Fung, Numbers Rule Your World

Today’s post is not a review since Kaiser Fung’s book is peripheral to the theme of this blog. But I thought I’d call my readers attention to it; it belongs to the genre carved out by Malcolm Gladwell and the Freakonomics duo. By the way, “Freakonomics: The Movie” is being released this fall; the trailer is on YouTube.

Numbers Rule Your World: The Hidden Influence of Probability and Statistics on Everything You Do (McGraw-Hill, 2010) is perfect late summer reading for anyone even vaguely interested in statistical thinking—or traffic congestion, or credit scores, or SAT questions. Or state lottery fraud, or lie detector tests, or food recalls. Fung, a professional statistician, also blogs at Junk Charts and Numbers Rule Your World.

Knight, Chart Your Way to Profits

In this second edition of Chart Your Way to Profits: The Online Trader’s Guide to Technical Analysis with ProphetCharts (Wiley, 2010) Tim Knight accomplishes two tasks admirably: first, he gives a clear description of chart patterns and technical indicators and, second, he explains how to use the ProphetCharts software.

In the good old days ProphetCharts provided free online charts. Then about five years ago INVESTools purchased Knight’s company (a sad day for me as my best source for futures data disappeared). Now, however, as a result of a TD Ameritrade buying binge, the software is available to clients of Think or Swim (so I have it once again) as well as INVESTools. The software is powerful. I particularly appreciate its range of available charting time frequencies, from one minute to a month, its user-friendly drawing tools, and its ratio chart option.

But back to the book. For those who want to know what’s new in the second edition, Knight explains on his blog slopeofhope.com that “it’s about 25% larger, three years more up-to-date with respect to features, and it has a lot more with respect to my own trading philosophy.”

Investors and traders who have read innumerable books on charting and technical analysis and who don’t use ProphetCharts might be tempted to move on to the next new thing. But they would miss the many helpful pointers that Knight gives in this more than 500-page book. That he devotes 69 pages to the head and shoulders pattern gives an idea of the depth of his analysis.

I can recommend this book without qualification to those who are unseasoned in technical analysis and charting and to those ProphetCharts users longing for much more than a software manual. I also suggest that experienced technical traders take a look.

The marginalizing of the individual investor

A brief read recommended by Barron's Alan Abelson: "The Marginalizing of the Individual Investor: The inside story of flash crashes, systemic risk, and the demise of value investing" by Harald Malmgren and Mark Stys. It is yet another look at high-frequency trading.

Abbink, Alternative Assets & Strategic Allocation

Don’t judge a book by its title. John B. Abbink’s Alternative Assets and Strategic Allocation: Rethinking the Institutional Approach (Wiley, 2010) is a fascinating work. It’s packed with well-reasoned insights about a range of markets and strategies and written with clarity, precision, and wit. Anyone who trades for his own account, runs a fund, or manages an institutional portfolio should put aside a day to read this book. It will be a day well spent.

Abbink contends that there are just three investment strategies that underlie all approaches to investing: directional strategies, cash flow strategies, and arbitrage strategies. They can be pursued individually or, more frequently, in combination. Returns from these three strategies can be enhanced through the techniques of leverage, hedging, tactical allocation, investor activism, accepting liquidity risk, or trading volatility.

Abbink analyzes a range of investment styles: long/short equity, direct lending, merger arbitrage, high-frequency trading, holding private assets for their cash flows, fixed-income arbitrage, and event-driven investment. He then moves on to position management and portfolio construction.

That’s the book in bald outline. Since I obviously cannot condense over 500 pages into a few paragraphs, I’m going to let Abbink speak on his own behalf. To begin, here are two passages, the first dealing with hedging and the second with opportunity cost.

“Hedging has become a portmanteau term—a concept that has gradually been made to carry so much freight that it has become very difficult to unpack. A hedge is a position that is put on to offset the volatility of another. This can lead to equivocation over which is the position and which is the hedge. Human nature being what it is, managers sometimes claim that the successful legs of hedged trades were invariably the investment positions, reflecting their sagacity, while the losses on the other legs of the trades ‘just reflected unavoidable hedging costs.’“ (p. 41)

Opportunity cost, Abbink writes, is “a fundamental concept that pervades all investment activity.” It results from “the necessary specificity of our actions… [W]e cannot choose to invest in general but must always select this or that particular investment.” Naturally, we can’t know in advance which will be a high-flyer and which a dud, so we reduce opportunity cost through diversification. “Although the return of the best-performing asset will unquestionably be diluted through diversification, there is a compensating reduction in the aggregate volatility of the portfolio if the less promising assets are carefully chosen.” Abbink views opportunity cost as a pervasive investment risk. “However, opportunity cost is different from all the other pervasive risks in one important respect. While operational or credit risks relate to things that may go wrong, but against which we can take preventative measures, opportunity risk is an ironclad promise that something will turn out other than as desired. Opportunity cost embodies the relationship between risk and return in its purest form: as the Devil’s Dictionary defines it, an opportunity is unavoidably “a favorable occasion for grasping a disappointment.” (pp. 413-15)

Lest my readers think that Abbink’s book is a series of quips, let me quote a paragraph from his chapter on fixed-income arbitrage which describes an option strategy. “Consider a butterfly trade around a yield-curve discontinuity…. In this instance the trading strategy would be implemented by taking a long position at B and shorting positions at A and C that have a combined value equivalent to that of the long position. The trade is productive whether the yield at B drops into line with the yield curve or the curve rises to bring itself into line with B’s yield: the returns are symmetrical and thus the trade is directionally hedged, as any true arbitrage must be, by definition.” (p. 203)

Abbink’s book brings a fresh perspective to topics often relegated to academic papers, making them accessible to investors, both individual and institutional. It’s one of the most thought-provoking books I’ve read in quite a while.

