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All About Asset Allocation, Second Edition by Richard Ferri

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asset allocation, asset-backed security, barriers to entry, Bernie Madoff, capital controls, commodity trading advisor, correlation coefficient, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, equity premium, estate planning, financial independence, fixed income, full employment, high net worth, Home mortgage interest deduction, implied volatility, index fund, Long Term Capital Management, Mason jar, mortgage tax deduction, passive income, pattern recognition, random walk, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, Sharpe ratio, too big to fail, transaction costs, Vanguard fund, yield curve

Over that period of time, the return of the multi-assetclass portfolio at 50 percent stock and 50 percent bond portfolio CHAPTER 4 76 FIGURE 4-5 Multi-Asset-Class Portfolio versus Two-Asset-Class Portfolio, 1973–2009 11% Annualized return 50% global stocks, 50% bonds Global stocks 40% global stocks, 60% bonds 10% U.S. stocks 9% 50% S&P 500 index, 50% intermediate T-notes Fixed blend Treasuries only 8% 4 6 8 10 12 14 16 18 20 Standard deviation TA B L E 4-3 Portfolio Returns, 1973–2009 100% Treasuries 50% S&P 500, 50% T-Notes 100% S&P 500 Total return Standard deviation 7.7% 5.5% 9.1% 10.1% 9.7% 18.8% Multi-Asset class 100% Bonds 50% Global Stock 50% Bonds 100% Equity Total return Standard deviation 8.0% 5.7% 9.6% 10.6% 10.2% 18.9% S&P 500 ⫹ T-Notes was increased by 0.4 percent annualized over using only Treasury bonds and U.S. stocks. A multi-asset portfolio of only 40 percent stocks provided higher returns and lower risk than a 50 percent U.S. stock and T-note portfolio. Adding three more asset classes to Multi-Asset-Class Investing 77 U.S. stocks and T-notes pushed the efficient frontier line toward the desirable northwest quadrant. You may be wondering, why bother with multi-asset-class investing for such a small percentage of increase in return or reduction in risk? First, the example includes only five asset classes, and you will probably use more. The diversification benefit should increase by adding more asset classes.

The challenge is finding those investments that have different characteristics and expected real returns. Part Two is a review of most common asset classes that are available to you, and a few that are not so common or not so available. For many asset classes the cost and illiquidity of product negates any diversification benefit. 87 CHAPTER 5 88 A FOUR-STEP PROCESS At its core, an asset allocation strategy involves four steps: 1. Determine your investing portfolio’s risk level based on your long-term financial needs and tolerance for risk. This is converted into an equity and fixed-income allocation. 2. Analyze asset classes and select those that are appropriate based on their unique risk, expected return, past correlation with other asset classes, and tax efficiency, if applicable. 3. Choose securities that best represent each asset class selected in Step 2. Low-cost index funds and select ETFs make good choices because they offer broad diversification and closely track asset-class returns. 4.

First, people should select an asset allocation mix that is best for their needs. Second, they should select individual investments that best represent those asset classes. The selection of investments to represent asset classes takes a lot of time because there are thousands of investments to choose from. I try to make the investment selection easy in this book. For further reference, I’ve also written other books, including All About Index Funds, 2nd edition, and The ETF Book, 2nd edition. In general, you are looking for investments that have broad asset class representation and low fees. Index mutual funds and ETFs are a perfect fit for this purpose. They give you broad diversification within an asset class at a reasonable cost. However, you need to be very selective in the funds you buy. There are vast differences in cost and strategy even among index funds and ETFs.

 

pages: 1,088 words: 228,743

Expected Returns: An Investor's Guide to Harvesting Market Rewards by Antti Ilmanen

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Andrei Shleifer, asset allocation, asset-backed security, availability heuristic, backtesting, balance sheet recession, bank run, banking crisis, barriers to entry, Bernie Madoff, Black Swan, Bretton Woods, buy low sell high, capital asset pricing model, capital controls, Carmen Reinhart, central bank independence, collateralized debt obligation, commodity trading advisor, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, debt deflation, deglobalization, delta neutral, demand response, discounted cash flows, disintermediation, diversification, diversified portfolio, dividend-yielding stocks, equity premium, Eugene Fama: efficient market hypothesis, fiat currency, financial deregulation, financial innovation, financial intermediation, fixed income, Flash crash, framing effect, frictionless, frictionless market, George Akerlof, global reserve currency, Google Earth, high net worth, hindsight bias, Hyman Minsky, implied volatility, income inequality, incomplete markets, index fund, inflation targeting, interest rate swap, invisible hand, Kenneth Rogoff, laissez-faire capitalism, law of one price, Long Term Capital Management, loss aversion, margin call, market bubble, market clearing, market friction, market fundamentalism, market microstructure, mental accounting, merger arbitrage, mittelstand, moral hazard, New Journalism, oil shock, p-value, passive investing, performance metric, Ponzi scheme, prediction markets, price anchoring, price stability, principal–agent problem, private sector deleveraging, purchasing power parity, quantitative easing, quantitative trading / quantitative finance, random walk, reserve currency, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, riskless arbitrage, Robert Shiller, Robert Shiller, savings glut, Sharpe ratio, short selling, sovereign wealth fund, statistical arbitrage, statistical model, stochastic volatility, systematic trading, The Great Moderation, The Myth of the Rational Market, too big to fail, transaction costs, tulip mania, value at risk, volatility arbitrage, volatility smile, working-age population, Y2K, yield curve, zero-coupon bond

This persistence may reflect some of the same influences that are seen in traditional asset classes, but stale prices and return smoothing are also likely to have contributed. Figure 14.2 shows how well a simple trend-following strategy performed in four asset classes. In each class I simulate the one-year moving average rule for about 15 liquid assets (the interest rate and bond futures are all within G10 markets; currencies and equity indices also include a handful of countries outside the G10). The approach is again deliberately naive except that I apply volatility weighting. Diversification both within and across asset classes smooths returns (I target 10% volatility for each asset class). For example, all four asset classes have respectable SRs between 0.7 and 1.0, but the composite has a volatility of only 6% and an impressive SR of 1.4.

It is not clear what will work in the 2010s; I stress the possibility that government bonds will lose their safe haven status. Diversification should not ignore valuations. Especially if many asset classes are overpriced in good times, it seems likely that they may suffer together when bad times hit. The best results arise by combining the general goal of broad diversification with the underweighting of expensive and overcrowded asset classes or strategies. Diversification across strategy styles or risk factors is often more effective than diversification across asset classes (recall the three-dimensional cube in Figure 1.2). Enabling purer style and factor exposures is therefore a key underappreciated benefit of investing in alternative assets (albeit not exclusive to them). Style diversification. Combining value and momentum tilts (or related carry and trend tilts), which often are negatively correlated, provides more effective diversification than most static asset classes.

The latter episode reminds us of overcrowding risk, which can make any strategy hurt—typically, following persistent successes and excesses. Box 29.2. Style diversification vs. asset class derivatives As a simple exercise, I study combinations of four asset classes (U.S. stocks, bonds, real estate, and funds of hedge funds) and the four strategy styles reviewed in Chapters 12–15 (equity value, currency carry, commodity trends, and volatility selling). Each composite is rebalanced to equal weights every month between 1990 and 2009. The asset class composite has greater market-directional risk: its correlation with global equities is 0.80, compared with 0.27 for the strategy style composite. The asset class composite also has average correlation among its four components (0.30) than does the strategy style composite (—0.05). Thanks to its superior diversification, the strategy style composite has a double Sharpe ratio compared with its constituents’ average Sharpe ratio (1.2 vs. 0.6).

 

Commodity Trading Advisors: Risk, Performance Analysis, and Selection by Greg N. Gregoriou, Vassilios Karavas, François-Serge Lhabitant, Fabrice Douglas Rouah

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Asian financial crisis, asset allocation, backtesting, capital asset pricing model, collateralized debt obligation, commodity trading advisor, compound rate of return, constrained optimization, corporate governance, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, discrete time, distributed generation, diversification, diversified portfolio, dividend-yielding stocks, fixed income, high net worth, implied volatility, index arbitrage, index fund, interest rate swap, iterative process, linear programming, London Interbank Offered Rate, Long Term Capital Management, market fundamentalism, merger arbitrage, Mexican peso crisis / tequila crisis, p-value, Ponzi scheme, quantitative trading / quantitative finance, random walk, risk-adjusted returns, risk/return, Sharpe ratio, short selling, stochastic process, systematic trading, technology bubble, transaction costs, value at risk

Returns-protection diversifiers have relatively high correlations in both the up and down markets with a generic asset class (such as the S&P 500 Index). 2. Returns-enhancing diversifiers possess correlations with the same generic asset class in an up market but are relatively less correlated in a down market. 3. “Ineffective” diversifiers are assets that do not add value, even though they may possess significant correlation coefficients with the generic asset class. CTA Strategies for Returns-Enhancing Diversification 339 To illustrate, a hedge fund strategy that has a negative correlation coefficient in an up-market regime and positive correlation coefficient in a down-market regime provides diversification with no incremental returns. We classify this in the third category, that is, as an ineffective diversifier.

This provides for an even greater flow of capital across international boundaries. As a result, distinctions between international and domestic stocks are beginning to fade. This diversification vacuum is one reason why “skill-based” investing has become so popular with investors. Hedge funds and managed futures and other skill-based strategies might be expected to provide greater diversification than international equity investing because the returns are dependent on the special skill of the manager rather than any broad macroeconomic events or trends. However, diversification need not rely solely on active skill-based strategies. Diversification benefits also can be achieved from the passive addition of a new asset class such as commodity futures. This chapter examines the downside portion of the return distribution for a diversified portfolio of stocks and bonds.

This chapter examines the downside portion of the return distribution for a diversified portfolio of stocks and bonds. We then blend in hedge funds, managed futures, and commodity futures to see how the distribution changes when these alternative asset classes are added. DESCRIBING DOWNSIDE RISK The greatest concern for any investor is downside risk. If equity and bond markets are indeed becoming increasingly synchronized, international diversification may not offer the protection sought by investors. The ability to protect the value of an investment portfolio in hostile or turbulent markets is the key to the value of any macroeconomic diversification. Within this framework, investment strategies and asset classes distinct from financial assets have the potential to diversify and protect an invest- 222 RISK AND MANAGED FUTURES INVESTING 25 Frequency 20 15 10 5 0 – 8% 8% 7% 9% – 7% 6% – 6% % 4% 3% –5 – 5% 4% – 3% 1% 2% – 2% – 1% 0% 1% – 0% %– −1 2% %– −2 3% %– −3 5% 4% %– −4 %– −5 7% 6% %– −6 %– −7 %– −8 Return FIGURE 11.1 Frequency Distribution, Portfolio with 60/40 Stocks/Bonds ment portfolio from hostile markets.1 Hedge funds, managed futures, and commodity futures are a good choice for downside risk protection.

 

pages: 363 words: 28,546

Portfolio Design: A Modern Approach to Asset Allocation by R. Marston

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asset allocation, Bretton Woods, capital asset pricing model, capital controls, carried interest, commodity trading advisor, correlation coefficient, diversification, diversified portfolio, equity premium, Eugene Fama: efficient market hypothesis, family office, financial innovation, fixed income, German hyperinflation, high net worth, hiring and firing, housing crisis, income per capita, index fund, inventory management, Long Term Capital Management, mortgage debt, passive investing, purchasing power parity, risk-adjusted returns, Robert Shiller, Robert Shiller, Ronald Reagan, Sharpe ratio, Silicon Valley, superstar cities, transaction costs, Vanguard fund

Nonetheless, it’s entirely possible that small-cap stocks could perform well in a portfolio consisting of bonds and stocks depending on the correlations among the asset classes. To examine this possibility, we will consider a three asset portfolio consisting of large and small-cap stocks, represented by the Russell 1000 and 2000 indexes, and bonds, represented by the Barclays Capital Aggregate Bond Index. As an alternative to this portfolio, the Russell 2500 small/mid-cap index will replace the Russell 2000 small-cap index. Table 3.9 reports the returns and risks of each asset for the period from 1979 to 2009. The table also reports the correlations among the asset classes. The correlation between large-cap and small-cap stocks is high at 0.85. So there is limited diversification benefit from mixing these two types of U.S. stocks. The correlation between large caps and the Russell 2500 small/midcap index is even higher at 0.90.

managers on balance seem to have added marginally to Yale’s performance even in the crisis. So does Yale’s loss in 2009 undermine its earlier performance? As David Swensen said in February 2009, Propublica (February 18, 2009). For the period during which we’re in crisis, the hoped-for benefits of diversification disappear. But once the crisis passes, then the fact that these different asset classes are driven by fundamentally different factors will reassert itself, and you’ll get the benefits of diversification. It would be nice if we could always have the benefit of diversification, but life doesn’t work that way. VERDICT ON ALTERNATIVE INVESTMENTS No doubt asset allocation is improved with the addition of alternative investments. The adoption of alternatives will not guarantee Yale-size returns because other investors do not have the advantages of the Yale Endowment.

For the period as a whole, the correlation between emerging market stocks and the S&P 500 is moderately lower than that found between the EAFE index and the S&P 500. A correlation of 0.66 is certainly lower than would be found between two types of U.S. stocks, like small-cap and large-cap stocks or value and growth stocks. So it shouldn’t be surprising that diversification into emerging market stocks could lower the risk of an American stock portfolio. But, as shown in later chapters, emerging market stocks do not offer as much diversification as some alternative asset classes. This should not be that surprising given that many emerging market economies depend on exports to P1: a/b c06 P2: c/d QC: e/f JWBT412-Marston T1: g December 8, 2010 17:41 Printer: Courier Westford 108 PORTFOLIO DESIGN TABLE 6.3 Correlations between Emerging Market Stocks and Developed Market Stocks 1989-2009 EAFE MSCI EM 2000-2009 EAFE MSCI EM Correlation with S&P 500 Correlation with EAFE 0.71 0.66 0.68 0.88 0.79 0.88 Data Sources: MSCI and S&P.

 

pages: 490 words: 117,629

Unconventional Success: A Fundamental Approach to Personal Investment by David F. Swensen

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asset allocation, asset-backed security, capital controls, cognitive dissonance, corporate governance, diversification, diversified portfolio, fixed income, index fund, law of one price, Long Term Capital Management, market bubble, market clearing, market fundamentalism, passive investing, pez dispenser, price mechanism, profit maximization, profit motive, risk tolerance, risk-adjusted returns, Robert Shiller, Robert Shiller, shareholder value, Silicon Valley, Steve Ballmer, technology bubble, the market place, transaction costs, Vanguard fund, yield curve

In the portfolio construction process, diversification requires that individual asset-class allocations rise to a level sufficient to have an impact on the portfolio, with each asset-class accounting for at least 5 to 10 percent of assets. Diversification further requires that no individual asset class dominate the portfolio, with each asset class amounting to no more than 25 to 30 percent of assets. The principle of equity orientation induces investors to place the bulk of the portfolio in higher-expected-return asset classes. Domestic equities, foreign equities, and real estate deserve large allocations, allowing the equity-oriented asset classes to drive long-term returns. Domestic bonds and inflation-indexed bonds receive low allocations, allowing the fixed-income-oriented asset classes to provide diversification without excessive opportunity cost.

THE SCIENCE OF PORTFOLIO STRUCTURE Basic financial principles require that long-term investment portfolios exhibit diversification and equity orientation. Diversification demands that each asset class receive a weighting large enough to matter, but small enough not to matter too much. Equity orientation requires that high-expected-return asset classes dominate the portfolio. Begin the portfolio structuring process by considering the issue of diversification, using the six core asset classes. The necessity that each asset class matter indicates a minimum of a 5 or 10 percent allocation. The requirement that no asset class matter too much dictates a maximum of a 25 or 30 percent allocation. The basic math of diversification imposes structural parameters on the portfolio construction process. Investors achieve equity orientation by investing a preponderance of assets in the high-expected-return asset classes of domestic equity, foreign developed equity, emerging market equity, and real estate.

Fully 70 percent of assets promise equity-like returns, meeting the requirement of equity orientation. Asset-class weights range from 5 to 30 percent of assets, meeting the requirement of diversification. A portfolio with assets allocated according to fundamental investment principles establishes a strong starting point for individual investment programs. Ultimately, successful portfolios reflect the specific preferences and risk tolerances of individual investors. Understanding the quantitative and qualitative characteristics of asset-class exposure creates a basis for determining which asset classes to include and in which proportions to invest. Chapter 2, Core Asset Classes, offers a primer on those asset classes likely to contribute to investor goals. Chapter 3, Portfolio Construction, outlines a methodology that blends science and art in combining the core asset classes to produce a portfolio.

 

pages: 300 words: 77,787

Investing Demystified: How to Invest Without Speculation and Sleepless Nights by Lars Kroijer

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Andrei Shleifer, asset allocation, asset-backed security, Bernie Madoff, bitcoin, Black Swan, BRICs, Carmen Reinhart, cleantech, compound rate of return, credit crunch, diversification, diversified portfolio, equity premium, estate planning, fixed income, high net worth, implied volatility, index fund, invisible hand, Kenneth Rogoff, market bubble, passive investing, pattern recognition, prediction markets, risk tolerance, risk/return, Robert Shiller, Robert Shiller, sovereign wealth fund, too big to fail, transaction costs, Vanguard fund, yield curve, zero-coupon bond

We saw earlier that the world equity portfolio’s largest constituent by a wide margin is also the US, and if you only add US corporate bonds you will not get the diversification benefits of international exposure. But this is not just true of US investors. Any investor that adds corporate bonds only in their home geography may have diversified asset classes, but at the same time have increased geographic concentration. Adding a broad portfolio of international corporate bonds can rectify this concentration issue. Figure 7.8 Add diversified corporate bonds to the portfolio Figure 7.9 World corporate debt in $ billions Based on data from Bank for International Settlements, end 2011, www.bis.org Looking to the future, the non-US portion of world corporate debt is likely to increase further and thus augment the importance of getting both the asset class diversification of adding bonds and also the geographic diversification of adding international ones to your rational portfolio.8 When you add corporate bonds to your rational portfolio, consider Figure 7.9 and make sure you diversify internationally.

The best theoretical and actual portfolio The rational portfolio is a compromise: a compromise between what we would like to create in a theoretical world and what is available practically. In an ideal (theoretical) world we should own a small slice of all of the world’s assets to maximise diversification and returns. This clearly is not possible in reality, but the rational portfolio is a very good simplification that we can actually implement. Because the asset classes of the rational portfolio have active and liquid markets for the pricing of thousands of individual securities, we don’t need any specific insight to select securities in those markets. And because government bonds, equities and corporate bonds give a very good representation of the world’s assets, a portfolio representing those asset classes is a very good simplification of what we should ideally be striving for in a portfolio. We can accept the premise that market forces have set a price on individual securities and the aggregate market at a level that is consistent with the risk/return characteristics of that asset class.

And if we allocate along the same lines as the efficient markets we will achieve maximum diversification and the best risk/return profile. Figure 7.14 The rational portfolio Table 7.3 The rational portfolio at different risk preferences (percentages) We need to take a combination of equities and other government and corporate bonds and combine that with our ‘safety asset’, the minimal risk asset. How much risk we want is then determined by how much of the minimal risk asset, and how much of the combination of the other asset classes, we want. Construct your portfolio in this way and you will have an outstanding portfolio for the long run. In implementing the portfolios outlined above look for products that, as closely as possible, represent the various asset classes: Assetclass Description Minimal risk asset UK, US, German, etc. or equivalent credit quality of maturity matching investor’s time horizon.

 

The Intelligent Asset Allocator: How to Build Your Portfolio to Maximize Returns and Minimize Risk by William J. Bernstein

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asset allocation, backtesting, capital asset pricing model, computer age, correlation coefficient, diversification, diversified portfolio, Eugene Fama: efficient market hypothesis, fixed income, index arbitrage, index fund, Long Term Capital Management, p-value, passive investing, prediction markets, random walk, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, South Sea Bubble, the scientific method, time value of money, transaction costs, Vanguard fund, Yogi Berra, zero-coupon bond

You must ask three questions in sequence: 1. How many different asset classes do I want to own? 2. How “conventional” a portfolio do I want? 3. How much risk do I want to take? Asset Classes How many different asset classes should you own? You might as well ask the meaning of life. About all one can say is “more than three.” Portfolios come in many degrees of complexity, and the number of assets you employ will depend largely upon how much you tolerate dealing with this complexity. I’ll make a small confession at this point; I’m an asset-class junkie—I just can’t own enough of the things. I enjoy dealing with them, and if I have to manage a portfolio with 20 or 30, that’s all right. But the law of diminishing returns applies to asset classes. You get the most diversification from the first several. The next several, maybe a bit more.

