Sunday, November 19, 2017

Arnold, The Deals of Warren Buffett, vol. 1

Glen Arnold, a former academic (professor of investment and professor of corporate finance) turned more or less fulltime investor as well as a prolific author of books on finance, is an unabashed fan of Warren Buffett. He is a Berkshire Hathaway shareholder and regularly travels from England to Omaha for the Berkshire annual meetings.

Arnold set out to discover why Buffett chose the companies he invested in and what lessons individual investors can learn from Buffett’s decisions. Volume 1 of The Deals of Warren Buffett (Harriman House, 2017) covers the period leading to Buffett’s first $100 million in net worth, which he reached in 1978 at the age of 48.

Contrary to myth, Buffett didn’t always have a Midas touch. Apart from his most notable failure, Berkshire Hathaway the textile company, he lost money when he was in his early 20s on Cleveland Worsted Mills and an Omaha gas station he bought together with a friend.

But many of his investments were staggeringly successful, certainly dwarfing the $2,000 he lost on the gas station. Arnold goes through Buffett’s early investments one by one, from lesser known companies such as Rockwood & Co., Sanborn Maps, Dempster Mill, Hochschild-Kohn, and Associated Cotton Shops to such Berkshire staples as American Express, Disney, See’s Candies, and the Washington Post.

Throughout, Arnold stresses Buffett’s investing principles, exemplified in each of these deals, that can withstand the test of time. Among them: Grand principles are more important than a grand plan. Market moods can be incomprehensible to value investors, but stick with sound investing principles in good times and bad. And, re managers, good jockeys will do well on good horses, but not on broken-down nags. And so, in general it’s important to avoid businesses with problems.

Buffett followers will welcome this addition to the already huge Buffett bibliography. Arnold’s book will be even more illuminating to investors who are in search of an overarching rationale for their investing decisions. Why not learn from the best?

Wednesday, November 15, 2017

Vermeulen, Breaking Bad Habits

Many of the principles articulated in Freek Vermeulen’s excellent book Breaking Bad Habits: Defy Industry Norms and Reinvigorate Your Business (Harvard Business Review Press, 2017) can easily be extended beyond the confines of business organizations. So even if you aren’t a business executive (but of course especially if you are), you can profit from the book’s antidotes to bad practices.

Bad practices thrive on inertia. To overcome this inertia and reinvigorate the organization one should implement “complementary processes that foster ongoing creation and renewal.” For instance, embrace change for change’s sake, make your life difficult, balance exploration with exploitation, be varied and selective. Here I’ll skip over the first recommendation, which, when “Change for Change’s Sake” appeared in HBR in 2010, prompted a spate of hate mail and emails where Vermeulen was addressed as “You Idiot.” To do justice to the nuanced concept would require too much space.

Instead, let me start with the second recommendation: make your life difficult. The author suggests undertaking a challenging variant on one’s existing product or service. For instance, a fertility clinic might treat a 49-year-old woman with one ovary; a law firm might take on a difficult legal case that no one else wants to touch. “It needs to be a challenge, but … one from which you could see or at least feasibly suspect that its learnings will spill over into your normal-day stuff.”

The third recommendation, balance exploration with exploitation, means that a business should try new things but at the same time focus on profiting from existing competitive advantages.

And, the last recommendation: be varied and selective. Essentially this calls for letting a thousand flowers bloom but allowing 999 of them to die.

On another front, this one complete with an investing tip, Vermeulen cites a study on employee satisfaction. The share price of companies that made it onto Fortune magazine’s list of best companies to work for “rose about 3.5 percent faster than others’ did.” The stock market, however, underestimates the effect of happy employees. Investors did not factor employee satisfaction into their valuation of the company. “Only when—inevitably—the employees’ happiness started to bear fruit in terms of the company’s profits did the share price make a happy jump in surprise.”

Sunday, November 12, 2017

Diaconis & Skyrms, Ten Great Ideas about Chance

Ten Great Ideas about Chance by Persi Diaconis and Brian Skyrms (Princeton University Press, 2018) grew out of a course that the authors team-taught at Stanford, which had as a prerequisite one undergraduate course in probability or statistics. It is, as the authors describe it, “a history book, a probability book, and a philosophy book.” In writing about the ten great ideas—measurement, judgment, psychology, frequency, mathematics, inverse inference, unification, algorithmic randomness, physical chance, and induction—they proceed more or less chronologically within each topic, starting with Cardano and Galileo and the notion that chance can be measured.

The second idea, that judgments can be measured and that coherent judgments are probabilities, is the one most obviously relevant to finance. Here, as clearly seen in prediction markets, “the probability of A is just the expected value of a wager that pays off 1 if A and 0 if not. If you pay a price equal to P(a) for such a wager, you believe that you have traded equals for equals. For a lesser price you would prefer to buy the wager; for a greater price you would prefer not to buy it. So the balance point, where you are indifferent between buying the wager or not, measures your judgmental probability for A.” In this idealized model “an individual acts like a bookie—or perhaps like a derivatives trader—and buys and sells bets. … She buys fair or favorable bets and sells fair or disadvantageous bets, doing business with all comers. A Dutch book can be made against her if there is some finite set of transactions acceptable to her such that she suffers a net loss in every possible situation. We will say that she is coherent if she is not susceptible to a Dutch book.” Over time, given a change in evidence, she will revise her probabilities using the “unique coherent rule,” Bayesian updating. “Any other rule leaves one open to a Dutch book against the rule—a Dutch book across time, a diachronic Dutch book.” Market makers, beware the diachronic Dutch book!

