Margins and edges

We don’t know what we want—to be part of the mainstream or to live on the margin, to stay in our comfort zone or to venture out to the edge.

Well, that’s not exactly true.

We don’t want to be marginalized. We don’t want to live a precarious life financially, not knowing where out next meal is coming from. Most of us don’t want to cross the margin of civilized behavior. But we do want a margin of safety, we allow for a margin of error, and sometimes it’s to our advantage to trade on margin. Breakthroughs often happen at the margins.

In a book a margin is that area between what is important, the text, and what is no longer even a book, everything beyond the edge. It’s a place between that which matters and that which, to the engaged reader, doesn’t. But it’s also a place where the reader can add his own thoughts, where he can be creative.

Margins have two dimensions; edges, only one. Margins are for wimps (like those who want to live another day); edges, for daredevils. People who live on the edge take risks, almost by definition without a safety net. Living on the edge can be exciting and illuminating. But the edge itself is unforgiving. There’s no second dimension in which to tiptoe forwards and backwards. You can win big, you can lose everything. The edge is not a place for risk management.

We are inclined to be in awe of those who, to our minds, live at the edge. But sometimes their contribution lies not in fearlessly standing at the edge but in working in the margin, moving the edge away from themselves. Scientists, for instance, push back the edge of ignorance. Smart traders find a way to hedge or otherwise mitigate risk.

I suspect that the humble margin deserves more respect, even though I can find no upside to being marginalized. We ourselves have to choose to test boundaries, to push beyond our comfort zone, to take on risk. Perhaps then our profit margin will improve. We don’t want others to push us out because we are deemed unworthy of being part of the mainstream—because we are poor, different, or just easy to ignore.

Updegrove, The Lafayette Campaign

A change of pace: some light reading for those who watch programs like “Mr. Robot” and even the dreary “CSI: Cyber.” (I exercised through about ten minutes of the latter show before I pulled the plug once and for all.)

Andrew Updegrove, author of The Alexandria Project, is back with another Frank Adversego cyber-thriller, The Lafayette Campaign: A Tale of Deception and Elections. If you (well, only if you’re a Republican) think that the worst case scenario is that Donald Trump decides the next presidential election, assuming that he runs as a third-party candidate, think again. Elections can be tipped or determined not only by third-party candidates (Ralph Nader is often said to have been the spoiler in 2000) and Supreme Court decisions but also by hackers.

The more electronic elections become, the more hackable they are. Competing rogue forces can devote funds and skills to shaping their outcome. Indeed, just think about it. Why give millions of dollars to PACs, money which is often wasted, when you can fund a bunch of hackers? The Chicago “vote early and often” pols and the RNC Watergate crew worked in the pre-digital era. Today their exploits seem laughably primitive. Elections can be stolen much more elegantly with a few lines of code.

The Lafayette Campaign is a fast-paced thriller that takes the reader through the machinations of election cyber-fraud. A perfect beach book.

Process vs. results

How many times have you read that, in investing and especially in trading, it’s the process that matters. Results either follow or don’t. Since the financial markets are more or less random, one can’t control the results, only the process.

In a book that’s coming out in late September, a book that should be on everyone’s radar screen and that I’ll review later—Superforecasting by Philip E. Tetlock and Dan Gardner—the authors criticize the American intelligence community for not systematically assessing its forecasts.

“What there is instead is accountability for process: Intelligence analysts are told what they are expected to do when researching, thinking, and judging, and then held accountable to those standards. Did you consider alternative hypotheses? Did you look for contrary evidence? It’s sensible stuff, but the point of making forecasts is not to tick all the boxes on the ‘how to make forecasts’ checklist. It is to foresee what’s coming. To have accountability for process but not accuracy is like ensuring that physicians wash their hands, examine the patient, and consider all the symptoms, but never checking to see whether the treatment works.” (p. 73)

Similarly, I think that educators who teach traders and investors to focus only on process, not results, may be selling them short. Traders and investors need to learn to think probabilistically, to size trades accordingly, to make and revise forecasts in the light of new evidence. And they need to check their forecasts, including the time horizon of these forecasts, against the outcomes.

