Sunday, October 30, 2016

Baggini, The Edge of Reason

Julian Baggini is a British philosopher who knows how to write for a general audience. Yale University Press has just released his latest book, The Edge of Reason: A Rational Skeptic in an Irrational World. Although about half of the book deals with morality and political philosophy, I’m going to focus here on a couple of salient epistemological points. I trust readers will see their relevance to the effort to develop rational views of largely irrational financial markets.

Baggini sets forth a notion of reason “which is thin enough for there to be mutually comprehensible reasoning between individuals and cultures in a shared discursive space, without it being so thin as to enable anything to count as reasoning, from nuanced step-by-step argument to thumping the table and insisting on the correctness of your position.” His ‘thin’ view “sees rational argument not as a formal, mechanistic, rigid method but simply as the process of giving and assessing objective reasons for belief. These reasons are those which are assessable and comprehensible by any competent thinker, which stand or fall irrespective of our personal values, and are compelling yet open to revision if the evidence changes.”

Reason, Baggini argues, requires judgment. It is “not a pure algorithm that can be set up and left to run by itself to produce true conclusions.” It cannot be completely schematized and formalized. The inescapability of judgment in reasoning is “philosophy’s dirty secret.”

Moreover, frequently philosophy doesn’t rely on arguments at all; instead, it calls on us to attend to and then interpret an observation. “Attending is often more useful than argument. As Wittgenstein put it, the best way to respond to a skeptic who says ‘I don’t know if there is a hand here’ is to say ‘look closer.’ Attending is a crucial element in good reasoning and provides the clearest example of the ways in which philosophising inevitably requires the use of judgement and cannot rely solely on what logic and evidence dictate.”

But back to arguments. A rational argument is “always in principle defeasible—open to revision or rejection—by public criteria of argument and evidence.” This is not the same as to say that it is always falsifiable in Popper’s sense of the word. Popper’s mistake “was to over-specify something which, if stated in more general terms, should be uncontroversial.” First of all, Popper intended falsifiability to be a criterion for demarcating between science and non-science. “So even if the principle works, it does not allow us to distinguish between the rational and the non-rational, unless we make the further claim that the only form of rational discourse is the scientific one. This is impossible, since such a claim would not be a scientific claim but a philosophical one, and so would be self-refuting.” Second, it’s not clear that all scientific claims are actually falsifiable. For Popper, “falsifiability is possible because theories imply predictions, and we can see if these predictions are borne out or not.” But, as Hilary Putnam argued, “’theories do not imply predictions’ in the straightforward way Popper believed. ‘It is only the conjunction of theory with certain ‘auxiliary statements’ … that, in general, implies a prediction…. This means ‘we cannot regard a false prediction as definitively falsifying a theory’ since there is always some uncertainty of the status of the auxiliary statements and their link with the theory being tested.”

Rationality is being sorely tested in the world today. Baggini’s book won’t, of course, prompt people to shut down vituperative Twitter streams or put an end to radical terrorism. Still, as Baggini writes in his introduction, “The rehabilitation of reason is urgent because it is only through the proper use of reason that we can find our way out of the quagmires in which many big issues of our time have become stuck.”

Wednesday, October 26, 2016

Kinahan, Essential Option Strategies

J. J. Kinahan, chief strategist and managing director of TD Ameritrade, formerly of thinkorwim, has written a primer for would-be options traders—Essential Option Strategies: Understanding the Market and Avoiding Common Pitfalls (Wiley, 2016). The book is clearly written and well developed, and it more or less covers all the bases. But since it is but one of many introductions to trading options, what distinguishes it from its competitors?

For starters, it avoids the sometimes difficult math that litters beginning books on options. The only concession to numerical concepts is Kinahan’s heavy reliance on standard deviation. But even here, he says simply that “SD refers to the range of stock prices around the average price or mean. The theory says that a stock will close within one standard deviation roughly 68.2 percent of the time, within two SDs 95.4 percent of the time, and within three SDs 99.7 percent of the time.” That, and elementary school math, is all you need to understand Kinahan’s primer.