Ten Great Ideas about Chance takes intrinsically difficult notions that great minds struggled with over the centuries (I personally would put induction at the top of the list) and makes them accessible to anyone with a basic grasp of probability.

Sunday, November 5, 2017

Johnson, Derivatives Markets and Analysis

R. Stafford Johnson’s Derivatives Markets and Analysis (Bloomberg/Wiley, 2017) is part of the Bloomberg Financial Series. As such, the Bloomberg terminal, and how to use it, plays a central role in the text.

The book is a wonderful resource, however, even for the financial professional or student without access to a Bloomberg terminal. Johnson, a professor of finance at Xavier University, has put together more than 750 pages of information about and case studies involving futures and forwards, options, and financial swaps. He includes problems and questions, along with Bloomberg exercises.

Although Johnson starts with the basics, quickly enough he takes the reader into the complexities of hedging. For instance, in the case of options, in one chapter he explains the standard strategies and some defensive follow-up strategies. In the next chapter he discusses ways to hedge stock portfolio positions—by creating a floor or a cap for a stock portfolio using index options and by using range forward contracts. He also discusses hedging currency, commodity, and fixed-income positions with options.

The book has a section on option pricing, with chapters on option boundary conditions and fundamental price relations, the binomial pricing model, the Black-Scholes pricing model, pricing non-stock options and futures options, and pricing bond and interest rate options.

Johnson’s book is not for the average retail investor. But, with its mix of theory and practice, it is exceedingly useful both as a textbook and as a reference book.

Sunday, October 29, 2017

Hirsch, Stock Trader’s Almanac 2018

The Stock Trader’s Almanac is now in its fifty-first edition. It remains a must for traders who use seasonal factors to time the market.

The spiral bound, navy-covered almanac opens flat for easy access to its data or for jotting down notes. The format remains essentially the same as in previous years, with a calendar section, a directory of trading patterns and databank, and a strategy planning and record keeping section. The calendar section has on facing pages historical data on market performance (verso) and a week’s worth of calendar entries (recto). January’s verso pages, for example, give the month’s vital statistics, January’s first five days as an early warning system, the January barometer (which has had only nine significant errors in 67 years, including 2009, 2010, 2014, and 2016, so it may be losing some of its predictive power), and the January barometer in graphic form since 1950. Each trading day’s entry on the recto pages includes the probability, based on a 21-year lookback period, that the Dow, S&P, and Nasdaq will rise. Particularly favorable days (based on the performance of the S&P) are flagged with a bull icon; particularly unfavorable trading days get a bear icon. A witch icon appears on monthly option expiration days. At the bottom of each entry is an apt quotation. There’s about a five-square-inch space in which to write.

The Stock Trader’s Almanac pays particular attention to the presidential cycle, and the prospect for 2018 is mixed. “Midterm election years have been the second worst year of the four-year cycle, while eighth years of decades have been the second best, so 2018 promises to be laced with cross-currents.” On the negative side, “in the last 14 midterm election years, bear markets began or were in progress nine times.” But if the market sinks in 2018, it might provide an excellent buying opportunity because, ”from the midterm low to the pre-election year high, the Dow has gained nearly 50% on average since 1914.”

What other seasonals are powerful? The best six months strategy has a good track record. “Investing in the Dow Jones Industrial Average between November 1st and April 30th each year and then switching into fixed income for the other six months has produced reliable returns with reduced risk since 1950.”

The first trading day of the month is uncommonly strong (save in 2014). Beginning in 1997, the Dow gained a total of 6352 points in 238 first days, for an average daily point gain of 26.69. The other 4733 days gained 7232 points, only 1.53 on average.

This almanac is chock full of data that will delight those traders who believe that past is prologue. Even those who are skeptical have to pay attention to data that seasonal traders rely on and that therefore tend to move markets.

Wednesday, October 25, 2017

Bayoumi, Unfinished Business

Do we need yet another book on the financial crisis? For those who take banking regulation in the European Union and the United States seriously, the answer is yes. In Unfinished Business (Yale University Press, 2017) Tamim Bayoumi, a deputy director at the IMF, delves into, in the words of the subtitle, “the unexplored causes of the financial crisis and the lessons yet to be learned.” He shows that the Euro crisis and the U.S. housing crash were “parasitically intertwined.”

Policymakers were deluded by the efficient markets hypothesis into thinking that financial markets were largely self-regulating. And they were overconfident in the effectiveness of monetary policy. For instance, after the 1980s, when the U.S. experienced a noticeable decrease in the volatility of output (the “great moderation”), conventional wisdom attributed most of this moderation to better monetary policy. And after the technology bubble popped in 2001, the Federal Reserve “ascribed the limited impact on the US economy to its swift monetary response.” So why, if there was a major downturn in house prices, wouldn’t the Fed be able to do the same thing again?

Policymakers in the U.S. and Europe were not only overconfident in their ability to contain crises. They also adopted a stance of benign neglect, “the view that countries should look after their own internal affairs and that the benefits from cooperating with other countries are too small to be worth the trouble.” They were convinced that financial market spillovers between countries were small. “Across the North Atlantic, the main consequence of benign neglect was that policymakers missed the implications of increasing external financing of the US and Euro area periphery housing booms.”

Bayoumi extends his analysis by offering a history of the international monetary system in five crises: the collapse of the Bretton Woods fixed exchange rate system, the Latin American debt crisis, the European exchange rate mechanism crisis, the Asian crisis, and the North Atlantic crisis (which in many respects was “an amalgam of these earlier experiences”).

In the wake of the financial crisis regulations were imposed on banks in the U.S. and Europe. But “many deeper weaknesses remain.” There is, in the words of the author, “still an awful lot of unfinished business.”

