Financial Reference

Hedge funds have a problem. It’s a problem I would love to have — to much money and not enough good investment ideas. We’ll at least I’ld love to have the first problem. The problem is that too many people are looking for yield in a low yield environment. To find yield, people are taking on too much risk — both interest rate risk and default risk. (I.e. people are not getting paid enough to lengthen the duration of their portfolio or to invest in the bonds of riskier companies.) Even Greenspan has commented on this problem.

In the search of higher cash returns, more people have entrusted their savings to hedge funds. Hedge funds, generally speaking, try to produce alpha or excess return. They employ a variety of strategies to reach this goal. Many of them trade often, use leverage, and try to create yield for their investors.

But the biggest mark of a hedge fund is the compensation structure. Hedge funds charge 2% of assets and 20% of profits. Of course, they don’t pay 20% of losses. (They will generously stop charging 20% of profits until they recoup previous losses.) The idea is to give the managers a large incentive to perform. The effect is often much different.

If a manager of a regular corporation had the option of betting $1mm on a fair flip of a coin, there is no way he would take the gamble. But, if a hedge fund came across the same gamble, he would be incented to take it. If he was successful, he would have an extra $200K in comp. If not, he would still get 2% of assets.

If you think this scenario is too academic, check this Reuters article out. Hedge funds have been investing in “cat” bonds for while. Cat bonds are bonds whose payments are correlated with catastrophe losses. They allow reinsures to spread the risks of their losses and give a higher yield to investors willing to accept more risk. After Katrina, I thought some of these hedge funds would realize that they didn’t appreciate the risks.

But the opposite has occurred. Hedge funds are now setting up captive reinsurance companies and trying to compete with established reinsurance companies. Good luck. They don’t have the expertise or relationships to compete. They will drive prices down, will make our insurance more affordable (thank you), and hopefully hurt their investors. Reinsurance is based upon long-term contracts and relationships; insurance companies (especially well-financed ones) do not want to change their reinsurer often. The hedge funds will have to compete on price (and probably charge significantly less) to get customers.

This begs the question: why don’t the hedge funds just invest in established reinsurance companies? The answer is 2 and 20. There is a small probability of a major event. If it occurs, they don’t have to pay — and may even liquidate and restart so they don’t have to make up their losses. If it doesn’t occur, they get 20% of a much larger gain. If they, instead, invested in reinsurance companies they would be at the mercy of the market to value their investments. It’s easy money for the managers even though there is a much better alternative for investors.

The better question is: why would investors in hedge funds pay 2 and 20 for reinsurance exposure?

The last two days I have opened the Wall Street Journal (my main source of news, besides the Daily Show…) Greenspan has been in the first section. He was on the front page yesterday warning of consumer’s reliance on housing loans to support their spending habits. Today he was on the second page warning that investors are not appreciating risks to the economy.

I know that when Greenspan speaks, the press and investors listen. But the warnings he provided over the last few days are not new. We all know that people have been taking money out of their homes — just listen to the radio ads or look at new mortgage businesses being formed. And, when people have money, they usually find a way to consume more, rather than save. We also know that there is “froth” (to say the least) in the housing market so consumers will not be able to tap increases in home equity in the future.

Also, we know that investors are doing anything to look for more yield. The risk spread between junk and treasuries is absurdly low. The yield spread between short and long-term bonds is also extremely low — i.e. the yield curve is flat. The flat yield curve has previously been referred to by Greenspan as a “conundrum.” And we can all see the low price being paid for taking on extra risk by looking at bond mutual fund yields.

There is no new information in these articles. Well, maybe a little — the risks be more obvious than we previously thought. But, if they are so obvious, when will the market take notice? Do we remember how the “irratonal exuberance” warning ended?

I’m having flashbacks to 2000 today. Back in 2000, Time Warner merged with AOL to create a media behemoth. The goal was to unlock synergies between delivery and content. Obviously, that didn’t turn out as management had hoped. (On a side note, the new Time Warner re-believes that AOL is the key to their future.)

Today, Yahoo announced a plan to enter the content world by hiring eight new financial columnists. With, I’m sure, more to come. I hope, for their sake, they are only trying to differentiate themselves by providing a little exclusive content, rather than trying to revamp their business model. We shall see.

On the positive side, I’ll take any free financial content I can get.