This 40/60 stock/bond portfolio is available from DFA, about which more will be said in Chapter 8: ■ 8% U.S. large-cap growth ■ 8% U.S. large-cap value ■ 4% U.S. small-cap growth ■ 4% U.S. small-cap value ■ 4% REIT ■ 4% international large-cap value ■ 2% international small-cap growth ■ 2% international small-cap value ■ 1.2% emerging markets large-cap growth ■ 1.2% emerging markets large-cap value ■ 1.6% emerging markets small-cap growth ■ 15% one-year corporate bonds ■ 15% two-year global bonds ■ 15% five-year U.S. government bonds ■ 15% five-year global bonds First, the complexity of this portfolio should satisfy all but the most exacting portfolio buff, with no less than 15 asset classes. Secondly, it is quite conventional, with a 28/12 domestic/foreign split, and it is much heavier in large-cap than small-cap stocks. This portfolio provides adequate safety and diversification, and yet its return only rarely varies more than a half-dozen percent from a domestic 40/60 S&P 500/T-bill mix. You now have an idea of how the allocation process works. First, decide how many different stock and bond asset classes you are willing to own. Increasing the number of asset classes you employ will improve diversification but will also increase your work load and Optimal Asset Allocations 83 tracking error. The Gap Portfolio gets around this problem with a heavy weighting of large and domestic stocks in its equity portion.

For example, if you need the money in two years, your stock allocation should not exceed 20%; if you will need the money in seven years, it should not exceed 70%. 2. Determine how much complexity you can tolerate. Is keeping track of six different asset classes more than you can handle? Or are you an “asset-class junkie” who craves a portfolio of exotic birds such as Pacific Rim small companies or emerging markets value exposure? For starters, you’ll need at least four asset classes: ■ U.S. large stocks (S&P 500) ■ U.S. small stocks (CRSP 9-10, Russell 2000, or Barra 600) ■ Foreign stocks (EAFE) ■ U.S. short-term bonds If this is all you can handle, fine. The above four classes will provide you with most of the diversification you’ll need. However, if you can tolerate the added complexity, I’d recommend breaking things down a bit further: ■ ■ ■ ■ U.S. large stocks—market and value U.S. small stocks—market, value, and REITs Foreign stocks—Europe, Japan, Pacific Rim, emerging markets, and small cap U.S. short-term bonds Implementing Your Asset Allocation Strategy 145 3.

 

pages: 317 words: 106,130

The New Science of Asset Allocation: Risk Management in a Multi-Asset World by Thomas Schneeweis, Garry B. Crowder, Hossein Kazemi

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asset allocation, backtesting, Bernie Madoff, Black Swan, capital asset pricing model, collateralized debt obligation, commodity trading advisor, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, diversified portfolio, fixed income, high net worth, implied volatility, index fund, interest rate swap, invisible hand, market microstructure, merger arbitrage, moral hazard, passive investing, Richard Feynman, Richard Feynman, Richard Feynman: Challenger O-ring, risk tolerance, risk-adjusted returns, risk/return, Sharpe ratio, short selling, statistical model, systematic trading, technology bubble, the market place, Thomas Kuhn: the structure of scientific revolutions, transaction costs, value at risk, yield curve

Again, while holding a diverse set of assets may reduce risk in certain market environments, historical evidence alone may not provide the basis for deciding which assets to hold (the benefits of emerging markets shown in historical data may simply be due to the unique currency moves of that time period). Practitioner research generally focuses on a limited number of asset classes (stocks, bonds, cash, real estate; and so forth), largely because these are the asset classes that most practitioners have to sell. As shown during 2008, those asset classes do not provide the range of assets necessary to provide adequate diversification. Moreover, those asset classes do not contain many of the assets or investment approaches that provide today’s investors the ability to manage risk (however you define it). Just as important, many of the historical correlations reported by these asset classes are, in fact, not representative of correlations between many modern asset vehicles in current market environments. For instance, the historical low correlation numbers between stocks and bonds and real estate is due in part to the fact that real estate prices generally have not represented their true market value but their accounting value, which may not change over time, in contrast to their true sale price, which may often change over time.

However, down markets are where the portfolio shock truly takes place and where the diversification decision is truly tested. Throughout this review the chapter focuses within each section on the sources of return and the risks inherent within each asset class. Finally, the book uses this chapter as a starting point for the benchmark issues discussed in Chapter 8. 134 Sources of Risk and Return in Alternative Investments 135 Keep in mind that this chapter focuses on the general performance of each investment area rather than the performance of individual funds or managers. The performance of a portfolio of style pure managers (managers who consistently trade the same strategy in basically similar ways) is expected to have the same general factor sensitivities as the average manager in that strategy but with lower risk. ASSET CLASS PERFORMANCE In Exhibit 7.1, results for the return and risk performance of various traditional and alternative asset classes are presented.

However, the correlations of private equity with the other nonequity based indices are very low, suggesting that, over the most recent eight-year period, additional diversification benefits could have been achieved by adding private equity to a non-equity based portfolio, but that adding private equity to an equity biased portfolio may offer limited diversification. It can be observed from Exhibit 7.15 that the information ratios for portfolios that include at least a 10% investment in private equity hedge funds failed to dominate those portfolios that do not include an investment 153 Sources of Risk and Return in Alternative Investments EXHIBIT 7.15 Multiple Asset Class Portfolio Performance (2001−2008) Portfolio Annualized Returns Standard Deviation Information Ratio Maximum Drawdown Correlation with Real Estate Portfolio A Portfolio B Portfolio C Portfolio D A B C D 1.7% 1.34% 2.9% 2.4% 7.5% 9.0% 7.2% 8.9% 0.22 0.15 0.39 0.27 −21.0% −27.1% −21.9% −27.8% 0.81 0.84 Equal Weights S&P 500 and BarCap US Aggregate 90% Portfolio A and 10% Private Equity 75% Portfolio A and 25% HF/CTA/Real Estate/Commodities 90% Portfolio C and 10% Private Equity in private equity.

 

pages: 537 words: 144,318

The Invisible Hands: Top Hedge Fund Traders on Bubbles, Crashes, and Real Money by Steven Drobny

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Albert Einstein, Asian financial crisis, asset allocation, asset-backed security, backtesting, banking crisis, Bernie Madoff, Black Swan, Bretton Woods, BRICs, British Empire, business process, capital asset pricing model, capital controls, central bank independence, collateralized debt obligation, Commodity Super-Cycle, commodity trading advisor, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency peg, debt deflation, diversification, diversified portfolio, equity premium, family office, fiat currency, fixed income, follow your passion, full employment, Hyman Minsky, implied volatility, index fund, inflation targeting, interest rate swap, inventory management, invisible hand, London Interbank Offered Rate, Long Term Capital Management, market bubble, market fundamentalism, market microstructure, moral hazard, North Sea oil, open economy, peak oil, pension reform, Ponzi scheme, prediction markets, price discovery process, price stability, private sector deleveraging, profit motive, purchasing power parity, quantitative easing, random walk, reserve currency, risk tolerance, risk-adjusted returns, risk/return, savings glut, Sharpe ratio, short selling, sovereign wealth fund, special drawing rights, statistical arbitrage, stochastic volatility, The Great Moderation, time value of money, too big to fail, transaction costs, unbiased observer, value at risk, Vanguard fund, yield curve

There are pension funds that have 80 or 90 percent of their assets invested in equities, arguing that in the long term, this will result in higher returns compared to a more traditional portfolio. This cannot be a smart way of constructing a portfolio. Diversification into more asset classes, perhaps using instruments with embedded leverage, can produce the same or even higher returns with less risk. If you are talking about diversification in the endowment model sense, we may have just witnessed a version of what [George] Soros calls “reflexivity,” whereby people’s behavior affects both the real economy and the markets through a feedback loop (see box). If everyone is looking for the same type of diversification for the same reasons using the same instruments, less diversification would automatically result when you need it most. Five or 10 years ago, it was reasonably important to know how crowded your trades were.

If I were running a real money portfolio, I would be out of the dollar completely, as I am now. Real money should cut off the tails. By this I am speaking less about employing efficient stops and more about constructing a safety net. Wait and buy value. Don’t allocate to an asset class just because you feel the need to diversify, to be involved in every asset bucket. I believe it was Warren Buffett who once said, “Diversification, diworsification.” Trying to create a recipe for managing a portfolio is like trying to create a recipe for making someone laugh: it’s impossible. Diversification has evolved such that people use it to absolve themselves of any blame. Because everything is spread around, they don’t have to commit to anything. Rational and purposeful concentration makes sense, but not dogmatic concentration, such as everything in one stock market.

In terms of asset mix, 2008 demonstrated in dramatic form how truly undiversified the classic 60-40 policy portfolio mix really is. Most plans put too much faith in the equity risk premium, when this is but one of the many risk premia that could be assumed. Further, the diversification that managers thought they had in alternative assets was proven mostly a mirage, as many of the “nonequity” assets included in asset mixes—private capital, real estate, and infrastructure, for example—turned out to be very equity-like after all. In hindsight this makes sense, since all three are businesses packaged in an illiquid form, not securities or asset classes, per se. The diversification that most plans had hoped for in their active programs turned out to be just as much of an illusion. Fixed income departments that had expanded their mandate into credit (which is really just a slice of the equity risk premium) also found their books looking suddenly very equity-like and surprisingly illiquid.

 

pages: 345 words: 87,745

The Power of Passive Investing: More Wealth With Less Work by Richard A. Ferri

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asset allocation, backtesting, Bernie Madoff, capital asset pricing model, cognitive dissonance, correlation coefficient, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, endowment effect, estate planning, Eugene Fama: efficient market hypothesis, fixed income, implied volatility, index fund, Long Term Capital Management, passive investing, Ponzi scheme, prediction markets, random walk, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, Sharpe ratio, too big to fail, transaction costs, Vanguard fund, yield curve

There is no definitive statement in trust law that says how much a portfolio should be diversified, although there is wording that states, “Risk that can be eliminated by adding different stocks (or bonds) is uncompensated risk. The object of diversification is to minimize this uncompensated risk of having too few investments.”1 By definition, index funds provide the most diversification in each asset class and eliminate all uncompensated risk. In contrast, active fund managers rely on less diversification to beat the index. The managers either limit their holdings to a few favorable securities or they avoid unfavorable sectors. In addition, strategic asset allocation maintains broad diversification to many asset classes while tactical asset allocation may have no exposure or limited exposure to one or more major asset classes. The duty to control cost and taxes when applicable. There is no statement in trust law as to what the cost of investing should be, only that “it is important for trustees to make careful cost comparisons, particularly among similar products of a specific type being considered for a trust portfolio.”2 Index funds have much lower expenses than active funds that invest in the same class of securities.

Step 4: Investment Selection Tobin explains asset allocation as risk diversification between risky assets and non-risky assets. In order to expand risk diversification, each investment in a portfolio could have some measure of fundamentally different risk than the other investments. At times the unique risk of one asset class will not be correlated with the return of another asset class, and this reduces overall portfolio risk. For example, during different periods the return of real estate doesn’t move in the same direction as the return of stocks. This gives a portfolio diversification. Of course there will be unavoidable risk overlap in all risky assets during a crisis, which cannot be avoided. The different investments selected for a portfolio have a number of characteristics. For example, asset classes to be included in a portfolio should have these traits: 1.

Investment Decisions Investors create workable portfolios by first putting an asset allocation together that best suits their needs and ability to handle risk, and second, by selecting individual investments that best represent those asset classes. In general, you are looking for investments that have broad asset class representation and low fees. The data from market indexes are the backbone for study and design of asset allocation strategies. This makes passively-managed index funds and ETFs an excellent choice for portfolio selection. Their overall higher return than actively managed funds, broad diversification, low cost, low tracking error with the markets, and high tax efficiency make these funds ideally suited to an asset allocation strategy. In addition, there are a large and growing number of index funds and ETFs on the market today that track most asset classes, styles, and sectors. On the surface, it appears that selecting a few passive funds in different asset classes would be an easy task.

 

pages: 162 words: 50,108

The Little Book of Hedge Funds by Anthony Scaramucci

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Andrei Shleifer, asset allocation, Bernie Madoff, business process, carried interest, Credit Default Swap, diversification, diversified portfolio, Donald Trump, Eugene Fama: efficient market hypothesis, fear of failure, fixed income, follow your passion, Gordon Gekko, high net worth, index fund, Long Term Capital Management, mail merge, margin call, merger arbitrage, NetJets, Ponzi scheme, profit motive, quantitative trading / quantitative finance, random walk, Renaissance Technologies, risk-adjusted returns, risk/return, Ronald Reagan, Saturday Night Live, Sharpe ratio, short selling, Silicon Valley, too big to fail, transaction costs, Vanguard fund, Y2K, Yogi Berra

Through the magical power known throughout the land as diversification—a risk management strategy whereby investors put uncorrelated positions in their portfolio so as to yield higher returns and reduce risk. Loosely translated: Don’t put all your eggs in one basket. In knowing the fundamental relationship between risk and reward, diversification involves more than simply holding a traditional portfolio full of stocks. As discussed in Chapter 1, financial advisors would have investors believe that the easiest way to provide an increased level of diversification is to load your portfolio with stocks and long-term government bonds as they generally have a low correlation with each other. However, the 2007–2009 economic crisis proved that being long in securities of different asset classes and/or being in cash isn’t enough protection.

These types of products put relatively small investors in the catbird seat, benefitting from the aggregation but also from the rigorous analysis and risk management. Diversification = Mitigated Risk As discussed previously, a fund of hedge funds holds a diversified portfolio of various hedge funds that invest in different asset classes, alternative investment styles, and geographic regions. Although there is not a magic number, it is recommended that a fund of hedge funds invest in about 30 to 50 managers, with the typical sweet spot being around 35 to 40 managers. In composing a portfolio of multiple hedge funds, a fund of hedge funds diversifies holdings, which, in turn, diversifies idiosyncratic risks. Specifically, its model helps mitigate the risk of directly investing in hedge funds because it diversifies risk thematically by multiple asset class exposure. In doing so, it reduces the risk associated with investing in a single hedge fund or hedge fund manager.

This collected pool of capital—assets under management—enables them to meet the investing threshold of certain hedge funds that have a high level of entry. Unlike a hedge fund, the fund of hedge funds manager does not make direct investments in securities himself. Instead, he invests in a multiple number of actual hedge funds so as to enhance diversification. This blending of different funds—that exhibit different investing strategies and represent multiple asset classes—delivers a more consistent return than any individual fund because it lowers the total risk of the portfolio. As such, a fund of hedge funds’ emphasis is on long-term performance with minimal volatility. So, just how does a fund of hedge funds manager allocate his portfolio? In order to employ a repeatable investment process that achieves risk-adjusted returns and protects capital, the portfolio manager conducts forward-looking fundamental research that focuses on the evolution of opportunity sets and the ability of the manager to execute a given strategy.

 

pages: 335 words: 94,657

The Bogleheads' Guide to Investing by Taylor Larimore, Michael Leboeuf, Mel Lindauer

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asset allocation, buy low sell high, corporate governance, correlation coefficient, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, Donald Trump, endowment effect, estate planning, financial independence, financial innovation, high net worth, index fund, late fees, Long Term Capital Management, loss aversion, Louis Bachelier, margin call, market bubble, mental accounting, passive investing, random walk, risk tolerance, risk/return, Sharpe ratio, statistical model, transaction costs, Vanguard fund, yield curve

In actual practice, you'll find that most investment choices available to you will have a correlation coefficient somewhere between 1.0 (perfect correlation) and 0 (noncorrelated). It's very difficult to find negatively correlated asset classes that have similar expected returns. The closer the number is to 1.0, the higher the correlation between the two assets, and the lower the number, the less correlation there is between the two investments. So, a correlation figure of 0.71 would mean the two assets are not perfectly correlated, but a fund with a correlation figure of 0.52 would offer still more diversification, since it has an even lower number. Despite what some investors think, simply owning a large number of mutual funds doesn't automatically achieve greater diversification. If a portfolio holds a number of funds that overlap and are highly correlated, there is little benefit. R-squared is a simple way the investment community uses to differentiate between investments that are highly correlated and those that are not.

After careful consideration of all the factors we've discussed here, you and your spouse agree on a portfolio allocation of stocks and bonds that seems about right for you. Congratulations! You've just made your most important portfolio decision. Subdividing Your Stock Allocation It's important for maximum diversification that our stock allocation contain various subcategories. This is because different types of stocks perform differently at different times. No investor wants to own a portfolio that has all of its equity investments in an underperforming asset class. Accordingly, we want to have some exposure to as many different types of stocks as is reasonably practical. Morningstar's Style Box, Table 8.3, is a useful tool that shows how your portfolio's equity holdings are divided between the different styles and sizes. You can use the Style Box to analyze your portfolio at no charge at www morningstar.com.

Jack Bogle had this to say: "You could go your entire life without ever owning a sector fund and probably never miss it." Real Estate Investment Trusts (REITs) area special type of fund and are sometimes considered a separate asset class from stocks and bonds. This is because REIT funds often behave differently than other stocks. This characteristic of noncorrelation can make them a worthwhile addition to larger portfolios. We suggest that REIT funds not exceed 10 percent of your equity allocation. International Stocks U.S. stocks represent about half the value of world stocks, with foreign stocks representing the other half. Foreign stocks offer diversification and possibly higher returns, but they also carry more risk in the form of political instability, weak regulation, higher transaction costs, and different accounting practices.

 

pages: 407 words: 114,478

The Four Pillars of Investing: Lessons for Building a Winning Portfolio by William J. Bernstein

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asset allocation, Bretton Woods, British Empire, buy low sell high, carried interest, corporate governance, cuban missile crisis, Daniel Kahneman / Amos Tversky, Dava Sobel, diversification, diversified portfolio, Edmond Halley, equity premium, estate planning, Eugene Fama: efficient market hypothesis, financial independence, financial innovation, fixed income, German hyperinflation, high net worth, hindsight bias, Hyman Minsky, index fund, invention of the telegraph, Isaac Newton, John Harrison: Longitude, Long Term Capital Management, loss aversion, market bubble, mental accounting, mortgage debt, new economy, pattern recognition, quantitative easing, railway mania, random walk, Richard Thaler, risk tolerance, risk/return, Robert Shiller, Robert Shiller, South Sea Bubble, transaction costs, Vanguard fund, yield curve

With the remaining $1,000 from her first year’s savings she can purchase only one fund in her IRA. The logical choice is the Vanguard 500 Index Fund. So her initial target allocation will be split between just two asset classes—taxable cash and sheltered S&P 500. Each year thereafter, she plans to contribute the maximum allowed in her IRA, placing the excess in her taxable money fund for emergencies. And thanks to the Tax Relief Reconciliation Act of 2001, the amounts that she can contribute to her IRA will increase from $3,000 in 2002 to $5,000 in 2008. At what point does she start to diversify into other asset classes? I’ve already mentioned the tradeoff between diversification and fees; each asset class will provide her with additional diversification, but will also cost her the $10 per year fee for fund accounts of less than $5,000. There are many ways to approach this problem, but a reasonable compromise would be to add an additional fund for each $5,000 contributed.

And while Fidelity does not sport these onerous fees, she found its selection of index funds too limited. Obviously, there’s a tradeoff here between diversification and expense. Yvonne would like to own all of the asset classes shown above, but does not wish to pay up to 1% per year in extra fees for the benefit of owning a lot of small fund accounts. Even worse, it will be at least a few years before she can save enough to meet the $1,000 minimum for the 11 funds listed. For this reason, setting up a retirement account for a young person is a thorny problem. Yvonne can theoretically get around this by buying an “asset allocation fund” that invests in many different assets, but it is my opinion that these vehicles do not offer adequate diversification and often perform poorly. It is better to use a proper asset-class-based indexed approach from day one. Here’s how Yvonne should proceed.

(Or, as Dan Wheeler of Dimensional Fund Advisors puts it, the problem with diversification is that it works, whether or not we want it to.) Again, it all comes down to tracking error: how much does it bother you when an asset grossly underperforms the rest of the market? Because of the high volatility and tracking error of REITs, the maximum exposure you should allow for this asset class is 15% of your stock component. Precious metals stocks—companies that mine gold, silver, and platinum—historically have had extremely low returns, perhaps a few percent above inflation. Not only that, they tend to have very poor returns for very long periods of time and are extremely volatile. Why expose yourself to this asset class? For three reasons. First, precious metals stock returns are almost perfectly uncorrelated with most of the world’s other financial markets.