Monday, October 23, 2017

Watkins, The Complete Guide to Successful Financial Markets Trading

For many years Simon Watkins was a senior Forex trader, eventually becoming director of Forex at the Bank of Montreal and head of Forex institutional sales for Credit Lyonnais. His extensive Forex experience informs his markets overview in The Complete Guide to Successful Financial Markets Trading (ADVFN Books, 2017).

Watkins takes the reader through foreign exchange, equities, commodities, and bond trading. He then turns to technical analysis, risk/reward management and hedging, risk-on/risk-off and other correlations, and key risks on the horizon. All this in about 265 pages, including many illustrative charts.

The book’s strength is its top-down and markets correlation analysis. By taking a macro perspective for the most part, it complements most books on trading. And it does this surprisingly well.

The author doesn’t offer an in-depth study of any of the many topics he addresses, but he points to vital connections among them. This is something that most traders and investors ignore, often to their detriment.

Wednesday, October 18, 2017

Crawford, How Not to Get Rich

Let me explain right away what this strangely titled book is about. Its full title and subtitle are How Not to Get Rich: The Financial Misadventures of Mark Twain (Houghton Mifflin Harcourt, 2017). Alan Pell Crawford follows Mark Twain, the consummate investing pechvogel, from one doomed scheme to the next. “Twain’s passion wasn’t to work in a print shop, pilot riverboats, write for newspapers, or even—as he would do in his twenties—prospect for gold and silver out West. Twain’s goal was to make money and then make even more money. Writing books was just a means to an end.”

Twain married well, far above his station, though primarily for love, it would seem. In his thirties, he had nothing to recommend him save a bestselling book he had written (The Innocents Abroad) that “some people found amusing.” But with his marriage he finally “had money to burn.” He lived in a mansion in Buffalo, a wedding present, and was lent $25,000 to buy a third share in the Buffalo Daily Express. With the death of his wife’s father, eight months after the marriage, Twain and his bride inherited $250,000—some $4.4 million today.

Twain and his wife stayed in Buffalo for only about a year before departing for Hartford. The house they built, described as a “brick-kiln gone crazy, the outside ginger-breaded with woodwork, as a baker sugar-ornaments the top and side of a fruit loaf,” was assessed at $1,420,000 in today’s dollars. The Twains entertained lavishly, spending more than $100,000 a year on food and drink.

Twain was productive during the Hartford years, both as a writer and as an inventor. (The penchant for invention seems to have been in the Twain blood; both his father and his brother tried their hand at inventing, unsuccessfully.) His invention was a self-pasting scrapbook, on which he may have made more than a million dollars.

And he started investing, first in the Hartford Accident Insurance Company, which at the end of 18 months “went to pieces.” He passed up the opportunity to invest in the National Bell Telephone Company, whose share price in June was $110 and by December had shot up to $995. But he put money into the New York Vaporizer Company, which was a dud. And he bought four-fifths of the patent for Kaolotype, a process for book illustration that turned out to be a fraud.

Twain poured a lot of money into a publishing company that failed. But by far his worst investment was in the Paige Compositor, a typesetting machine that was “a marvel of complexity” and that was finally abandoned.

As his assets dwindled away and his creditors hovered, Twain paced the floor at night. He said: “I am terribly tired of business, by nature and disposition unfit for it.”

Twain’s good fortune was to meet Henry Huttleston Rogers, “one of the most ruthless tycoons of his day.” “At his peak, Rogers would have been worth $40.9 billion in today’s money, outranking even his contemporary J.P. Morgan.” Rogers had Twain transfer all of his assets to his wife and then steered the publishing company into voluntary bankruptcy. The compositor company was dissolved.

Twain went on an international lecture tour to pay back some of his debts. Rogers handled his money, paying back debts and making savvy investments on Twain’s behalf. When Twain died in 1910, his estate was appraised at more than $11 million in today’s dollars.

Despite all of his business failures, Twain told a group of alumni from Eastern Business College in Poughkeepsie in 1901 that he had been “well served … through the years by his own mad and endless determination to make a great fortune.”

Sunday, October 8, 2017

The Crossley ID Guide: Waterfowl

Back in 2011 I reviewed The Crossley ID Guide: Eastern Birds. In that post I suggested some ways in which identifying a bird is similar to identifying a good trading opportunity. It’s not as much of a stretch as you might think.

Richard Crossley has now published his fourth flexibound guide, this one to waterfowl. Like his previous books, it features gorgeous, lifelike compositions that are “painted in pixels.” It shows North American ducks, geese, and swans in their natural seasonal settings (winter/spring and summer/fall) as well as in flight. The illustrations also include juveniles at various stages of development. There are some mystery birds to identify, with answers provided. The second half of the book is text written by Paul Baicich and Jessie Barry, giving a detailed account of each species. All in all, about 500 pages of absolutely wonderful material


If you are a birder or a hunter, this book definitely belongs on your bookshelf. It is available at Crossley’s site.

Wednesday, October 4, 2017

Burchard, High Performance Habits

Most self-help books fail because they offer easy paths to success. Brendon Burchard’s High Performance Habits: How Extraordinary People Became That Way (Hay House, 2017) describes what it takes to become a person who creates ever-increasing levels of both well-being and external success over the long term. And it takes a lot.

Many factors can affect your long-term success—luck and timing, for instance. But Burchard sets out six things that “are under your control and improve your performance more than anything else we’ve measured.” First, seek clarity on who you want to be, how you want to interact with others, what you want, and what will bring you the greatest meaning. Second, generate energy so that you can maintain focus, effort, and well-being. Third, raise the necessity for exceptional performance, tapping into the reasons you absolutely must perform well. Fourth, increase productivity in your primary field of interest, focusing on prolific quality output. Fifth, develop influence with those around you. And sixth, demonstrate courage.

