Optimizing Trend-Following Strategies

Trend following on the pure basis of riding along with the crowd, without thorough planning or execution, often directs toward undesirable returns. Just think of all the uninformed investors who had shelled out all that hard earned money in mid 2007, just as the stock markets had begun to decline.

As much as I don’t like the idea of trend following, the strategy can result in a positive expectancy via precise planning and flawless execution. The following presents some of the points to help increase winning rates along with an example of a definite, objective exit plan.

Volatility

Stocks move more in a single direction (or “trends”) when volatility increases, and vice versa. Logically, anyone who applies a trend-following scheme would experience a higher winning rate if trading occurred ONLY during volatile periods.

The mornings in New York. Large orders, or at least portions of them, tend to enter the exchanges in the mornings and as they get filled, volatility lowers. The trend following day traders could take advantage of this phenomenon and trade only in this period.

It gets trickier for longer term players. Historically, volatility has always moved in a semi-mean reverting manner, and does not provide definite future outlooks. However, to gain a slight edge, trend followers could wait until volatility figures reach historically low levels (15-20ish) to exploit the mean-reverting nature and start loading up on positions.

Definite Exit Plan

“Let the winners run” or apply a hard stop order for loss control, and you might as well your money down the drain. What you need is a determined plan of profit taking, and position liquidation if profit levels never get reached.

Example:

You could use range indicators as a sign for reward/risk control. The stock markets tend to stop drifting in a certain direction with respect to historical ranges.

With a simple ATR indicator, you can project up or down movement potential in the consequential time step. And if price does not reach target by the end of the unit of time, simply exit with a lower profit or loss. This is what “calculated risk” intends.

Conclusion

I have provided some more ideas regarding improving entries and exits at Creative Trading Tactics for further reference. The above mention some, certainly not all areas a trend following trader/investor can tweak to increase winning rate or average winner/loser size ration to further return expectancy. The pursue of knowledge never ends.

Day of Mathematicians

As mathematicians convened for another Auckland gathering at AUT, the beautiful day went by hastily. More than an academic forum, the prominent, striking men and women shared distinct fragments of highlighted lives.

Origins

Most of them have spent life times researching, teaching, and traveling the globe to spread profound algebraic goodness. Sprouted via Auckland (Cooper, Gauld, Gover, Hunter, Khoussainov, Martin), Canada (Raphael), China (Tan), and the US of A (Lawson and Piotrowski), the guests managed to captivate everyone with both novel reflections and witty anecdotes.

The Battle Wounded

Dr. Gauld’s compacted and photogenic family chronicle led the way toward the history of Poincaré Conjecture. It concerned critical point connections, such as untying knots in 4-dimensional space, where circular spatial movements of the arms became necessary; he endured in spite of a recovering shoulder joint though it probably triggered some winces (or quiet chuckles) in the audience.

Common Language

For both Dr. Raphael and Dr. Tan, English was not their first languages (well, Dr. Raphael spoke fluently with a French accent that some would probably claim “alluring”), and of course that has never stopped them in the past, nor this day. With the aid of highly evolved computer generated presentations, yes overhead projectors have become “un-cool”, communication eased while everyone submerged in oceans of numbers.

Two Particular Mathematicians, Two Identical Names

The last speaker of the day, Dr. Piotrowski, electrified the room with his larger-than-life personality. Eyes bulged, mouths opened, and hair possibly shocked upright, everybody laughed and the occasionally gasped throughout the half hour talk.

Not all understood the complex closed graphs theorem connected with topology (perhaps just me), Dr. Piotrowski enthralled every single person in the room with the tale of two Polish mathematics scholars, finished in the same year, undergoing ridiculously insignificant probability, of having the same exact first and last names. This mathematical irony could become a subject of enthusiasm for generations to come.

“17:35 to infinity”

Dr. Jiling Cao and Peter Watson, the administrator, at the Dept of Mathematics mean business when it comes to partying. Mouth watering cheese pastries, mini salmon rolls, exotic samosas burst into thousands of little flavor crystals with each nibble. Locally distinguished wine flowed through the room, and furthered appetite, along with enthusiastic mingling.

Dr. Lawson mentioned current conditions of Batton Rouge, Dr. Hunter continued with some afterthoughts on Markov chain, and Dr. Piotrowski explained how incredibly cultured Cleveland had grown. Freely discussed, everybody exchanged segments of each others’ mind, and while slightly buzzed off the divine drinks, anything and everything sounded particularly fascinating.

The night went on, and so did the festivity of great people, great minds. Somehow, somewhere, mathematics has become very cool.

This article is also published at the American Chronicle

Money Market Thoughts

Optimization of returns via money markets calls for the pursuit of high yielding liquid instruments while minimizing associated risks. A variety of investment vehicles remain available to the retail investors, but finding and exploiting high yield of limited risk takes a bit of research.

Debt Securities Primer

The US government issues treasury bills, notes, and bonds regularly. Treasury bills do not hold coupon payments and mature within a year, the notes range from two to ten years, and bonds up to thirty years. Their rates vary with respect to their shifts in supply and demand and the Federal Reserve’s sentiment toward the general economy.

Banks issue notes and bonds as well. As they clearly hold higher default risk than the US government, these instruments generally offer higher interest rate returns for compensation. It takes more work to manage said risks, but it could result in higher returns.

Risks Involved

Counterparty Risk- it runs with all debt based instruments, where the debtor may become unable to repay the promised amount due to insolvency. While low, this risk exists for American banks and requires active management to mitigate.

Interest Rate Risk- If the US Federal Reserve decides to raise interest rates and the holder needs to sell the debt instrument before maturity date, a net loss would likely occur.

Opportunity Cost- money market investment vehicles have historically provided lower returns than equity or commodity alternatives. Depending on economic conditions, investors experienced higher returns off the stock or commodity markets than debt securities (of course with higher risks, too). Timing is critical.

The Strategy

Noted above, the most efficient manners of money market investment rely on strategic planning. For preservation and low risk growth of capital, money markets do well under negative economic conditions. One of few indications of an oncoming bear market lies in the inverted yield curve, i.e. where short term rates are higher than long term counterparts.