 

pages: 337 words: 89,075

Understanding Asset Allocation: An Intuitive Approach to Maximizing Your Portfolio by Victor A. Canto

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accounting loophole / creative accounting, airline deregulation, Andrei Shleifer, asset allocation, Bretton Woods, buy low sell high, capital asset pricing model, commodity trading advisor, corporate governance, discounted cash flows, diversification, diversified portfolio, fixed income, frictionless, high net worth, index fund, inflation targeting, invisible hand, law of one price, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, market bubble, merger arbitrage, new economy, passive investing, price mechanism, purchasing power parity, risk tolerance, risk-adjusted returns, risk/return, Ronald Reagan, shareholder value, Sharpe ratio, short selling, statistical arbitrage, the market place, transaction costs, Y2K, yield curve

Figure 6.3 illustrates the SAA produced by my interpretation of the various asset classes’ market weights. Either exchange-traded funds (ETFs), or passively managed low-cost index funds, could fill most buckets in question. ETFs and the low cost-managed index funds are diversified baskets of securities designed to track the performance of well-known indices, proprietary indices or basket of securities. The major differences between the two is that the ETF are traded as individual stocks on major exchanges while the passive funds are subject to the traditional mutual funds-pricing mechanism (that is, at the close of market). They offer diversification or exposure to an entire market index or sector with one security at very low costs (that is, management fees). Each asset class was available at some point over the last three decades.

Chapter 6 To Start, a Benchmark 113 But, the results also show the SAA produces a much lower correlation with the market. The diversification in the portfolio seems to produce the highly desirable lower risk outcome without any reduction in returns, something economists call a free lunch. Ideally, one would then search for those asset classes that would add alpha (that is, excess returns to a portfolio) without increasing beta (that is, the risk of the portfolio in relation to the benchmark). Now, let’s apply the Sharpe ratio. Once more, the Sharpe ratio divides a portfolio’s excess returns (returns less risk less Treasury bill returns) by its volatility. In effect, the Sharpe ratio treats each asset class as a separate portfolio, focusing on the standard deviations that measure total risk. If a portfolio in question represents an individual’s entire investment, then volatility matters and the Sharpe ratio is a fitting comparison tool.

One conclusion is this: The only possible contribution international stocks can make to a portfolio is as risk-reducing or diversification mechanisms. 20 UNDERSTANDING ASSET ALLOCATION Based on the statistics presented in Table 2.2, the CAPM investment implications are fairly straightforward: Avoid growth stocks in your portfolio, include some international stocks as a risk-reduction measure, take some value stocks also as a risk-reduction measure as well as an excess-return-producing measure, and add in small-cap stocks to generate some risk-adjusted excess returns (alpha). In the process of developing traditional, and optimal, asset allocations for their clients, investment advisors typically have looked to the long-run historical expected returns for the various asset classes as well as the historical variance–covariance matrix, which shows the ways market variables either move away from one another or travel in tandem.

 

pages: 236 words: 77,735

Rigged Money: Beating Wall Street at Its Own Game by Lee Munson

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affirmative action, asset allocation, backtesting, barriers to entry, Bernie Madoff, Bretton Woods, buy low sell high, California gold rush, call centre, Credit Default Swap, diversification, diversified portfolio, estate planning, fiat currency, financial innovation, fixed income, Flash crash, follow your passion, German hyperinflation, High speed trading, housing crisis, index fund, joint-stock company, moral hazard, passive investing, Ponzi scheme, price discovery process, random walk, risk tolerance, risk-adjusted returns, risk/return, too big to fail, trade route, Vanguard fund, walking around money

Bar Charts Source: http://upload.wikimedia.org/wikipedia/commons/thumb/b/b4/Piecharts.svg/2000px-Piecharts.svg.png The individual investor is told asset allocation is diversifying a portfolio among different types of asset classes such as stocks, bonds, and cash. Advisers always try to make a big deal out of some assets such as international stocks and commodities because they have become much more in vogue this past decade. asset class Describes the general type of asset in the context of a portfolio. Stocks, bonds, real estate, and commodities are the most common portfolio assets for investors. However, asset classes also include stamp collections, Beanie Babies, and private equity. Usually used by advisers to impress clients with the broad diversification of terms a single asset class can be split up into. This aids in selling more mutual funds with different asset classes. For example, U.S. stocks can be split up into large-cap growth, large-cap value, large-cap high-dividend yield, and large-cap sector-that-is-currently-going-up which you don’t own because your sector is going down.

I thought inflation and bond declines would have happened by now, but with trillions of extra dollars in the system, the bull run received a shot in the arm. One of the primary reasons for including bonds in a portfolio is the diversification factor, coupled with income generation. That said, how is an investor supposed to commit large allocations of capital in fixed income ETFs with that sinking feeling that this 30-year party may be over? MLPs are neither stock nor bond, but they can be an alternative to a portfolio seeking diversification and income outside of traditional asset classes. If you were thinking of buying higher-volatility bond ETFs like HYG, JNK, or PFD, read on and find another way to capture higher risk return and diversification. In their simplest form, MLPs are publicly traded organizations that are structured as limited partnerships (LP) rather than corporations.

Several people have been awarded the Nobel Prize in Economics for suggesting this. Perhaps the winners are chosen randomly as well. Of course, all of these asset classes are expected to go up over time. You wouldn’t buy something if it wasn’t designed to make a profit, right? Because they don’t move together, one asset will surely be moving up while another moves down. Thus, we have a group of different assets that all go up in the long run, but their random movement allows us to sleep at night knowing we have constructed a diversified portfolio. All you need is a professional adviser that can lead you to the Promised Land by telling you how much of each asset you should have based on the level of risk appropriate. The Original Pie Crust Where did this idea of diversification come from? In 1952 an American economist named Harry Markowitz wrote an article describing “Portfolio Theory.”

 

The Handbook of Personal Wealth Management by Reuvid, Jonathan.

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asset allocation, banking crisis, BRICs, collapse of Lehman Brothers, correlation coefficient, credit crunch, cross-subsidies, diversification, diversified portfolio, estate planning, financial deregulation, fixed income, high net worth, income per capita, index fund, interest rate swap, laissez-faire capitalism, land tenure, market bubble, merger arbitrage, new economy, Northern Rock, pattern recognition, Ponzi scheme, prediction markets, risk tolerance, risk-adjusted returns, risk/return, short selling, side project, sovereign wealth fund, statistical arbitrage, systematic trading, transaction costs, yield curve

Selecting the correct number of funds within a portfolio has already been mentioned: too many investments detract from performance, while having too few deters from portfolio diversification. Figure 1.2.5 represents the analysis of a selected portfolio to identify ‘the right level of diversification’. The figures were generated by running 5,000 simulations for each number of funds. Each simulation defines an equally weighted random portfolio. The portfolio is selected from 500 equity funds with data history from 2003 to 2008. The average portfolio volatility is the average volatility observed across the 5,000 simulations. Studies like this show that diversification steadily results in a volatility that is more attributable to the index of the asset class universe and becomes less a function of the fund selection itself. This stems from a complex interaction between the 17.50 100.00 17.00 90.00 80.00 16.50 70.00 Volatility (%) 16.00 Fund portfolio volatility (LEFT) % Reduction in unsystematic volatility (RIGHT) 15.50 60.00 50.00 15.00 40.00 14.50 30.00 14.00 20.00 10.00 13.00 0.00 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 13.50 ឣ Unsystematic risk reduction (%) ____________________________________________ PORTFOLIO RETURN BEHAVIOUR 23 Number of funds Source: Citi Private Bank as at December 2008 This figure is for discussion purposes only and for use in the context of this particular chapter.

With careful structured planning through offshore investment companies (PICs) they can ensure that taxable income is at a minimum via debt structuring and that they can be protected from future ឣ 60 REAL ESTATE AND FORESTRY ______________________________________________ capital gains tax liabilities. This therefore becomes an excellent method of longterm capital growth and wealth preservation. Real estate value has experienced historically low volatility. Until recently, UK real estate has shown steady returns over the long term relative to other asset classes. In the context of portfolio diversification, real estate has a low correlation with other asset classes. Real estate has proved to be an effective inflation hedge. Who invests in which type of real estate structure? Generally speaking, the higher the clients’ net worth, the more likely they are to entertain niche funds or investment vehicles and direct real estate investment. As an example, assuming an average lot size in Mayfair of say £40 million and a typical loan to value likely to be available today of 50 per cent, a typical client would need to fund a purchase from pure equity to the amount of £20 million.

This is contrary to traditional advice suggesting you should buy the best you can afford and buy fewer pieces. Their research has been confirmed by a similar study of the prints and sculpture market. They also found that holding objects for over 20 years increased return and reduced risk by 75 per cent. The Mei and Moses findings for the period 1953 to 2003 are shown graphically in Figure 4.2.6. Research into diversification by Rachel Campbell (2008) showed that art has a low correlation with equities and other financial asset classes. Adding fine art to a diversified portfolio is likely to produce a slightly greater return for each unit of risk and a significantly better return with less volatility than stocks and bonds on their own. Based on data from 1980 to 2006, Campbell found that contemporary art offered the highest returns; Old Masters had the lowest, while also being the least volatile.

 

pages: 504 words: 139,137

Efficiently Inefficient: How Smart Money Invests and Market Prices Are Determined by Lasse Heje Pedersen

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algorithmic trading, Andrei Shleifer, asset allocation, backtesting, bank run, banking crisis, barriers to entry, Black-Scholes formula, Brownian motion, buy low sell high, capital asset pricing model, commodity trading advisor, conceptual framework, corporate governance, credit crunch, Credit Default Swap, currency peg, David Ricardo: comparative advantage, declining real wages, discounted cash flows, diversification, diversified portfolio, Emanuel Derman, equity premium, Eugene Fama: efficient market hypothesis, fixed income, Flash crash, floating exchange rates, frictionless, frictionless market, Gordon Gekko, implied volatility, index arbitrage, index fund, interest rate swap, late capitalism, law of one price, Long Term Capital Management, margin call, market clearing, market design, market friction, merger arbitrage, mortgage debt, New Journalism, paper trading, passive investing, price discovery process, price stability, purchasing power parity, quantitative easing, quantitative trading / quantitative finance, random walk, Renaissance Technologies, Richard Thaler, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, shareholder value, Sharpe ratio, short selling, sovereign wealth fund, statistical arbitrage, statistical model, systematic trading, technology bubble, time value of money, total factor productivity, transaction costs, value at risk, Vanguard fund, yield curve, zero-coupon bond

Its consistent cumulative return is seen in figure 12.3, which illustrates the hypothetical growth of $100 invested in 1985 in the diversified TSMOM strategy and the S&P 500 stock market index, respectively. 12.4. DIVERSIFICATION: TRENDS WITH BENEFITS To understand this strong performance of time series momentum, note first that the average pairwise correlation of these single-asset strategies is less than 0.1 for each trend horizon, meaning that the strategies behave rather independently across markets so one may profit when another loses. Even when the strategies are grouped by asset class or trend horizon, these relatively diversified strategies also have modest correlations. Another reason for the strong benefits of diversification is our equal-risk approach. The fact that we scale our positions so that each asset has the same ex ante volatility at each time means that, the higher the volatility of an asset, the smaller a position it has in the portfolio, creating a stable and risk-balanced portfolio.

Reactive risk management is usually a form of drawdown control (discussed in detail below) and stop-loss mechanisms. Even before you react to losses, you can manage risk prospectively. Prospective risk management comes in several forms, including diversification, risk limits, liquidity management, and tail hedging via options and other instruments. To control risk, a hedge fund often has risk limits, meaning prespecified restrictions on how large a risk the hedge fund will ever take. The risk limit can be at the overall fund level and/or at the more granular level of each asset class or strategy. Hedge funds often also have position limits that restrict the notional exposure (regardless of how low the risk is estimated to be). Furthermore, some hedge funds have a strategic risk target, meaning an average level of risk that the fund intends to take over the long term.

Further, while my dissertation was on equities, we extended the research to bonds (remember, I was a bond trader), currencies, commodities, and several other asset classes. LHP: What are the differences/similarities between quantitative and discretionary investment? CSA: I think good judgmental managers are often looking for the same things we are—cheap stocks with a catalyst as to why they won’t remain cheap, and vice versa for shorts. In fact, for a long time I used to think we did something very different, until I realized that “catalyst” and “momentum” share a lot in common and so do quants and more discretionary managers. In fact, be it for rational or irrational reasons, I think this is the type of management, quant or judgmental, that adds value over time. The big difference between quants and non-quants comes down to diversification, which quants rely on, and concentration, which judgmental managers rely on.

 

pages: 280 words: 79,029

Smart Money: How High-Stakes Financial Innovation Is Reshaping Our WorldÑFor the Better by Andrew Palmer

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Affordable Care Act / Obamacare, algorithmic trading, Andrei Shleifer, asset-backed security, availability heuristic, bank run, banking crisis, Black-Scholes formula, bonus culture, Bretton Woods, call centre, Carmen Reinhart, cloud computing, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Daniel Kahneman / Amos Tversky, David Graeber, diversification, diversified portfolio, Edmond Halley, Edward Glaeser, Eugene Fama: efficient market hypothesis, eurozone crisis, family office, financial deregulation, financial innovation, fixed income, Flash crash, Google Glasses, Gordon Gekko, high net worth, housing crisis, Hyman Minsky, implied volatility, income inequality, index fund, Innovator's Dilemma, interest rate swap, Kenneth Rogoff, Kickstarter, late fees, London Interbank Offered Rate, Long Term Capital Management, loss aversion, margin call, Mark Zuckerberg, McMansion, mortgage debt, mortgage tax deduction, Network effects, Northern Rock, obamacare, payday loans, peer-to-peer lending, Peter Thiel, principal–agent problem, profit maximization, quantitative trading / quantitative finance, railway mania, randomized controlled trial, Richard Feynman, Richard Feynman, Richard Thaler, risk tolerance, risk-adjusted returns, Robert Shiller, Robert Shiller, short selling, Silicon Valley, Silicon Valley startup, Skype, South Sea Bubble, sovereign wealth fund, statistical model, transaction costs, Tunguska event, unbanked and underbanked, underbanked, Vanguard fund, web application

As we have seen in the first chapter, the advantages of diversification have long been known—to Chinese merchants thousands of years ago and to Geneva bankers in the eighteenth century. But it was first captured in formal theory in 1952, when a twenty-five-year-old graduate student at the University of Chicago named Harry Markowitz published a paper called “Portfolio Selection.” The gist of Markowitz’s theory was that the return on an investment had to be weighed against the risk of its going awry and that these “risk-­adjusted” returns could be improved by diversifying. Putting all your money into the shares of a single firm might deliver a high return, but it exposes you to disaster if that firm goes broke. Better to spread your money across different bets, be they geographies, industries, or asset classes. Securitization is another take on this idea: by pulling a lot of different loans into a single investable security, the income stream it produces should become more stable.

Lo is a long way from having to worry about that. The cancer megafund is an idea at the start of its life rather than one that has been thrashed to within an inch of it. Asset classes have to get very big before they can have an impact on the financial system as a whole, let alone potentially require the taxpayer to step in when things go wrong. And even if you do fret about speculative excess, he says, better that investors’ animal spirits are directed toward solving the biggest social issues than to funding the purchase of McMansions. But he is alive to the potential dangers of securitization. For example, the benefits of diversification come about only if assets in the fund genuinely do not all rise and fall together—in the jargon, if they are “noncorrelated.” Putting your money into a basket of equities spreads your risk across a lot of different companies, but that isn’t much help if the whole stock market tanks; investing in mortgages across the United States is all very well unless there is a national downturn.

And the greater the amount of uncertainty, the more important it is to spread your bets. This is also an argument for having a megafund devoted to a lot of different diseases, rather than one focused on cancer. But that would bring costs of its own by making it harder for investors to assess the portfolio. And since cancer is itself a collection of many different diseases, with a lot of different potential treatments, there is already plenty of scope for diversification. If diversification is the key to providing a more acceptable mix of risk and reward, then Lo’s proposed megafund needs to hold a lot of assets. The more assets, the more shots on goal, is the way he puts it. That in turn means the funds must be able to attract a lot of capital to fund these assets. And that means they need to be able to attract investors in debt instruments like bonds. Far more money flows each year to bonds than shares.

 

pages: 263 words: 89,368

925 Ideas to Help You Save Money, Get Out of Debt and Retire a Millionaire So You Can Leave Your Mark on the World by Devin D. Thorpe

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asset allocation, call centre, diversification, estate planning, Home mortgage interest deduction, index fund, knowledge economy, mortgage tax deduction, payday loans, random walk, risk tolerance, Skype, Steve Jobs, transaction costs, women in the workforce

If you plan to invest in multiple mutual funds over time, you may want to open a brokerage account with Schwab, Fidelity or TD Ameritrade where you can invest in a variety of mutual funds easily. How Do I Diversify My Retirement Savings Appropriately? Diversification is a key concept in successful investing, especially for retirement. This article will help you understand what diversification really means, why diversification is important for you and your family, and how you can easily create the needed diversification in your investment portfolio. Definition: Diversification refers to spreading your investments around among a variety of both asset classes (stocks, bonds, real estate) and individual investments within those asset classes. Why: Diversification is important because if you are not careful, you can end up with a bunch of different investments that all move in the same direction at the same time with the same result you’d get from just one, more easily managed investment.

By investing in mutual funds or exchange traded funds (ETFs), you get the benefit of diversification at the level of individual investments but you may not be getting diversification at the level of asset classes. A “small cap growth fund,” which invests in smaller growth companies with a bias for technology stocks, for instance, may have dozens of stocks in it, but most will be similar companies that face similar risks and will react in much the same way to changes in the economy or to competition. Invest in multiple funds. In order to improve your diversification, invest in multiple funds, not just one. Don’t invest in five small cap growth funds, spread your money among several funds with different strategies. Invest in Stock funds and bond funds. To maximize diversification, be sure to invest both stock funds and bond funds.

For retirees, bonds represent the central pillar of your investment program as they generate income you can spend. Diversification: Do not put your entire stock allocation into one or two stocks. Don’t invest it all in twelve different stocks all from the same industry. The market prices assets as part of a portfolio; when you concentrate your investments you take risk that no one is paying you to take. Investing in a wide range of stocks is called diversification. You should do the same with bonds, too. Funds: The easiest way to get diversification is by buying mutual funds or ETFs (Exchange Traded Funds—always referred to as ETFs). Funds invest in dozens of different stocks or bonds, providing good diversification. Each fund has an objective. It is a good idea to buy funds with a variety of different objectives.

 

pages: 416 words: 118,592

A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing by Burton G. Malkiel

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accounting loophole / creative accounting, Albert Einstein, asset allocation, asset-backed security, backtesting, Bernie Madoff, BRICs, capital asset pricing model, compound rate of return, correlation coefficient, Credit Default Swap, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, Elliott wave, Eugene Fama: efficient market hypothesis, experimental subject, feminist movement, financial innovation, fixed income, framing effect, hindsight bias, Home mortgage interest deduction, index fund, invisible hand, Isaac Newton, Long Term Capital Management, loss aversion, margin call, market bubble, mortgage tax deduction, new economy, Own Your Own Home, passive investing, pets.com, Ponzi scheme, price stability, profit maximization, publish or perish, purchasing power parity, RAND corporation, random walk, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, short selling, Silicon Valley, South Sea Bubble, The Myth of the Rational Market, The Wisdom of Crowds, transaction costs, Vanguard fund, zero-coupon bond

THE CORRELATION COEFFICIENT AND THE ABILITY OF DIVERSIFICATION TO REDUCE RISK Correlation Coefficient Effect of Diversification on Risk +1.0 No risk reduction is possible. +0.5 Moderate risk reduction is possible. 0 Considerable risk reduction is possible. –0.5 Most risk can be eliminated. –1.0 All risk can be eliminated. Now comes the real kicker; negative correlation is not necessary to achieve the risk reduction benefits from diversification. Markowitz’s great contribution to investors’ wallets was his demonstration that anything less than perfect positive correlation can potentially reduce risk. His research led to the results presented in the preceding table. As shown, it demonstrates the crucial role of the correlation coefficient in determining whether adding a security or an asset class can reduce risk.

Receipt of a large new contract, the finding of mineral resources, labor difficulties, accounting fraud, the discovery that the corporation’s treasurer has had his hand in the company till—all can make a stock’s price move independently of the market. The risk associated with such variability is precisely the kind that diversification can reduce. The whole point of portfolio theory is that, to the extent that stocks don’t always move in tandem, variations in the returns from any one security tend to be washed away by complementary variation in the returns from others. The chart How Diversification Reduces Risk: Risk of Portfolio (Standard Deviation of Return), similar to The Benefits of Diversification, illustrates the important relationship between diversification and total risk. Suppose we randomly select securities for our portfolio that on average are just as volatile as the market (the average betas for the securities in our portfolio will be equal to 1).

