” (p. 204), he also describes some more focused ETF portfolios.

The book concludes with a list of ETF resources, a risk profile questionnaire, and an ETF glossary.

The Strategic ETF Investor is a thorough, competent guide to using ETFs in the “perfect” portfolio. The retail investor who is relatively new to the world of ETFs and asset allocation will learn a great deal from it.

Wednesday, June 13, 2012

Levine, How to Make Money with Junk Bonds

Robert Levine’s How to Make Money with Junk Bonds (McGraw-Hill, 2012) is a first-rate introduction and navigation guide to the high-yield world. Starting with an analysis of the fictional Millie’s messenger company and her eventual leveraged buy-out of the competition, Billy’s Messengering, Levine explains how to find good investment candidates. (Poor Millie’s doesn’t cut the mustard.)

At the core of successful junk bond investing is credit analysis. The investor has to assess a company’s business risk, financial risk, and covenant risk before he can decide how much risk he himself is willing to assume in buying the company’s bonds and how much he wants to be paid to assume this risk.

Levine advocates a two-step approach to investing in junk bonds, what he calls the Strong-Horse Method, an image that evokes power and speed. The first step is credit analysis: “A Strong-Horse company is one that can improve in creditworthiness and generate excess cash flow to pay down debt over time.” (p. 43) The second step is to “relate the results of the Strong-Horse credit analysis to the yield of the bond. … [S]potting an underrated credit can yield additional coupon while the price simultaneously increases.” (pp. 47-48)

In keeping with the classic value investing mantra—buy low, sell high—Levine explains that “You should buy or own Strong-Horse companies when spreads are at the widest level (lowest prices), and you should not own the bonds when the spreads are tight, that is, when the yields are low and the prices high.” (p. 56)

Levine fleshes out his method, which has outperformed both the S&P 500 Index and the BoA Merrill Lynch High Yield Index for the 1-, 5-, 10-, 15-, and 18 ½-year periods, with multiple examples. He offers caveats. And he explains the logistics of investing directly in junk bonds as well as investing in junk bond mutual bonds. All this in clear prose that even someone with no experience in junk bonds can understand.

The underlying message of this book is that high-yield bonds are not intrinsically high risk; in fact, they “fit between stocks and bonds along the risk spectrum.” (p. xvii) As such, they can be a value-enhancing addition to an investment portfolio. How to Make Money with Junk Bonds points the way.

Friday, June 8, 2012

Pring, Investing in the Second Lost Decade

In early 2013 the authors, all principals of Pring Turner Capital Group, plan to launch the Pring Turner Dow Jones Business Cycle ETF “to advisors and investors who have been searching for an ‘all-seasons’ investment vehicle.” Investing in the Second Lost Decade: A Survival Guide for Keeping Your Profits Up When the Market Is Down (McGraw-Hill, 2012) by Martin J. Pring with Joe D. Turner and Tom J. Kopas explains the rationale for the fund and, more generally, for using financial and business cycle analysis.

As the title indicates, the authors believe that we have another ten years to go in the current secular bear market. Actually, in the best case scenario we could put in a bottom in 2016; in the worst case scenario the bear market could last until 2022 or beyond.

Although the stock market is “probably in for rough sledding for the bulk of another decade,” there is a secular bull market in inflation-sensitive real assets. Even though there will be cyclical corrections along the way, “if you are observant and fortunate enough to spot a new cyclical commodity bull market as the secular uptrend resumes, there are a host of rewarding vehicles.” (p. 66)

Business cycles are much shorter than secular trends; typically business cycle swings last four to five years; secular trends, 20+ years. A business cycle normally has six stages, moving from economic contraction to economic expansion. The six stages move sequentially approximately 85% of the time, so the investor can use them as a guideline to dynamically adjust his portfolio’s asset allocations. Following these stages, he would buy bonds, buy stocks, buy inflation-sensitive, sell bonds, sell stocks, and sell inflation-sensitive.

Nothing, of course, is ever so clear-cut. Pring Turner has a proprietary barometer for identifying business cycle stages—the Dow Jones Pring Business Cycle Index, which will serve as the basis for their ETF. For those who want a dumbed-down version, the authors provide a “generally reliable” cheat sheet for identifying the current business cycle stage, using the 12-month moving average of each asset class (stocks, bonds, commodities).

Although the authors provide a little more meat in appendixes to the text, the retail investor would be hard pressed to undertake active cycle-based portfolio management using only this book. Hence, of course, the ETF.

Tuesday, June 5, 2012

Coates, The Hour Between Dog and Wolf

Traders should be unemotional. No, traders should tap into their emotions and use these emotions as trading inputs. The debate rages on, mostly at the level of pop psychology, rarely rising to a level that is even quasi-scientific.

John Coates, a senior research fellow in neuroscience and finance at the University of Cambridge who previously worked for Goldman Sachs and ran a trading desk for Deutsche Bank, changes all this—or so one would hope. The Hour Between Dog and Wolf: Risk Taking, Gut Feelings and the Biology of Boom and Bust (Penguin Press, 2012) is a compelling narrative of the links between biology and the trading floor. It’s one of the most intriguing books I’ve read in a long time.