Interest rates tend to move in a semi-mean reversion manner, i.e. debt security returns do not normally drift in either direction. The strategy is simple. With most capital in a savings account, one could invest added portions in the short term debt instruments only when they carry higher rates than the long term rates, and simply hold on to them until maturity. A if the rates increase higher, add on to the investments.

Risk Management

The aforementioned strategy helps to maximize short term returns via US treasury and bank backed debt securities. At the same time, by applying the inverted yield analysis, the investor would more often than not mitigate opportunity cost associated with equity or commodity returns.

Holding until maturity remains the only sure-fire way to avoid interest rate risk. Despite that, due to the quasi-mean reverting nature of interest rates, the above strategy of “buying high” would result favorably for the investor frequently. The return from the savings account would also cushion the unlikely losses.

As for default risks regarding bank solvency, it requires the investors to stay informed of financial industry matters. Stock prices, insider transactions, and institutional equity holdings of said banks provide important indications of their financial outlooks.

Final Wrap Up

The money market allows for lower risks; and at the same time lower returns as well. To optimize returns over in the long term, it pays to become informed in debt, commodity, and equity markets. In the world of finance, relevant knowledge is power.

Explaining Public Bearish Sentiment

The game of financial markets functions to extract wealth from a majority of the players, and most of the public investors have now taken sizable losses and taken on extremely negative attitudes. They are probably wrong.

Public Crowd Holds Mostly Trend Followers

Trend followers represent those who tend to arrive “late to the party”. As the market peaked in 07, risk considerations did not exist for average investors; and now, as general volatility takes a breather, nothing but despair and misery. Numerous investors had liquidated stock positions taking relatively large losses, while professional traders began to cover short positions for profit.

By the time moms and pops have expressed strong downside, cataclysmic sentiment; the festivity of liquidations would have reached almost at an (perhaps short term) end. Naturally, the least uninformed investors take the hardest hits, and get out near price bottoms. Now that a large segment of the panic selling volume has been exhausted; what next?

The Liquidity Game Repeats

With the currently softening selling pressure, and the Federal Reserve continuously injecting liquidity, the short term trend of the general stock markets will likely stay on the positive side. Repeated throughout financial history, bargain hunters commence raiding as downside forces ease. With lessening selling and increased demand, price tends to drift upwards.

This happens with every liquidity cycle, yet the masses of public investors still behave as anticipated. Many still hold on to the dream of going from rags to riches from “picking the right stocks”, unaware of its irrelevance with logical, profitable stock trading.

Playing the Game Logically

Yes, it is damn scary right now to feel bullish, since no certainty exists within the financial markets. Despite that, the 2008 election, historical liquidity cycles, and overwhelming public “fear” had always lead to a positive expectation of the equity markets, however unlikely it may seem. Keep in mind however; a positive statistical expectation indicates a higher-than-50% probability, not absolute certainty.

Thank you for reading!

Winning Requires Non-Competition

Hard work alone does not suffice for success, it also takes brains. The wits portion suggests that only when a period of non-competition is created, can the business operate at full profit earning potential.

Creativity

It takes incredibly exhaustive thinking to come up with a financial opportunity that most others have not yet embraced. Whether it a product that the people want but are not getting, or a statistical edge in the financial markets that most traders have over looked, once discovered “serious business” commences.

Periods of Non-Competition

As mentioned in Innovation Crucial For Success, the key to maximizing returns lies in these limited windows of time where no competition exists; a period where trend followers struggle desperately to replicate the said products. Even once imitation products or services become available, competition would push for price and marketing wars for what little is left of the market.

The same goes for the financial markets. The general trend-following traders or investors tend to arrive “late to the party” as they buy once price has already rallied significantly, and vice versa. Historical equity prices have shown that price drifts do not last, i.e. there is no certainty of up trends to continue, and probability of eventual decline stays definite.

Prolonging Period of Non-Competition via Confidentiality

Successful businesses hold trade secrets, because they like to minimize competition for as long as possible. It is that simple. As soon as relevant information becomes leaked, rivalry begins. This explains why most businesses stay busy with R&D to have new, hopefully innovative products ready by the time existing sales face competition.

In the world of finance, the same goes. Once the professional and successful trader takes a long position in an investment instrument, he expects the uninformed trend followers to later on put in additional buy orders and create an upward drift in price. It would be disadvantageous toward the successful trader if the common investors became aware and competed for the liquidity. For this reason, the industry functions to keep the public investors in the dark.

Start Thinking Ingeniously

TV analysts push for buying of stocks fervently, why not make downside bets. Why do they never provide an exit recommendation? Many still believe that importing from China provides an edge in price, while the smart businessmen have already begun to source from Vietnam at much lower costs. It is about staying ahead.

Last Words

Lateral thinking, taking on new possibilities, and upholding secrecy remains the only manner of winning in the worlds of business and financial markets. Only free thinking coupled with open mindedness allows for great things.

08 Presidential Campaign Effect On Stock Markets

The presidential battle will likely cause the markets to climb this year due to political interests and statistical evidence. The candidates along with their campaign contributors have invested heavily in the forms of money and political whip cracking, and they play to win.

Current US Economic State

Still winding from the credit crunch effect, the financial markets have experienced increased volatility with spring. The major stock index growths have slowed while financial institutions hummed busily with contingency plans. The global liquidity squeeze has commenced, yet somehow looks on hold. The near term future looks mystifying.

The markets nevertheless have stayed afloat and investors mostly happy, even in spite of somewhat unenthusiastic sentiment expressed by Ben Bernanke lately. This resulted from additional liquidity provided by the US Federal Reserve along with equity buying sentiment via lowered interest rates. The next economic downturn has been slowed down.

Current Popular Candidates, Campaign Designs, and Contributors

Hilary Clinton, Barack Obama, and John McCain have applied tremendous media exposure since the campaigns commenced. It is then logical to conclude that these candidates have more than adequate funds raised and readily available, most likely via business interests.

The campaigns aim at several key topics. The American voters have lately become absorbed with the Iraq war, Iran, social benefits, and immigration mostly, and the candidates respond elaborately regarding these issues. With the economy and fiscal responsibilities less mentioned, the voters are designed to focus more readily at the said subjects.

