Friday, February 29, 2008

Stock Market Downside Bets

As mentioned in “Prisoner’s Dilemma” I posted a while ago, most efficient teamwork requires absolute faith and discipline from every player. Conflict between individual and collective payoff exists in continuous time. On top of all this, majority of people do not act rationally. It then makes sense that most business type games do not operate in the most efficient manner where maximum potential payoff could occur. The next logical suggestion sets forth that the average multi-staff business has a higher probability toward failure than success.

OK, the question lies in how we can exploit this for profit. Most simply, downside bets on the stock markets. Allow me to illustrate why and how it is done.

An economist visited AUT early 2007 and lectured regarding corporate crisis management. He mentioned that 1 out of 3 corporations experience a crisis every 5 years that it will never recover from. Sounds pretty serious. Enron, WorldCom, AMD, CROX and the New Zealand finance companies come to mind.

David Birch, former head of a business data mining firm, proposed the following Survival Rate of new businesses.

• First year: 85%
• Second: 70%
• Third: 62%
• Fourth: 55%
• Fifth: 50%
• Sixth: 47%
• Seventh: 44%
• Eighth: 41%
• Ninth: 38%
• Tenth: 35%

The numbers show that the conventional “90% failure rate” stands completely unfounded. Despite that, new businesses in general have the odds against them after five years of operations. According to this data, 1 in 2 businesses face failure after first 5 years of operation. This also concurs generally with the “business cycle” theory of economics majors.

Keep in mind if the business goes completely under, your investment on the downside bet would profit close to 100%. E.g. in the last couple of bullish years, a downside bet on the NZ financing companies would have taken losses of 10%-15% each year; and as the funds became fudged, the downside bet would have made well over 50-90%, hence a positive expectancy.

What moves the prices of stocks? The gist of it lies in supply and demand on the exchanges. When volume in initiated buy orders overwhelms sell orders, price moves up, and vice versa. Rational long term investors or short term traders may put in large buy orders making price climb, but sooner or later they will want to take profit, or cut losses. All the while, there is absolutely no guarantee whether the seller would repurchase the stocks.

In other words, there is certainty that stock holders will eventually initiate sell orders creating price drops, yet there is not of anyone recommitting in buying shares of the same stock needed for a rally. This observation alone puts the downside bets at better odds than upside.

Behaviorally speaking, even the professional fund managers “panic” when it comes to low grade holdings. As soon as they realize how worthless anything has become, they would want to dump as much of it as possible while trying to preserve capital. Of course the potential buyers would demand substantial discounts for taking on further risks. This phenomenon explains partially why asset values tend to decline at higher velocity than growth. Another advantage toward the downside bets.

Two simple approaches exist to accomplish this for individual stocks.

  1. short-selling positions
  2. Put options

I will not get into details of what they mean. Look them up, a sea of information on them exist on the internet.

Research becomes easy when you look for a hopeless business. With the past corporate accounting shenanigans, we all know companies like to fudge their financial statements to appear profitable with promise of further growth. However, they do not have as much incentive to present misleading negative information as demand for their stocks is needed in order to finance business operations.

With that, if the financial statements look great, it still remains questionable; yet if the numbers seem awful, they are probably true. I would suggest the following to precede downside bias for a listed company.

· Low total cash holding vs. Market Cap

· High P/E ratio

· High Debt/Equity ratio

· Low Short Interest

Low cash means the company will not likely able to afford any repurchase of their own stocks, drying up supply. A high P/E ratio would give institutional traders a sentiment of “over-valued”, and consider selling to take profit. A high debt/equity ratio displays how financially disconcerting the company has become. Lastly, the earlier you get in on the short action, the more you will likely make in profit. You do not want to come “late to the party”.

Of course a wealth of additional information could provide a trader with higher winning rate. The above would give anyone a definite edge compared to some newbie “investor” who buys and holds hoping for some Warren Buffet pipedream.

Jesse Livermore, a great stock trader, made several hundred million dollars in 1929 shorting the railroad stocks. Goldman Sachs made several billion dollars last year making downside bets on mortgage backed credit derivatives. When the fudge comes, it becomes a game of hot potato. The buy and holders face blowing up, while the downside bets rake in profits. Which side will you take?

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Thursday, February 28, 2008

Coffee House Competition

I live in Remuera district, sort of the upper eastside of Auckland. Every few days I walk through the strip of shops to see friends; it appears that coffee shops have filled the streets. The Remuera Shopping Center basically consists of two blocks of retailers, neck to neck, and I have counted seven coffee based beverage establishments cramped in this space.