Burchard’s HP6 go beyond the usual nostrums: work hard, be passionate, focus on your strengths, practice a lot, stick to it, and be grateful. You can be a grateful hard worker and still be on the bottom of the pile. Or you can be passionate and practice a lot—and burn out.

Some of Burchard’s suggestions seem hokey, but for the most part they ring true. I, of course, haven’t tried the vast majority of them. I just finished reading the book, after all. But what’s the worst that can happen? That you do nothing, just keep going the way you always have. Unless, of course, you’re already a consistently high performer.

Sunday, October 1, 2017

Carver, Smart Portfolios

Robert Carver, author of Systematic Trading, has turned his attention to the thorny problem of portfolio construction. In Smart Portfolios: A Practical Guide to Building and Maintaining Intelligent Investment Portfolios (Harriman House, 2017) he deals with such topics as how to blend assets with different levels of risk, the reasons that forecasting returns is so difficult, and how to calculate the true costs of your investments.

One problem that investors face is that not only is the future uncertain, the past is as well. This is a point that Carver drives home multiple times. He shows, for instance, that “the uncertainty of the past is largest for risk-adjusted returns. We can be 95% confident that the estimated relative Sharpe Ratio (SR) of the two assets was within a range of around 0.5 SR units. For US stocks and bonds this uncertainty range is -0.16 to 0.36. This is a huge degree of estimation error: our estimates of Sharpe Ratio are effectively worthless.” By contrast, “the uncertainty of standard deviation estimates is much lower than for the Sharpe Ratio,” and “in typical financial data estimates of bond and equity correlations are 95% likely to be within a range of around one-third (actual range -0.12 to 0.21).”

To manage the problem of past parameter uncertainty in portfolio construction, he assumes that risk-adjusted returns are identical for all assets, he uses risk weighting to account for differences in asset volatility, and he employs a technique he calls handcrafting to handle correlations sensibly.

In over 500 pages Carver takes the reader through both theoretical considerations and practical applications. He shows how to build a smart portfolio top-down, contingent on portfolio size, from an institutional investor to a person with $40,000. He introduces two forecasting models (momentum and yield) to aid in the construction of a portfolio. And he addresses the need for maintenance, such as smart rebalancing and portfolio repair.

Smart Portfolios is a sophisticated but not overly technical treatment of a topic that every investor has to come to grips with. As such, it is a recommended read.

Wednesday, September 27, 2017

Reynolds, From Here to Security

Robert L. Reynolds, president and CEO of Great-West Financial and Putnam Investments, was a pioneer in the 401(k) business for Fidelity Investments in the 1980s and 1990s. In From Here to Security: How Workplace Savings Can Keep America’s Promise (McGraw-Hill, 2018) he advocates improving and extending workplace savings plans.

First, however, it is imperative to make Social Security—“the country’s largest, most successful, and most popular government program”—solvent over the long term. “As multiple bipartisan commissions have shown in recent years, the compromises needed to restore Social Society to fiscal health are blindingly obvious, namely a balanced combination of revenue increases and benefit cuts.” The problem is that Social Security has long been viewed as the “third rail” of American politics—“Touch it and you die!” Moreover, compromise is not exactly the hallmark of Congress these days.

To supplement Social Security, working Americans traditionally relied on defined benefit pensions. But today pensions are flat-lining. Defined contribution plans are taking their place, extending coverage to more workers and workplaces. Roughly half of American workers have access to 401(k)-type plans. The problem is that, although they serve middle- and upper-income workers well, they don’t reach low-income, part-time, or contingent workers—or those in small firms that have no payroll savings plans at all. This is especially troubling in a gig economy.

Moreover, it is not enough to extend 401(k)-type plans to more workers. Reynolds suggests that the holy grail of the next generation of workplace savings is “to convert accumulated assets into guaranteed lifetime income” so that people won’t run out of money before they run out of time. Annuities are one obvious solution to this problem, although annuities often get a bad rap.

Reynold’s book, which describes where we’ve been and where, in his opinion, we should be going to achieve retirement security for the largest number of American workers, raises policy issues that should definitely get more attention in Washington.

Sunday, September 24, 2017

Kula et al. Beyond Smart Beta

More than 4,400 ETFs are currently available globally, and more than one million indices are calculated daily—“a dizzying range of asset classes, strategies and exposures.” In Beyond Smart Beta: Index Investment Strategies for Active Portfolio Management (Wiley, 2017) authors Gökhan Kula, Martin Raab, and Sebastian Stahn explore exchange-traded products and the evolution of indexing to “unchain innovation—the future of active investing in passive products.”

After a lengthy account of the characteristics of exchange-traded products, the authors turn to the evolution of indexing. The first generation of indexing ties classic benchmark indices to “the market”—the Dow Jones Industrial Average, to cite the most classic. The authors provide 24 mostly full-page tables highlighting the main features of major benchmarks—equity, sector, fixed-income, and commodities.

Smart beta indices represent the second generation. They are “designed to provide exposure to specific factors, market segments or systematic strategies.” Typical factors are value, size, momentum, low volatility, quality, and dividend yield. The authors analyze each of these factors, pointing out their advantages and disadvantages.

In the third generation of indexing, optimized indexing is combined with risk-based dynamic asset allocation. This generation of indexing aims “to control for and to mitigate costly behavioral biases.” One example is target volatility indexing. “Investors in equity-based ETFs are always better off in the long run investing in the corresponding target volatility ETF instead of the pure equity ETF.” Another example is the best-of-assets strategy, which switches allocation levels between equities and fixed-income depending on specific market signals.