The presidential campaign contributions include a vast amount of corporate interests, and they intend to keep voters attentive and associate positive economic times with the candidates. To maintain political objectives, large donators would likely attempt to help the economy stay afloat and growing for the year.

Quantitative Evidence

According to seekingalpha.com, by the 4^th year of past presidential terms, the S&P index has provided an average return of 8.62%, and 3.75% for the second term. The numbers do not lie, and put forth a positive expected return. This numerical representation affirms the theory that election years generally call for bullish economic times, despite the ongoing fiscal shenanigans.

Last Words

Despite the above, the US financial industry has never experienced a shake up as hard as the recent credit market matters. This problem is unprecedented and investors should take caution with bullish bets. When it comes down to it, wiser decisions still hinge on diligent research and meticulous planning.

Eliot Spitzer's Investigations Before The Political End

The following video explains material Spitzer had investigated in before the revelations of his personal sexual conquests. Shocking, full of hot air, or nothing unexpected?

Effect of Hedge Funds Today

As the hedge fund industry continues to grow, the markets have turned increasingly volatile today. This logically hurts the less-informed retail investors as it forces more price instability related risks onto their positions even in bullish periods.

Growth of Hedge Funds

Presently, the hedge fund industry exceeds $1 trillion, and still expanding as money managers attempt to squeeze every drop from the apparently saturated market. The investment vehicles utilized range from equity, commodities, debt instruments, to derivatives of all forms. Some make directional or market neutral bets while others attempt arbitrage. Nevertheless, the relative large sums create significant price impacts with each order.

Increased Risks for Public Investors

Prices move as a result of relatively large initiated orders, and the hedge fund industry does just that. This evermore evident phenomenon hurts the uninformed investors as it leaves them literally “buying at tops and selling at bottoms”, due to a lack or delay of information.

Wall Street rumors and news releases tend to reach fund managers first, where the public usually stands last in line. This creates unfounded risks in present industry condition as the price affecting hedge funds have first dibs on most relevant information, and they usually take action before the mainstream crowd to preserve or amplify returns.

Volatility from Hedge Fund Sentiment

With so much more capital influenced today, vague rumors or corporate press releases all potentially trigger backbreaking ripples across these secretive investment pools. Collective fund management sentiment has created unprecedented power in the industry, as seen in the present liquidity issues faced by “prime” mortgage backed investment vehicles.

Back in 1998, a quasi-recession resulted from the fall of Long Term Capital Management, a hedge fund run by two Nobel Prize winners. Their failure, a loss of “only” $4.6 billion, had caused such market turmoil that many individual investors had lost fortunes, some everything.

When ratings agencies downgraded General Motors debt to junk bond status in May of 2005, the shock throughout the hedge fund industry caused a steep correction in the major indexes. Only after awareness of GM solvency, along with heavy buying from the public, did this near-catastrophe go unnoticed.

Solutions for Individual Investors

Without an edge, statistical or information regarded, the uneducated investors face sharp negative expectancies in the present financial environment. The solution requires a bit more work than ever before, like any other business. Do the researches, study how the hedge funds and Wall Street institutions function, learn the math, become informed. When it comes down to it, follow the money and you will not mind the work.

From Gambling To Winning The Financial Markets

Gambling, a term loosely applied by those who understand little of mathematics particularly in the area of statistics or probability, implies playing a game with negative expectancy. People in general like to make assumptions about subjects that they do not fully understand, therefore justifying apathy, despair, often via past personal failures.

Why Most People Fail

Trading the financial markets, relevant knowledge separates the winners from chumps. Like any industry, a few industry leaders make the bulk of profits, followed by a whole lot of trend following losers. The markets do not offer an infinite sum of payoff for the players, hence the first come first serve phenomenon. If you follow the general crowd, and play the game like everybody else, then of course this feat qualifies as “gambling” as the public, uninformed mass plays with a negative expectancy.

Playing To Win

It takes creativity, intelligent planning, and flawless execution just like all other good things in life. Statistics, stochastic calculus, general probability papers serve as few of many subjects of study to help in the quest for wisdom. Alongside this, you must also read up and learn how the financial exchanges work, along with correlations between them. Only after all this, could connections become realized, and winning edges created.

The financial markets resemble that of a war field, where casualties result from loss in money and pride, and the winners get the loot. The Art of War was one of the most helpful books I had ever invested in years ago. According to Sun Tzu, you should only fight, when you win.

Avoid Risk of Single Stock Failures

Several means remain available today to avoid or minimize risk involved with business failures for the equity holders. According to business survival statistics I had listed in the past (Stock Market Downside Bets), it moves below 50% after five years of operations. Managing this form of risk is crucial for the long term bullish investors.

Exchange Traded Funds

Making mutual funds obsolete, these listed baskets of goodies have become available to the general public with a variety of underlying stocks or commodities without the hefty management fees. The commodity ETF’s such as silver, gold, or oil pose virtually no risk of bankruptcy outside of the expected volatilities.

Insider Transaction Analysis

If the insiders have expressed way more volume in selling than buying in the past few months, it means they believe the price will likely dip. Since they always know more about the business operations than the public, their sentiment usually carries some weight.

Investment of Short Positions Exclusively

This would allow the investor to reap exceptionally large rewards off corporate disasters. It usually couples with heavy volatility, e.g. Bear Stearns stocks had gone from $54 to $3 over a single weekend this month (Mar. 08). A statistician speaker at the Auckland University of Technology had mentioned that one in four corporations experiences a calamity that it will never recover from, every 5 years.

This type of investment naturally completely mitigates the risk of loss from business failures, and carries a positive statistical expectancy. But it carries unique forms of risks and takes a much more active management to pull off.

Basic Options

If bullish, a basic position in a call option or leap would allow for unlimited profit potential, yet limited loss due to lowered cost of the option contracts. Of course, the game with options compared to underlying stock/commodity trading resembles that of chess with checkers. A whole variety of strategies exist to profit off underlying price or volatility swings. The serious investor would find value learning about options.