Second, Kinahan gives a lot of space in this book to probability cones—the probability of profit and the probability of touching. With each strategy he discusses he provides not only a risk graph but also two probability cones. He uses these cones to determine whether the price of a position is worth paying. For instance, in the case of long vertical spreads, as a rule of thumb he is looking for “a better than 50 percent probability of the position at least breaking even and an 80 percent or better probability of it touching the higher strike through the expiration.”

Third, Kinahan walks the reader through case studies, with time parameters, risk factors, and of course probabilities.

For the beginning trader, Kinahan’s book is valuable. The intermediate trader may find a few tips that he can incorporate into his playbook. The advanced trader, or anyone with a quant bias, can move on.

Sunday, October 23, 2016

Sironi, FinTech Innovation

The wealth management industry is undergoing profound changes. Technology, coupled with advances in financial thinking, can now offer everything, in the words of the subtitle of Paolo Sironi’s FinTech Innovation (Wiley, 2016) , “from robo-advisors to goal based investing and gamification.” Sironi, who works at IBM as a thought leader for wealth management and investment analytics and who earlier wrote Modern Portfolio Management: From Markowitz to Probabilistic Scenario Optimisation, explains these innovations to both wealth managers and investors.

Goal based investing is, in the author’s view, “the long-term game changer in the process of transformation of the wealth management industry.” An alternative to modern portfolio theory, it is personalized and probabilistic. It takes into account personal values, goals, time horizons, risk tolerances, and goal priority. Importantly, it “must allow for a recursive revision of every decision-making step.” Its risk measure is “the probability of achieving or missing a goal.”

Goal based investing can, at least in part, be reduced to an optimization problem. For instance, probabilistic scenario optimization is “a step-by-step process of portfolio filtering and ordering according to a probability measurement criterion … the end result is the asset allocation that shows the highest probability of achieving an investment goal, while complying with given allocation constraints and risk limits.”

Sironi suggests incorporating gamification into the investing process. As he writes, “Financial Gamification can be a powerful mechanism to learn how to tame emotions in order to size up higher return opportunities, face the potential realization of risks and losses, decide which risk management action seems better suited to mitigate them, and most of all visualize how uncertainty can affect our beliefs beyond personal knowledge, professional expectations, and measurable risk. … Gamification speaks the language of Goal Based Investing and sits squarely at the crossroads between digital technology, behavioural finance, and motivation theory. Its capability to help individuals modify their investment behaviour is an attractive feature in facilitating the revolution in investment perspective advocated by Goal Based Investing, and learning to focus on the best actions towards an individual’s goals rather than greed and fear stemming from attempts to tame the markets.” Goal based investing gamification is still visionary, but Sironi believes it could be “the ultimate case of innovation at the crossroad between FINance and TECHnology.”

I have intentionally focused on the “fin” side of “fintech” in this post. In so doing, I have been unfair to Sironi, who devotes about half of his book to technology. Of the four strategic imperatives he sets forth for asset management firms, the first three are: go digital, become income-oriented, and go robo-technology. For individual investors, however, the changes that will undoubtedly make the most difference will stem from harnessing technology in the service of financial innovation. Sironi gives a compelling glimpse into this promising future.

Sunday, October 16, 2016

Dimitrijević, Frontier Investor

If you’re considering expanding the global reach of your portfolio, Marko Dimitrijević’s Frontier Investor: How to Prosper in the Next Emerging Markets (Columbia University Press, 2016) is an excellent place to start.

First, a definition. What is a frontier market? Of the 193 members of the UN plus Hong Kong and Taiwan, 30 are developed markets and 14 (Brazil, Chile, China, India, Indonesia, Korea, Malaysia, Mexico, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey) are what the author calls mainstream emerging markets. The remaining 151 are frontier markets. Measured by purchasing power parity-adjusted GDP, frontier market countries generate 19% of the world’s PPP-adjusted GDP. By way of comparison, the United States and China each generates 16%; developed Europe, 15%.

Why go to the frontier? Because many of them are likely to be the next wave of emerging markets. Their economies are expected to expand an average of 50% faster than developed market economies over the five years through 2020, and this growth is structural. “With many frontier markets, investors can purchase a Turkey, Indonesia, or Brazil—not of today, but of twenty years ago, when policy and structural changes drove growth. … As a group, frontier markets exhibit the elements that create an auspicious economic outlook: manageable current account deficits (and sometimes surpluses); low levels of government and private debt; moderate inflation; and growing foreign direct investment.” They also have favorable demographics.