This simple illustration points out the basic advantage of diversification. Whatever happens to the weather, and thus to the island economy, by diversifying investments over both of the firms an investor is sure of making a 12½ percent return each year. The trick that made the game work was that although both companies were risky (returns were variable from year to year), the companies were affected differently by weather conditions. (In statistical terms, the two companies had a negative covariance.)* As long as there is some lack of parallelism in the fortunes of the individual companies in the economy, diversification can reduce risk. In the present case, where there is a perfect negative relationship between the companies’ fortunes (one always does well when the other does poorly), diversification can totally eliminate risk.

 

pages: 304 words: 80,965

What They Do With Your Money: How the Financial System Fails Us, and How to Fix It by Stephen Davis, Jon Lukomnik, David Pitt-Watson

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Admiral Zheng, banking crisis, Basel III, Bernie Madoff, Black Swan, centralized clearinghouse, clean water, corporate governance, correlation does not imply causation, credit crunch, Credit Default Swap, crowdsourcing, David Brooks, Dissolution of the Soviet Union, diversification, diversified portfolio, en.wikipedia.org, financial innovation, financial intermediation, Flash crash, income inequality, index fund, invisible hand, London Whale, Long Term Capital Management, moral hazard, Northern Rock, passive investing, performance metric, Ponzi scheme, principal–agent problem, rent-seeking, Ronald Coase, shareholder value, Silicon Valley, South Sea Bubble, sovereign wealth fund, statistical model, Steve Jobs, the market place, The Wealth of Nations by Adam Smith, transaction costs, Upton Sinclair, value at risk, WikiLeaks

The investors were subject to “idiosyncratic risk,” meaning factors that were specific to those companies rather than to the market as a whole. Diversification minimizes idiosyncratic risk, because if you invest in fifty companies, most of your money will still be safe even if one or two go bankrupt. That’s why academics call diversification the “only free lunch” for investors.35 All the free food at the diversification buffet may lead us to ignore a key fact: diversification is no defense against systemic risk, meaning risks to broad swaths of the market. That seems obvious; if the entire market declines, a diversified portfolio will decline, too. What is less obvious is that widespread diversification may actually increase systematic risk. It may even have helped cause the global financial crisis. To understand how, we first need to understand how the financial markets employ diversification. Most people might think that a good investor is someone like Warren Buffett, who identifies good investment opportunities, doesn’t place all his eggs in one basket, and watches those investments closely.

They began writing noor low-documentation loans in which so little corroboration of information was required of borrowers that the mortgages were commonly known as “liar loans.”38 None of it mattered to the bankers doing the underwriting. They thought they were protected by the magic of diversification; since they sold most of the loans and kept only small tranches of thousands of them, or hundreds of thousands, what could go wrong? If one egg broke, there were others. No one was watching the baskets of eggs. By overrelying on diversification, the bankers actually increased the risk: every basket and every egg were affected. Diversification turned from a prudent strategy to a justification for sloppy lending. Mindless diversification was no substitute for lending standards. Nearly a decade after the collapse of the housing market, we are still feeling its effects. The health of the system depends on someone, somewhere, “minding the store.”

INEXPENSIVE BETA RATHER THAN EXPENSIVE ALPHA As more and more people realize that trading shares is costly and adds little value, there has been a growing acceptance of “index” or “tracker” funds. These funds attempt to track the returns and risks of an asset class (as represented by a benchmark such as the S&P 500 or FTSE 100) and make no effort to outperform it. The great advantage of index funds is that they generally charge very low fees.57 Nearly a quarter of all mutual fund assets in the United States are now in index funds, as are about 17 percent in Europe.58 Even in the United Kingdom, a redoubt of active management, the market share of “trackers” recently reached a market record 8.7 percent in 2012, up from 7.4 percent in 2011.59 Many professionals create a “core and satellite” structure, using index funds as the core allocation to any asset class (say, bonds and stocks) and active managers for specialty allocations. USING COLLECTIVE ACTION The popularity of index funds has its own consequences.

 

pages: 192 words: 72,822

Freedom Without Borders by Hoyt L. Barber

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accounting loophole / creative accounting, Affordable Care Act / Obamacare, Albert Einstein, banking crisis, diversification, El Camino Real, estate planning, fiat currency, financial independence, fixed income, high net worth, illegal immigration, interest rate swap, obamacare, offshore financial centre, passive income, quantitative easing, reserve currency, road to serfdom, too big to fail

. • Defense stocks, which look like a growth industry to me. • Income-producing stocks (e.g., companies paying respectable dividends and that outpace inflation and taxation, including some well-performing blue chips). • Foreign currencies (e.g., stocks of portfolios, trusts, and funds for currency diversification). A basket of stable and appreciating currencies helps diversify your portfolio, but keep in mind that all currencies are in a soft-money cycle. A goldbacked Bancor could seriously hurt this asset class. • Global opportunities (e.g., stocks of countries with strong economies and currencies, such as we’ve seen with Brazil, Russia, China, and India in recent years; unique stock opportunities overseas; emerging markets and frontier investments). These could become riskier if an asset bubble takes place or inflation mounts.

Box 1911 Santa Barbara, California 93116-1911 This book is printed on acid-free paper Manufactured in the United States of America Depend upon it that lovers of freedom will be free. —Edmund Burke, 1774 18th-century Irish philosopher To ALH & K Contents Preface 1. Logistics of International Diversification xi 1 Asset Preservation Strategies 2 Challenges to Avoiding Taxation Anywhere 4 Structuring Your Personal, Business, and Financial Life 5 The T-8 Tax Havens and Offshore Banking Centers 8 Geopolitical Investment Diversification 10 Expatriating 10 The Great American Tax Loophole 12 Renouncing Your Citizenship 14 Economic Citizenship and Retirement Programs 15 Logistics of International Diversification 19 2. The Best Offshore Structures 20 International Business Corporation (IBC): Belize, Cook Islands, Nevis 21 The Offshore Corporation: Panama Style 23 Limited Liability Company (LLC): Nevis, Panama, Cook Islands 24 viii Contents Asset Protection Trust (APT): Belize, Nevis, Cook Islands 25 The Foundation: Panama 28 The Benefits of Owning Your Own Offshore International Bank 29 Establishing a Tax-Free Offshore Operating Business 30 Flags-of-Convenience: Offshore Ship and Yacht Registration 32 Country Profiles: Belize, Nevis, Panama, Cook Islands 32 3.

TIEAs are being negotiated with the United States, Canada, and other countries, but the financial-related insurance products are still superior, providing strong financial secrecy, as well as their asset and investment management services. • Hong Kong: Offshore corporations, offshore banking and investing; strong bank secrecy; no TIEA with the United States or Canada. GEOPOLITICAL INVESTMENT DIVERSIFICATION Here is a concept that complements taking your financial life offshore and expatriating, as we’ve discussed, and, to take it a step further, in conjunction with your own personal (private) conservative monetary policy, which we’ll explore in a later chapter. Today, it’s not just having diversified investments but how they are owned and where. Geopolitical investment diversification compartmentalizes your holdings, in the same way a submarine is compartmentalized and built for an unexpected attack. It can also be thought of as the shell game in which you must locate the little ball from under one of the three walnut shells.

 

pages: 385 words: 128,358

Inside the House of Money: Top Hedge Fund Traders on Profiting in a Global Market by Steven Drobny

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Albert Einstein, asset allocation, Berlin Wall, Bonfire of the Vanities, Bretton Woods, buy low sell high, capital controls, central bank independence, Chance favours the prepared mind, commodity trading advisor, corporate governance, correlation coefficient, Credit Default Swap, diversification, diversified portfolio, family office, fixed income, glass ceiling, high batting average, implied volatility, index fund, inflation targeting, interest rate derivative, inventory management, Long Term Capital Management, margin call, market bubble, Maui Hawaii, Mexican peso crisis / tequila crisis, moral hazard, new economy, Nick Leeson, oil shale / tar sands, oil shock, out of africa, paper trading, Peter Thiel, price anchoring, purchasing power parity, reserve currency, risk tolerance, risk-adjusted returns, risk/return, rolodex, Sharpe ratio, short selling, Silicon Valley, The Wisdom of Crowds, too big to fail, transaction costs, value at risk, yield curve, zero-coupon bond

Because finding high-quality, uncorrelated trades is not easy, the ability to find multiple better-than-average independent bets is what separates a star hedge fund manager from the rest of the herd.To become a star, the notion of diversification must be pushed to an extreme. Diversification in this sense goes far beyond traditional notions of the term. It means diversifying in many different ways, and the flexibility to do so is particularly evident within the global macro style of investing. Global macro managers have the breadth of mandate to look for inefficiencies and opportunities across the spectrum of products, geographic regions, and strategies. Here we’ll briefly examine why global macro is an optimal strategy for building a diversified portfolio. Asset Classes and Products The easiest way for a global macro hedge fund manager to find diversified, independent bets is to trade different asset classes and different investment products within those asset classes. Global macro managers monitor interest rates, equities, currencies, commodities, and real estate, and within each of these categories, managers consider a range of products.Whether it be cash, physical commodities, futures, derivatives, or direct investment, the key is to not limit choice.

Global macro managers monitor interest rates, equities, currencies, commodities, and real estate, and within each of these categories, managers consider a range of products.Whether it be cash, physical commodities, futures, derivatives, or direct investment, the key is to not limit choice. Better-than-average bets are a rarity and can occur in some products but not others for various fundamental or technical reasons. As such, global macro managers need to watch all asset classes and products all the time with an eye out for such inefficiencies.The mandate of global macro hedge funds affords the latitude to allocate capital to any asset class or product, allowing global macro managers the freedom to exploit a particular inefficiency in the most effective manner. 348 INSIDE THE HOUSE OF MONEY Geography Global macro hedge fund managers also achieve diversification by investing anywhere geographically. By doubling the number of countries a manager can invest in, the number of independent investment opportunities available more than doubles.There are innumerable independent bets that can be made within countries, across countries, within regions, and across regions.

Amidst this evolution and change in the hedge fund business, one strategy has remained true to its original mandate of absolute return investing, seeking outsized returns from investments anywhere in the world, in any asset class and in any instrument: global macro. H xi xii PREFACE Global macro investing is still a relatively unknown and misunderstood area of money management but increasingly of interest. Given that my firm, Drobny Global Advisors, advises global macro hedge funds on market strategy and counts most of the top funds as clients, I am often asked the question,“What is global macro?” The classic definition—a discretionary investment style that leverages long and short positions in any asset class (equities, fixed income, currencies, and commodities), in any instrument (cash or derivatives), in any market around the world with the goal of profiting from macroeconomic trends—often fails to satisfy.What I think people are really asking is,“How does one define what the top global macro money managers actually do?”

 

pages: 353 words: 88,376

The Investopedia Guide to Wall Speak: The Terms You Need to Know to Talk Like Cramer, Think Like Soros, and Buy Like Buffett by Jack (edited By) Guinan

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Albert Einstein, asset allocation, asset-backed security, Brownian motion, business process, capital asset pricing model, clean water, collateralized debt obligation, correlation coefficient, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, discounted cash flows, diversification, diversified portfolio, dividend-yielding stocks, equity premium, fixed income, implied volatility, index fund, interest rate swap, inventory management, London Interbank Offered Rate, margin call, market fundamentalism, mortgage debt, passive investing, performance metric, risk tolerance, risk-adjusted returns, risk/return, shareholder value, Sharpe ratio, short selling, statistical model, time value of money, transaction costs, yield curve, zero-coupon bond

Investopedia explains Portfolio Prudence suggests that investors construct an investment portfolio in accordance with their risk tolerance and investment objectives. One should think of an investment portfolio as a pie that is divided into pieces of varying sizes that represent a variety of asset classes and/or types of investments to accomplish an appropriate riskadjusted return. For example, a conservative investor may favor a portfolio with large-cap value stocks, broad-based market index 226 The Investopedia Guide to Wall Speak funds, investment-grade bonds, and cash. In contrast, a risk-loving investor may hold small-cap growth stocks, aggressive large-cap growth stocks, some high-yield bonds, international investments, and maybe some alternative investments. Related Terms: • Alpha • Diversification • Modern Portfolio Theory—MPT • Asset Allocation • Style Drift Preferred Stock What Does Preferred Stock Mean? A class of stock that has a priority claim on a company’s assets and earnings over common stock.

Related Terms: • Cash Flow • Free Cash Flow—FCF • Net Present Value—NPV • Cash Flow Statement • Internal Rate of Return—IRR 78 The Investopedia Guide to Wall Speak Diversification What Does Diversification Mean? A risk management investment strategy in which a wide variety of investments are mixed within a portfolio; the rationale is that a portfolio of different investments will, on average, yield higher returns and pose a lower risk than any individual investment within the portfolio. Diversification strives to smooth out unsystematic risk in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the benefits of diversification will hold only if the securities in the portfolio are not correlated. Investopedia explains Diversification Studies and mathematical models have shown that maintaining a well-diversified portfolio of 25 to 30 stocks will yield the most cost-effective level of risk reduction.

Fixed assets are expected to provide benefits beyond one year: manufacturing equipment, buildings, and real estate. Related Terms: • Balance Sheet • Depreciation • Tangible Asset • Current Assets • Intangible Asset 14 The Investopedia Guide to Wall Speak Asset Allocation What Does Asset Allocation Mean? An investment strategy that aims to balance risk and reward by spreading investments across three main asset classes—equities, bonds, and cash—in accordance with an individual’s goals, risk tolerance, and investment horizon. Historically, different asset classes have varying degrees of risk and return and therefore behave differently over time. Investopedia explains Asset Allocation There is no simple formula to determine the proper asset allocation for every individual. However, the consensus among financial professionals is that asset allocation is one of the most important investment components.

 

pages: 339 words: 109,331

The Clash of the Cultures by John C. Bogle

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asset allocation, collateralized debt obligation, corporate governance, corporate social responsibility, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, diversified portfolio, estate planning, Eugene Fama: efficient market hypothesis, financial innovation, financial intermediation, fixed income, Flash crash, Hyman Minsky, income inequality, index fund, interest rate swap, invention of the wheel, market bubble, market clearing, mortgage debt, new economy, Occupy movement, passive investing, Ponzi scheme, principal–agent problem, profit motive, random walk, rent-seeking, risk tolerance, risk-adjusted returns, Robert Shiller, Robert Shiller, shareholder value, short selling, South Sea Bubble, statistical arbitrage, The Wealth of Nations by Adam Smith, transaction costs, Vanguard fund, William of Occam

Well, here is what one large corporation tells us: “We consider current and expected asset allocations, as well as historical and expected returns on various categories of plan assets . . . evaluating general market trends as well as key elements of asset class returns such as expected earnings growth, yields and spreads. Based on our analysis of future expectations of asset performance, past return results, and our current and expected asset allocations, we have assumed an 8.0 percent long-term expected return on those assets” (italics added, General Electric Annual Report, 2010). Such disclosure has become sort of annual-report boilerplate. All well and good, but, as they say, let’s add some “granularity” (a word I don’t much care for), making some assumptions that are arbitrary but not unrealistic. The table below shows one version of how various markets and asset-class managers must perform in order for a pension plan to reach that elusive goal. A Template for DB Returns During the Coming Decade In effect, I present in the chart the very analysis that at least some corporations use—yet without their disclosure of the specific numbers they use.

As to the value added by managers, my long experience tells me that it is extremely unlikely that any manager can possibly deliver the 3 percentage points of excess return that are required. Good luck in picking one in advance. What’s more, for DB plan managers as a group—competing with one another—zero Alpha is the expected outcome. (In fact, with the typical costs that I’ve assumed, pension managers will, in the aggregate, produce negative Alpha.) Even if our asset class returns for equities and bonds are realized, venture capital and hedge funds would have to earn returns that are far above historical norms. If those asset classes fail to do so, the actual realized return for this example would fall by 2 percentage points, to 6 percent per year. Mark your calendars for 2022, 10 years hence, and see who’s made the best estimate. For me, subjectively, even 6 percent is an ambitious goal. (The 10-year U.S. Treasury bond is presently yielding less than 2 percent, the 30-year Treasury about 3 percent.)

See also Retirement system design problems with growth in passively managed index funds in simplifying speculative investment options in Delaware Democracy, corporate Derivatives Dimensional Fund Advisors Directors Diversification Dodd-Frank Wall Street Reform and Consumer Protection Act (2010) “Do ETFs Badly Serve Investors?” (Tower and Xie) Domestic equity mutual funds Double-agency society Earnings, managed Econometric techniques “Economic Role of the Investment Company, The” (Bogle) Economics (Samuelson) Economist, The Efficient Market Hypothesis (EMH) Ellis, Charles D. Emerging markets stock funds Employee Retirement Income Security Act (ERISA) Employer, stock of Equity diversification Equity index funds Equity mutual funds. See also Actively managed equity funds assets costs domestic emerging markets expense ratio, average failure of large-cap number of returns small capitalization volatility, increase in Equity ownership, institutional ERISA (Employee Retirement Income Security Act) Essinger, Jesse Estrada, Javier Exchange traded funds (ETFs): assets Economist on future of growth in history of holding periods institutional versus individual investors in managers, leading number of problems with profile focus and selection risk profile of returns as speculation trading volumes traditional index funds versus turnover Vanguard Wall Street Journal listing of Exchange traded notes (ETNs) Executive compensation: average worker’s pay compared to cost of capital and highest increase in ratchet effect reform, progress on reform suggestions as “smoking gun,” tax surcharge on Exile on Wall Street (Mayo) Expectations, investment Expectations market Expenses.

 

pages: 368 words: 145,841

Financial Independence by John J. Vento

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Affordable Care Act / Obamacare, Albert Einstein, asset allocation, diversification, diversified portfolio, estate planning, financial independence, fixed income, high net worth, Home mortgage interest deduction, mortgage debt, mortgage tax deduction, oil shock, Own Your Own Home, passive income, risk tolerance, time value of money, transaction costs, young professional, zero day

This is an amazing discovery which goes against the basic premise “the higher the risk, the higher the return.” The beauty of diversification is that when you have a group of asset classes, some of which are negatively correlated, you can reduce the volatility (i.e., risk) of your portfolio and at the same time possibly increase your rate of return. Many financial scholars have come to realize that all investment classes fluctuate in value, but that different asset classes fluctuate differently under different sets of circumstances. It has also been found that many asset classes are not positively correlated and in fact in some cases are inversely correlated. Distributing your investment risk among different asset classes can help to smooth out your investment return. Diversification is an investment strategy that every investor should use. Diversification is also one of the main reasons I am a big advocate of mutual funds and exchange-traded funds (ETFs) for both novice and experienced investors.

It attempts to minimize risk for a given level of expected return, by cautiously choosing the size of various asset classes within a portfolio. This theory discovered that if you spread your investment dollars among several different asset classes, you may be able to lower your volatility on your overall investment portfolio without sacrificing your return on investment. This is possible because different types of assets often change in value in opposite ways because they are negatively correlated. For example, generally, when we see the c09.indd 234 26/02/13 2:51 PM Managing Your Investments 235 value of stocks increase, the value of bonds tends to decrease. This is an example of negatively correlated asset classes. The theory also showed that diversification can also lower risk even if assets’ returns are not negatively correlated.

The basic idea is that while one asset class may be increasing in value one or more of the others may be decreasing. Therefore, asset allocation and diversification may help you ride out market fluctuations and protect your portfolio from a major loss in any one asset class. They may also provide you with the staying power and control over your emotions even after a big downturn in the market. However, it is important to understand that asset allocation and diversification do not guarantee against loss. They are simply strategies that may help smooth the ride to your financial independence, point X. It is fundamental to find a mixture of asset classes with the highest potential return within your risk profile. Exhibit 9.4 shows seven sample asset allocation models that can be used as a guide to fit into your own risk tolerance level. There are, of course, an unlimited number of variations to these sample models. 5 Before you rebalance your portfolio, you should consider whether the method of rebalancing you decide to use will trigger transaction fees or tax consequences.

 

pages: 297 words: 91,141

Market Sense and Nonsense by Jack D. Schwager

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asset allocation, Bernie Madoff, Brownian motion, collateralized debt obligation, commodity trading advisor, conceptual framework, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, fixed income, high net worth, implied volatility, index arbitrage, index fund, London Interbank Offered Rate, Long Term Capital Management, margin call, market bubble, market fundamentalism, merger arbitrage, pattern recognition, performance metric, pets.com, Ponzi scheme, quantitative trading / quantitative finance, random walk, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, Sharpe ratio, short selling, statistical arbitrage, statistical model, transaction costs, two-sided market, value at risk, yield curve

Although it is true that most CTAs pursue systematic, trend-following approaches and most global macro funds (including those that trade only futures and FX) are primarily discretionary, there are discretionary CTAs and systematic global macro funds. In this light, the distinction between the groups as separate asset classes appears artificial. If anything, it makes more sense to differentiate along strategy approaches, such as systematic macro versus discretionary macro (with each group containing both CTAs and global macro hedge funds), rather than between global macro managers and CTAs. Fund of hedge funds. As the name implies, these funds allocate to other hedge funds. Most funds of funds seek to allocate to a broad mix of hedge fund strategies in order to enhance portfolio diversification. Some funds of funds, however, create thematic portfolios (e.g., long/short equity, credit, managed futures, etc.) for investors seeking exposure to a specific strategy group.