Final Words

As shown, it all simply takes a bit of research and discipline, and average investors can preserve capital, mitigate financial misfortunes. Like everything else good in life, a little bit of diligence could go a long way.

Realistic Risks of Long Term Stock Investments

Long investment positions of corporate common stocks carry inherent risks. Advisers, agents like to avoid this subject as it requires more profound considerations via the client investor, and understanding it would reveal the often unjustified entry-costs and management fees.

Risk of General Market Downturn

The stock markets have a positive correlation to general economic swings, and wield at least a couple of bearish years each decade. This leaves the probability of stock markets ending each year at higher levels of 70-80% at best. The industry analysts, advisers or brokers facilitate public ignorance of this easily in bullish periods, where any stock seems to rally effortlessly with the illusion that no forms of risk exist.

Realistically, just the opposite is true. The longer a certain stock has rallied continuously, the more likely institutional holders look to take profit (i.e. sell) before the bearish period commences, or perhaps they know something that the public does not. Of course they need chumps to provide liquidity and buy off them, the role usually played by the general public; this is where the financial advisers and brokers do their magic and sell the “risk-free” sentiment, where “Of course it’ll go up!”

Risk of General Volatility Even In Bullish Periods

Prices do not move in nice smoothed curves, but rather ugly zigzags as result of constant quasi-auction based trading on the exchange floors. Even in a bull market, the general fluctuations occur and the simple attitude of ignoring this risk and “focus on the far horizon” typically ends in mediocre or terrible performance.

Accurate assessment of potential loss due to volatility could require a lot of number crunching, but simple methods exist as well. The ATR, or Average True Range, for the historical annual price ranges provides a rough estimate. Most of the free web based price charting services provide this one of many available volatility indicators.

Risk of Corporate Bankruptcy

Stocks from Enron or WorldCom had performed well in the bull market of the 90’s, and their demise never appeared obvious until the selling began. This risk always exists in long term long side stock investments, and it increases with length of holding period.

In other words, longer held stock positions carry higher risk of losing close to 100% of the associated value according to historical statistics. Longer held short positions face higher risk of getting squeezed short, i.e. the original lender of the shares demand them back, but even that has a lower loss potential than the upside bets.

Consistent Investment Profit Takes Work

Solutions exist to mitigate or limit the above mentioned risks. Taking short positions, applying market-neutral strategies, arbitrage schemes are some of the many options available to the retail investors. Investment managers who does not acknowledge or disclose these issues imply incompetence or dishonesty, and probably do not deserve the hefty fees.

It takes dedicated self-education, then planning and flawless execution to win in this game. Like many other good things in life, complex, but not impossible. I will discuss some of these solutions in a future article.

TV Hinders the Learning Process (I Think)

Forewarned, this article contains a lot of personal negative bias toward the entertainment industry, and was not accepted at suite101.com. I would still welcome any feedback on this tops here, thank you for reading!
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Television programs today have taken on unconventional forms of education and impede learning and maturing processes of psychologically developing audiences. Once recognized however, the resolution simply points to alternative pastime activities.

Onslaught of Commercials Shows and Movies

As the entertainment industry expands, an evermore widening selection of television programs has become publicly available. Every single day, individuals young or old experience assaults of advertisements and various scripted personalities. Inadvertently, the publicized manners of content arrive complemented with questionable influences. In other words, they create false ideals and hence alter common public perceptions.

False Principles

As propagandas lobby the public toward government biases, television advertisements perform the equivalent for products or services. With advances in behavioral research, commercials today thrust and exploit popular desires and fears. A typical theme accentuates the fear of crowd rejection, and the solution for acceptance lies somehow magically within the advertised item. Unfortunately the validity of these premises rarely gets scrutinized.

Change of Values

Television shows and films inspire emotional amusement, while the underlying opinions and impressions leave lasting effects. The public icons hold immense power over young audiences. Partying instead of studying, pursuit of coolness, or glorification of crime promote undesirable values toward growing adults.

Behavior Modification

While in the learning process within a campus environment, top priorities logically center on education and preparations for a rewarding life beyond school. Instilled with questionable beliefs and attitudes via television, many confounded individuals of this generation attempt to obtain the newly advocated ideals. This today has resulted in substantial consumerism, associated credit bubbles, lowered academic achievements, or wide range moral decay.

Alternative Utilizations of TV Time

No successful corporate executive or industrialist has ever coupled success with television watching. With less time in front of the tube, opportunities become available for attainment toward a variety of purposes. Getting into shape, writing that book, learning recipes for health improvement, or completing the school assignments on time, these goals all of sudden have become simply realistic with the additional time available. Once analyzed and meticulously executed, productivity often ends highly rewarding.

Limit TV Time for Better Campus Life and Beyond

As established above, television hinders the growth development of viewers, especially those in the educational and maturing stage of life. On the other hand, limited exposure to mass media entertainment leads to free and independent thought, uninterrupted learning; and of course, realistic happiness.

Position Sizing and Risk Management

With the recent horribly tragic events of real estate and debt instrument investment experiences, some public information on risk management deserves attention. Position sizing deals with the portion of total asset exposed to risk/reward.

Putting it all on the line or "betting the ranch" tends to carry exceptionally high risks of ruin, since it leads to large losses as soon as the underlying event goes south. It would make more sense to allow many different "bets", all with positive statistical expectancies, to occur at once. As the law of large numbers kicks in, a positive return will eventually follow. Luck determines the speed of it.

Quick example-

Basic trend following stock investment strategies carry approximately 33% winning rate on average. (Some still come out profitable after long strings of trades, because the average winners carry much larger size than the limited losing trades.)

This basically implies that out of each 10 lowly correlated positions, one would expect 2-4 winners at best, but those home-run winners will bring all the money home.

To execute this and lower the risk of total loss, many professional traders commit (i.e. risk) 1-5% of capital per trade/investment unit. Strings of losing trades occur from time to time, and this scheme remains the only method of surviving them before the large winners ensue. The more probabilistic trials, the probability of the statistical edge kicking in becomes much larger.