I’m sorry I haven’t posted lately. It was a rough week for me all around — I was sick, worked too much, and the market wasn’t too kind. It is the first time our portfolio had a very rough week. In the past, my portfolio has taken beatings, but this was completely different.

From past experiences, I know that these things happen from time to time. Net worth does not increase linearly (assuming you take some risk). And, since I take a lot of risk, our net worth jumps around quite a bit.

But I need to make some changes now that I’m married with child because my wife does not react to volitility in the same way, I have more responsibilities because of my son, and we do not have as much free cash flow to protect our portfolio.

I realize now that I can’t continue taking the risks I have taken in the past. It hurts, but I can’t continue to manage to my own risk tolerance and not take into account my new circumstances. After a conversation with my wife, we decided on a new investment plan involving lower leverage and more diversification.

We have a very large exposure in Property & Causualty insurance and reinsurance stocks. Needless to say, the last few days have not been kind.

In times like these, when your portfolio begins free-fall, I always remember a quote from one of the best investors of all time, Peter Lynch, “I’ve always said, the key organ here isn’t the brain, it’s the stomach. When things start to decline - there are bad headlines in the papers and on television - will you have the stomach for the market volatility and the broad-based pessimism that tends to come with it?”

I’m not going to pretend that losses don’t affect me, but I’ve learned to keep my finger off the trigger. The worst thing to do is to take risk but then sell as soon as the market turns against you. I’m still optimistic about the long-term prospects of the companies we own but days like today, test my confidence to the fullest.

The Fed increased the target for the federal funds rate to 3.75% today. The Fed’s statement included: “Higher energy and other costs have the potential to add to inflation pressures.”

The market tanked. Everything on my “My Yahoo” page went from green to red in a moment.

High energy costs and increases in materials costs (most likely due to high energy prices) are causing the Fed to raise their target rate. And all of these factors are weighing on the market. But, I would argue, the risks are overblown.

The story goes: high energy prices slow down the economy but high energy prices also increase the price of goods and inflationary pressures. Soon, people start having nightmares of 1970s stagflation.

The Fed, by raising its target rate, said that the risks of inflation outweigh the risks of stagnation; or, alternatively, that it’s going to keep the same playbook despite the risks of stagnation due to the Hurricane. (I wonder: would we be concerned about stagnation instead of inflation if the Fed had not raised rates?)

High energy prices are being double-counted. They are leading to lower growth assumptions and higher discount rates (through a higher inflation assumption). So, if we buy stocks now we have a large upside if energy prices decline. Not a bad position given that energy prices should come down.

Based on recent articles I’ve read, the cost of producing a barrel of oil is somewhere between $25-35. From Econ 101, if the cost of production is less than the price, there should be more entrants, forcing the price down.

I have no clue how long it is going to take to be back in equilibrium — where the cost of production is equal to the price — but when it does, I bet the price will be lower than the $66 it’s trading at right now. And when oil prices go down, growth should increase, inflationary pressures should ease, and stocks should do well.

Of course, the worst could happen — our oil wells could run dry, new technology could not be developed to tap new fields, and new technology could not be developed to reduce our dependence on oil. But I wouldn’t bet on it.

An aside: I’m not good at economic forecasts and my timing is usually horrible, but I have done well over the long-run. Also, I don’t recommend trying to predict the direction of commodity prices but rules are made to be broken…

I just realized that I have been posting for a while and have never introduced myself. Even though I am only 26, I have been investing for about 10 years. I started by using my parent’s financial planner to help me pick two active mutual funds.. She recommended I pick funds with high Morningstar ratings. It was more than I knew at the time so I followed her advice.

Later, I found out she had a cushy relationship with the fund family she pushed the hardest. I doubt there was anything illegal going on and the fund family has a decent lineup of funds but she did have a conflict she did not disclose to me. Ever since then I have been a skeptic about investment advice and have been learning how to manage money on my own.

Since that time I have spent way too much time talking to other investors, reading books, 10Ks, and 10Qs — doing anything I can to gain an advantage — and more importantly, doing anything I can to make sure I don’t screw up. Despite all of my efforts to the contrary, I have done a lot of dumb things.