One trend that has legs is customized indexing, where investors can construct a bespoke index solution that may exhibit a better risk-return profile for their specific needs. MSCI is currently calculating more than 7,000 customized indexes globally for over 700 clients, around 70% of which can be launched within 48 hours.

Academics keep churning out papers, firms keep churning out new ETFs. There’s no end in sight.

Wednesday, September 20, 2017

Zeisberger et al., Mastering Private Equity

Claudia Zeisberger, a professor at INSEAD, and two INSEAD alumni, Michael Prahl and Bowen Whtie, joined forces to write Mastering Private Equity: Transformation via Venture Capital, Minority Investments & Buyouts and its companion case study volume Private Equity in Action—Case Studies from Developed and Emerging Markets (Wiley, 2017). Industry professionals added their thoughts to each chapter of Mastering Private Equity.

The core book, written for both graduate students and professionals, is structured like a textbook (including lots of color). It is divided into five sections: private equity overview, doing deals in PE, managing PE investments, fund management and the GP-LP relationship, and the evolution of PE.

Mastering Private Equity is a model of clarity. For instance, in a table the authors summarize the advantages and disadvantages of various exit options. The advantages of a sale to a strategic buyer are: full exit, often pay a premium (synergies), pay in cash. The disadvantages are: less sophisticated buyers prolonging process, strategics require a majority stake. The advantages of a sale to a PE fund are: ample dry powder in market, can ‘warehouse’ company until eventual IPO. The disadvantages are: sophisticated and demanding buyers, minority stake may reduce pool of potential investors. As for an IPO, the advantages are: potential for high returns, access to future liquidity, often preferred by management, high profile exit. The disadvantages are: lock-up, risks of going to market, uncertainty of returns, strain on management time. The last alternative is a dividend recapitalization. Here the advantages are: returns cash to limited partners, no new shareholders, does not dilute equity stake. The disadvantages are: partial exit, value of investment unknown, not a high profile exit.

All of the cases covered in Private Equity in Action are taught in INSEAD’s various business programs. They span the globe, from an Indian vineyard and rice farming in Tanzania to creating a private equity fund in Georgia.

Anyone who wants to better understand private equity, especially PE with a global reach, would do well to read these books.

Sunday, September 17, 2017

Henriques, A First-Class Catastrophe

Black Monday (October 19, 1987), when the Dow Jones Industrial Average fell over 22%, was not a black swan event. Although it occurred in the context of heightened geopolitical risk, with Iran hitting two American-owned ships with Silkworm missiles and the United States retaliating by shelling an Iranian oil platform in the Persian Gulf, the potential for a huge market sell-off had been telegraphed day after day in 1987.

Diana B. Henriques, an award-winning financial journalist writing for The New York Times, is the author of The Wizard of Lies (the best-selling book about Bernie Madoff, subsequently made into an HBO movie), Fidelity’s World, The Machinery of Greed, and The White Sharks of Wall Street. In A First-Class Catastrophe: The Road to Black Monday, the Worst Day in Wall Street History (Henry Holt, 2017) she once again lives up to her reputation for careful, exhaustive research and engaging prose.

People (I among them) have often claimed that the financial market is a complex adaptive system. Henriques convincingly shows that, in the run-up to Black Monday, it was complex but not reliably adaptive and certainly not a system. Moreover, she claims, “we are still living in the world revealed to us on Black Monday.” In fact, the factors that led to the 1987 crisis “have become even more deeply embedded in Wall Street’s genetic code.”

Henriques explores multiple areas in which the financial market (and here I include equities, bonds, and derivatives) exhibited the potential for cracks in the 1970s and 1980s, starting with the fractured regulatory agencies. Also contributing to the crisis was the introduction of indexing, initially for pension funds, would give rise to herding; these huge funds were “all likely to shift their assets in the same direction at the same time.” Portfolio insurance, often incorrectly cited as the cause of Black Monday, relied on index arbitrageurs (and there had to be enough of them) to zig when it zagged. Computerization sped up trading and the back office processing of orders but brought with it the inevitable glitches.

Populating these potentially problematic areas were people who were protective of their turf, powerful, and creative—regulators and heads of exchanges, agents for financial behemoths, and innovators. As a result of the extensive interviews the author did with the primary players, we get a sense of how they understood their roles in this calamity.

A First-Class Catastrophe is a first-class book. Perhaps through it we will learn some lessons that were ignored in the wake of Black Monday.

Wednesday, September 13, 2017

Page, The Diversity Bonus

Scott E. Page is one of my favorite writers. A professor of complex systems, political science, and economics at the University of Michigan, he is the author of The Difference, Complex Adaptive Systems, and Diversity and Complexity. He also gave a wonderful on-line course on model thinking, still available on Coursera.

The Diversity Bonus: How Great Teams Pay Off in the Knowledge Economy (Princeton University Press, 2017) continues his thinking on the complicated, often contentious subject of diversity. The core logic for how diversity produces bonuses relies on linking cognitive diversity (differences in information, knowledge, representations, mental models, and heuristics) to better outcomes on tasks such as problem solving, predicting, and designing. Cognitive diversity is to be distinguished from identity diversity (differences in race, gender, age, physical capabilities, and sexual orientation), although identity diversity can often contribute significantly to cognitive diversity.

Some people try to view diversity as analogous to a diversified investment portfolio, but they miss the point. “The portfolio performs like the average. The problem-solving team performs like the best. Actually, the team does even better if team members can share ideas.”