Coates’s previously published research papers offer a glimpse into this book, but no more than a glimpse. Let’s start with the title, a French expression meaning literally dusk, when the light is so dim that you can’t distinguish a dog from a wolf. More subtly and aptly, according to the website Naked Translations, “it also expresses that limit between the familiar, the comfortable versus the unknown and the dangerous… It is an uncertain threshold between hope and fear.”

Traders live in the gloaming, and their bodies (and consequently their risk management skills) respond accordingly. They spend a good part of their day faced with novelty, uncertainty, and uncontrollability—“three types of situation [that] signal threat and elicit a massive physiological stress response.” (p. 217) If markets are more or less normal, traders can usually handle this stress because it is moderate and exists over a short period of time. If, however, stress goes on for an extended period of time, this chronic exposure can impair their cognitive and physical performance.

Coates explains in wonderfully clear prose the physiological mechanisms that affect traders’ behavior. He describes, for instance, how the brain of a skilled trader can separate signal from noise and how the trader can feel in his body “when the chaos on the screens can be safely ignored and when it cries a warning that should be heeded.” (p. 140)

He looks at the reactions of two traders to a rapidly dropping market, one of whom is invigorated while the other finds it impossible to think clearly. “[O]ddly, inappropriately,” the second trader’s body “has atavistically prepared him to fight with or run away from a bear. The stress response is prehistorically hamfisted in this regard. It does not distinguish very clearly between physical, psychological and social threats, and it triggers much the same bodily response to each one. In his way the stress response, so valuable in the woods, can prove archaic and dysfunctional when displaced onto the trading floor, or for that matter any workplace. We need to think, nor run.” (pp. 209-10) Coates writes that “some studies have even suggested that under conditions of extreme stress our prefrontal cortex is effectively taken offline, impairing analytic thought and leaving our brains to run on stored reactions, largely emotional and impulsive ones. … Shell-shocked traders, under the influence of an overly active amygdala, become prey to rumor and imaginary patterns.” (p. 227)

Coates contends that traders can be trained to be tough, to view novel events as challenges to embrace instead of crippling stressors. Although he admits that “it is too early in this research to recommend any particular toughening regime,” he suggests that since the new training programs will have to be able to access the primitive brain, not just the rational cortex, they “may turn out to involve a lot more physical exercises than they do at present.” (p. 254)

The Hour Between Dog and Wolf is a very rich book, one that every trader and risk manager should read. I recommend it unequivocally. (Just don’t send me to boot camp.)

Monday, June 4, 2012

Schwager, Hedge Fund Market Wizards

Jack D. Schwager, author of the bestselling Market Wizards and The New Market Wizards as well as Stock Market Wizards, has a new book in his “wizard” series: Hedge Fund Market Wizards (Wiley, 2012). Let me say up front that this is a terrific book, perhaps even better than the classic Market Wizards, which was recently re-released in paperback. Schwager interviews fifteen hedge fund managers, all of whom have “demonstrated an ability to generate superior return/risk performance.” Some are familiar names; others, I must confess, I had never heard of—which may be part of the reason that they are such stellar performers.

The “macro men” are Colm O’Shea, Ray Dalio, Larry Benedict, Scott Ramsey, and Jaffray Woodriff. The “multistrategy players” are Edward Thorp, Jamie Mai, and Michael Platt. There are seven “equity traders”: Steve Clark, Martin Taylor, Tom Claugus, Joe Vidich, Kevin Daly, Jimmy Balodimas, and Joel Greenblatt.

Each interview is tailored to the person being interviewed, so the reader is not subjected to a dull cookie-cutter format. Naturally, some themes reverberate throughout the book and Schwager distills them into forty market wizard lessons in the final chapter. But the richness of this book comes from its portraits of a diverse group of traders with equally diverse trading styles.

There are system traders and discretionary traders. There are grinders who rarely have outsized days and traders who are looking for the home run. There are those who will average down and those who wouldn’t think of doing such a thing. One trader says that stop orders are for fools while another says that stops are necessary and should be placed at a level that says you’re wrong.

Schwager’s questions slowly unveil each hedge fund trader’s approach to the markets, what I suppose you could call his trading personality. Some traders took a while to develop a winning personality, and they share their struggles. Some are enthusiastic about their lives as traders and hedge fund managers, whereas at least one is still “searching to be satisfied by something.”

Although the reader can search for golden nuggets in this book (and there are many), the fact is that the nuggets are only as valuable as the person who implements them as a reflection of his own trading personality. And that’s what is so useful about Schwager’s interviews: they show how top hedge fund managers think, feel, and act. The reader can, over the course of more than 500 pages, judge for himself how his own trading personality measures up. And perhaps, inspired by some of these trading stars, start on a self-improvement program.