As they all operate coffee machines and rental spaces of equivalent caliber, they basically belong in a fair non-cooperative game. The same beverages are available in every one, most notably the “Short/Long Black” for Single/Double Espresso, and “Flat White” for Latte.

Did they all simply ignore the little issue of competition? Allow me to break this down into simple figures. With seven of them running simultaneously, any individual store would have a statistical expectancy of only 1/7th of potential payoff in the form of revenue each day.

So, every one of them start the days with 6/7th of potential revenue basically lost due to strategies of competing shops. The obstacle to business growth becomes apparent, or is it only to me? It gets so slow that half of them look empty whenever I walk by.

What about expenses, can these shops somehow lower over all costs by 6/7th, too? Not likely. Commercial property rent in this area runs quite steeply. With the high minimum wage in New Zealand, the store staff puts additional burden upon the businesses.

They are everywhere.
Down in the other direction from my place toward New Market, roughly five coffee shops operate within a three minute stretch. The only one that seems to flourish, Café Monet, serves food along with drinks. They must have good chefs, as I notice more people there for food than coffee. Two out of these five run almost next door to each other, closer to Broadway by the bus stops. They each could easily take up twenty customers at once. I have never observed more than four patrons inside. They now have greeters stationed at the entrance hoping to entice anyone passing by. The greeters remind me of Walmart, except these have thick New Zealand accents and they sound desperate for business.

Oh yeah, a short walk into Broadway and there goes Starbucks, business as usual all day long. Somehow the local shops seem aware enough to stay at least a block away from the giant franchise.

Any game theorist would notice how the shops did not rationalize strategies therefore giving up maximum payoff potentials. They should have done their homework, and seen the odds against them. Minimize risk, extract reward, and the odds will swing your way.

Impossibility Revisited.

My great grand father lost a fortune in the Hong Kong stock market early in the century, prejudiced by the American economic “slow down” of 1929. Both dad and grandpa used to repeat that story, warning me to stay far from stock trading. They and majority of the population believe resolutely that generating consistent returns trading financial instruments presents impossibility.

What about Warren Buffet? He made his first few million dollars decades ago trading the stock markets via arbitrage and directional tactics. James Altucher wrote a book describing Buffet’s exact strategies in “Trade Like Warren Buffet”.,M1

Ever heard of Dan Zanger? Look him up. He turned $10K into $18Million within 18 months, short-term trading stocks. Buffet, Zanger, and guys like George Soros are living proof that most people simply made an incorrect conclusion about something they obviously do not understand.

I had become obese several times in the past, and people had said I had nil chance of getting in shape.

I spent some time doing research, and followed through with the resistance training and carbohydrate cycle diet. The fat burned off and I had stayed lean since 2004. Soon it became a life style easy to maintain. Interestingly, the negatively opinioned “friends” mostly grew bigger over the years.

Life is not easy, full of probabilities and it only becomes more negatively expected as outsiders shove problems into our minds instead of solutions. People in general tend to equate their own failures with feats of impossibility. Soon I realized nobody knew any better about anything than me. Success, in small doses, came as I avoided the skeptical crowds. Laser focus, flawless execution of simply the solutions made the odds end up in my favor.

Nobody has the right to declare what you can or cannot accomplish.

Avoid the cynics. Remember those childhood dreams? Get out a notebook and start a list of what you can do to achieve them. Brain storm, forget limits. Concentrate on the solutions. When statistical probabilities swing your way, nothing is impossible.

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Wednesday, February 27, 2008

Accumulation of Wealth

What does it take to become wealthy? What does one need to feel wealthy? Encarta Dictionary suggests a characterization of abundance, “enjoying an abundance or great quantity of something”. The next logical question lies in how one would define the term “abundance”. Is it more objectively adaptable or subjectively determined?

Some would describe abundance in the manner of possessing an “endless supply of money”. With the way reserve banks keep creating money supply, the illusion of a bottomless money filled pit becomes easily accepted. Notwithstanding acts of reserve banks, every single individual holds a discrete finite amount of monetary value. In other words, nobody carries “” for net worth.

We can conclude that all of us play the same game. Roughly 98% of us must accumulate monetary wealth from the ground up. Then how is it that some people seem to never run out of money, and some struggle just to make ends meet?

Anyone can create the impression of having an abundance of wealth. The key lies in a simple mathematical concept.

Spend less than your income, and let the surplus grow. I.e. if you make $1,000 a week, don’t spend more than $1,000 within every 7 days and invest the remainder in something.