Page is careful not to overpromise on the benefits of diversity. Although in some cases cognitive and identity diversity produce bonuses, “in others (see the US Congress) they contribute to conflict.” Wall Street, however, is a place where both cognitive and identity diversity pay off. “Team-run funds outperform individuals and gender-mixed teams outperform all-male teams.”

Page’s book offers a compellingly pragmatic justification for both cognitive and identity diversity. Unlike normative arguments for identity diversity and inclusion, which “seek to redress past wrongs or create a more equitable future,” the diversity-bonus logic “shows that cognitively diverse teams perform better on complex tasks.” The widespread view that diversity harms performance (exemplified by Antonin Scalia’s opinion that schools and employers face a choice: they can choose diversity, or they can choose to be “super duper”) overstates the case. True, “replacing a member of a relay team with a slower runner or hiring a data analyst who makes errors at a higher rate based on identity considerations sacrifices quality on the altar of social justice.” But when it comes to complex tasks, having a diverse team is not a sacrifice but is often instead a benefit.

Sunday, September 10, 2017

Kinlaw et al., A Practitioner’s Guide to Asset Allocation

William Kinlaw, Mark P. Kritzman, and David Turkington have written a carefully researched book that reaches sometimes counterintuitive (or at least counter to common wisdom) conclusions. A Practitioner’s Guide to Asset Allocation (Wiley, 2017) is directed at professional investors and advisors, but some of the material might be useful to systematic traders as well. Although the authors rely on quantitative analysis, they do not overwhelm the reader with math and statistics. For those who need a brief refresher course to understand the gist of the text, there is a chapter late in the book explaining basic statistical and theoretical concepts.

Among the misconceptions the book sets out to rectify are:

1. Asset allocation explains more than 90% of investment performance.

2. Investing over long horizons is less risky than investing over short horizons.

3. Factors offer greater potential for diversification than asset classes.

4. Equally weighted portfolios perform better out of sample than optimized portfolios.

The authors explore such questions as whether, to increase expected return, it’s preferable to apply leverage to a less risky portfolio than to concentrate a portfolio in riskier assets, as theory holds. Answer: “what is inarguable theoretically does not always hold empirically when we introduce more plausible assumptions.”

They also address the thorny problem of regime shifts. They investigate three approaches to managing risk (using volatility as a proxy for risk): stability-adjusted optimization, regime-sensitive asset allocation, and tactical asset allocation based on regime indicators. They suggest that the first two approaches “yield static portfolios that most likely will still experience wide swings in their volatility.” Tactical asset allocation is more flexible, and “although this additional flexibility may not always improve performance, we have provided encouraging evidence to suggest that some investors might profit from tactical trading, given the right insights and methods.”

There’s a lot of meat in this book. Investors and advisors who devote time to it, especially those with some quant skills, will come away enriched.

Friday, September 8, 2017

Zomorodi, Bored and Brilliant

Boredom has become a fashionable subject. Henry Alford, in his New York Times (August 10) review of seven books about boredom, suggests that “the ‘boredom boom’ would seem to be a reaction to the short attention spans bred by our computers and smartphones.” Boredom is something we have lost to technology--something, we are told, we should strive to regain. Most authors these days aren’t seeing boredom as “the graveyard of your spirit” but as “a lull before the gorgeous storm.”

Put down your smartphone. The boredom that follows will foster creativity. Or at least that’s the thrust of Manoush Zomorodi’s Bored and Brilliant (St. Martin’s Press, 2017). The author, host of her own weekly radio show and podcast on WNYC, Note to Self, created the Bored and Brilliant Project. It was “a weeklong series of challenges designed to help people detach from their devices and jump-start their creativity.”

If you’re addicted to your gadgets, Zomorodi’s book might help you step back a bit. If, however, you want to understand how having free time can trigger your imagination, you’ll have to turn elsewhere. Similarly, if you want to understand what boredom is in all of its varied manifestations, you’ll need another guide.

Thursday, September 7, 2017

Gardner, The Motley Fool Investment Guide, 3d ed.

The Motley Fool will probably always be most closely associated with the 1990s and the roaring stock market. But their business is still going strong. And so now, for the third edition, David and Tom Gardner have completely updated their classic The Motley Fool Investment Guide: How the Fools Beat Wall Street’s Wise Men and How You Can Too (Simon & Schuster) for a new generation of investors.

For those with the motivation and the proper temperament, the Gardners advocate stock picking over index investing. They are partial to small caps and recommend “’business-focused investing’—that is, seeking out great and amazing growth-opportunity businesses.”

Tom Gardner, in constructing his Everlasting Portfolio, considers five features of companies: culture, strategy, financials, safety, and valuation. David Gardner is more aggressive. He advocates Rule Breaker investing, which is about “seeking growth in dynamic companies that are disrupting and shaping industries, businesses, economies, and even our daily lives.” These companies are the first movers in important and emerging industries, they have visionary leadership and smart backing, they have identifiable competitive advantages, they’re good brands, their stocks have already done pretty well, and stodgy backward-looking observers will declare their shares overvalued.

After the authors take the would-be investor through some basic accounting principles, they introduce advanced topics, such as shorting stocks and options.

To the new investor, the authors say “there’s no rush. Consider starting with an index fund or some blue-chip stocks exclusively in your first year. … When you’re convinced you can outdo index-fund investing, and you’re confident you have the timeline and temperament to stick with it even when things don’t go your way, explore the worlds of Rule Breakers, small-cap stocks, and other corners of the market that might appeal to you. Find your edge, and then over time, push your edge to the edge.”