The two biggest mistakes I’ve made are that I have been overconfident and overly aggressive. During college and especially during law school, I played a high stakes financial game and didn’t appreciate the risks I was taking. I took out as much student, credit card, and margin debt as I reasonably could (I never paid more than 10% on the debt) and invested the proceeds in undervalued stocks. Even though I was eventually proved correct in my valuations, for a while my positions went the wrong way. I didn’t have any extra capital to support my positions in the short-run and was forced to periodically liquidate part of my portfolio.

Eventually I was proved to be very correct in my analysis and was rewarded for taking the risk. But it was still a mistake to lever myself to the point at which I could not support my portfolio. Had I had extra cash flow from a job, more lines of credit, or less leverage I could have survived any liquidation and not had to sell any of the undervalued shares on the open market.

Since then I have always left extra margin in my investment account and had lines of credit available for emergency. Over time, I will scale back my leverage to decrease my risk and increase my cash flow. It will allow me to have more flexibility and more toys as I grow older.

Unlike a lot of blogs, I don’t reveal my personal balance sheet or income statement. All I can say is that my wife and I are well-off and should have the freedom to retire early even after paying for our child’s education.

The Important (Non-Financial) Part of My Life

I got married in June and have a 10-month old boy. (I know, the math doesn’t work…) My wife and I both work in the actuarial field — so I usually avoid talking about insurance in my blog even though it is a very important part of the financial picture.

My background is as varied as my interests — I have degrees in math, economics, and psychology; and I have an unused law degree. I also manage accounts for a couple of friends and have had very good results managing their accounts and my own.

The WSJ just came out with a Saturday edition that emphasizes personal finance. Their lead article made me want to revisit a blog I posted a few days ago.

The WSJ article (subscription req’d) “New Tools to Hedge Your Home” discusses a new and old way to hedge your home.

A problem with the old way, selling short an index of homebuilders, is that this is an imperfect hedge. In addition, the index of homebuilders has performed extremely well historically — often much better than the increase in home prices. It’s not a good long-term strategy to be short something that historically has performed extremely well.

There is a new way to hedge the value of your home through the use of derivatives. The first to market is HedgeStreet. Through their website you can speculate on the short-term direction of real estate prices in six markets. If the value of your home is correlated with the value of the real estate index in any of the six markets listed, you can hedge the short-term value of your home.

But I would advise against using derivatives to hedge the short-term value of your home. First, if you do not plan on selling your home soon, a lower price only means that your property taxes might go down. (The site currently does not allow for long-term hedging — the longest contract is for three months.)

Second, the markets are currently very illiquid and so hedging can be very difficult and expensive. As more contracts and market-makers enter the market, hopefully these problems will be fixed.

Third, derivatives are complicated instruments that can easily be misused.

Fourth, the hedges will probably be far from perfect for your circumstances.

The biggest problem I have with the products is that it reflects our current preoccupation with short-term changes in real estate values. Currently, real estate values are generally overvalued, but over the long-run values should increase from their current prices. I would not recommend investing more in real estate at this point, but there is no need to speculate in a negative NPV transaction that isn’t really hedging your real risk.

A sell-side analyst “works for a brokerage or firm that manages individual accounts and makes recommendations to the clients of the firm.” Investopedia. Every time a stock is upgraded or downgraded, one of these analysts are at work.

Their obligation is to the firm they work for, not to individual investors. Depending on the firm they work for, their objective could be to: increase trading, please a company by issuing a favorable recommendation, increase client satisfaction, or to avoid any number of other normal pressures a person faces at work.

During the internet bubble, some sell-side analysts developed quite a following. So much so that we still remember their names to this very day: Meeker, Blodget, Grubman to name a few.

After the internet bubble popped, these idolized analysts’ names were dragged through the mud. I’m not saying they didn’t do anything wrong, but a lot of them did what their job required of them. If they could explain away the irrational exuberance during the time, if they could convince themselves and the world that they knew the secret to the new economy, they could make a killing. And they did.

They made their clients happy by producing eye-popping returns (at least until the bubble popped); they made their companies happy by bringing in more assets and investment banking business; and they made themselves very wealthy. The good analysts knew the bubble couldn’t last but it was fun while it lasted.

At least in today’s more rational market, these abuses don’t happen. Analysts are there to tell you how they really feel about an investment. They are not there to make money for themselves or their firm. They have an undying to devotion to the well-being of the individual investor. Or so I thought…(Okay, I never really did.)