That, in a nutshell, is the top-down story. But “even with run-ups in 2013 and early 2014, frontier market equities are still cheap on an absolute and relative basis, especially given their expected growth. And most frontier equity markets are inefficient, which means they may hold undiscovered bargains that the frontier market investor can take advantage of. This market inefficiency also helps explain the low correlation of frontier equities as a whole with other asset classes, as well as the low correlations between individual frontier markets, making frontier markets an attractive portfolio diversification tool.”

So, how do you go about investing in frontier markets? For a variety of reasons Dimitrijević is not a fan of passive investing. To mention just one problem, passive investors are stuck with the index constituents. Active investors, on the other hand, “can use a combined top-down and bottom-up approach to not only pick better companies from those countries already in an index but also to expand their universe to encompass countries with strong and improving fundamentals that are implementing structural reforms.”

Dimitrijević gives tips for the do-it-yourself investor. For bond investors, he has a chapter on special situations in distressed debt. He also explains the opportunities available in privatizations, saying that they “can offer outstanding bargains to those willing to do the additional work.”

Of course, there are risks in frontier markets that the average retail investor may not be aware of. Dimitrijević outlines the most important risks, such as political risk, currency risk, and market liquidity risk.

Frontier Investor is a well-researched book, complete with detailed examples. It belongs in the library of every global investor.

Sunday, October 9, 2016

Harford, Messy

Back in the days that some people thought such things were important, I was criticized for having a messy college dorm room. Although I have no recollection of the details of my sub-par housekeeping (which may well have involved an unmade bed), I suspect that my books, notebooks, and papers were strewn about, left wherever I last used them, some probably in the unmade bed. All I can say in my defense is that I graduated at the top of my class, despite (or perhaps because of) being messy. Since then, over time, I have become neater, and less accomplished.

Tim Harford wouldn’t go so far as to assert a definite causal link. But in Messy: The Power of Disorder to Transform Our Lives (Riverhead Books/Penguin Random House, 2016) he argues that “often we are so seduced by the blandishments of tidiness that we fail to appreciate the virtues of the messy—the untidy, unquantified, uncoordinated, improvised, imperfect, incoherent, crude, cluttered, random, ambiguous, vague, difficult, diverse, or even dirty.”

“Messy,” as you can see from the above list, is itself a messy notion. Harford exploits this quality to cover a range of topics that might not otherwise seem related. Here’s a very short sampling: distraction, collaboration, workplaces, improvisation, winning, financial engineering, setting targets, computerized disaster, stomach ulcers, online dating, and playgrounds.

Harford, best known for The Undercover Economist, knows how to make his points with compelling stories and quotations. For instance, Harford uses Jorge Luis Borges’s tale of the “Celestial Emporium of Benevolent Knowledge,” a fabled Chinese encyclopedia, to explain that “organizing things into categories is not as easy as it might at first seem.” “This Oriental tome, according to Borges, organizes animals into categories thus: (a) those that belong to the emperor; (b) embalmed ones; (c) those that are trained; (d) suckling pigs; (e) mermaids; (f) fabulous ones; (g) stray dogs; (h) those that are included in this classification; (i) those that tremble as if they were mad; (j) innumerable ones; (k) those drawn with a very fine camel’s-hair brush; (l) etcetera; (m) those that have just broken the flower vase; (n) those that at a distance resemble flies.” Harford comments that although this looks like a joke, “most of these apparently absurd categories have practical merit. Sometimes we need to classify things according to who owns them; at other times we must describe their physical attributes, and different physical attributes will matter in different contexts. Sometimes we must be terribly specific—a cat is not a good substitute for a suckling pig if you are preparing a feast, and if we are to punish wrongdoing (whether breaking a vase or committing an armed robbery), we must identify the wrongdoer and no one else. But while each category is useful, in combination they are incoherent…. Our categories can map to practical real-world cases, or they can be neat and logical, but rarely both at once.”