This mitigation of the impact of a single fund experiencing a large loss is perhaps the most critical benefit of diversification and is a factor that remains important well beyond 10 funds. Table 17.1 Idiosyncratic Risk: Single Fund Loss Impact versus Portfolio Size Figure 17.3 Idiosyncratic Risk: Single Fund Loss Impact versus Portfolio Size A Qualification The analysis in this chapter and the argument in favor of diversification assume that added investments are as attractive as existing investments. If, however, diversification requires extending the portfolio to include less desirable investments, the net benefit of diversification can no longer be assumed. In this case, the investor must weigh the trade-off of including second-tier investments versus the benefit of reduced risk provided by diversification. In fact, if carried to an extreme, diversification would guarantee mediocrity by leading to index-like performance.

If an index return is desirable, then it can be achieved much more efficiently by investing directly in an index or a fund that benchmarks the index. It follows that insofar as a goal of any investment process is, presumably, to surpass index performance, then diversification must, by definition, be limited. Although diversification is beneficial, if not essential, beyond some point more diversification can be detrimental. Each investor must determine the appropriate level of diversification as an individual decision. Investment Misconception Investment Misconception 46: The diversification benefits beyond 10 holdings are minimal (even for heterogeneous investment universes such as hedge funds). Reality: Research studies that conclude that diversification benefits beyond 10 are minimal are invariably based on what happens on average across thousands of portfolios rather than what happens in the worst case to a specific portfolio (that is, tail risk).

 

pages: 225 words: 61,388

Dead Aid: Why Aid Is Not Working and How There Is a Better Way for Africa by Dambisa Moyo

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affirmative action, Asian financial crisis, Bretton Woods, colonial rule, correlation does not imply causation, credit crunch, diversification, diversified portfolio, en.wikipedia.org, European colonialism, failed state, financial innovation, financial intermediation, Hernando de Soto, income inequality, invisible hand, M-Pesa, market fundamentalism, Mexican peso crisis / tequila crisis, microcredit, moral hazard, Ponzi scheme, rent-seeking, Ronald Reagan, sovereign wealth fund, The Chicago School, trade liberalization, transaction costs, trickle-down economics, Washington Consensus, Yom Kippur War

A portfolio which includes local emerging-market bonds offers diversification since correlations with other securities (stocks and bonds) are low, and potential returns from an improving credit environment and currency appreciation in emerging economies are attractive. The GEMLOC Program has three separate but complementary parts. An investment manager would be assigned to promote investment in the local-currency bonds of emerging-market countries, as well as develop investment strategies for local-currency bond markets. Shortly after the GEMLOC announcement, the bond investment organization PIMCO was selected to fulfil the role of investment manager. Next, Markit, a private-sector data and index firm, was chosen to develop a new independent and transparent bond index, for the emerging-markets local-currency debt asset class. A country’s inclusion in the new index (known as GEMX) is based on a country’s score on investability indicators, such as market size, and a set of criteria developed by the ratings, risk and research firm CRISIL.

The evidence of ten countries suggests that investors made higher returns on bond lending to foreign countries than in safer home governments; despite the former’s wars and recessions, foreign bondholders got a net return premium of 0.44 per cent per annum on all bonds outstanding at any time between 1850 and about 1970. Third, investing in the broader class of emerging markets can enhance portfolio diversification. The notion of portfolio diversification is at the core of asset management. It pertains to the need to spread your risks and rewards across investments. In essence, you diversify a portfolio to garner the same amount of returns for a reduced amount of risk. A very basic example of the diversification concept is illustrated by two separate islands, one that produces umbrellas and another that produces sunscreen. If you were to invest only in the island that produces umbrellas, you would make a fortune when it was unseasonably wet, but you would do poorly when it was a very dry year.

Like the sunscreen and umbrella islands, emerging markets and developed markets are so disparate that the opportunity to enhance a portfolio’s performance by having some exposure to both markets is considerable; smoothing out the risks and enhancing the returns. In the past, research has found that emerging-market debt (broadly as a group, as well as for individual countries) has low (and sometimes even negative) correlations with other major asset classes. To put it simply, emerging-market investments tend to fare well when other asset classes (say, developed-market stocks and bonds) fare less well. Indeed, the correlation of key emerging-market spreads (the difference between the risk-free rate and the rate charged to a riskier concern) and US bond returns is typically negative – moving in the same direction when the global economy is universally bad. Emerging-market debt has the advantage of being countercyclical to the developed business cycle, since, in a global recession, poor countries can find it cheaper to repay their debts.

 

pages: 350 words: 103,270

The Devil's Derivatives: The Untold Story of the Slick Traders and Hapless Regulators Who Almost Blew Up Wall Street . . . And Are Ready to Do It Again by Nicholas Dunbar

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asset-backed security, bank run, banking crisis, Basel III, Black Swan, Black-Scholes formula, bonus culture, capital asset pricing model, Carmen Reinhart, Cass Sunstein, collateralized debt obligation, Credit Default Swap, credit default swaps / collateralized debt obligations, delayed gratification, diversification, Edmond Halley, facts on the ground, financial innovation, fixed income, George Akerlof, implied volatility, index fund, interest rate derivative, interest rate swap, Isaac Newton, Kenneth Rogoff, Long Term Capital Management, margin call, market bubble, Nick Leeson, Northern Rock, offshore financial centre, price mechanism, regulatory arbitrage, rent-seeking, Richard Thaler, risk tolerance, risk/return, Ronald Reagan, shareholder value, short selling, statistical model, The Chicago School, time value of money, too big to fail, transaction costs, value at risk, Vanguard fund, yield curve

In the spring of 2000, the Barclays salesman in Germany, Christian Stoiber, brought Chandra to meet a pair of eager clients: LB Kiel and its sibling, Hamburgische Landesbank. Diversification, Motherhood, and Apple Pie A former LB Kiel executive summed up the bank’s strategy at the time succinctly: “What we were aiming for was diversification, which is a normal way if you manage your portfolio actively. We utilized our credit investment business to diversify our risks away.” In other words, follow the strategy advised by investment professionals everywhere. Doubting the benefit of diversification is the financial equivalent of doubting the goodness of motherhood and apple pie. But what do bankers actually mean by diversification? It turns out that there are three distinct types. The first type can be called actuarial diversification and applies to situations in which investments turn out either good or bad over a longtime horizon.

If you argued that variance (the degree to which investment returns fluctuated around their average) was a bad thing, then adding more investments—or diversifying your portfolio—was unquestionably a good thing. Or as Markowitz put it, “A rule of behavior which does not imply the superiority of diversification must be rejected as a hypothesis and a maxim.”11 Expressed even more simply, if variance was “risk,” then Markowitz proved that diversification was “risk management.” Since this flavor of diversification protects against falls in prices, justifying it requires plenty of historical price data and deft use of statistics.12 Then there is a third type of diversification, the joker in the pack. Behavioral economists call it naive diversification, in part because it seems to be hardwired into the human psyche. Psychological experiments show that when people are not restricted to a single choice on a menu, they will spread their allocation across whatever is available.

That’s why many finance experts say that for long-term investors, diversification is the closest thing to a free lunch. The problem for LB Kiel was that finding new lending opportunities across the world—the equivalent of additional coins or dice that were independent of what happened in Germany—was intensive, time-consuming work. It involved a lot of due diligence to avoid the seductive trap of naive diversification. That’s why what Barclays offered them seemed so appetizing—it had already done the hard work of scouring the globe and assembling a smorgasbord of hard-to-access assets. How convenient it would be for LB Kiel to get its financial free lunch in processed form, like a TV dinner ready for the microwave. Perhaps by buying some of the structured products Barclays was peddling, LB Kiel could get some instant diversification. The only drawback was that the $15 billion portfolio that Usi managed on Barclays’ behalf was mostly speculative grade, ranging from double- to triple-B in quality.

 

How I Became a Quant: Insights From 25 of Wall Street's Elite by Richard R. Lindsey, Barry Schachter

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Albert Einstein, algorithmic trading, Andrew Wiles, Antoine Gombaud: Chevalier de Méré, asset allocation, asset-backed security, backtesting, bank run, banking crisis, Black-Scholes formula, Bonfire of the Vanities, Bretton Woods, Brownian motion, business process, buy low sell high, capital asset pricing model, centre right, collateralized debt obligation, corporate governance, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, discounted cash flows, disintermediation, diversification, Emanuel Derman, en.wikipedia.org, Eugene Fama: efficient market hypothesis, financial innovation, fixed income, full employment, George Akerlof, Gordon Gekko, hiring and firing, implied volatility, index fund, interest rate derivative, interest rate swap, John von Neumann, linear programming, Loma Prieta earthquake, Long Term Capital Management, margin call, market friction, market microstructure, martingale, merger arbitrage, Nick Leeson, P = NP, pattern recognition, pensions crisis, performance metric, prediction markets, profit maximization, purchasing power parity, quantitative trading / quantitative finance, QWERTY keyboard, RAND corporation, random walk, Ray Kurzweil, Richard Feynman, Richard Feynman, Richard Stallman, risk-adjusted returns, risk/return, shareholder value, Sharpe ratio, short selling, Silicon Valley, six sigma, sorting algorithm, statistical arbitrage, statistical model, stem cell, Steven Levy, stochastic process, systematic trading, technology bubble, The Great Moderation, the scientific method, too big to fail, trade route, transaction costs, transfer pricing, value at risk, volatility smile, Wiener process, yield curve, young professional

I believe my pedagogical approach helped many nonquants grasp the fallacy of time diversification. Are Optimizers Error Maximizers? Hype versus Reality. In my business and research, I often apply mean-variance optimization, and for the most part obtain results that are robust to reasonable input errors. Nonetheless, I often hear the refrain that small errors in the inputs to a mean-variance optimizer lead to large errors in its output. I am not sure how this belief became so prevalent, but I have a couple of conjectures. JWPR007-Lindsey May 7, 2007 17:15 Mark Kritzman 259 Optimizers were first used to allocate portfolios across marketable securities such as publicly traded stocks and bonds, and they performed quite reasonably. Then investors included real estate and privately placed bonds. The reported returns of these asset classes were based on appraisals and matrix pricing rather than market transactions; hence, they displayed artificially low volatility.

As this debate intensified, I reexamined the BHB methodology and discovered it was specious for reasons other than its reliance on realized returns. I contrived an experiment to demonstrate its fundamental flaw. I hypothesized a world in which all asset classes had the same performance, but within each asset class the performance of individual securities varied significantly. In this hypothetical world, security selection explained 100 percent of the difference in the performance among funds, while asset allocation had no impact whatsoever. I essentially created a world with a single asset class, thus rendering the asset allocation decision irrelevant. I then applied the BHB methodology, and it revealed that asset allocation determined 100 percent of performance and security selection determined none of it—the exact opposite of the truth.15 JWPR007-Lindsey May 7, 2007 17:15 Mark Kritzman 261 The Future for Quants Quantitative analysis has advanced from the fringes of the investment management profession to the mainstream and is well on the way to becoming the dominant paradigm of the investment industry.

Diversifying market risk will become less important as the growing retiree base turns its attention to longevity risk, stability of income risk, healthcare cost risk, and inflation risk. For example, an outcome investment product might focus on inflation protection with a bucket of assets that include real assets such as commodities, inflation protected bonds, and real estate. This means that, in the future, asset class lines will blur and become less important. What will be important will be a rigorous design of new products that addresses the new risks for the retired Boomers. This is where quants will continue to excel. These new outcomeoriented products will need a solid analytical design where the relationships across asset classes can be documented, well understood, and made to work together in the most efficient manner possible. Traditional fundamental research will be less important because the goal will not be to find undervalued stocks or bonds, but instead, to focus on financial outcomes.

 

pages: 701 words: 199,010

The Crisis of Crowding: Quant Copycats, Ugly Models, and the New Crash Normal by Ludwig B. Chincarini

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affirmative action, asset-backed security, automated trading system, bank run, banking crisis, Basel III, Bernie Madoff, Black-Scholes formula, buttonwood tree, Carmen Reinhart, central bank independence, collapse of Lehman Brothers, collateralized debt obligation, collective bargaining, corporate governance, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, delta neutral, discounted cash flows, diversification, diversified portfolio, family office, financial innovation, financial intermediation, fixed income, Flash crash, full employment, Gini coefficient, high net worth, hindsight bias, housing crisis, implied volatility, income inequality, interest rate derivative, interest rate swap, labour mobility, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, low skilled workers, margin call, market design, market fundamentalism, merger arbitrage, Mexican peso crisis / tequila crisis, moral hazard, mortgage debt, Northern Rock, Occupy movement, oil shock, price stability, quantitative easing, quantitative hedge fund, quantitative trading / quantitative finance, Ralph Waldo Emerson, regulatory arbitrage, Renaissance Technologies, risk tolerance, risk-adjusted returns, Robert Shiller, Robert Shiller, Ronald Reagan, Sharpe ratio, short selling, sovereign wealth fund, speech recognition, statistical arbitrage, statistical model, systematic trading, The Great Moderation, too big to fail, transaction costs, value at risk, yield curve, zero-coupon bond

Even through one of the hottest bull markets ever, this fixed-income money tree left the S&P 500 in the dust.10 Continue the comparison across a host of major asset classes high-yield bonds, real estate, gold, silver, world bonds, or world equity and the story is the same. The LTCM money tree was the best deal around. More than that, LTCM added diversification to many investors’ holdings. The LTCM portfolio had a low correlation to many standard asset classes that an investor might already hold. Only the HFRI Relative Value Index, which is a diversified index of relative value hedge funds and not really investable, had a Sharpe ratio in the same ballpark as that of LTCM.11 LTCM’s returns from 1994 to 1997 were impressive, but it wasn’t the leverage per se that boosted them above the average. Other asset classes could not have been leveraged to achieve the same high return with a similar level of risk.

TABLE 14.1 The LTCM Spinoff and Copycat Returns Table 14.1 shows JWMP’s performance and that of other well-known relative-value hedge funds and major asset classes, such as the S&P 500. JWMP’s raw returns didn’t fare well against copycat funds.6 Its Sharpe and Sortino ratios put JWMP somewhere in the middle of this selection of relative-value funds.7 JWMP controlled its downside better than the other funds. Its worst monthly return was −2.99%, which is better than all but two of its peers (Parkcentral and Smith Breeden). A portfolio of relative-value hedge funds (HFR RV Index) has a much higher Sharpe ratio than all the selected relative-value funds.8 The JWMP fund provided a much better alternative to standard asset classes over this period. Its Sharpe ratio was nearly double that of the asset class with the highest Sharpe ratio in this table, showing that these other asset classes could not be leveraged to provide the same level of return as JWMP without having much more monthly risk.

Table K.12 contains the annualized returns of many major asset classes in the United States and around the world. That is, over each relevant period, the table shows the annualized return had the investor been invested in that asset class over that period. The long-run return of the U.S. equity market has been about 9.73%. Thus, had an investor bought $1 of the S&P 500 in 1900, by the end of 2008 that investor would have had a total of $22,565. In the 1980s, it was 17% and in the 1990s it was 18%, well above the historical average. Most developed countries’ stock markets did well prior to the crisis and during the 1980s and 1990s. Brazil’s stock market did remarkably well in local currency terms, but one must also remember that this country had tremendous inflation which tempered these high returns. TABLE K.12 Asset Class Annualized Returns Prior, During, and After the Financial Crisis Bond markets did not do as well over longer histories.

 

pages: 478 words: 126,416

Other People's Money: Masters of the Universe or Servants of the People? by John Kay

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Affordable Care Act / Obamacare, asset-backed security, bank run, banking crisis, Basel III, Bernie Madoff, Big bang: deregulation of the City of London, bitcoin, Black Swan, Bonfire of the Vanities, bonus culture, Bretton Woods, call centre, capital asset pricing model, Capital in the Twenty-First Century by Thomas Piketty, cognitive dissonance, corporate governance, Credit Default Swap, cross-subsidies, dematerialisation, diversification, diversified portfolio, Edward Lloyd's coffeehouse, Elon Musk, Eugene Fama: efficient market hypothesis, eurozone crisis, financial innovation, financial intermediation, fixed income, Flash crash, forward guidance, Fractional reserve banking, full employment, George Akerlof, German hyperinflation, Goldman Sachs: Vampire Squid, Growth in a Time of Debt, income inequality, index fund, inflation targeting, interest rate derivative, interest rate swap, invention of the wheel, Irish property bubble, Isaac Newton, London Whale, Long Term Capital Management, loose coupling, low cost carrier, M-Pesa, market design, millennium bug, mittelstand, moral hazard, mortgage debt, new economy, Nick Leeson, Northern Rock, obamacare, Occupy movement, offshore financial centre, oil shock, passive investing, peer-to-peer lending, performance metric, Peter Thiel, Piper Alpha, Ponzi scheme, price mechanism, purchasing power parity, quantitative easing, quantitative trading / quantitative finance, railway mania, Ralph Waldo Emerson, random walk, regulatory arbitrage, Renaissance Technologies, rent control, Richard Feynman, risk tolerance, road to serfdom, Robert Shiller, Robert Shiller, Ronald Reagan, Schrödinger's Cat, shareholder value, Silicon Valley, Simon Kuznets, South Sea Bubble, sovereign wealth fund, Spread Networks laid a new fibre optics cable between New York and Chicago, Steve Jobs, Steve Wozniak, The Great Moderation, The Market for Lemons, the market place, The Myth of the Rational Market, the payments system, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, Tobin tax, too big to fail, transaction costs, tulip mania, Upton Sinclair, Vanguard fund, Washington Consensus, We are the 99%, Yom Kippur War

Understanding correlation, and judging it, is critical to effective portfolio management by intermediaries. A fairly small number of securities is enough to provide effective diversification if the risks those securities carry are completely different. On the other hand, even a very long list of securities with similar characteristics provides little real diversification. Investing in companies in different economic sectors and different countries was once an effective route to diversification. But large corporations today operate in many businesses and are global in their scope. They have common sales profiles, so that Pfizer and Glaxo, Exxon and Shell, have fortunes very similar to each other. Not very much diversification is therefore achieved from a portfolio of big multinational companies like these. The Gaussian copula – the ‘formula that killed Wall Street’ – was a method of calculating how the correlation between defaults on the components of an asset-backed security determined its overall default probability.

By supporting an industry structure not well adapted to the needs of users, policymakers preserved not just the financial system but also the institutions that had given rise to the instability. The adverse consequences for business, for households and for economic growth and economic policy will be described in later chapters. Diversification Behold, the fool saith, ‘Put not all thine eggs in the one basket’ – which is but a matter of saying, ‘Scatter your money and your attention’; but the wise man saith, ‘Put all your eggs in the one basket and – WATCH THAT BASKET.’ Mark Twain, Pudd’nhead Wilson’s Calendar, 1894 Financial intermediation can facilitate diversification. A small share of several projects is less risky than a large share of a single one. If you toss a coin once, you either win or lose: if you toss a coin thirty times, you will have ten or more wins 98 per cent of the time. Sharing the risks and rewards of a pool of assets with a group of people with similar objectives means that you can derive the same average return with lower risk of major loss (but correspondingly reduced possibility of substantial gain).

Sharing the risks and rewards of a pool of assets with a group of people with similar objectives means that you can derive the same average return with lower risk of major loss (but correspondingly reduced possibility of substantial gain). Individuals can – and should – use this principle in building their own portfolios. Professional intermediaries can provide a service by offering ready-made diversification, so that savers can acquire a share in a portfolio with the purchase of a single security in a mutual fund or investment company. The coin-tossing game reduces risk effectively because the results of successive throws are independent of each other. Diversification is most effective if the values of the assets in a portfolio are uncorrelated. For example, the risk that interest rates will rise sharply is unrelated to the risk that a cancer drug will fail its clinical trials, or the risk that Apple’s new product range will flop.