It is that easy. With a positive net-income/time, having the surplus invested and grown, money related stress becomes a thing of the past.

Exempli Gratia:

If one manages to save $100 each week and put in a New Zealand bank saving’s account of 7%/annum, the following growth would transpire via the annuity formula.


R= $100 (amount invested each deposit period)

n= number of deposit periods

r= 0.07 or 7% (annual interest rate)

m= 52 (52 weeks or deposit periods in a year)

i= r/m = 0.07/52 0.001346 or 0.1346% (periodic interest rate)

S(n)= Future Value after n deposit periods

After 6 months-

S(26)= $2,644.21

After 2 years-

S(104)= $11,155.06

With this scheme, one’s wealth would only grow with respect to time. This is how wealth becomes accumulated, and it grows at an accelerated rate. Yes it may appear tedious and tiresome at first having to keep a record of expenses, income, and investments, the reward becomes well worth the effort. In time it becomes an effortless part of a financially secure life style.

Manage the spending. Exploit investments. Grow rich. It’s not that hard right?

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Tuesday, February 26, 2008

Work, Happiness, Game of Life

As far as I can remember, school counselors had always said something along the lines of “Get a job you love, and you’ll never work for a day.” The worn out axiom suggests that my life long purpose lies in a pursuit for some “lovable” repetitive task. Does that make sense?

I love my family, close friends, and olive oil (more on that later); yet to this date no tedious process has kept my passion. I want happiness out of life. Nothing short of it would do.

According to CNN, it has been quantified since 2003 (

The formula,

Happiness = P + 5E + 3H

P = Personal Characteristics (optimism, adaptability, resilience)

E = Existence (health, social life, financial wealth)

H = Higher Order (self-esteem, expectations, ambitions)

Given the variables, happiness becomes an output in the payoff function in the game of life. People like you and me represent players in the game, and the rational ones work to maximize happiness as total payoff.

It becomes clear. Our work serves simply a pathway, or process toward happiness. It seems much more sensible to focus on things we want out of life, rather than “loving” the routes toward them.

We wake up every morning making the decision on the kind of work, i.e. strategy, to uptake in order to achieve greater levels of happiness as payoff.

Exempli Gratia:

Some mothers choose to set up home offices so they could afford to have more time with their kids.

Mark Chen, an old friend, chose to work for a global conglomerate because it provided him financial stability and a chance to fulfill his corporate ambitions.

My uncle Philip operates several pro-athlete gyms in California and invests in Macao casinos because these ventures offer greater wealth and social life.

Therefore, choose paths with the least extent of resistance, with the greatest potential in payoff, and you are mathematically bound to find happiness at the end of the road. J

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Monday, February 25, 2008

Defense Against Top 5 Aggressive Sales Tactics

Well performing sales people claim the ability of selling "ice to Eskimos"; in other words they expect you to give them money for useless crap. By understanding their underlying strategies, you can break the spell and avoid becoming chumps.

A typical Sales Pitch contains 5 major underlying schemes

1) Hope Creation
An investment adviser once said "Even Warren Buffet buys and holds for the long term..." implying that you could become as wealthy as Buffet if you only invested through his recommended funds.

Logically speaking, turning a few thousand dollars into several billion within a few decades, making 10-20% in the bullish years and losing 30-50% in bearish periods, presents a mathematical impossibility. In fact it gives a negative expectancy but that's for another discussion.
(Besides, Warren Buffet made his first few million applying short term arbitrage trading mostly along with selling life insurance, hence the sales person's connotation was a complete deception.)

2) Sense of Urgency
"The fund will become closed to investors by the end of the week, you must act now." They want you to rush, and avoid thinking rationally as if you do, you could realize how bad of a deal they offer.

Take your time when it comes to your hard earned money. Nobody has the right to rush you. Work through the numbers, check out the competitors, make sure you UNDERSTAND the risks involved.

3) Authoritative Appearance
"I've been in this business for 15 years, trust me..."

Do not trust strangers whose only motive lies in extracting wealth from the likes of us. If they really understand the industry so well, why do they still operate in that tiny little office, 9 to 5, struggling to pay the mortgage?

4) Unbiased Appearance
Many sales people like to present themselves as 3rd party entities, giving you a positive "review" of the product/service sold. It gives the illusion of trustworthiness. This aligns with the marketing concept of "placement" in movies or TV shows, where they push the subconscious suggestion of said product/service.