Sell-side analysts are, after all, trying to sell you something. In that spirit, most of the stocks a company covers are ranked as a “buy”. After all, who wants to buy a “hold” or a “sell?” In fact, Jefferies & Co. has 10 buys for every one sell; A.G. Edwards has 15 buys for every sell. (WSJ Online; Subscription Req’d.) It’s so bad that most investors recognize a “hold” for what it is — a “sell” with connections.

If you thought the game has changed, it hasn’t. Just the timing has — there is no crash so the losses aren’t as visible. If you decide to use the “expertise” of a broker’s firm, make sure you know what percent of the firm’s recommendations are “sells” and how their recommendations have performed over time compared to an index. Assuming that they aren’t playing games with the numbers, chances are that after fees their recommendations will have underperformed and you would be much better served in a boring, yet lucrative, index fund.

Back in 1938, John Burr Williams codified the fundamental principle of value investing: the value of a stock is the present value of its future dividends. It seems obvious, but underlying this statement is some very powerful, yet often forgotten, advice.

We forget at our our own peril. “From 1871 to 2003, 97 percent of the total after-inflation accumulation from stock comes from reinvesting dividends. Only 3 percent comes from capital gains.” (The Future For Investors) (By the way, if you are looking for a great introduction to investing, read this book!)

Not only have dividends been the driving force behind the real returns of the market as a whole, but the returns of individual stocks are driven by their yield. Jeremy Siegel sorted the stocks comprising the S&P 500 every year by dividend yield. He found, “in strictly increasing order, the portfolios with higher dividend yields offered investors higher returns.” (Ibid.)

David Dremen found similar results looking at the 1500 largest companies from 1970-1996. (Contrarian Investment Strategies: The Next Generation) He found that higher yielding stocks produced higher returns.

In addition, both authors found that “high yielding stocks also provide you with the best protection in a bear market.” (Ibid.) So, stocks with high dividends return more and offer better downside-protection. (So much for “tinstaafl”.)

There is one small difference between the findings of the two studies, however. The Siegel study found that the highest yielding quintile produced the highest return while the Dremen study found the highest yielding quintile produced the second highest return (to the second highest yielding quintile). I’m guessing it’s just because there is still enough variance left in the data to get different results with slightly different methodologies and data sets.

Either way, I am going to continue buying stocks with large dividends. And I am not going to worry whether a dividend is too high — just whether the company can support it in the future. For a reasonable dividend strategy — I agree with most of what he has to say except that I don’t worry as much about a high payout ratio (dividends/earnings) — see this blog).

But there is one big question left unanswered: why do dividends predict higher returns? From a strictly mathematical viewpoint, they should reduce the value of the company because they increase the tax burden.

I can think of three reasons why dividends increase value: (1) Dividends encourage managers to make better investments with the cash they have — i.e. they don’t have cash to burn on bad investments; (2) management will only give out large dividend payments if they are very confident about the future; and (3) a company can not pay dividends if it does not have cash earnings (without diluting shareholders).

Interestingly enough, there are people who argue that an increased payout ratio (dividends/earnings) is an indicator of higher future growth. (See, e.g., this month’s SmartMoney, p. 56.) I’m not yet convinced this is true because there is a very strong mathematical reason for the opposite to occur: the growth rate is = (1-Payout Ratio)*ROE. The mathematical relationship between the payout ratio is the exact opposite as what they are claiming!

In any case, there is very little doubt that buying high dividend paying stocks is good for your financial health. And I personally invest in high dividend paying stocks — I own no REITs, trusts, or bonds but have a yield of nearly 4%. (Of course, I think the companies I own have other good attributes as well. I don’t invest solely based on one factor.) Even if the market goes sidewise for some time, I will still get close to a t-bond return. And, if history is any guide, I should outperform the market over the long-run.

I don’t know if you’ve seen the new show on TLC called “Flip This House.” I haven’t, but I think I can figure out the premise: someone purchases a house, puts some elbow-grease into it, and tries to sell it for a profit — an amazingly common theme in this crazy time.

Every time I open a newspaper or magazine (or watch TV) I hear about how much people have made in real estate or how dumb they are for investing in real estate right now. For example, last month’s Money magazine featured condo flippers. Some people are buying condos that won’t be built for years with extreme leverage. This is crazier than being a tech speculator in the late 90s. At least the techies were not as leveraged, had a market to sell into when the crash came, and didn’t have to pay huge transaction fees.