 

pages: 467 words: 154,960

Trend Following: How Great Traders Make Millions in Up or Down Markets by Michael W. Covel

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Albert Einstein, asset allocation, Atul Gawande, backtesting, Bernie Madoff, Black Swan, buy low sell high, capital asset pricing model, Clayton Christensen, commodity trading advisor, correlation coefficient, Daniel Kahneman / Amos Tversky, delayed gratification, deliberate practice, diversification, diversified portfolio, Elliott wave, Emanuel Derman, Eugene Fama: efficient market hypothesis, fiat currency, fixed income, game design, hindsight bias, housing crisis, index fund, Isaac Newton, John Nash: game theory, linear programming, Long Term Capital Management, mandelbrot fractal, margin call, market bubble, market fundamentalism, market microstructure, mental accounting, Nash equilibrium, new economy, Nick Leeson, Ponzi scheme, prediction markets, random walk, Renaissance Technologies, Richard Feynman, Richard Feynman, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, shareholder value, Sharpe ratio, short selling, South Sea Bubble, Stephen Hawking, systematic trading, the scientific method, Thomas L Friedman, too big to fail, transaction costs, upwardly mobile, value at risk, Vanguard fund, volatility arbitrage, William of Occam

Now, in reading Trend Following, the do-it-yourselfers might argue that having a book that illustrates these same basic principles takes some of the fun out of it. Actually, Covel, like any good trend follower, has not focused solely on the endpoint. He gives you a deep understanding of the most important part: the path. Unlike so many other books that xv A prudent investor’s best safeguard against risk is not retreat, but diversification. [And] true diversification is difficult to achieve by [simply] spreading an investment among different stocks (or different equity managers), or even by mixing stocks and bonds, because the two are not complementary. David Harding Winton Capital xvi [Trend following firm] Aspect Capital is aptly named. Its group of physics-trained leaders took it from the aspect ratio of plane design, that is, the wider the wing span, the more stable the plane.

He [I]f you’re trying to reduce the volatility or uncertainty of your portfolio as a whole, then you need more than one security. This seems obvious, but you also need securities which don’t go up and down together [reduced correlation]… It turns out that you don’t need hundreds and hundreds of securities [to be diversified]. Much of the effective diversification comes with 20 or 30 wellselected securities. A number of studies have shown that the number of stocks needed to provide adequate diversification are anywhere from 10 to 30. Mark S. Rzepczynski John W. Henry & Co.6 250 Trend Following (Updated Edition): Learn to Make Millions in Up or Down Markets is worse off than someone who tries and fails or someone who never had any desire in the first place. But there is hope. If you study risk, you will find there are two kinds: blind risk and calculated risk.

Their expertise is to take these different markets and “make them the same” through price analysis. When you look at a breakdown of performance at any given time, losses are typically negated by winners. This is by design because no one ever knows which market will be the one to take off with a big trend that pays for all of the losses—hence the need for diversification. AHL is even more precise about its need for Chapter 10 • Trading Systems 255 diversification in an uncertain world: “The cornerstone of the AHL investment philosophy is that financial markets experience persistent anomalies or inefficiencies in the form of price trends. Trends are a manifestation of serial correlation in financial markets—the phenomenon whereby past price movements inform about future price behavior. Serial correlation can be explained by factors as obvious as crowd behavior, as well as more subtle factors, such as varying levels of information among different market participants.

 

The Smartest Investment Book You'll Ever Read: The Simple, Stress-Free Way to Reach Your Investment Goals by Daniel R. Solin

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asset allocation, corporate governance, diversification, diversified portfolio, index fund, market fundamentalism, passive investing, prediction markets, random walk, risk tolerance, risk-adjusted returns, risk/return, transaction costs, Vanguard fund

Chapter 21 Too Many Stocks, Too Few Bonds fnvemnmt policy {assu allocation] is the foundation upon which portfolios should be constructed and managed. -Charles D. Ellis, Invmmmt Policy Another imponant factor in proper investing-after taking account of COS t S and understanding risk-is asset allocation. Asset allocation refers to the percentage of an investment portfolio held in each of the major asset classes-stocks, bonds and cash. Many academic studies have shown that the vast majo rity of a portfolio's variabili ty in retu rns is accou nted for by asset allocation. Very little is accounted fo r by either market timing or by picking the "right" security within an asset class. Therefore, it is curious that aU the hype you hear from hyperactive bro kers and advisors relates to market timing and stock picking. When is the last time your hyperactive broker called yo u for the sole purpose of discuss ing your asset allocation? Too Many Stocks, Too Few Bonds 71 Most Hyperactive Investors have portfolios that are underweighted in bonds and overweighted in stocks.

Stocks historically have provided the highest returns and the greatest risks" Bonds provide sign ificantly lower returns than stocks but at lower risk. Cash. the term for short-term, highly liquid investmentS, barely keeps up with inflation, bur is very dose to risk-free. 122 The Real Way Smart Investors Beat 95~ of the "Pros" By splitting your portfolio up among these asset classes. you can target the specific level of return you wish to get for the specific level of risk you are willing to take. Economists have very accurately modelled how different balances among these three asset classes affect both return and risk with in a portfolio. Academ ic research has shown that asset allocat ion accounts for 90% or more of the variability of returns from any particular portfolio. T he specific securities held in the portfolio (stOck picking) accounts for about 5%. and digress~ ing fro m the ideal asset allocation to take into account outside influences on the markets (marker riming) accounts fo r about 2%.

If prominent brokerage firms filled with hyperactive brokers have no demonstrated ability to give accurate and reliable advice, and if you give credence to New York Attorney General Eliot Spitzer's observation about their "lack of integrity," why would you continue to rely on them for investment advice? No advisor who advocates Smart Investing was the subject of any of these allegations. These advisors do not believe, employ or rely upon stock analysts. Smart Investing advisors make no predictions about the future performance of the market as a whole or about any particular stock. Instead, they focus on asset classes (and their returns), asset allocation, risk management and a solid, academically based belief system that has consistently been demonstrated to outperform hyperactive brokers and advisors over the long term. m~jor 9 " " " "iall: stocK$,boijtisa a company;" loans to a ~ifrt,,,,i3,~+ entity. Cash;is not just ;-'","rO""\1 leqtujnc~c:trtj;l, saVln!;;Js accounts:heJd in banks ASoSE§ "are the" three ;aopds:a(e Brokers Aren't on Your Side 41 AsseT.ALLOCATION is'th~way thatassetcl~1ses . givid€l(:fup in. an investmerifportfolio.

 

pages: 320 words: 33,385

Market Risk Analysis, Quantitative Methods in Finance by Carol Alexander

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asset allocation, backtesting, barriers to entry, Brownian motion, capital asset pricing model, constrained optimization, credit crunch, Credit Default Swap, discounted cash flows, discrete time, diversification, diversified portfolio, en.wikipedia.org, implied volatility, interest rate swap, market friction, market microstructure, p-value, performance metric, quantitative trading / quantitative finance, random walk, risk tolerance, risk-adjusted returns, risk/return, Sharpe ratio, statistical arbitrage, statistical model, stochastic process, stochastic volatility, transaction costs, value at risk, volatility smile, Wiener process, yield curve

All the material presented in this chapter is motivated by these optimal capital allocation decisions. There are two main applications of optimal capital allocation in finance: • • Global asset management. This is usually regarded as a multi-stage optimization process: first, select the optimal weights to be assigned to different asset classes (such as bonds, equities and cash); then, within each class, allocate funds optimally to various countries; finally, given the allocation to a specific asset class in a certain country, select the individual investments to maximize the investor’s utility. Constraints on allocations may be needed, such as no short sales, or to restrict investments within a certain range such as ‘no more than 10% of the fund is invested in US equities’. Capital allocation in an investment bank.

In Section I.2.4.2 we explained how to express the variance of a linear portfolio as a quadratic form w Vw where V is the covariance matrix of asset returns. We shall not be concerned here with the manner in which the forecasts of risk and return are constructed. For the purpose of the present chapter it does not matter whether the asset risk and returns forecasts are based on subjective beliefs, historical data with statistical models, or some combination of these.12 I.6.3.1 Portfolio Diversification We illustrate the diversification principle using a simple example of a long-only portfolio with just two assets. We suppose that a proportion w of the nominal amount is invested in asset 1 and a proportion 1 − w is invested in asset 2 with 0 ≤ w ≤ 1. We denote the volatilities of the assets’ returns by 1 and 2 and the correlation of their returns by . Then the variance of the portfolio return R is given by13 VR = w2 12 + 1 − w2 22 + 2w 1 − w 1 2 (I.6.24) Suppose, for the moment, that asset 1 has been selected and we have fixed the portfolio weight w on that asset.

Since the portfolio is long-only, the vector x has non-negative elements, and in this case it can be shown that VR = w Vw = x Cx ≤ 1 C1 (I.6.28) The inequality (I.6.28) is the matrix generalization of the upper bound for the portfolio variance that was derived above for two assets. We have thus proved the principle of portfolio diversification, i.e. that holding portfolios of assets reduces risk, relative to the sum of the risks of the individual positions in the assets. And the lower the correlation between the asset returns, the lower the portfolio risk will be. Maximum risk reduction for a long-only portfolio occurs when correlations are highly negative, but if the portfolio contains short positions we want these to have a high positive correlation with the long positions for the maximum diversification benefit. In a long-only portfolio the weighted average of the asset volatilities provides an upper bound for the portfolio volatility, which is obtained only when the assets are all perfectly correlated.

 

pages: 357 words: 91,331

I Will Teach You To Be Rich by Sethi, Ramit

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Albert Einstein, asset allocation, buy low sell high, diversification, diversified portfolio, index fund, late fees, mortgage debt, mortgage tax deduction, prediction markets, random walk, risk tolerance, Robert Shiller, Robert Shiller, shareholder value, Silicon Valley, Vanguard fund

(Friendship is actually a real place. My friend grew up there, and he told me what he and his buddies used to use as a gang sign: two hands clasping in friendship. I mocked him endlessly for that.) It is important to diversify within stocks, but it’s even more important to allocate across the different asset classes—like stocks and bonds. Investing in only one category is dangerous over the long term. This is where the all-important concept of asset allocation comes into play. Remember it like this: Diversification is D for going deep into a category (for example, buying different types of stocks: large-cap, small-cap, international, and so on), and asset allocation is A for going across all categories (for example, stocks and bonds). 80 YEARS OF AVERAGE ANNUAL RETURNS FOR STOCK AND BONDS * * * The group at Vanguard Investment Counseling & Research recently analyzed eighty years of investment returns to help individual investors understand how to allocate their money.

But in your thirties and older, you’ll want to begin balancing your portfolio with bonds to reduce risk. What if stocks as a whole don’t perform well for a long time? That’s when you need to own other asset classes—to offset the bad times. The Importance of Being Diversified Now that we know the basics of the asset classes (stocks, bonds, and cash) at the bottom of the pyramid, let’s explore the different choices within each asset class. Basically, there are many types of stocks, and we need to own a little of all of them. Same with bonds. This is called diversifying, and it essentially means digging in to each asset class—stocks and bonds—and investing in all their subcategories. As the table on the next page shows, the broad category of “stocks” actually includes many different kinds of stock, including large-company stocks (“large-cap”), mid-cap stocks, small-cap stocks, and international stocks.

They demonstrated that more than 90 percent of your portfolio’s volatility is a result of your asset allocation. I know asset allocation sounds like a B.S. phrase—like mission statement and strategic alliance. But it’s not. Asset allocation is your plan for investing, the way you organize the investments in your portfolio between stocks, bonds, and cash. In other words, by diversifying your investments across different asset classes (like stocks and bonds, or, better yet, stock funds and bond funds), you could control the risk in your portfolio—and therefore control how much money, on average, you’d lose due to volatility. It turns out that the amounts you buy—whether it’s 100 percent stocks or 90 percent stocks and 10 percent bonds—make a profound difference on your returns. Later, other researchers tried to measure how closely volatility and returns were correlated, but the answer ends up being pretty complicated.

 

pages: 224 words: 13,238

Electronic and Algorithmic Trading Technology: The Complete Guide by Kendall Kim

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algorithmic trading, automated trading system, backtesting, corporate governance, Credit Default Swap, diversification, en.wikipedia.org, family office, financial innovation, fixed income, index arbitrage, index fund, interest rate swap, linked data, market fragmentation, natural language processing, quantitative trading / quantitative finance, random walk, risk tolerance, risk-adjusted returns, short selling, statistical arbitrage, Steven Levy, transaction costs, yield curve

They also provide a wide range of market statistics on how the cost varies depending on the market, order type, and size of the order. It comes as little surprise that equity markets were the first ones to adopt this type of trading, but what about other major asset classes such as fixed income, foreign exchange, and commodities? Chapter 11: Electronic and Algorithmic Trading for Different Asset Classes reviews how electronic trading has taken ground depending on the asset class in question, providing some interesting and revealing answers to which classes are most likely to be affected next and how your area in the industry might be changed by it. Of course, every part of the industry, including the new asset classes entering into the electronic trading world, is impacted by regulatory reporting requirements set in place by financial authorities. Chapter 12: Regulation NMS and Other Regulatory Reporting examines the philosophy behind compliance and regulatory laws, describing various types of reporting such as electronic blue sheets, Regulation NMS, and DPTR in the United States and MiFID in Europe.

Whether or not algorithms can work effectively with illiquid securities such as small cap stock and many fixed income instruments remains to be seen. Algorithms, which were traditionally associated with one particular asset class, namely equities, are diversifying into other markets that are rapidly evolving toward electronic trading. Participants in other asset classes such as derivatives tend to be comfortable and savvy with technology to begin with, so moving to a more systematic algorithmic approach to some of these classes may not seem as radical. Algorithmic trading may soon find a place in futures, options, and foreign exchange. Fixed-income instruments are most likely to be the last asset class to move into algorithmic trading or rely on electronic communication networks to facilitate order flow. However, this technologically advanced strategy is offered in small quantities or to very liquid markets in fixed income such as U.S.

Fixed-income trading is decidedly a different instrument, with numerous types of asset classes, and their complexities in comparison to simple common stock would require a different use of technology and business design to compete in the evolving electronic landscape. Electronic trading in the U.S. and European markets has continued to develop and evolve, however, with trading platforms developing value-added services such as historical pricing data, confirmation, allocation services, order management systems, and electronic research delivery. U.S. Fixed Income Market 2005 Money Market 13% ABS 8% Corporate 20% Municipal 9% Fed Agencies 11% MBS 23% Treasury 16% Exhibit 11.1 Breakdown of asset class and debt outstanding ($24.9 trillion USD). Source: Bond Market Association. Electronic and Algorithmic Trading for Different Asset Classes 113 Electronic trading can widen access to trading systems across several dimensions.

 

Stocks for the Long Run, 4th Edition: The Definitive Guide to Financial Market Returns & Long Term Investment Strategies by Jeremy J. Siegel

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asset allocation, backtesting, Black-Scholes formula, Bretton Woods, buy low sell high, California gold rush, capital asset pricing model, cognitive dissonance, compound rate of return, correlation coefficient, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, dividend-yielding stocks, equity premium, Eugene Fama: efficient market hypothesis, fixed income, German hyperinflation, implied volatility, index arbitrage, index fund, Isaac Newton, joint-stock company, Long Term Capital Management, loss aversion, market bubble, mental accounting, new economy, oil shock, passive investing, prediction markets, price anchoring, price stability, purchasing power parity, random walk, Richard Thaler, risk tolerance, risk/return, Robert Shiller, Robert Shiller, Ronald Reagan, shareholder value, short selling, South Sea Bubble, technology bubble, The Great Moderation, The Wisdom of Crowds, transaction costs, tulip mania, Vanguard fund

No single market is always dominant, and the globalization of the world markets affords investors more opportunities for spreading their risk than are available in the domestic markets. 168 PART 2 Valuation, Style Investing, and Global Markets DIVERSIFICATION IN WORLD MARKETS Principles of Diversification It might surprise investors that the principal motivation for investing in foreign stocks is not that foreign countries are growing faster and therefore will provide investors with better returns. We learned in Chapter 8 that faster growth in no way guarantees superior returns. Rather, the reason for investing internationally is to diversify your portfolio and reduce risk.5 Foreign investing provides diversification in the same way that investing in different sectors of the domestic economy provides diversification. It would not be good investment policy to pin your hopes on just one stock or one sector of the economy. Similarly it is not a good policy to buy the stocks only in your own country, especially when developed economies are becoming an ever smaller part of the world’s market.

Capital 137 Conclusion 138 CONTENTS CONTENTS ix Chapter 9 Outperforming the Market: The Importance of Size, Dividend Yields, and Price-to-Earnings Ratios 139 Stocks That Outperform the Market 139 Small- and Large-Cap Stocks 141 Trends in Small-Cap Stock Returns 142 Valuation 144 Value Stocks Offer Higher Returns Than Growth Stocks 144 Dividend Yields 145 Other Dividend Yield Strategies 147 Price-to-Earnings (P-E) Ratios 149 Price-to-Book Ratios 150 Combining Size and Valuation Criteria 152 Initial Public Offerings: The Disappointing Overall Returns on New Small-Cap Growth Companies 154 The Nature of Growth and Value Stocks 157 Explanations of Size and Valuation Effects 157 The Noisy Market Hypothesis 158 Conclusion 159 Chapter 10 Global Investing and the Rise of China, India, and the Emerging Markets 161 The World’s Population, Production, and Equity Capital 162 Cycles in Foreign Markets 164 The Japanese Market Bubble 165 The Emerging Market Bubble 166 The New Millennium and the Technology Bubble 167 Diversification in World Markets 168 Principles of Diversification 168 “Efficient” Portfolios: Formal Analysis 168 Should You Hedge Foreign Exchange Risk? 173 Sector Diversification 173 Private and Public Capital 177 x The World in 2050 178 Conclusion 182 Appendix: The Largest Non-U.S.-Based Companies 182 PART 3 HOW THE ECONOMIC ENVIRONMENT IMPACTS STOCKS Chapter 11 Gold, Monetary Policy, and Inflation 187 Money and Prices 189 The Gold Standard 191 The Establishment of the Federal Reserve 191 The Fall of the Gold Standard 192 Postdevaluation Monetary Policy 193 Postgold Monetary Policy 194 The Federal Reserve and Money Creation 195 How the Fed’s Actions Affect Interest Rates 196 Stocks as Hedges against Inflation 199 Why Stocks Fail as a Short-Term Inflation Hedge 201 Higher Interest Rates 201 Nonneutral Inflation: Supply-Side Effects 202 Taxes on Corporate Earnings 202 Inflationary Biases in Interest Costs 203 Capital Gains Taxes 204 Conclusion 205 Chapter 12 Stocks and the Business Cycle 207 Who Calls the Business Cycle?

Two economists tested whether the “monitoring interval” affected the choice between stocks and bonds.26 They conducted a “learning experiment” in which they allowed individuals to see the returns on two unidentified asset classes. One group was shown the yearly returns on stocks and bonds, and other groups were shown the same returns, but instead of annually, the returns were aggregated over periods of 5, 10, and 20 years. The groups were then asked to pick an allocation between stocks and bonds. The group that saw yearly returns invested a much smaller fraction in stocks than the groups that saw returns aggregated into longer intervals. This was because the short-term volatility of stocks dissuaded people from choosing that asset class, even though over longer periods it was clearly a better choice. This tendency to base decisions on the short-term fluctuations in the market has been referred to as myopic loss aversion.

 

pages: 272 words: 19,172

Hedge Fund Market Wizards by Jack D. Schwager

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asset-backed security, backtesting, banking crisis, barriers to entry, Bernie Madoff, Black-Scholes formula, British Empire, Claude Shannon: information theory, cloud computing, collateralized debt obligation, commodity trading advisor, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, delta neutral, diversification, diversified portfolio, family office, financial independence, fixed income, Flash crash, hindsight bias, implied volatility, index fund, James Dyson, Long Term Capital Management, margin call, market bubble, market fundamentalism, merger arbitrage, oil shock, pattern recognition, pets.com, Ponzi scheme, private sector deleveraging, quantitative easing, quantitative trading / quantitative finance, risk tolerance, risk-adjusted returns, risk/return, riskless arbitrage, Sharpe ratio, short selling, statistical arbitrage, Steve Jobs, systematic trading, technology bubble, transaction costs, value at risk, yield curve

These were largely the BBB tranches of the mortgage securitization pools that were going into the CDOs Paul Singer had talked about. So he and Charlie had already started to do some work at the MBS level when we became aware of the CDO angle.10 In the past, one important argument that was given to support the value of CDOs was that they provided portfolio diversification—that is, the collateral that went into CDOs was sourced from different asset classes. One could argue that there was a diversification benefit to having credit card receivables, aircraft leases, and various forms of real estate debt in a single structure. By late 2006, however, CDOs were composed almost entirely of the lowest-rated tranches of subprime mortgage securitizations. This homogeneous composition of the CDOs meant that the argument justifying a lower correlation assumption went out the window.