Creative thinking hacks

Today I’m back to Scott Berkun’s The Myths of Innovation. If his chapter on creative thinking hacks is “a high-speed, condensed version of a course [he] taught at the University of Washington,” this post is the warp-speed, ultra condensed version.

An idea, he contends, is a combination of other ideas. Let’s simply accept this definition on faith because, whether or not it’s true, it gets us on the road to creativity. “Over time, creative masters learn to find, evaluate, and explore more combinations than other people. They get better at guessing which combinations will be more interesting, so their odds improve. They also learn there are reusable combinations, or patterns, that can be used again and again to develop new ideas or modify existing ones.” (p. 169)

Standing in the way of creativity is inhibition: “We don’t want to do anything that could yield an unexpected result. We seek external validation … , but creativity usually depends on internal validation. … Creativity has more to do with being fearless than intelligent.” (pp. 170-71)

So how do we go about becoming creative?

Start an idea journal. “You will never have to show anyone else this journal, so there should be no filters—it’s safe from judgment.”

Give your subconscious a chance. “Find time to turn your mind off.”

Use your body to help your mind. “If your body is active, your mind will follow.”

Inversion. “If you’re stuck, come up with ideas for the opposite of what you want.”

Switch modes. “Everyone has a dominant way of expressing ideas: sketching, writing, talking. If you switch the mode you’re working in, different ideas are easier to find, and your understanding of a particular problem will change.”

Take an improvisational comedy class. [You can be creative here and try to figure out why this would be helpful.]

Find a partner. “Some people are most creative when they’re with creative friends.”

Stop reading and start doing. “The word create is a verb. Be active. … If all your attempts at being creative consist of passive consuming, no matter how brilliant what you consume is, you’ll always be a consumer, not a creator.” (pp. 173-74) Yes, I hear you!

We need downtime to learn

That's the gist of one of the most e-mailed articles in today's New York Times: "Digital Devices Deprive Brain of Needed Downtime." Isn't it amusing that everyone, including me, is using digital devices to tell others why they shouldn't use them so much?

Isbitts, The Flexible Investing Playbook

In The Flexible Investing Playbook: Asset Allocation Strategies for Long-Term Success (Wiley, 2010) Robert A. Isbitts sets out to reeducate investors. The “next many years,” he claims, “will be about two things.” First, buy and hold is dead; investors should rent the market instead of owning it. Second, risk management is critical. (p. 6)

Isbitts reworks the classic 60/40 approach to investing. The old mantra was to put 60 percent of your money in stocks and 40 percent in bonds. Isbitts’ take is tactical—try to make at least 6 percent for every 10 percent move up in the market and try to limit losses to 4 percent for every 10 percent move down in the market. Easier said than done, as everyone who manages money would undoubtedly attest. It’s one thing to write about cycles: up, down, and transition. It’s another thing entirely to offer effective guidelines to identify these market phases in real time. Although Isbitts and his team engage in cycle analysis, he circumvents the problem of timing, in part at least, by appealing to asset allocation.

He discusses three model portfolio strategies. First, the hybrid strategy “pursues long-term preservation and growth of capital over a one- to three-year period by investing in a combination of investment styles expected to exhibit low correlation to the broad stock and bond markets.” Second, the concentrated equity strategy pursues the same goals “over a three- to five-year period by investing in a group of equity money managers (through their mutual funds) who run concentrated portfolios.” Third, the global cycle strategy extends the time horizon to five to ten years. It invests “in a mix of funds that target global, secular business themes.” (pp. 131-32)

These strategies can be pursued individually. But, taken concurrently, they offer the investor the ability to hedge his position during “countertrend” declines in stock prices while holding onto his core long-term positions. As should be apparent, this three-pronged approach to asset allocation is not designed for the investor with a small account. Isbitts’ background is in wealth management.

The final part of the book deals with evaluating performance. Benchmark envy, he writes, “is one of the most destructive forces to investors.” (p. 177) Benchmarks should be used for comparison over “long stretches of time—5 to 10 years,” not as a short-term measure of whether an investment is working out.

Isbitts describes some useful ways to keep score: capture ratios, standard deviation, rolling returns, and R-squared. Here I’ll confine myself to only two: capture ratios and rolling returns.

The capture ratio “is a statistic that tells you how much of the market’s move you have experienced.” (p. 180) If your portfolio grows by 8% during a 10% up move in the market, you would have a 0.80 up capture ratio. If the market goes down 10% and your portfolio falls by 6%, you would have a down capture ratio of 0.60. If in the same bear market scenario your portfolio has a 2% gain, your down capture ratio is -0.20. The capture ratio is a useful statistic because it shows how various portfolios have performed historically and how they might react to future market conditions.

Isbitts argues in favor of using rolling returns in place of trailing or annual returns to evaluate a manager’s past effectiveness. He illustrates the problem with the standard metrics with this table of the “annual returns of three different hypothetical portfolios.”

As you might suspect, these are not three different portfolios. A is the return of the S&P 500 from February 2002 to January 2007; B is the index’s return from October 2002 to September 2007; C is its return from July 2002 to June 2007.

If the investor looks at rolling returns graphs (and they can be for whatever length his analytics tool permits—3-, 6-, 12-month, or for those with a very long time horizon 5- or 10-year) he can glean important information. The author suggests studying how often a fund’s “rolling 12-month return has crossed into negative territory and for how long” and doing peak-to-trough analysis “whereby we analyze returns from different market tops to market bottoms, and vice versa.” (p. 186)

This is a thoughtful book on portfolio construction, one which financial advisors would do well to read. The individual investor might not be able to implement all of Isbitts’ suggestions, but the principles set forth in this book should enable him to both reassess the potential robustness of his portfolio and make some improvements to his mix.