But the really strange real estate conversation is: should you sell your home and rent? It belies the real change in philosophy towards housing: people are looking at their homes as an investment rather than a place to live. Yes, housing is overpriced, but people should not be selling their houses because they think they are overpriced because:

(1) The transaction costs can eat away at any difference between the price and true value of the home.
(2) Even if the housing market is overvalued, that does not mean that after you sell, the value of your house will decrease. Trying to time a market — even if it’s overvalued — is hard.
(3) There are other reasons to own a home rather than rent — like freedom, attachment, and pride of ownership.

Even though real estate is probably overpriced, you shouldn’t sell your house to rent. Instead of looking at a house as a sure road to riches, if you see it as a place to live, you’ll be much happier with your return.

The reason a fund complex launches a new fund is to try to attract more assets. I’m okay with that. But sometimes a fund complex takes it too far. Take, for example, the new Van Kampen IPOX 30 Index Portfolio.

IPOX allows the investor access to recent large IPOs. But there are significant problems with the fund — drawbacks that make the fund uninvestible. The fund charges up to a 4.95% sales load!

There is no secondary market for the shares. The company states that they are creating one and that you can deal the shares back to the company.

In addition, despite their claims that their strategy will produce market beating returns, I have significant doubts because (1) IPOs have traditionally underperformed (see Buying IPOs Is a Loser’s Game) and (2) according to a recent Morningstar study, high expenses mean low returns.

If you want the excitement of IPOs feel free to play around with this fund but if instead, you would like to increase your net worth, I would stay away.

I found a letter in this month’s SmartMoney that is a great example of how not to invest:

I bought 1,000 shares of Getty Images at $68.70 after reading “99Pound Gorillas” in your January issue. During the course of the next five to six months, the stock bounced around between $72 and $77. I began to view this as a trading range.
Well, in August’s “No Monkey Business Here,” you recommended taking some gains since the stock has treached $73. I was somewhat in agreement. But the following day I read, in the same issue, Paul Sturm’s “Cut Your Losses; Ride Your Winners.” The research about how people sell winning stocks too early made a lot of sense. Later that day, Getty came out with good earnings. Near the end of the week, the stock was over $82. All of this is evidence that the study discussed in Sturm’s article is 100 percent right on, for this situation.

Let’s count the mistakes:
1) Relying on someone else’s analysis (especially a magazine!) and not even making an attempt to value the security.
2) OK, he made a really bad attempt — apparently the true value can be derived from trading ranges.
3) Again, relying on a magazine for a valuation.
4) Attributing skill to a very random outcome.
5) Believing in a strategy because it worked for a very small sample. (I didn’t read — or more likely, did read but don’t remember — Sturm’s article. He may be right, but a sample size of one is completely not credible.)

The frustration I get from reading claims like these are a big reason I started this blog. (That and my wife thought I needed another outlet for my financial opinions.) Although there is little to no connection between his actions and the results, he attributes his results to his actions. Going forward, he probably won’t be so lucky — as the saying goes, a fool and his money are soon parted.

By the way, there is a very good book on this subject, Fooled by Randomness, a book that will help anyone be a better and more humble investor.

I know long-term interest rates are going to increase. Heck, I knew this six months ago. It was going to happen — and happen soon. I would have put money on it (but luckily I didn’t).

I’m continually amazed by pundits and my ability to see the future so clearly, only to forget our predictions so easily. And those of us that do remember have ready excuses due to “unforeseen events.”

Each time I find a sure thing, I give myself a few days to think it over. Usually, I start finding problems with my idea. Most of us would be better off if we did this more often — much like shop-a-holics should put something on hold instead of making an immediate purchase. Buyers and sellers remorse is a big part of investing — and can cost you much more than a trip to the mall.

However, many people still try to time the market — moving money in and out of the market to try to get better returns. Of course, these timers inevitably end up hurting themselves in the end.

Money calculated the return investors actually earned investing in 700 mutual funds from 1998-2001 and compared that value to the returns of the funds over the same time period. The shareholders annual return was 1%, compared to 6% for the funds.

The difference is that shareholders were buying and selling at exactly the wrong moments. When the fund performed well, the investors gained confidence, and cash flowed in to the fund. When the fund performed poorly, the investors lost confidence, and cash flowed out. The investors were buying at the top and selling at the bottom.