All said and done, you want to run the investments like a casino, where the edge sits on your side. Luck determines whether an individual investment unit ends profitably or negatively. Study and gain that positive expectancy. Plan the position sizes meticulously. The money will follow.

ING Freezes Withdrawals In Two Funds, INDEFINITELY

This is just wrong, investors punished for mistakes of the management team. ING, one of the larger fund management firms based in Australia has frozen all withdrawals from 2 of their credit instrument based funds. The reason given, lack of liquidity.

Lack liquidity, that just means ING has had a hard time selling the damn things off to others at adequate prices. The supposedly highly qualified fund managers at ING had made decisions on the trades/investments knowingly. They even had the balls to claim the 2 involved funds as "low risk", when they had absolutely no clue how these instruments would perform in a bearish environment.

Irresponsible and clueless, with the early warnings last July, ING could have adapted much more conservative strategies to prevent this dire stage. Having associated investment advisers push the funds as "low risk" or "safe" is outright FRAUD.

Innocent and mislead, the investors have been left out in the cold, without their money. For some, this means life savings they had killed themselves for. The link article mentions an 85 year old woman who has $300k lost from one of the funds.

This is completely unacceptable. The ING managers screwed up, and deserve punishment, not the people. ING should be forced to liquidate assets to raise enough cash to fund withdrawals, and contain the problem within its own premise.

Anyway, they're talking about it over the radio now. I might just give them a call.

http://www.nzherald.co.nz/section/3/story.cfm?c_id=3&objectid=10497816&ref=rss

Irrationality The Key To Crowd Mentality

All men are fallible. As hard as we try, nothing in this world operates at 100% efficiency. The mind drains as the body exhausts, and decision processes begin to slip. One of debatable issues within game theory contends with the notion that games could end deterministically, given that players take rational courses of action. Here lies the problem. No man or woman can realistically make every single choice at optimal rationality.

Does that mean everybody has gone nuts? Madness remains a subjective term, most of the time I think. The answers may sit along deviations of standpoints regarding payoff measures. The differences in material, emotional, or spiritual desires help make the individuality culture embraced today.

Trying to quantify “estimated” (in other words guessed) potential payoffs of modeled games has not provided much precision in outcome projections. As personal value diverges so much between individuals and cultures, perhaps another approach should be considered.

Why do people do the things they do? As majority of the population does not have scholar backgrounds in applied mathematics, the general crowd probably apply more emotional payoff instead of mathematical means for decision making.

E.g. this observation explains why the stock markets often experience higher volatility, or speed of price movement, in downward slides. As more traders look to sell, diminishing number of buyers or liquidity remains in the markets. Then the sellers panic, lowering price quite easily and willfully to desperately rid of the unwanted shares. Simply put, buyers tend to hold more patience than sellers. This happens again and again in financial history, and suggests that emotional response could occur in a collective fashion.

Emotional sentiments present a limited range of distribution. Then does it not make more sense to quantify only the potential emotive outcomes as it is how most of the population operates? In a practical sense, an investor could find general economic sentiment more important than pure price valuation. This concept probably sits at the heart of most marketing campaigns, and offers the key to underlying human influence.

How Safe Is Your Bank?

Ben Bernanke, chairman (or God as referred in the finance industry) of the American Federal Reserve expects a number of banks to fail within the next few years. These banks hold YOUR money. What seems unthinkable has become quite probable with the unfolding of the credit debacle. The mainstream media has downplayed this issue with subtleness while those in the know have become quite disconcerted.

Everyone has the right to become informed, and I want to bring you up to speed. Within the last decade, lobbyists had worked Washington meticulously and succeeded in blurring the line between commercial and investment banks. Long story short, commercial banks had begun to sell debt as investment vehicles along with insurance in the form of Credit Default Swaps or CDS.

The problem here lies in the mismanagement of risk. The existing mathematical models the bank analysts utilize assume a normal distribution with a fairly constant default rate of only 2-5% (or outside of 2 standard deviations) on the debts. Simply put, this is wrong. The credit market has a moderately positive correlation to the general economy, and in the face of a commenced recession default risks will naturally rise sharply. Stock traders had first realized this last July as the S&P500 index commenced to experience heavy dips.

The banks will hurt. They hold liability for the underlying debt within the CDS’, and their reserves are paper thin as it is with the “fractional reserve” policies. US banks have requested a rescue package from the US government of $700 Billion US dollars (that figure contains 11 zeros), as they expect to owe that much in the coming five years due to credit defaults. It has become apparent that some banks or financial institutions will fail without question.

Look up the information this article contains, verify the numbers, not just my words. We live in a financially treacherous time. The banks claim to recruit only the best from Ivy League. Then the next logical question points to whether this debacle originated from ineptitude or intentional negligence. Either way, the bankers deserve punishment, not the people.

Latest major publication regarding this,
"Banks face 'systemic margin call,' $325 billion hit: JPM" http://biz.yahoo.com/rb/080308/wallstreet_losses_jpm.html?.v=1

Diversification Doesn't Lower Risk

“You want to reduce your portfolio risk. Diversify, diversify, diversify…” I remember hearing some stock broker ranting on TV a decade ago, as the bear market hit US in 98 along with the collapse of Long Term Capital Investments. The audience at the studio watched her intently, the pain of recent losses still apparent on their faces. They all wanted desperately a way out of the hole, and turned to this supposedly professional for advice. She kept going with the metaphors of eggs and baskets, how risk is bad... Just exactly how and why, she did not bother mentioning.

Hedging Via Diversification Limits Returns

The concept never made sense to me even before any exposure to the financial markets. You buy a stock, then you buy some more because you hope they will move against each other, does that not simply lead to low potential returns, if any, and high commission costs?

ETF’s and Hedge Funds Increase Correlations

With the advent of Exchange Traded Funds and the explosion of hedge funds throughout the world, correlations between stocks, bonds and commodities have become much higher than the days of Markowitz (founder of modern portfolio theory). Most of the cause points to speed of information between newly developed funds making similar price impacting transactions concurrently. The markets have changed.