At some point, prices go up today simply because they went up yesterday. Okay, you know that markets trend. What else do you know for certain? You also know that diversification works. That is what the systematic trend-following strategy is built on: markets trend and diversification works. It doesn’t have any economic information. But that leaves open two questions: How do you accurately identify trends without being overly subject to whipsaws, and how have you managed to keep risks so constrained? First, the systematic trend-following strategy trades over 150 markets. Second, the systematic team looks at past correlations in weighting those markets. Currently, because of the whole risk-on/risk-off culture that has developed, diversification is quite hard to get. When I first started trading about 20 years ago, U.S. and European bond markets weren’t really that correlated.

Taylor, for example, believes that if he has a strong conviction that a stock will move much higher over the long term, then cutting exposure on interim weakness to limit the depth of a monthly loss would be a mistake. Similarly, Greenblatt asserts that value investors must maintain a longer-term perspective and not be swayed by interim losses, providing the fundamentals haven’t changed. For longer-term investors, such as Taylor and Greenblatt, monthly loss constraints would be in conflict with their strategy. 26. The Power of Diversification Dalio calls diversification the “Holy Grail of investing.” He points out that if assets are truly uncorrelated, diversification could improve return/risk by as much as a factor of 5:1. 27. Correlation Can Be Misleading Although being cognizant of correlation between different markets is crucial to avoiding excessive risk, it is important to understand that correlation measures past price relationships. It is only relevant if there is reason to believe that the past correlation is a reasonable proxy for future correlation.

 

pages: 349 words: 134,041

Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives by Satyajit Das

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accounting loophole / creative accounting, Albert Einstein, Asian financial crisis, asset-backed security, Black Swan, Black-Scholes formula, Bretton Woods, BRICs, Brownian motion, business process, buy low sell high, call centre, capital asset pricing model, collateralized debt obligation, complexity theory, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, cuban missile crisis, currency peg, disintermediation, diversification, diversified portfolio, Eugene Fama: efficient market hypothesis, financial innovation, fixed income, Haight Ashbury, high net worth, implied volatility, index arbitrage, index card, index fund, interest rate derivative, interest rate swap, Isaac Newton, job satisfaction, locking in a profit, Long Term Capital Management, mandelbrot fractal, margin call, market bubble, Marshall McLuhan, mass affluent, merger arbitrage, Mexican peso crisis / tequila crisis, moral hazard, mutually assured destruction, new economy, New Journalism, Nick Leeson, offshore financial centre, oil shock, Parkinson's law, placebo effect, Ponzi scheme, purchasing power parity, quantitative trading / quantitative finance, random walk, regulatory arbitrage, risk-adjusted returns, risk/return, shareholder value, short selling, South Sea Bubble, statistical model, technology bubble, the medium is the message, time value of money, too big to fail, transaction costs, value at risk, Vanguard fund, volatility smile, yield curve, Yogi Berra, zero-coupon bond

There aren’t enough well-rated, OECD banks to go around. To go beyond the push and pull, banks needed to shift risk to investors. Traditionally investors have been content to lose money investing in government bonds, shares and property. They had to be convinced about a new ‘asset class’. Bankers trooped to investors and their masters, the asset consultants. They wailed a new siren song – ‘credit is a new investment asset’. DAS_C10.QXD 5/3/07 282 7:59 PM Page 282 Tr a d e r s , G u n s & M o n e y There was ‘diversification’ – credit did not move together with other asset classes. There was ‘return’ – credit risk gave you a higher return than government bonds. There was ‘volatility’ – risk margins fluctuated. Ford Motor Credit’s risk margins (the spread) had fluctuated between about 1.00% and about 6.00%. Excited investors immediately assumed that with their superior skills they would make money.

Excited investors immediately assumed that with their superior skills they would make money. They didn’t seem troubled at all that the volatility may translate into losses, not profits. They, too, ‘knew things’. Then, there were the real reasons. Credit investing took off when all other asset classes showed different degrees of morbidity. In the early 2000s, the equity market’s stellar run was over. Bond yields were at record lows, property prices looked inflated, financed by a flood of money fleeing carnage elsewhere. The only game in town was credit and hedge funds. Investors unsurprisingly discovered ‘credit’. It was, it seemed, a new asset class. The question was how to package up the credit risk for investors. They didn’t like CDS, it was off-balance sheet and didn’t require money initially. What were they going to do with their cash? Worst of all, it was a ‘derivative’ – a WMD.

Hedge funds are not noted for their transparency. Lack of disclosure means that you don’t know how far the ship is off course until it is on the rocks. Cases of fraud and other common crimes also began to surface. There was every sign that the hedge fund universe was overheated. At the suggestion that there was a ‘bubble’, one manager bristled that hedge funds weren’t an ‘asset class’, therefore there was no ‘bubble’ to burst. Only asset classes experienced bubbles. The semantics weren’t reassuring. Hot tubbing I worked diligently at the case, my expert report was lodged with the court. The other side put on their expert, Sherman, an American ex-academic who had worked briefly at a dealer. In the competitive world of expert work, I sneered that he hadn’t been in markets recently. His last publication was in 1987.

 

pages: 244 words: 79,044

Money Mavericks: Confessions of a Hedge Fund Manager by Lars Kroijer

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Bernie Madoff, capital asset pricing model, diversification, diversified portfolio, family office, fixed income, forensic accounting, Gordon Gekko, hiring and firing, implied volatility, index fund, Jeff Bezos, Just-in-time delivery, Long Term Capital Management, merger arbitrage, new economy, Ponzi scheme, risk-adjusted returns, risk/return, shareholder value, Silicon Valley, six sigma, statistical arbitrage, Vanguard fund, zero-coupon bond

Buying protection? The main concern with a broadly diversified portfolio is that diversification can give a false sense of security. When the shit hits the fan, all markets act as one and our fancy charts go out the window, along with correlation assumptions. During the 2008 meltdown, no markets were spared, just as in September 2001 when they all took a hit at the same time. Imagine disasters like a particularly virulent form of SARS, widespread armed conflict, or other yet unimaginable disasters, and it is hard to imagine a broad index anywhere in the world that would not be hurt. In that scenario, our chart would have done us much more harm than good. We would have taken on greater risk, thinking that the diversification had lowered our risk, but when we most needed protection there would be none, as all the individual markets would be falling simultaneously.

If they failed, the repercussions would be swift and severe. If they succeeded, the rewards would be massive by any normal standard – probably too big. It was certainly exciting, but not in the way most people seemed to think. The term ‘hedge fund’ is often thrown around as if we all know what it is, or are meant to know. To me, hedge funds constitute investment funds that invest in a very broad array of assets classes, often across multiple geographies, and with very different risk profiles. Sometimes hedge-funds are extremely narrow in their strategy while many engage in multiple strategies within the same fund. Like a mutual fund, the hedge-fund manager charges an annual management fee, but in addition charges a performance fee on profits. The performance fee is typically where the really big bucks are made.

It now manages around $2 trillion today before gearing, depending who you ask (after dipping following the 2008/09 turmoil, this is near or at an all-time peak). The industry grew as individuals and institutions increasingly opened their eyes to what were seen as uncorrelated returns that would earn them a profit even in a bear market. Asset growth really took off as larger institutions accepted hedge-fund allocations just as they had allocations in private equity or other asset classes. It seemed a good idea to allocate at least some assets in investments that could be expected to do well in falling markets. As some of the earlier hedge funds had stellar returns that appeared uncorrelated to the wider market, the investment opportunity attracted ever-increasing numbers. Obviously, many (including myself) saw this growing investor base as an opportunity to set up new funds to meet the increasing demand.

 

pages: 1,042 words: 266,547

Security Analysis by Benjamin Graham, David Dodd

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asset-backed security, backtesting, barriers to entry, capital asset pricing model, carried interest, collateralized debt obligation, collective bargaining, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, diversified portfolio, fear of failure, financial innovation, fixed income, full employment, index fund, invisible hand, Joseph Schumpeter, locking in a profit, Long Term Capital Management, low cost carrier, moral hazard, mortgage debt, p-value, risk-adjusted returns, risk/return, secular stagnation, shareholder value, The Chicago School, the market place, the scientific method, The Wealth of Nations by Adam Smith, transaction costs, zero-coupon bond

Fueled by performance pressures and a growing expectation of low (and inadequate) returns from traditional equity and debt investments, institutional investors have sought high returns and diversification by allocating a growing portion of their endowments and pension funds to alternatives. Pioneering Portfolio Management, written in 2000 by David Swensen, the groundbreaking head of Yale’s Investment Office, makes a strong case for alternative investments. In it, Swensen points to the historically inefficient pricing of many asset classes,10 the historically high risk-adjusted returns of many alternative managers, and the limited performance correlation between alternatives and other asset classes. He highlights the importance of alternative manager selection by noting the large dispersion of returns achieved between top-quartile and third-quartile performers.

Developing innovative sources of ideas and information, such as those available from business consultants and industry experts, has become increasingly important. 9 They did consider the relative merits of corporate control enjoyed by a private business owner versus the value of marketability for a listed stock (p. 372). 10 Many investors make the mistake of thinking about returns to asset classes as if they were permanent. Returns are not inherent to an asset class; they result from the fundamentals of the underlying businesses and the price paid by investors for the related securities. Capital flowing into an asset class can, reflexively, impair the ability of those investing in that asset class to continue to generate the anticipated, historically attractive returns. 11 Nor would they find one in leveraged buyouts, through which businesses are purchased at lofty prices using mostly debt financing and a thin layer of equity capital. The only value-investing rationale for venture capital or leveraged buyouts might be if they were regarded as mispriced call options. Even so, it is not clear that these areas constitute good value. 12 Professor Michael Porter of Harvard Business School, in his seminal book Competitive Strategy (Free Press, 1980), lays out the groundwork for a more intensive, thorough, and dynamic analysis of businesses and industries in the modern economy.

Since then, prudence has become a moving target as investors, gaining comfort over time from the actions of their peers, have come to invest in more exotic and increasingly illiquid asset classes. 8 Great innovations in technology have made vastly more information and analytical capability available to all investors. This democratization has not, however, made value investors any better off. With information more widely and inexpensively available, some of the greatest market inefficiencies have been corrected. Developing innovative sources of ideas and information, such as those available from business consultants and industry experts, has become increasingly important. 9 They did consider the relative merits of corporate control enjoyed by a private business owner versus the value of marketability for a listed stock (p. 372). 10 Many investors make the mistake of thinking about returns to asset classes as if they were permanent.

 

pages: 248 words: 57,419

The New Depression: The Breakdown of the Paper Money Economy by Richard Duncan

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asset-backed security, bank run, banking crisis, banks create money, Ben Bernanke: helicopter money, Bretton Woods, currency manipulation / currency intervention, debt deflation, deindustrialization, diversification, diversified portfolio, fiat currency, financial innovation, Flash crash, Fractional reserve banking, income inequality, inflation targeting, Joseph Schumpeter, laissez-faire capitalism, liquidity trap, market bubble, market fundamentalism, Mexican peso crisis / tequila crisis, money: store of value / unit of account / medium of exchange, mortgage debt, private sector deleveraging, quantitative easing, reserve currency, Ronald Reagan, savings glut, special drawing rights, The Great Moderation, too big to fail, trade liberalization

In 2007, TCMD outstanding in the United States amounted to $50 trillion. Therefore, the $5 trillion invested into the United States by foreign central banks accounted for 10 percent of all the credit extended in the country. Where did those central banks invest so much money? Central banks are conservative. They prefer to invest in government bonds since they are believed to be the safest asset class. The U.S. government, however, simply did not issue enough bonds to satisfy $5 trillion worth of demand from foreign central banks. Exhibit 2.6 illustrates the large gap between the amount of dollars central banks outside the United States accumulated as foreign exchange reserves and the amount of bonds the U.S. government sold. EXHIBIT 2.6 U.S. Government Debt Issuance (and Retirement) vs. the Increase in Dollar-denominated Foreign Exchange Reserves Source: IMF, Office of Management and Budget Note: In Exhibit 2.6, bond sales and buybacks are assumed to exactly match the government’s budget deficits and surpluses each year.

Extreme inflation is like fire in that it consumes the savings of the public in a conflagration of rising prices. Extreme deflation is ice-like. It leaves the economy frozen in a liquidity trap with high unemployment and no growth. Both would end in disaster for the economy and, therefore, for society. However, the two would impact asset prices very differently. This chapter looks at how very high rates of inflation and extreme deflation would affect the various asset classes. It is not inconceivable that, as this economic calamity plays out over the next decade, the economy could be hit by both. Government policy will determine the outcome. As of now, it remains very uncertain which direction government policy will take. Fire The United States has experienced five episodes of very high rates of inflation. Each one has resulted from the issue of fiat money.

See Balance of payments Fortune magazine Fractional reserve banking, money creation through Freddie Mac: conservatorship of credit creation and decline in liquidity reserves quantitative easing and U.S. debt guarantees and Friedman, Milton General equilibrium, theory of Germany Glass–Steagall Act Globalization Global savings glut theory, of Bernanke Goldman Sachs Gold reserve requirement, end of and creation of fiat money Government Accountability Office report Government sector: inflation and deflation’s effects on percentage of total credit market debt rational investment option for results of spending cuts in Government-sponsored entities (GSEs): credit supply and GSE-backed mortgage pools inflation and deflation’s effects on quantitative easing and U.S. debt guarantees and Great Depression economic conditions during Friedman’s conclusions about Greece Greenspan, Alan Gross domestic product (GDP): change in value added, by industry debt as percentage of driven by credit equation of exchange and during Great Depression ratio of credit growth to GSE-backed mortgage pools History of Economic Analysis (Schumpeter) Hoover, Herbert Household sector: debt and inflation and deflation’s effects on Human Action (von Mises) Hyperinflation Inflation and deflation credit and inflation derivative regulation and effects on asset classes Fisher’s theory of debt-deflation inflation in 2011 inflation likely in 2012 inflation likely without additional quantitative easing and fiscal stimulus New Great Depression scenarios and protectionism and wealth preservation during Innovation, in Mitchell’s theory of business cycles Interest rates, in U.S.: bond sales and cut by Federal Reserve to encourage credit expansion money supply and quantitative easing and trade balances and International Monetary Fund Ireland Jackson, Andrew Japan Johnson, Lyndon JP Morgan JPMorgan Chase Keynes, John Maynard Korea Labor market, changes in marginal cost of wages in.

 

pages: 354 words: 26,550

High-Frequency Trading: A Practical Guide to Algorithmic Strategies and Trading Systems by Irene Aldridge

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algorithmic trading, asset allocation, asset-backed security, automated trading system, backtesting, Black Swan, Brownian motion, business process, capital asset pricing model, centralized clearinghouse, collapse of Lehman Brothers, collateralized debt obligation, collective bargaining, diversification, equity premium, fault tolerance, financial intermediation, fixed income, high net worth, implied volatility, index arbitrage, interest rate swap, inventory management, law of one price, Long Term Capital Management, Louis Bachelier, margin call, market friction, market microstructure, martingale, New Journalism, p-value, paper trading, performance metric, profit motive, purchasing power parity, quantitative trading / quantitative finance, random walk, Renaissance Technologies, risk tolerance, risk-adjusted returns, risk/return, Sharpe ratio, short selling, Small Order Execution System, statistical arbitrage, statistical model, stochastic process, stochastic volatility, systematic trading, trade route, transaction costs, value at risk, yield curve

As discussed in Chapter 4, some markets are not yet suitable for high-frequency trading, inasmuch as most trading in these markets is performed over the counter (OTC). According to research conducted by Aite Group, equities are the most algorithmically 19 Evolution of High-Frequency Trading 60% 50% Equities Futures Options FX Fixed Income 40% 30% 20% 10% 0% 2004 2005 2006 2007 2008 2009 2010 Year FIGURE 2.7 Adoption of algorithmic execution by asset class. Source: Aite Group. executed asset class, with over 50 percent of the total volume of equities expected to be handled by algorithms by 2010. As Figure 2.7 shows, equities are closely followed by futures. Advances in algorithmic execution of foreign exchange, options, and fixed income, however, have been less visible. As illustrated in Figure 2.7, the lag of fixed income instruments can be explained by the relative tardiness of electronic trading development for them, given that many of them are traded OTC and are difficult to synchronize as a result.

Foreign Exchange Foreign exchange has a number of classic models that have been shown to work in the short term. This section summarizes statistical arbitrage applied to triangular arbitrage and uncovered interest rate parity models. Other fundamental foreign exchange models, such as the flexible price 190 HIGH-FREQUENCY TRADING TABLE 13.1 Summary of Fundamental Arbitrage Strategies by Asset Class Presented in This Section Asset Class Fundamental Arbitrage Strategy Foreign Exchange Foreign Exchange Equities Equities Equities Equities Futures and the Underlying Asset Indexes and ETFs Options Triangular Arbitrage Uncovered Interest Parity (UIP) Arbitrage Different Equity Classes of the Same Issuer Market Neutral Arbitrage Liquidity Arbitrage Large-to-Small Information Spillovers Basis Trading Index Composition Arbitrage Volatility Curve Arbitrage monetary model, the sticky price monetary model, and the portfolio model can be used to generate consistently profitable trades in the statistical arbitrage framework.

Technological developments markedly increased the daily trade volume. In 1923, 1 million shares traded per day on the NYSE, while just over 1 billion shares were traded per day on the NYSE in 2003, a 1,000-times increase. 10 HIGH-FREQUENCY TRADING 100% 80% Equities Futures Options FX Fixed Income 60% 40% 20% 0% 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Year FIGURE 2.2 Adoption of electronic trading capabilities by asset class. Source: Aite Group. Technological advances have also changed the industry structure for financial services from a rigid hierarchical structure popular through most of the 20th century to a flat decentralized network that has become the standard since the late 1990s. The traditional 20th-century network of financial services is illustrated in Figure 2.3. At the core are the exchanges or, in the case of foreign exchange trading, inter-dealer networks.

 

pages: 576 words: 105,655

Austerity: The History of a Dangerous Idea by Mark Blyth

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accounting loophole / creative accounting, balance sheet recession, bank run, banking crisis, Black Swan, Bretton Woods, capital controls, Carmen Reinhart, Celtic Tiger, central bank independence, centre right, collateralized debt obligation, correlation does not imply causation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency peg, debt deflation, deindustrialization, disintermediation, diversification, en.wikipedia.org, ending welfare as we know it, Eugene Fama: efficient market hypothesis, eurozone crisis, financial repression, fixed income, floating exchange rates, Fractional reserve banking, full employment, German hyperinflation, Gini coefficient, global reserve currency, Growth in a Time of Debt, Hyman Minsky, income inequality, interest rate swap, invisible hand, Irish property bubble, Joseph Schumpeter, Kenneth Rogoff, liquidationism / Banker’s doctrine / the Treasury view, Long Term Capital Management, market bubble, market clearing, Martin Wolf, moral hazard, mortgage debt, mortgage tax deduction, Occupy movement, offshore financial centre, paradox of thrift, price stability, quantitative easing, rent-seeking, reserve currency, road to serfdom, savings glut, short selling, structural adjustment programs, The Great Moderation, The Myth of the Rational Market, The Wealth of Nations by Adam Smith, Tobin tax, too big to fail, unorthodox policies, value at risk, Washington Consensus

But deprived of fuel for the asset cycle, all those wonderful paper assets that can be based off these booms—commodity ETFs, interest rate swaps, CDOs and CDSs—to name but a few—will cease to be the great money machine that they have been to date. Having pumped and dumped every asset class on the planet, finance may have exhausted its own growth model. The banks’ business model for the past twenty-five years may be dying. If so, saving it in the bust is merely, and most expensively, prolonging the agony. Anticipating John Quiggin’s Zombie Economics, we may have endured austerity to bring back the nearly dead. Is there any evidence for this bold conjecture? A bit. Banks everywhere are delevering, which will reduce lending, hitting growth and thus the volume of business that they conduct. Bank equity prices and market capitalization have fallen drastically over the past two years. Revenues by asset class are falling. Underwriting has shrunk and trading is not what it used to be.4 Fixed costs are increasing while bonuses are shrinking and the sector as a whole is getting smaller.5 Meanwhile, what growth there is seems to be on the retail rather than the investment banking side.6 But retail depends more directly on the real economy, which is shrinking because of austerity.