Every investor and trader forecasts, however much they may belittle the notion. Why not learn to do it better and make it a key measurable metric?

Answers to word triplet problems

As promised, here are the answers to yesterday's puzzles:

reading, service, stick? Answer: lip

baby, spring, cap? Answer: shower

Word triplet problems

The pace of reviews will slow over the next few weeks. It’s not that I’m being lazy. I continue to read and write reviews. But some of the books that I’ve written about won’t be published for some time, and most publishers want reviews to appear close to the book launch date. Right now I have posts scheduled for August, September, even October.

In the meantime, I’ll try to fill the gap with some random thoughts, bits of trivia, and brain teasers. Today’s post belongs to the last category.

From Innovating Minds, a book that will see the light of day only in October (so stay tuned for the review), two word triplet problems. In these problems you are given three apparently unrelated words and are asked to think of a fourth word that is related to all three words and that can form a phrase with each of them. For example, the words “age,” “mile,” and “sand” all are associated with “stone”: “Stone Age,” “milestone,” and “sandstone.”

Okay, ready? Here are two sets of words. See if you can find the missing fourth word in each case.

reading, service, stick

baby, spring, cap

I’ll post the answers tomorrow.

Zopounidis and Galariotis, Quantitative Financial Risk Management

Quantitative Financial Risk Management: Theory and Practice, edited by Constantin Zopounidis and Emilios Galariotis (Wiley, 2015) is a collection of 15 papers, written primarily by academics. The papers deal with five main topics: supervisory risk management, risk models and measures, portfolio management, credit risk modeling, and financial markets.

One paper that I think should be of general interest to investors is William T. Ziemba’s “Portfolio Optimization.” Ziemba argued in 2005 that the Sharpe ratio needed to be modified to evaluate properly the returns of great investors since the ordinary Sharpe ratio penalizes gains. The modified measure (DSSR—downside symmetric Sharpe ratio) uses only losses to calculate the denominator.

So what kinds of DSSRs do the great investors/traders have? Berkshire Hathaway’s is 0.917. Compared to four other funds (Quantum, Tiger, Windsor, and the Ford Foundation), it has the highest monthly gains but also the largest monthly losses. “It is clear,” the author writes, “that Warren Buffett is a long-term Kelly type investor who does not care about monthly losses, just high final wealth.”

By comparison, “the great hedge fund investors [Ed] Thorp at DSSR = 13.8 and [Jim] Simons at 26.4 dominate dramatically. In their cases, the ordinary Sharpe ratio does not show their brilliance. For Simons, his Sharpe was only 1.68.” Be careful, however, what you wish for. One fund that the author studied had an infinity DSSR. “That one turned out to be a Madoff-type fraud!” (pp. 203-204)

Carlson, A Wealth of Common Sense

Ben Carlson, a popular financial blogger, has written his first book, A Wealth of Common Sense: Why Simplicity Trumps Complexity in Any Investment Plan (Wiley, 2015). Before I started reading it, I contemplated a host of ways in which one could write a truly awful book using the words “wealth,” “common sense,” and “simplicity” in its title. Fortunately, Carlson fell into none of these traps. His is an elegant, well documented account of how to become a wealth-building investor—not an extraordinary investor, not one who tries to compete with the professionals at their own game, but an investor who finds his edge in simplicity, patience, discipline, and a focus on the long-run.

Carlson’s advice applies to all kinds of investors. He is not saying, for instance, that value trumps growth or that passive mutual funds are preferable to actively managed funds. There’s no perfect portfolio, except in hindsight.