Everybody is biased, one way or another. Pushing a product as a 3rd party usually stems from more deceptive sales people, as they probably have more to hide about the associated product/service.

5) Fear
This is a popular tactic among TV commercials. They present you a problem, then their product/service as the easy fix. E.g. (paraphrasing) pimples will make you extremely unpopular, never get a date, or an invite to Christmas dinner (wooo, so much to fear!); UNLESS, you buy this cream/spray, whatever... You get the drift

Understand that these unfounded anxiety issues do not originate from a lack of advertised products/services.

Armed with the above, I sincerely hope you have become more ready against the sales deceptions.

Sunday, February 24, 2008

Roulette Theory

This subject has interested me for a while, mainly due to the fact that mathematically speaking, I believe the possibility of a strategy to obtain a slight statistical edge to the player exists. Well, without further or do, here goes.

The graph displays bets available for European roulette, which has a slightly lower edge for the house with the single 0, where American roulette contains a 0 and a 00.

Let us focus on the 3rd's, i.e. boxes where you can bet on "1st-12","2nd-12", and "3rd-12".

The probability of each spin landing in one of the 3rd's is 12/37, or 0.3243~ (32.43%), and 0.027~ (2.7%) for the 0 to get hit.

What this means, is that over in the long run, roughly out of every 100 spins, each 3rd would expect to get hit roughly 32 times, and the 0 roughly 3 times.

Now the payoff. With respect to betting size on a 3rd, winning on a 3rd gives a 200% profit, and a losing bet results in a loss of 100%. i.e. a $1 bet makes $2 in profit if won, otherwise the original bet amount of $1.

This presents a winner/loser size ratio of 2/1=2.

Statistical expectancy. This is how much you would expect to win or lose over in the long run. If you play like any other newbie at the casino, the following becomes expected.
$2*0.3243 - $1*(1-0.3243) = -0.0271
The negative expectancy points to a gradual loss of roughly 3% over the period of roughly 1,000 spins. So what is needed to make the expectancy positive?

The following lies the key to this theory-
The game is deterministic. i.e. we KNOW the exact statistical expectation of how it will end in the long run, and with that knowledge it then becomes entirely feasible to adopt a strategy to exploit that information.

(At this point, I know the math professors at AUT would probably disagree with me quite passionately. I welcome anyone to debate against the above notion.)

To reiterate, we can mathematically expect 32 hits out of each 3rd with each 100 spins (or 16 out of 50 spins), however we will need at least 34 winners to be profitable at the end of 100 spins (or 17 winners out of 50 spins). Now, what if in the first 50 spins, the first 3rd or the "1st-12" landed only 10 times? For the statistical expectancy of 32 hits to fulfill the next 50 spins, or the second half of 100 spins, will have a higher than 50% chance of turning out 22 hits on the "1st-12" bet spot. And viola, an expected winning session.

What is the exact probability of the statistical expectancy to be fulfilled with respect to the number of spins? I will address this issue in the near future. I hope you enjoyed this reading :)

Prisoner's Dilemma of Game Theory

An interesting game of the following scenario-
You have two people in jail, awaiting do process. You know they're guilty of some awful crime, but you have no concrete evidence. If they cooperate with each other and both deny the crime, they would get away with a fine, a slap on the wrist. Now, you separate them and inform each that if he/she confesses and the other doesn't, he/she would get off completely; and if they both confess, they'd get a more lenient jail sentence.

Player1 / Player2




(2 , 2)

(0 , 3)


(3 , 0)

(1 , 1)

The table displays potential payoffs with respect to player 1 and 2. Each prisoner or player in this game must estimate the strategy of the other. The obviously best solution for both lies in them cooperating with each other and avoid therefore any jail time. However, each would risk receiving the maximum penalty to adopt that strategy. The payoff for confession lies in either walking free or a less severe punishment.

One can notice the conflict between individual and group interests easily. For each player, the potential payoff becomes higher if he/she chooses to confess. However as a group, the most efficient strategy results from both players cooperating with each other, where they both receive a payoff of 2 utilities.

The game resembles many group-work situations I have experienced in the past. Conflict of interest arises all the time, and it takes integrity and emotional strength to stick to the plan for the "greater good", or good of the group. Businesses have failed, relationships ruined, because some people choose strategies with greater individual payoff which could become self-sabotaging in the long run as the collective suffers.

Simple solutions exist. Team players must choose to be a "team player". A business, marriage, family, or a simple friendship requires all players to cooperate continuously for success. That sometimes requires faith in each other and individual sacrifice, and the result would be well worth it.