The world is a messy place, and people and companies that enjoy outsize success are often messy as well. “The story of Amazon is a long series of crazy goals, brutal fights, and squandered billions—an utter mess.” The most creative people work on multiple projects. (Harford shares some tips on how to do this without becoming unduly stressed.)

Messy is a wonderful book that challenges the “good housekeeping” approach to life. It’s well worth a read.

Wednesday, October 5, 2016

Belcher, The Beginner’s Handbook for Stock & Bond Investing

Financial markets will remain vibrant only if ordinary folks consider them an attractive place to invest their hard-earned cash. For many, investing is simply a matter of ticking a box (let’s say for a 401K) or hiring a professional. They can reap the benefits of investing without knowing much of anything about stocks or bonds. Just like they pay people to mow their lawns, wash their cars, take care of their kids, they pay people to manage their money.

Then there are the DIYers. And those who, though they may opt to hire a professional, at the very least want to understand what he’s doing.

Everybody has to start somewhere. The Beginner’s Handbook for Stock & Bond Investing by John G. Belcher, J., is a short, ridiculously inexpensive introduction. And it’s surprisingly thorough. It covers stock pricing and valuation, bond pricing, stock and bond categories, mutual funds and ETFs, and sound investment practices.

If you’re trying to convince your teenager to become an investor, this is probably not the best place to start. The book doesn’t have a hook. But for the person who has some interest in investing but knows next to nothing about it, this is a fine primer. It would also be useful to someone who knows a little bit about stocks but for whom bonds are a black hole. Actionable knowledge for the price of a donut.

Monday, October 3, 2016

McIntosh, The Snowball Effect

In The Snowball Effect Timothy J. McIntosh, the founder and CIO of SIPCO Investment Management Company, makes the case for investing in dividend paying stocks. His argument is that “time is the best ally of the long-term, buy-and-hold income investor. The initial results are slow to come about and not that impressive, but in due time, compounding dividends and interest end up snowballing into mindboggling returns, even during periods of market stagnation.”

McIntosh points to four long-term secular bear markets in the Dow between 1906 and 2015: 1906-1924, 1929-1954, 1966-1982, and 2000-2011. During these four periods, almost 70% of the 110-year range, stock prices barely budged. They saw annualized price returns of -0.24%, 0.11%, 0.21%, and 0.32%. With dividends reinvested, however, the annualized returns during these four periods were 6.19%, 5.53%, 4.82%, and 2.78%. “The conclusion: The only reliable way to make positive returns during secular bear market periods is to invest in dividend-paying stocks like those in the Dow.”

McIntosh also investigates small cap stocks, bonds, and covered calls as income-producing investments. But the primary focus of the book is large-cap dividend companies. Although the author recommends some corporate bond ETFs and micro-cap dividend stocks, the bulk of the book is taken up with a detailed description of “the top 100” dividend-paying companies. IBM leads the pack. Rounding out the top ten are Wal-Mart, McDonald’s, Nestle, Lockheed Martin, Chevron, Verizon, Cisco, Occidental Petroleum, and Travelers. In each case the author provides values and rankings for dividend yield, dividend growth, trailing P/E, S&P financial rating, and beta and has a table for the past 11 years showing the company’s yearly dividend, dividend growth, and average dividend yield.

Will investments that generate income continue to be the key to earning consistent returns, as they were for the last 110 years? The problem is that the income component from both stocks and bonds is currently near cycle lows. Between 1906 and 1990 Dow stocks provided an average dividend yield of over 4%. No longer. McIntosh expects the dividend contribution to total return over the next decade to be closer to 2%. “This is a direct result of companies giving preference to stock buybacks and reinvesting their profits in capital expenditures.”

Hence the sample portfolio of 100 especially attractive dividend-paying stocks. McIntosh put together a $100,000 portfolio and projected the dividends and interest it would return for each year between 2016 and 2020. In 2016 the total income would be about $3650; in 2020, about $6475. Continuing this projection further into the future, McIntosh anticipates a total income of $14,350 by 2025. The upshot is that “although the prices of all the stocks and the DVY ETF held in the portfolio stagnated from 2016 through 2025, the portfolio’s value continued to grow the original investment, $100,001.20, to $163,498.85 by the end of 2025—a 4.99 percent annual total return.” That’s some decent snowballing.