Some of his advice addresses ways in which we can avoid sabotaging ourselves. One suggestion: “Setting up a systematic process imposes discipline on your lesser self. You will still have to make discretionary decisions many times over the years, but just know that you are by far the easiest person to fool. Understand why you should or shouldn’t do something based on your knowledge of yourself and use a plan to create a hurdle that makes it difficult to make poor decisions.” (p. 152)

This piece of advice stems from Carlson’s overarching model of investing: “Philosophy [your core investing beliefs] leads to an investment strategy which leads to portfolio construction which is all worthless if you don’t have a process in place that allows you to follow each of these steps.” (p. 89) Read that sentence again. Whether you are managing a $1,000 or a $10 million portfolio, odds are that you are missing one or more pieces of the puzzle.

Carlson exposes thirteen market myths, including “stocks are riskier than bonds,” “a yield on an investment makes it safer,” “commodities are a good long-term investment,” and “housing is a good long-term investment.” Re the last: “Think of housing as more of an asset that forces you to build equity over time than an investment that is likely to compound your savings.” (p. 82)

He explores asset allocation, arguing that “it is by far the most important portfolio decision you will make. Stock picking is for home-run hitters who will likely strike out. Asset allocation is for those who wish to safely get on base time after time with a high probability for success.” (p. 146)

A Wealth of Common Sense should provide value to investors at all levels of experience and net worth. It forces the reader to re-think how he goes about investing and how he can stay true to his principles, through good markets and bad.

Freedman & Nutting, Equity Crowdfunding for Investors

Until 2012, by law, angel investing was restricted either to the very wealthy or to the founders of private companies, along with their family and friends. Title III of the JOBS Act lifted this restriction, allowing startups and burgeoning businesses to sell equity to all investors, not just accredited ones, through online crowdfunding portals. Pending final rules from the SEC and FINRA, crowdfunding portals with unrestricted Title III offerings may launch this year.

This will be an entirely new investment opportunity for “the rest of us,” one that needs a help manual, with online updates. And we get just that in Equity Crowdfunding for Investors: A Guide to Risks, Returns, Regulations, Funding Portals, Due Diligence, and Deal Terms by David M. Freedman and Matthew R. Nutting (Wiley, 2015). Freedman is a financial and legal journalist; Nutting, a corporate lawyer who is a director of the National Crowdfunding Association.

Equity crowdfunding is fundamentally different from rewards-based crowdfunding, the best known example of which is Kickstarter. If you invest in a company on Kickstarter, the best you can get is the promised reward—a T-shirt, for instance. You are not getting any equity in the company. No matter how successful the company is, all you have to show for your investment is one lousy T-shirt.

Of course, a T-shirt is better than nothing, which is probably what you’ll reap from your equity investment. Ian Sobieski, founder and manager of the Band of Angels, one of the most successful angel groups in the U.S., said that they’d made more than 200 investments (actually, the authors write, 270). “If you take the top nine performing deals out of the basket, the IRR [internal rate of return] drops to zero. So only one in 20 really moves the needle. Since the average investor invests in only 10-or-so deals, the odds of any one angel being in a winner are only 50 percent.” (p. 105)

The authors suggest that a person needs two qualities to be a successful investor in equity crowdfunding: judge of character and patience. “When you invest in a company that has a limited track record in terms of revenue, or even product distribution, you need to judge whether the founder (or founding team) has what it takes to succeed. Experienced angel investors commonly ‘bet on the jockey, not the horse.’” (p. 114) And you must be willing to hold onto your shares. “In equity crowdfunding, under Title III, when an investor buys shares in a company, he or she must hold those shares for at least a year before trying to sell them, with some exceptions. Even after the first year, those shares may be difficult to sell—who will buy them? There may not be a ready market or exchange for them; in other words, they are illiquid. In the past, angel investors typically had to wait seven or eight years before an exit or liquidity event occurred or selling their shares became realistic, if, in fact, the companies still existed after eight years.” (p. 115)

If, despite the caveats, you’re still game, Freedman and Nutting lay out in great detail how to get started, how to navigate the portals as well as the law, and how to be a wise investor. As the regulatory bodies continue to write the final rules, it’s a perfect time to get a head start on what will undoubtedly be an exciting new area for would-be angels.