The investors would have been much better off to buy and hold rather than to let their emotions control their investment strategy.

Before you decide to buy or sell, make sure you have good reasons and that your emotions aren’t guiding your decision. Don’t think that you can predict the future or get upset with yourself for your lack of foresight. (For example, it was obvious to me that the market was overvalued in the late 90s, and I should have cashed in, but if I would have given myself the leeway to bet against the NASDAQ, I would have been broke way before the bubble eventually popped.)

Maybe interest rates will stay flat for a while, maybe they won’t. But I’m smart enough to know that I don’t know what will happen; and smart enough that my investment strategy doesn’t totally depend on my forecast of the future.

Every once in a while, I think about something other than finance — this is one of those moments. Even less often, I think about politics. But the recent news surrounding the coming John Roberts confirmation hearings is aggravating.

First, let me start with a little background about me: I have never voted for a Republican Presidential candidate — but most of that is because of W. (I am only 26 and so two of my votes would be better described as settling for the person I disliked the least.) But I can’t believe the politics being played right now by the Democrats before the confirmation hearings of Roberts.

Despite disagreeing with almost everything Roberts believes in, he is a good candidate. A person is not unfit for the judiciary because we disagree with him. Yet, politicians and the media have been attacking Roberts because he argued the “wrong” side of cases.

He argued for overturning Roe v. Wade when it was his job to do so. By the way, it is a lawyer’s job to argue for his client to the best of his ability. (I still remember a little about law from my days in law school — I have a law degree but am not a practicing lawyer.)

Democrats: let’s face the facts. Roberts has beliefs that are the exact opposite of ours. Roe v. Wade may be overturned, states may get more rights, religion may become a part of our government — and I hate to think about these things happening (at least 2 of the 3) — but Roberts is a good candidate. He has the intelligence, experience, and morality necessary to perform the duties of the Chief Justice of the Supreme Court. Although I fear the ramifications of a Chief Justice Roberts, there is no good reason to stop his confirmation.

Actively managed mutual funds are one of the most popular investments for individual investors. They give individual investors access to diversification and professional management. So they should be a good investment for most people, right? Actually, it’s quite the opposite.

Actively managed mutual funds are not as good as other investments (including, most notably, index funds and ETFs) because there are many unchecked conflicts of interest between the manager and the shareholders of the funds. This can be seen in the performance of active mutual funds — which consistently underperform index funds (up to 4.5% after tax according to one study cited in the article cited below).

The objective of a mutual fund manager is to maximize the value of their management contract — i.e. increase the assets under management and increase expenses. These are the exact opposite of what the shareholders want.

The bigger the fund, the lower the probability that the manager will be able to outperform the market. There are only so many good investment ideas a manager can have, and the more assets, the more the manager’s mediocre ideas are going to creep into the portfolio. Warren Buffet once opined that since people only have a few good ideas, investors should invest like they can only invest in 20 companies over their entire lifetime. The more diversified, the more the portfolio will start to perform like an index — but don’t worry, you’ll still be paying the fees like it’s actively managed.

In addition to the hefty expense ratio you’ll be paying, some managements have the gall to charge you for selling more of their product, by charging 12b-1 fees. They claim it’s for your benefit since the more assets, the lower they can make the expense ratio. However, most funds have not reduced expenses when they get more assets. So they charge you extra to make the fund more like an index but don’t pass on the benefit of lower expenses.

Another source of conflict people often overlook is that managers try to maximize before tax return and so turn over their portfolios more than shareholders would like. If you are holding the fund in a tax-free account, this wouldn’t matter, but for the rest of us, this is another reason to favor index funds and ETFs.

It just doesn’t make sense to expect superior performance from an actively managed mutual fund. It’s hard to outperform (especially on an after-tax basis) when you have a diversified portfolio with high fees and high turnover. So, if you do choose to go with an actively managed mutual fund, prefer funds with low turnover, low fees, and a concentrated portfolio. If you favor these funds, you will have a better chance of beating the market. Of course, you would probably be much better off buying an index fund or ETF.

(For a great interview on this issue — and for the source of much of this blog — check out WSJ.com “Yale Manager Blasts Industry” (Sept. 6, 2005) — sorry, I don’t have a link.)