Wednesday, September 6, 2017

Tillinghast, Big Money Thinks Small

Joel Tillinghast, the sole manager of the Fidelity Low-Priced Stock Fund from its inception in 1989 until 2011, when six co-managers were added, has been an outperformer. A $10,000 investment in his fund when it launched would have been worth almost $300,000 in 2015, versus roughly $74,000 for the Russell 2000 and $104,000 for the S&P 500. So it’s definitely worth listening to what he has to say in Big Money Thinks Small: Biases, Blind Spots, and Smarter Investing (Columbia Business School Publishing, 2017).

Tillinghast’s book is a cornucopia of investing wisdom, some acquired as a result of the inevitable mistakes, which he readily shares.

One bit of wisdom, which is not commonplace, is that Tillinghast focuses on a business’s distinctive character rather than its business strategy or positioning. “Most companies lack a strong character. This does not mean that they will be poor investments—only that they are less apt to be exceptional.” As examples of character, Tillinghast writes that, to him, “Apple seems smart, elegant, and occasionally quirky but otherwise easy to get along with. GEICO is honest, thrifty, and good-natured.”

He lists six things that make him nervous: companies that must lie to stay in business, tiny audit firms, inside boards, glamorous rollups, financial firms, and sunny havens.

Ascertaining the value of a stock requires assessing the four elements of value: profitability or income, life span, growth, and certainty. This is no easy task since these elements “reflect regular patterns of social behavior,” not the laws of physics. “Elevated profitability reflects a product that buyers want that, for whatever reason, they cannot get elsewhere. Longevity is shortened by periods when the immediate demand for a company’s product falls. … Growth reflects either substitution away from a competing product or a product that allows users to do something that they could not do before. Certainty reflects contracts and the general inertia of institutions and human behavior.”

Tillinghast provides case studies to illustrate his points, of which the above are but a tiny sample.

I suspect that most retail investors will be overwhelmed by the amount of work that Tillinghast puts into his investment decisions. They can still learn from his book, even if it’s not to turn their money over to shysters. But for those investors, retail and professional alike, who enjoy research and careful thinking Big Money Thinks Small is an engaging guide.

Sunday, August 27, 2017

Tegmark, Life 3.0

We don’t know whether artificial intelligence will ever attain the level of artificial general intelligence, with the ability to accomplish virtually any goal, including learning. That is, as the title of Max Tegmark’s illuminating book (Knopf, 2017) puts it, we don’t know whether we will ever reach Life 3.0. Even so, as we enter the age of AI, it is important to think about what sort of future we want so “we can find shared goals to plan and work for.” “If a technologically superior AI-fueled civilization arrives because we built it, … we humans have great influence over the outcome—influence that we exerted when we created the AI.”

Tegmark posits three stages of life: biological evolution (Life 1.0), cultural evolution (Life 2.0), and technological evolution (Life 3.0). In Life 1.0, with bacteria being a good example, both the hardware and software are evolved rather than designed. With Life 2.0, our current status as human beings, the hardware (DNA) is evolved but the software is largely designed, through learning. Life 3.0 will design both its hardware and software. “In other words, Life 3.0 is the master of its own destiny, finally fully free from evolutionary shackles.”

Tegmark is a professor of physics at MIT and president of the Future of Life Institute, which advocates for beneficial AI and AI-safety research. Both projects involve a heavy dose of ethical debate and decision making. For instance, should we have autonomous weapons, which select and engage targets without human intervention? The author and a colleague wrote an open letter in 2015 arguing against autonomous weapons, a letter signed by over 3,000 AI and robotics researchers and 17,000 others.

Life 3.0 engages the reader in a wide range of future scenarios, from those where superintelligence peacefully coexists with humans (even if, in one scenario, as a zookeeper) to those where humanity goes extinct and is replaced by AIs (or by nothing, if we self-destruct). Tegmark admits that “there’s absolutely no consensus on which, if any, of these scenarios are desirable, and all involve objectionable elements. This makes it all the more important to continue and deepen the conversation around our future goals, so that we don’t inadvertently drift or steer in an unfortunate direction.”

Wednesday, August 16, 2017

Partridge, Superinvestors

Matthew Partridge’s Superinvestors: Lessons from the Greatest Investors in History: From Jesse Livermore to Warren Buffett & Beyond (Harriman House, 2017) is a superficial book. In about 150 pages Partridge, who writes for MoneyWeek magazine in Great Britain and bases this book on a weekly column he did for the magazine in 2016, profiles and rates 20 so-called superinvestors. The idea was to look at “their strategies, performance, best investments and the lessons that ordinary investors could learn from them.”

Featured are an eclectic lot: Jesse Livermore, David Ricardo, George Soros, Michael Steinhardt, Benjamin Graham, Warren Buffett, Anthony Bolton, Neil Woodford, Philip Fisher, T. Rowe Price, Peter Lynch, Nick Train, Georges Doriot, Eugene Kleiner and Tom Perkins, John Templeton, Robert W. Wilson, Edward O. Thorp, John Maynard Keynes, John ‘Jack’ Bogle, and Paul Samuelson.

For those who like to keep score, Partridge rates these investors on four metrics: “their overall performance, their longevity, their influence on other investors and investing in general, and how easy it is for ordinary investors to emulate them.” For each metric an investor could earn between one and five stars. Leading the pack, with 18 points each, are Bogle and Graham. The runners-up, with 17 points each, are Fisher and Buffett.

Partridge’s takeaways from the investing careers of these men are: (1) the market can be beaten, (2) there are many roads to investment success, (3) be flexible ..., (4) … but not too flexible, (5) successful investing requires an edge, (6) when you do have an edge, bet big, (7) have an exit strategy, (8) ordinary investors have some advantages, (9) big isn’t always beautiful, and (10) it’s good to have some distance from the crowd.