While the investment fund industry grows, fund managers of similar sentiment tend to take action concurrently. This leads to unprecedented high levels of correlation between individual stocks, hence resulting in more volatile markets. In present industry conditions, and evident from recent turmoil, the volatility added risk has become effective regardless of diversification.

ING as an Example

ING, a fund management business based in Australia, likes their investment advisors boast “safety” of their holdings due to diversification. Look up ING fund unit prices, every single one has declined since the sell off of last July; some have taken draw downs up to 70%. So much for the magic of “diversification” huh?

Last Words

Does it even matter why or how this phenomenon has occurred? It simply happens, and knowing it alone could help you become a more informed investor or trader. The world changes, so does industries, and it takes work to adapt and stay profitable.

The market exists for the purpose of asset accumulation or reduction. With every transaction you make, the goal should remain to enlarge account size; anything else serves no purpose but noise. Read a few books and learn what risk management actually entails; it will make everything easier.

Thousands In New Zealand Lose Investments & Homes

Recently in New Zealand thousands of real estate investors took heavy losses from unscrupulous marketing of an intermediary firm Blue Chip. The NZ Herald mentioned that many of these people have lost the invested estate and their personal homes as well due to collateralized mortgage failures. Families and spirits broken, they will remember this lesson in the ages to come.

The ongoing travesty began to unfold a few weeks ago as realistic questions rose regarding actual bidding prices of residential properties peddled. Brokerage firms like Blue Chip rely on heavy price discrepancies to make a profit. In other words they must convince buyers to fork over prices well over what the firm believes is liquid (i.e. where many buyers exist), and vice versa with the sellers; the surplus becomes brokerage house’s income. Therefore, their primary interest conflicts heavily against the clients. The business model reeks of problematic schemes.

We can then resolutely conclude that property values pushed by brokers imply nothing but deceptions. According to the NZ Herald, many investors had risked their own homes all in good faith via advice from Blue Chip employees. They never bothered to even visit the physical locations or scrutinize price bids from private interests.

No absolute value exists for anything; it is just an estimate of however much the next buyer will likely prepare to shell out. So it basically hangs at the mercy of the local supply and demand shifts.

If the investors had only spent a few days to research how much value the next wave of estate buyers had realistically determined, many could have avoided this sham. Yes it might feel embarrassing becoming a victim of this sort, yet the actions of Blue Chip employees suggest misrepresentation, borderline criminal.
The people should be outraged, and Blue Chip or any other associated businesses must pay.

Notwithstanding the foregoing, it still remains better to take preventive measures than focusing on past mistakes. Verify EVERY number pushed by any person interested in selling something, because more often than not the figures expressed or implied do not match with mathematical reality. Learn what it really means to take “calculated” risks, and you will avoid many shenanigans like the above.

Statistical Expectancy

The world does not run on absolute certainty, yet the strategic decisions we choose affects future outcomes somehow. The irony seems amplified with those who understand little toward statistical expectancy. Having adequate grasp of this subject makes a more informed investor for any business or personal desires.

The concept is simple.

E = Expectancy

P(w)= Probability of winners

S(w)= Average winner Size

P(l)= Probability of losers

S(l)= Average loser size

E = [P(w)*S(w)]–[P(l)S(l)]

E.g. let’s look at New Zealand finance companies. They pledge to provide retail investors a slightly above the government bond interest rate as long as their own investments do not experience corrections or draw-downs. Historically speaking, credit markets have a positive correlation to the general economy, and the world has experienced at least 2 years of recession each decade, or 2 out of each 10 years. From this we can conclude that these companies will not end every single year profitably.

I.e. the rough probability of a losing year is then 2/10=0.2 or 20%, and the probability of them ending each year profitably stands at 1-2/10=0.8 or 80% at best. They offer retail investors annual rates of roughly 9.x% (I’ll round it up to 10%) in the years they make performance targets, and in a bearish year the average investor looks to take a loss of 30% to 70%, averaging 50%.

So can the average retail investor “expect” to profit over the long run using these companies?

Probability of a profitable year: (80% or 0.8)

Average investor profit: (10% or 0.1)

Probability of a bad year: (20% or 0.2)

Average investor loss: (50% or 0.5)

E= (0.8)(0.1)-(0.2)(0.5)

E=0.08-0.1

E= -0.02

A negative expectancy suggests a net loss will likely occur in the long run. In fact the average roulette player has a less negative expectancy than the above; in other words you would likely lose less money playing roulette at the casino than investing with the finance companies.

To make profit or receive greater reward consistently, you need the odds on your side. Having a positive expectancy remains one of few ways to verify that. So learn the math, and make wiser decisions.

Birthday Paradox And Risk Evaluation

Take any random pair of people and the probability of them having the exact same birthday sits at (1/365)≈0.0027 or roughly 0.27%. The chance of it seems so low that many would ignore and assume it never occurring.

The Birthday Paradox however makes available mathematical means to display that the “improbable” occurs quite more often than general belief. How many people does it take to have over 50% chance of a pair sharing the same birthday?

23

Explanation, please keep in mind this example ignores leap years.

1) With 23 people 253 possible pairs exist.

23*22/2=253

(Look up Permutations if you don’t understand this)

2) Now instead of finding the chance of two people having the same birthday, let us find the probability of them having DIFFERENT birthdays.

1-1/365≈0.9973 or 99.73% or 364/365 in fraction

3) Plugging in the number of possible pairs.

(364/365)^253≈0.4995 or 49.95% chance of having every possible pair within the group to have DIFFERENT birthdays.

4) Therefore, this concludes that out of a group of 23 people, there exists 50.05% probability of having a pair born on the same date.

As shown, it takes only 23 unique people or events for something formally considered “highly unlikely” to transpire. This suggests that business operators could adopt a more meticulous and mathematical approach to risk management.

Killer storms or typhoons come on the ocean infrequently. Yet, shipbuilders make certain to construct and design the vessels to endure the worst of conditions. When it comes down to life or death, survival relies on weathering the rare catastrophes.

Does your business model include contingency plans for short term negative outcomes or if competitors employ unforeseen strategies? The investors of bankrupt New Zealand financing companies had to learn this the hard way, with some losing a lifetime of savings. I often hear the phrase “take calculated risks”, yet not many people understand the calculation part. It certainly does not equate to guessing and hoping for the best.