A recent comment said that I don’t account for human nature in my strategies. I agree, I don’t. But I think there are good reasons for this. In investing and planning for our future, we have to try to beat the humanity right out of ourselves. Some examples of bad behaviors:

People have a tendency to spend, rather than save.

People have a tendency to buy into growth stories rather than boring, profitable companies.

People have a tendency to chase trends.

People have a tendency to buy after a run-up and not buy after a sell-off.

People have a tendency to put significance on insignificant events (e.g. recent stock performance).

The list could go on but my point is that we have to fight against our natural tendencies to the extent possible. Although the short-run is exciting (it’s fun to see our net worth go up and sad to see it go down), we should try to not react to short-term events and put more emphasis on the long-run. Easier said than done. I struggle with it every day.

The best thing you can do for yourself is to know what your weaknesses are: do you like to trade? Do you get caught up in manias? Do have trouble saving? Are you over/under-aggressive?

And create a plan — you can follow — to address these issues. Before you decide on an investment/savings plan, ask yourself whether you will be able to follow it.

The investment ideas I discuss are not for everyone — they have worked for me and may work for you — but that is up to you to decide.

I should be able to stop with the title, because it seems obvious that options are expenses. As Warren Buffet said, “If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And if expenses shouldn’t go into the calculation of earnings, where in the world should they go?”

It’s hard to argue with that logic, but special interests don’t heed to logic. (If I had millions on the line, maybe I could convince myself that options shouldn’t be expenses, too.) The arguments against options are:

(1) They are hard to value;
(2) Expensing options will overburden the technology industry and the US economy;
(3) If companies buy the stock on the open market to replace the shares they give, shareholders are not worse off.

There are probably other, equally ridiculous, reasons but I’ll limit myself to this list.

(1) It is true that stock options are hard to value — they are even harder to value than exchange-traded options because options given to employees have a longer term-to-maturity — but they are far from impossible to value. There are standard option-pricing formulas that will give good approximations of the value of the option.

Also, there are other items that effect the P&L that can be even harder to value — pension liabilities and assets; reserves for returns, asset impairment, insurance losses; and depreciation schedules, just to name a few. The difficulty of valuation does not mean that we should not value at all — it is much better to be approximately right than precisely wrong.

(2) Nothing like a statement: “we can’t make a profit if you make us keep ALL of our expenses on our books.” If that’s true, then maybe you shouldn’t exist.

Of course, the logic goes the other way as well — maybe because these companies have been inflating profits there is has been overinvestment (and the subsequent crash) in the technology sector.

(3) I can’t believe this argument even exists. It’s true that if you purchase shares on the open market with shareholder cash that the number of shares does not increase. But where is the shareholder’s cash?

The real reason for the battle is that executives want to take money from our pocket, put it in theirs and not tell us. And if they have to tell us, we might tell them to stop.

It’s sad that there is any debate about expensing options. It’s distracting from the real issue: how should companies value and expense options? Of course, if I was one of those executives, I wouldn’t want to tell my shareholders how much they’ve been paying me either.

One of the hardest things to do as an individual investor is to locate undervalued companies. There just isn’t enough time in the day for one person to scour the annual reports of many different companies — especially if you have a day job or family commitments. The time constraint is the biggest disadvantage facing an individual investor. Below is a summary of sources I have used and their advantages/disadvantages:

1) Lists of companies trading at their 52-week lows. Companies listed here are often cheap but can have serious operating issues and so you must be very confident that the problems are only short-term or that, even with the problems, the company is still undervalued.

2) Screens. Screens are an easy way to compare basic statistics about companies — and look for companies with high dividends, low P/E, etc. but often the companies that have great statistics sometimes have them because of one time positive events in the previous year or their future looks pitiful. For a good screener, try MSN’s deluxe screener.

3) News. I look for companies with current operating or financial issues, but good long-term prospects. This is a good source for finding companies with problems (e.g. Merck and Citigroup) but will bias your portfolio toward large cap stocks — as smaller companies get less coverage.

4) Industry Rankings. On finance.yahoo.com, you can look at competitors of any companies and get basic statistics as to how the company compares to others in its industry. Even though the industries listed, the categorization of companies are somewhat arbitrary and the statistics listed are not enough to value the company, they can give you a good starting point.

Hopefully, these sources will help you start on your road to selecting winning investments.

(I don’t currently have any interest in the companies listed.)