Sunday, August 13, 2017

Nevins, Economics for Independent Thinkers

Daniel Nevins, a veteran of the asset management industry and a self-taught economist, takes on the mainstream, predominantly Keynesian establishment in Economics for Independent Thinkers: A Practical, No-Nonsense Guide to Understanding Economic Risks (Wallace Press, 2017). For a more realistic, fertile paradigm he recommends returning to the likes of John Stuart Mill, Alfred Marshall, Walter Bagehot, and Arthur Cecil Pigou and, for more recent inspiration, to Wicksell, Mises, Minsky, Schumpeter, and behavioral economists.

Providing the structure for Nevins’s view is what he calls the C-H-B triad: credit cycles, human nature, and business environment. This structure is “intentionally nonmathematical. Whereas modern economists require all ideas to be expressed as models …, C-H-B tells us that abstract modeling is ill-suited for big risks like recessions, depressions, and crises.” Nevins, by the way, started his career as a quant.

Nevins lays out ten rules of economic analysis, including “Major changes in the economy are shaped largely by public policies,” “Some sources of financing are riskier than others,” “If you’re searching for clues about the future, production indicators don’t produce,” and “We shouldn’t torture the data until they speak.”

Today, Nevins argues, there are “extraordinary connections between the economy and investment results,” so “investors who ignore the economy may be setting themselves up to fail. … Decision makers who understand the economy’s stress points fare best.” They have “a better understanding of what might happen next in the economy” and, as a corollary, in the financial markets. Economics for Independent Thinkers provides an economic framework for improving investment decisions.

Wednesday, August 9, 2017

Faber, The Best Investment Writing

Meb Faber has assembled a wonderful collection of 32 short pieces in The Best Investment Writing, volume 1 (Harriman House, 2017). The contributors are Jason Zweig, Gary Antonacci, Morgan Housel, Ben Hunt, Todd Tresidder, Patrick O'Shaughnessy, Meb Faber, David Merkel, Norbert Keimling, Adam Butler, Stan Altshuller, Tom McClellan, Jared Dillian, Raoul Pal, Barry Ritholtz, Ken Fisher, Chris Meredith, Aswath Damodaran, Ben Carlson, Dave Nadig, Josh Brown, Wesley Gray, Corey Hoffstein and Justin Sibears, Jason Hsu and John West, John Reese, Larry Swedroe, Cullen Roche, Jonathan Clements, Michael Kitces, Charlie Bilello, and John Mauldin.

There’s such an abundance of research and thought in this volume that it’s hard to pick out a couple of pieces to write about. My choices are decidedly idiosyncratic.

First, Wes Gray’s “Even God Would Get Fired as an Active Investor.” Who can pass up a title like that? Gray’s “God” knows what stocks are going to be long-term winners and losers and initially constructs a long-only portfolio that will be the top decile five-year winner. The problem with “God’s” portfolio, rebalanced monthly and analyzed from 1927 to 2016, is that it has terrible drawdowns. Unfortunately, “God’s” long-short hedge fund has the same problem. As Gray writes, “The relative performance on God’s hedge fund is often abysmal and he’d surely make the cover of Barron’s or the WSJ on multiple occasions throughout his career. The passive index would eat his lunch on multiple occasions—often getting beaten by 50 percentage points—or more—on multiple occasions!” The moral of the story is that active investors must have a long horizon. And, I would add, the faith that they, or their fund managers, are more god-like than their competition.

Second, Jason Zweig’s “A Portrait of the Investing Columnist as a (Very) Young Man.” Zweig’s parents were antique dealers (as were mine), and young Jason was a quick study (I wasn’t). He recalls a sale he made and “a dirty old rag” he discovered—an early Frederic Church painting which ended up in the collection of the White House. He notes “how important it is to be in the right place at the right time. The art and antiques business in the 1970s was a remarkable confluence of inefficiencies and opportunities to exploit them.” That market has now changed dramatically: “undervalued art and antiques have all but disappeared.” The stock market, like the antiques market, has also stopped handing out rewards to the well-informed stock-picker. “If you’re applying the tools that worked so well in the inefficient markets of the past to the efficient markets of today, you are wasting your time and energy. … If investors are to prosper from inefficient markets, they have to evaluate which markets still are inefficient. Areas like microcap stocks or high-yield bonds, where index funds can’t easily maneuver, offer some promise.”

Monday, August 7, 2017

Coll, The Taking of Getty Oil

There are takeover battles and takeover battles. The Getty Oil-Pennzoil-Texaco battle in the 1980s was one of the ugliest and most litigious, finally resulting (thanks to Carl Icahn’s shuttle diplomacy) in Texaco, on the day that it emerged from bankruptcy protection, owning Getty Oil and settling the Pennzoil lawsuit against it for $3 billion. In 1987 Steve Coll wrote a masterful account of the maneuvering for Getty Oil by a large, some still well known, cast of characters. It has recently been republished—and is still a compelling read.

Coll, currently a staff writer for The New Yorker and dean of the Graduate School of Journalism at Columbia University, is the author of seven books, several of them winners of major prizes. A seasoned journalist who spent two decades at The Washington Post, Coll knows how to keep the reader engaged in a story, even one that’s long (in this case nearly 500 pages) and complicated. For one thing, he uses a lot of dialogue. And he keeps the players in the drama, such as the “flaky” Gordon Getty, front and center.

I’m very glad that The Taking of Getty Oil was republished and that a new generation of business people and investors can make its story part of their knowledge base.