I plan to discuss risk management in the near future. In the mean time, free resources are available everywhere at the library or over the internet. Learn to survive the worst of times, and everything will turn out A O K.

Order Out Of Chaos

Certainty does not exist in this world. Yes it feels nice to assume so, but it simply is not there. People like the idea of having stability like that of a job, as it provides a sense of certainty with every paycheck. They have however ignored the fact that vocational demand relies heavily on performance of employers; i.e. they put their lives at the mercy of the local economies.

Conventional “wisdom” then pushes the idea of luck determining winners from losers of life, mathematicians beg to differ. Most individual events occur with arbitrary outcomes; collectively, respectable forecasts have become possible.

E.g. it is unfeasible to predict how long it takes an individual atomic nucleus to lose energy, or experience “radioactive decay”. But studied collectively, the half-life periods of groups of them remain stable. This makes the outcome predictable. Ironic, isn’t it?

Finding and exploiting order out from randomness has served many business models well for centuries, most apparently the lottery scheme, casinos, and the financial markets. The minds behind these industries designed the games in deterministic manners.

The sole purpose of them serves to extract wealth from the uninformed public, hence the veil of mystique.

The next logical question lies in how one could learn and understand all this, then apply it to gain an edge in business. (Yes it is all about selling. Even in the form of a job, you basically offer your time for monetary gains in return.)

Statistics & Probability Theory

Learn the math and work the numbers. The path of least resistance lies in finding areas of high demand for particular skills you possess. No sure-fire winning methods exist for success in business, yet a bit of research and planning could provide an immense head start against the majority (losers).

Hard work alone is not sufficient. I have seen plenty of people working very hard at McDonald. You must learn to plan and research efficiently and diligently. The mind provides much more aggregate value than physical work; this explains why successful corporations focus so much in Research & Development. Educate yourself, make the odds swing your way, it is worth it.

Gullibility Of The Educated

Individuals educated in the scientific methods deviate from the crowd in thought process toward life’s problems and solutions in general. By means of higher knowledge, logic plays a more significant role instead of emotions.

Having spent years of studying mathematics, chemistry, physics, along with sociology, literature, etc., we understand more of the universe compared to the layman. Yet it still does not offer complete control over emotions. As result, we end up with mounting pride over time.

The above makes us vulnerable to a particular scheme of influence. Those in the sales industry coin it “the way to fool smart people...” (Paraphrased), and they attempt it on educated folks like you and me every single day.

Big, technical jargons.

The so-called sales experts demand credibility as they spew out random, nonsensical crap as the gist of this strategy. Pride prevents “smart” people from questioning unknown terms because doing so would risk being seen as slow or dim. As a consequence, the following sentiment emerges, “I’m very intelligent, and if I can’t understand him, he must be smarter than even me therefore he MUST be right!”

I have seen it happen in real time at a bank. An investment advisor lectured at a mid-aged, clean cut dressed couple. He wanted to recommend several funds, and he started talking very technical with words like “Sharpe Ratio”, “quantitative analysis”, “Dynamic hedging”, “Volatility Indexes” and etc. The couple just sat there staring at him wide eyed and never uttered a single word. They ended up “happy” customers, for that day.

Now the solution. Make the decision today, to deeply understand anything that could affect your life significantly, this includes finances. If an investment or business opportunity becomes offered, remind yourself that there is no need to rush into it that day. Take some time and learn the ropes. Work the numbers out, and see the opportunities and risks as they really exist. You will realize that many investment funds actually operate via negative expectancy, and they rely on clients as “suckers” to profit off the fees.

Becoming impervious to this tactic takes effort. Work becomes required in research and calculations. (Having profound understanding in mathematics had helped me greatly staying focused on logic rather than the emotion of pride.) One must let go of the ego, something built up over the years or even decades. Ask for clarifications, staying shy really hurts. When it comes down to it, losing a chunk of your time and wealth remains a dire consequence of staying quietly perplexed.

A difficult task, but that has never stopped you before has it? Nobody said life is supposed to be easy.

Subtleties Of Charisma

Charisma is something I had never learned from school. Experience however, presents it a crucial part of successful business. Most fundamentally speaking, to make a profit, somebody out there must stand willing to risk their hard earned capital for your product or service in return. More trust and confidence become necessary along with transaction values for them to work out. In the case of a trader of financial securities, the relationship with associated broker(s) could determine the level of discounts on commissions and possibly better order fills.

Having personable character helps, every little bit counts. It becomes the distinguishing quality between an amateur and a professional. More often than not, the client may not find your product/service particularly fascinating, but they decide to give you a chance anyway. This edge alone could improve odds of business success, alongside a wonderful social life.

The following list includes (but is not limited to) attributes I have adapted to enhance charisma. Keep in mind, to have this edge against competitors; one must adjust strategies that others overlook.

I. Killer Looks

Stay or get in shape-

Physical fitness implies discipline and finesse, something potential clients relates to your products/services intuitively. People do not think with political correctness. Obesity raises the question of one’s own quality of lifestyle and hence business management.

Adapt appearance accepted by the target demographic-

If the clients have a penchant for clean-cut looks, a cluster of unkempt hair, unshaved chin, or bushes grown out from the nose and ears would turn them away before any words become exchanged.

II. Conversations

Stay on topics interested by the clients-

People enjoy discussing issues interesting to THEM, not you. If you accomplish this, they would likely pursue further conversations. It helps to stay focused on the clients’ concerns, as this could also lead to more business opportunities.

Avoid political subjects-

Political matters could induce deviation even in the best of friendships. It is not your best interest to compromise business relationships this way.

Never insult others, expressly or implied-

This subject holds many details. I can not point out all but just the couple of mistakes I had made in the past.

Instead of correcting a mistake directly, it is best to do it subtly. Telling someone they made an error serves as an insult to that person’s intelligence and judgment.

You do not want to assume the client enjoys the same venues of activities as your buddies. Discrepancies of moral or ethical values hurt your appeal.