Yogi Berra once said, “It’s tough to make predictions, especially about the future.” (The quote is also attributed to Sam Goldwyn)

I hesitate to tell people to follow Yogi Berra’s advice — in any contect — but investors would be wise to heed Berra’s warning: the future is impossble to predict. We have a rough idea of what may happen but no idea what course the future will take.

I have been “certain” that long-term interest rates are going to increase. And I haven’t been the only one — Greenspan refers to flattening yield curve (i.e. short-term rates increasing and long-term rates decreasing to the point that you can earn as much investing in short-term securities as you can investing in long-term securities) as a “conundrum.”

At some point the yeild curve will become normal — where long-term rates are higher than short-term rates, but I have no idea when this will occur. Pundits (and I include economists in this category) have have come up with ex-post rationalizations of the flat yield curve. Some attribute the phenomenon to Asian countries having excess dollars to invest and others say it’s because our economy is heading into recession.

However, the first explanation doesn’t address the fact that other countries can easily shorten the maturity of their investments. The second doesn’t jive with current economic data, including recent reports of a better job market.

Despite the fact that forecasts are notoriously wrong, the financial news is littered with columns predicting the future. For example, the most recent cover story of Barron’s (subscription required) surveys sell-side analysts to come up with a predicted increase in the S&P 500 of 6.5% for the rest of the year. Even if we ignore the fact that sell-side analysts are notoriously optimistic because their job is to increase brokerage commissions, the predictions are usually wrong.

When investing, it is best to not try to time the markets — there is no way to know what is going to happen in the short-run. All we can do is to try to win in the long-run. Do not invest because people say the market is going to go up over the next few months; do not keep cash because people say the market is going to go down. No one knows what is going to happen and — if they did — they wouldn’t tell you!

Even the best investor of all time, Warren Buffet, ignores forecasts of future growth. He often purchases companies that are projected to have rough times ahead. For example, Berkshire Hathaway, GEICO, and Wells Fargo were headed toward trouble (according to economists) when Buffett made his initial purchases.

Instead of listening to pundits, it is much more lucrative to use the past results of a company to predict the future for that company. You should look at the previous five years ROE (return on equity) and ROIC (return on invested capital) to predict the future profitablity of the company. Minor adjustments can be made to reflect very good or bad recent operating conditions to approximate returns in a normalized operating environment.

Given the difficult task of forecasting the future, it is better to do analyses of individual companies, rather than chase popular sectors. In addition, you will have the benefit of increasing returns when the tide turns and your out of favor industry comes back into favor. Currently, I am very heavily weighted in large financial companies because many of the companies in this industry have high returns on capital and low valuations. Over time, as the industry regains favor I hope to cash in on rising values — and, in the meantime, I’ll happily collect the dividends.

“The reason I love investing is that there is a clear-cut definition of success. If it goes up, you win. If not, you lose.”

The comments above are a very common sentiment among investors and traders. Even though I know better, when I purchase a stock and it immediately goes up, I swell with pride. If it immediately goes down, I get frustrated that I was “wrong.”

But the true test is not what happens immediately after purchase — the test is whether you were correct in your purchase of the company. Did you purchase the company for below its intrinsic value? If so, it’s a good purchase.

You can not predict the short-run price of a stock, but over the long-run — by buying companies below their intrinsic value — you can increase your chances of winning.

For example, I have purchased a lot of shares in a reinsurer over the last year. Due to recent tragic events, the shares of the reinsurer have not performed well. According to my analysis, the shares became even more undervalued and so I purchased more yesterday. Today, the stock price increased substantially (though it’s still below my initial purchase price).

But that does not mean that my initial purchases were wrong or my last purchase was right. I still believe that all the purchases were right — but it is too early to know if my analysis will be redeemed in the end.

To make matters more complicated, the actually ending is only one possible outcome out of many. Countless events occur subsequent to purchase that change the value of the company. Needless to say, there is no way of predicting what will actually happen. All we can do is make our best guess.

For example, when I purchased shares in the reinsurance company, there was no way of knowing that there would be an extremely costly event. All I could know is that the probability existed.

So how do you know when you win? Although, it’s not as exciting or instantly gratifying as looking at immediate returns, looking at long-term returns of a portfolio to a comparable benchmark is the right way to measure success. So the next time you get upset over a “bad” purchase, look into whether you should buy more and increase your chances of winning over the long-run.