(I highly recommend the book “How to Win Friends and Influence People” by Dale Carnegie. It had helped both my business and social life of epic proportions. The book mentions the above conversational techniques along with examples.)

So when it comes down to it, people only help you readily if they like you. Connect with the clients, become a part of them, and perhaps their money could end up a part of you.

Don't Follow The Trend

The trend is not my friend. With every business industry, the leaders take the biggest cut out of the particular markets and the “followers” share the left over. This phenomenon provides a picture of current business culture, where the winning players set the trend, and a whole lot of losers work desperately to survive.

I have had two failed businesses before learning this valuable lesson. The world of economics does not operate in the manner of scientific laws in terms of cause and effect.

Every market of a specific product or service holds a very limited amount of payoff for each player, and the business cycle commences as the first player enters the game. Soon after, additional players enter hoping to eat up the remaining piece of the pie, where the trend becomes apparent. It is a deterministic game. Regardless of how the players strategize, by the product/service maturity stage, there would remain a few winners and a whole lot of losers.

Even in the world of stock or commodity trading, those performing with negative expectancy greatly outweigh ones who profit consistently. With the majority of traders literally embracing the idea of “trend following”, where one pursues historical price action for directional bias. Hence, the initial buyers/sellers take the largest slice of the pie. Does it not imply that this strategy gives nothing but fudge?

Waiting then emulating others’ strategies leads to nothing but arriving “late to the party”. You do not want to miss the party; that is where the money lies. Business schools still preach the cause and effect model, where case studies of past successful ventures fill curriculums. Perhaps this explains why their graduates do not have any particular edge in business operations than the average Joe.

When it comes down to it, innovators with the balls to execute novel ideas hold the highest probability of success.

Profitable opportunities exist all day long, but you must discover them yourself. It pays to become creative. Get a book on it, do your homework. Make something that the people want, but are not getting; and the odds of winning will certainly swing your way.

Hedge Trimming, (Hedge Fund) Article Abstract

This is an abstract off the article concerning the state of the American hedge fund industry, Hedge Trimming from The New Yorker.
http://www.newyorker.com/reporting/2007/07/02/070702fa_fact_cassidy

I found the article very informative, and decided to do a review of it here for those who do not have the time or easy access to that issue of the magazine.

John Cassidy enlightens the casual New Yorker audience with a review of the hedge fund industry. The story entails a former London banker, Harry Kat, who stumbled into the field while pursuing an academic life. What he had observed did not leave much of a morally respectable notion.

Privately owned, typical hedge funds operate as financial companies. They generally raise capital off moderately affluent clients, ranging from charitable groups to individuals of high net worth. The business model centers on absolutely returns via investments or speculative trading on the financial markets, while applying the “Two & Twenty” principle. 2% charged as management fees and 20% out of the excess returns, if any, as an incentive fee.

Behind the mystic hedge fund veil, questions arise. Cassidy ponders whether these companies actually provide additional value toward exclusively wealthy clients in spite of the “Two & Twenty” fee structure. The findings seem blurred at best. According to Kat however, as a professional in the industry, the average hedge fund does not meet expectations fully as many did not outperform much better than strategies he designed personally.

The hedge fund society holds a complex web of entities and peculiar relationships, and Cassidy provides a candid look inside. While no definitely conclusion resulted, it certainly helps readers make more informed decisions toward investment arenas of tomorrow.

Arbitrage Themed Business Models

“Well it takes too much money and risk to make money on your own…” Ever heard of that? Why did you ever assume it true? Classical arbitrage proves it completely false; it puts forth an operation that is both “self financing” and risk free. Seasoned businessmen and traders of financial instruments understand the concept and they apply it all the time.

So how do you pull it off? Why does nobody discuss it openly?

When it comes down to it, core business models of many SUCCESSFUL enterprises rely on arbitrage themed strategies. These guys play the game to win, and they do it by lowering risk dramatically compared to competitors and keeping it undisclosed.

For example:

Decades ago when China first opened its doors to the west, the first western importers made fortunes with the labor and material value discrepancies. They bought in bulk from China, then sold it to buyers in the west immediately at discounts and still made incredible profit margins. They would time the transactions so the revenues arrived before they paid off the Chinese vendors, hence never risking their own wealth. There lies the concept of self financing.

However, as more businesses learned to purchase at these Chinese bargain prices, the original low-price edge has lost its value as competition reigned. This explains partly why industrial secrets hold so much value.

Another example:

Corporate merger arbitrage. Warren Buffet disclosed this strategy as something utilized in his early days of fund management. He has unveiled it mostly because he believes this opportunity does not exist anymore as too many people have become aware of it.

A few weeks ago Microsoft offered to buy Yahoo in the form of stocks at $30 per share. On the day of announcement, Yahoo shares opened at roughly $25 and Microsoft at $34. As soon as the news hit, a truck load of traders initiated buy orders on YHOO, and short orders for MSFT.

The arbitrage strategy would go something like this:

1. Shorting selling 1,000 shares of MSFT, which credits the trader of $34,000, this serves the self-financing part.
2. Using that money one can now afford to buy 1,000 shares of YHOO at $25,000.
3. As soon as prices of both stocks converge, the difference of $9,000 becomes a risk free profit. The prices WILL converge if the merger goes through or in this case via price impact of the arbitrageurs.

Within minutes both stocks jumped toward $30. The ones who got in first made a self financing, risk free profit of roughly $9 per share. However, with the strategy a common knowledge, it has become very difficult to pull it off amongst the competing orders.

“Conventional wisdom” offers nothing useful, it pushes the idea that any business model requires “too much” risk. No law of man or nature forces one to risk bankruptcy to pursue one’s ambitions. From my experience, business owners have a higher probability of devastating failure only if they do not do their homework, i.e. no research, no planning, or flawless execution thereof.

Brainstorm. I had read that Google requires its R&D to come up with at least 100 new ideas each week, and they end with perhaps 5-10 good ones. But those good ones could end up bringing in a whole lot of revenue. Creativity counts.

Find ways to carry out your business with monetary risks as low as possible without compromising income. Become more creative, just slightly more than your competitors, and you will likely end up more successful than the rest.