As per above, government bond purchases by Asian central banks cut the supply of T-bills, and this made CDOs even more attractive. 19. Peter S. Goodman, Past Due: The End of Easy Money and the Renewal of the American Economy (New York: Henry Holt, 2010), chap. 5. 20. Gillian Tett, Fool’s Gold (New York: Free Press, 2009). 21. Or SPV (special purpose vehicle). 22. Diversification is more than “not putting all your eggs in one basket.” Good diversification seeks to add assets that are uncorrelated or negatively correlated with other assets in a portfolio. Uncorrelated assets still must be expected to earn more than one would expect to get by depositing cash in a checking account, to be worth risking money and inclusion in a portfolio. Moreover, uncorrelated assets do not deliver those returns in a synchronized fashion: they do not have to rise and fall at the same moment in time. 23.

You can only generate bubbles of this magnitude if there are assets that are either undervalued, or are at least perceived to be undervalued, and that can serve as fuel for the bubble. US equities had been flat for a generation back in the early 1980s. US housing was cheap and patterns of demand were changing. Commodities used to be a niche market. Finance changed all that, pumping and dumping these asset classes and taking profits along the way for twenty-five years. It was a great run while it lasted, but now, after the bust, could it be over? Figure 7.1 The Bubble behind the Bust (1987–2011) Sovereigns are stretched, and eventually liquidity support and zero rates will come to an end on what will be a much weaker underlying economy. Equities will decline in value, commodities too, as global demand weakens, and housing, outside a few markets, is not going to be increasing in value at 7 to 10 percent a year anytime soon.

 

pages: 130 words: 11,880

Optimization Methods in Finance by Gerard Cornuejols, Reha Tutuncu

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asset allocation, call centre, constrained optimization, correlation coefficient, diversification, finite state, fixed income, frictionless, frictionless market, index fund, linear programming, Long Term Capital Management, passive investing, Sharpe ratio, transaction costs, value at risk, Y2K

In these problems, the objective is not to choose a portfolio of stocks (or other securities), but to determine the optimal investment among a set of asset classes. Examples of these asset classes are large capitalization stocks, small capitalization stocks, foreign stocks, government bonds, corporate bonds, etc. Since there are many mutual funds focusing on each one of these different asset classes, one can conveniently invest in these asset classes by purchasing the corresponding mutual fund. After estimating the expected returns, variances, and covariances for different asset classes, one can formulate a QP identical to (1.13) and obtain efficient portfolios of these asset classes. The formulation (1.13) we presented above makes several simplifying assumptions and much of the literature on asset allocation/portfolio selection focuses on solving this problem without some of these assumptions.

We can further assume that the asset classes the company can choose from have random returns (again, with known distributions) denoted by Rit for asset class i in period t. Since the company can make the holding decisions for each period after observing the asset returns and liabilities in the previous periods, the resulting problem can be cast as a stochastic program with recourse: maxx P E[ i xi,T ] P (1 + R )x it i,t−1 − i i xi,t = Lt , t = 1, . . . , T xi,t ≥ 0 ∀i, t. P (1.15) The objective function represents the expected total wealth at the end of the last period. The constraints indicate that the surplus left after liability Lt is covered will be invested as follows: xi,t invested in asset i. In this formulation, x0,t are the fixed, and possibly nonzero initial positions in the different asset classes. Chapter 2 Linear Programming: Theory and Algorithms 2.1 The Linear Programming Problem One of the most common and fundamental optimization problems is the linear programming problem (LP), the problem of optimizing a linear objective function subject to linear equality and inequality constraints.

This last problem can be solved using the techniques we discussed for convex quadratic programming problems. 5.3. RETURNS-BASED STYLE ANALYSIS 5.3 63 Returns-Based Style Analysis In two ground-breaking articles, Sharpe described how constrained optimization techniques can be used to determine the effective asset mix of a fund using only the return time series for the fund and a number of carefully chosen asset classes [13, 14]. Often, passive indices or index funds are used to represent the chosen asset classes and one tries to determine a portfolio of these funds/indices whose returns provide the best match for the returns of the fund being analyzed. The allocations in the portfolio can be interpreted as the fund’s style and consequently, this approach has become to known as returns-based style analysis, or RBSA. RBSA provides an inexpensive and timely alternative to fundamental analysis of a fund to determine its style/asset mix.

 

pages: 545 words: 137,789

How Markets Fail: The Logic of Economic Calamities by John Cassidy

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Albert Einstein, Andrei Shleifer, anti-communist, asset allocation, asset-backed security, availability heuristic, bank run, banking crisis, Benoit Mandelbrot, Berlin Wall, Bernie Madoff, Black-Scholes formula, Bretton Woods, British Empire, capital asset pricing model, centralized clearinghouse, collateralized debt obligation, Columbine, conceptual framework, Corn Laws, correlation coefficient, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, Daniel Kahneman / Amos Tversky, debt deflation, diversification, Elliott wave, Eugene Fama: efficient market hypothesis, financial deregulation, financial innovation, Financial Instability Hypothesis, financial intermediation, full employment, George Akerlof, global supply chain, Haight Ashbury, hiring and firing, Hyman Minsky, income per capita, incomplete markets, index fund, invisible hand, John Nash: game theory, John von Neumann, Joseph Schumpeter, laissez-faire capitalism, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, margin call, market bubble, market clearing, mental accounting, Mikhail Gorbachev, Mont Pelerin Society, moral hazard, mortgage debt, Naomi Klein, Network effects, Nick Leeson, Northern Rock, paradox of thrift, Ponzi scheme, price discrimination, price stability, principal–agent problem, profit maximization, quantitative trading / quantitative finance, race to the bottom, Ralph Nader, RAND corporation, random walk, Renaissance Technologies, rent control, Richard Thaler, risk tolerance, risk-adjusted returns, road to serfdom, Robert Shiller, Robert Shiller, Ronald Coase, Ronald Reagan, shareholder value, short selling, Silicon Valley, South Sea Bubble, sovereign wealth fund, statistical model, technology bubble, The Chicago School, The Great Moderation, The Market for Lemons, The Wealth of Nations by Adam Smith, too big to fail, transaction costs, unorthodox policies, value at risk, Vanguard fund

The basic rationale for investing in an RMBS (or a CDO) was that financing loans to several thousand questionable borrowers was much safer than lending to any individual. Why would that be? Wall Street had three answers: diversification, subordination, and the building up of reserves. The argument for diversification was the same one that applies to salting away your retirement savings in mutual funds rather than investing in individual stocks. If you put all of your money in one company and it goes bankrupt, you lose everything; if you invest in five hundred companies, through an index fund, say, and one of them goes out of business, it shouldn’t have much impact on the value of the fund. A bit more formally, the Nobel-winning financial theorist Harry Markowitz demonstrated back in the 1950s that diversification allows investors to minimize the impact of particular damaging events, or what is often referred to as “idiosyncratic risk.”

The Wall Street firms and the rating agencies had both failed to probe the underlying logic of combining pools of subprime loans. In any group of assets, be it a stock, a mutual fund, or an RMBS, the benefits of diversification depend on the assets being truly diverse; in a statistical sense, they need to have a low degree of correlation. The subprime loans that were used in mortgage securitizations weren’t diverse at all. Most of them were situated in bubble areas, such as California, Nevada, and Florida, and the borrowers who had taken them out all had low credit ratings. Combining a hundred 2/28 mortgages from Fort Lauderdale with a hundred 2/28 loans from Las Vegas and another hundred from Orange County didn’t provide any real diversification of risk; it simply joined like with like. “The best way I can put it is this way,” the head of one Wall Street investment firm said to me shortly after the subprime crisis began.

If a mortgage holder whose loan has been securitized falls behind on his monthly payments, it is the buyers of the mortgage securities who lose out rather than the bank that issued the loan. Unlike many economists, Minsky took a keen interest in these developments, and he didn’t view them as wholly negative. In a 1987 paper, he pointed out that the purchase of mortgage bonds and other securitized products enabled investors to diversify their holdings across asset classes and geographic boundaries. (In 2007, it would transpire that some of the biggest holders of U.S. mortgage securities were obscure European banks.) Minsky also noted that the banking industry’s eager embrace of securitization was a reflection of the increased competition it was facing for deposits and borrowers. Mutual fund companies and other nonbank financial companies were providing interest-bearing checking accounts, and S&Ls, which previously had been tightly controlled, were offering depositors attractive interest rates.

 

pages: 194 words: 59,336

The Simple Path to Wealth: Your Road Map to Financial Independence and a Rich, Free Life by J L Collins

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asset allocation, Bernie Madoff, compound rate of return, diversification, financial independence, full employment, German hyperinflation, index fund, nuclear winter, passive income, payday loans, risk tolerance, Vanguard fund, yield curve

The Wealth Accumulation Portfolio This is what I’ve created for my daughter and what I tell her as to why. Here’s the thing: if you want to survive and prosper as an investor you have two choices. You can follow the typical advice we examined in Chapter 1 and seek out broad diversification with extensive asset allocations. Your hope is this will smooth the ride, even as it reduces your long-term returns. Screw that! You’re young, aggressive and here to build wealth. You’re out to build your pot of F-You Money ASAP. You’re going to focus on the best performing asset class in history: Stocks. You’re going to “get your mind right,” toughen up and learn to ride out the storms. You’ve heard the expression, “Don’t keep all your eggs in one basket.” You’ve likely also heard the variation, “Keep all your eggs in one basket and watch that basket very closely.”

Crucially, JL Collins covers the mental and emotional aspects of investing as well as the technical aspects which is rare amongst investment writers.” The Escape Artist www.theescapeartist.me “Jim enjoys a financially independent lifestyle while sharing money and life lessons through his blog. His Stock Series introduced passive index investing to a wide audience. Now you can get the same wisdom, distilled in book form. Jim tells you how to avoid common investing fears, misperceptions and mistakes. He teaches about diversification, asset classes, asset allocation and the best way to use retirement plans. This is a simple, proven path to investment success from a guy who actually did it. If you’re new to investing, don’t miss this crash course in the essentials!” Darrow Kirkpatrick Retired at 50 www.caniretireyet.com “I came of age in the midst of the Great Recession. Like many of my peers, I developed an unhealthy fear of the market.

Chapter 15 International funds As we’ve discussed earlier in the book, most advisors recommend far more funds and asset classes than the two I’ve suggested. Indeed as we’ve seen—scared witless after the 2008-9 market implosion— many would now have us invest in everything in the hope a couple pull through. To do this properly would require a ton of work understanding the asset classes, deciding on percentages for each, choosing how to own them, rebalancing and tracking. All for what will likely be subpar performance. Still, even for some who accept the advantages of simplicity, my two fund Wealth Preservation Portfolio seems incomplete. The readers of www.jlcollinsnh.com are an astute bunch and the missing asset class they ask about most frequently is international stocks. Since almost every other allocation you come across will include an international component, why doesn’t our Simple Path?

 

pages: 447 words: 104,258

Mathematics of the Financial Markets: Financial Instruments and Derivatives Modelling, Valuation and Risk Issues by Alain Ruttiens

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algorithmic trading, asset allocation, asset-backed security, backtesting, banking crisis, Black Swan, Black-Scholes formula, Brownian motion, capital asset pricing model, collateralized debt obligation, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, delta neutral, discounted cash flows, discrete time, diversification, fixed income, implied volatility, interest rate derivative, interest rate swap, margin call, market microstructure, martingale, p-value, passive investing, quantitative trading / quantitative finance, random walk, risk/return, Sharpe ratio, short selling, statistical model, stochastic process, stochastic volatility, time value of money, transaction costs, value at risk, volatility smile, Wiener process, yield curve, zero-coupon bond

Figure 14.5 Z-scores calculation 14.1.4 Performance contribution and attribution This sub-section aims to answer the following question: what are the explanatory factors of a performance? Performance Contribution The return of a portfolio P can be usefully analyzed per invested asset or, more commonly, per sub-sets, for example on a sector basis, or a country basis, or per currency. For an asset or asset class i (portfolio of assets or asset classes 1, …, i, …, n) of weight wi, having achieved a return ri, If we denote by rP the global portfolio return, above contributions are such as Example. A portfolio (all in $) invested in 3-month rolled-over futures contracts, made of 45% of S&P 500, 20% of Nasdaq 100 and 35% of Nikkei 225 (in $), the performance and contributions for 2005 were as shown in Figure 14.6. Figure 14.6 Example of a performance contribution calculation It is worth noting that such a calculation implies that the assets have been hold during the whole period (of 1 year here).

From Eq. 4.2 previously, the solution is Applied to the above data, it gives wL = 0.458 and wT = 0.542, that is, not far from the initial 50/50 composition of the portfolio in this example. As a conclusion to the Markowitz model, to be optimized, an efficient portfolio must be situated on the efficient frontier, which implies it needs to be: diversified, by combining various stocks presenting a low pair-wise correlation; and optimized in weights. Diversification has its limits, however. Understandably, more or less correlated stocks are affected by whole market movements, so that the benefit of such diversification is actually restricted to what is called the specific3 risk (specific to each individual stock), but the global market risk remains as a whole. In other words, by increasing the number n of diversified stocks, the benefit in terms of risk reduction diminishes progressively, up to an asymptotical risk level of pure market risk (see Figure 4.8).

Performance Attribution Performance attribution aims to evidence the portfolio (or fund) manager's skill about the portfolio performance track record. On the contrary to the “performance contribution”, which is only based on portfolio data, the performance attribution needs to refer to a benchmark, to assess the portfolio manager's skill. It analyzes how and to what extent, each of the assets, or more realistically, each asset class, is representing a part of the portfolio global excess return vis-à-vis the benchmark. The Case of Stocks Portfolios As a first step, we have to precise things about the excess return measure. Let us consider the above portfolio, that is destined to outperform a basket of 50% of SP 500, 25% of Nasdaq 100 and 25% of Nikkei 225 (in $), as its benchmark. During the same period, because of different weights, the benchmark has realized an rB of 8.10%, to be compared to 11.76% for our portfolio – see Figure 14.7.

 

pages: 519 words: 118,095

Your Money: The Missing Manual by J.D. Roth

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Airbnb, asset allocation, bank run, buy low sell high, car-free, Community Supported Agriculture, delayed gratification, diversification, diversified portfolio, estate planning, Firefox, fixed income, full employment, Home mortgage interest deduction, index card, index fund, late fees, mortgage tax deduction, Own Your Own Home, passive investing, Paul Graham, random walk, Richard Bolles, risk tolerance, Robert Shiller, Robert Shiller, speech recognition, traveling salesman, Vanguard fund, web application, Zipcar

On The Money: Don't Put All Your Eggs in One Basket One way investors reduce risk is through diversification, which means not putting all your money into one investment, whether it's a stock or bond or something else altogether. By spreading your money around, you smooth out the market's wild ups and downs while getting a similar return on your investment. You can diversify your investments in several ways, including: Within asset classes. The more different stocks you own, the better your diversification. Same goes for bonds. Among asset classes. In general, the movements of stocks, bonds, commodities (The Tools of Investing), and real estate aren't strongly correlated; for example, just because the stock market is down doesn't mean the real estate market will be down, too. The same is generally true of the returns on these asset classes—they're normally independent of each other.

By using techniques like dollar-cost averaging (see All-in-one funds), you ensure that you're not investing all your money when the market is high. There are other types of diversification, too. For example, when you buy foreign stocks, you're diversifying by geography. How much should you diversify and how should you do it? There's no one right answer—it depends on you and your financial goals. To learn more about this concept, check out this guide from the U.S. Securities and Exchange Commission: http://tinyurl.com/SEC-assets. Mutual Funds Mutual funds are collections of investments. They let people like you and me pool our money to buy small pieces of many investments. There are a lot of benefits to doing this, including: Diversification. For less than a thousand bucks, you can buy shares in a mutual fund that owns pieces of every company on the stock market.

The best way to do this is to invest in the stock market because, over the long-term, stocks offer the best possible return. (When talking about investments, your return is the amount you earn or lose.) How Much Do Stocks Actually Earn? In his book Stocks for the Long Run (McGraw-Hill, 2008), Jeremy Siegel analyzes the historical performance of several types of investments (economists call them asset classes). He tries to answer the question "How much does the stock market actually return?" After crunching lots of numbers, Siegel found that since 1926: Stocks have returned an average of about 10% per year. Over the past 80 years, stocks have produced a real return (meaning an inflation-adjusted return) of 6.8%, which also happens to be their average rate of return for the past 200 years. Bonds have returned about 5%.

 

pages: 461 words: 128,421

The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street by Justin Fox

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Albert Einstein, Andrei Shleifer, asset allocation, asset-backed security, bank run, Benoit Mandelbrot, Black-Scholes formula, Bretton Woods, Brownian motion, capital asset pricing model, card file, Cass Sunstein, collateralized debt obligation, complexity theory, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, Daniel Kahneman / Amos Tversky, David Ricardo: comparative advantage, discovery of the americas, diversification, diversified portfolio, Edward Glaeser, endowment effect, Eugene Fama: efficient market hypothesis, experimental economics, financial innovation, Financial Instability Hypothesis, floating exchange rates, George Akerlof, Henri Poincaré, Hyman Minsky, implied volatility, impulse control, index arbitrage, index card, index fund, invisible hand, Isaac Newton, John Nash: game theory, John von Neumann, joint-stock company, Joseph Schumpeter, libertarian paternalism, linear programming, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, market bubble, market design, New Journalism, Nikolai Kondratiev, Paul Lévy, pension reform, performance metric, Ponzi scheme, prediction markets, pushing on a string, quantitative trading / quantitative finance, Ralph Nader, RAND corporation, random walk, Richard Thaler, risk/return, road to serfdom, Robert Shiller, Robert Shiller, rolodex, Ronald Reagan, shareholder value, Sharpe ratio, short selling, side project, Silicon Valley, South Sea Bubble, statistical model, The Chicago School, The Myth of the Rational Market, The Predators' Ball, the scientific method, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, Thomas Kuhn: the structure of scientific revolutions, Thomas L Friedman, Thorstein Veblen, Tobin tax, transaction costs, tulip mania, value at risk, Vanguard fund, volatility smile, Yogi Berra

and Fisher’s answer was an emphatic yes. Parts of the piece sounded an awful lot like what would become standard advice a half century hence: The individual investor should be wary of “pitting his unaided judgment against the collective intelligence of the pools of professional traders,” Fisher warned, but there was safety in diversification. “The more unsafe the investments are, taken individually, the safer they are collectively, to say nothing of profitableness, provided that the diversification is sufficiently increased,” he wrote. Fisher admitted that neither he nor anyone else he knew of had “definitely formulated” this principle (that would have to wait until Harry Markowitz in 1952). But then Fisher twisted his reasonably sound advice into a distinctly dodgy apologia for high stock prices: Because so many investors now held well-diversified portfolios, they were willing to venture into risky stocks that previously would have interested only speculators.

In the sixteenth century, Shakespeare’s Merchant of Venice, Antonio, happily (if overconfidently) declared: My ventures are not in one bottom trusted, Nor to one place; nor is my whole estate Upon the fortune of this present year; Therefore, my merchandise makes me not sad.20 “Clearly, Shakespeare not only knew about diversification but, at an intuitive level, understood covariance,”21 Markowitz commented admiringly. Lots of people on Wall Street understood both concepts intuitively as well. Markowitz’s aim was to create what Irving Fisher had first suggested in 1906—a system that assigned numbers to an investor’s intuition and thus produced a consistent formula for portfolio building. He was trying to convert rules of thumb into science. The Markowitz approach to portfolio selection has been contrasted with that of Gerald Loeb, cofounder of the once-great brokerage E. F. Hutton. In 1935, Loeb wrote The Battle for Investment Survival, a daredevil’s guide to the market that still claims a following today. One of the book’s core messages is that “once you attain competency, diversification is undesirable.”22 That certainly wasn’t Markowitz’s attitude, but neither did his work entirely contradict it.

They focused instead on the two principles that everyone interested in shareholder rights could agree upon: All shareholders should be treated equally, and management’s job was to deliver the highest possible returns to shareholders. Less than two decades after Milton Friedman scandalized liberal readers of the New York Times with his argument that the job of corporations was to make money, union pension funds and liberal state politicians were joining hands to pressure CEOs to…make more money. Years later, as pension funds heeded their consultants’ calls to diversify into new asset classes, many even began investing in the funds of 1980s corporate raiders that had rebranded themselves as “private equity” firms. Unruh died in 1987, but Dale Hanson—hired away from Wisconsin’s state pension fund that year to run Calpers—proved a more than capable successor as a shareholder activist. Hanson saw that his potential allies weren’t just the other pension funds that belonged to the Council of Institutional Investors, but mutual fund companies such as Fidelity and Vanguard.

 

pages: 483 words: 141,836

Red-Blooded Risk: The Secret History of Wall Street by Aaron Brown, Eric Kim

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Albert Einstein, algorithmic trading, Asian financial crisis, Atul Gawande, backtesting, Basel III, Benoit Mandelbrot, Bernie Madoff, Black Swan, capital asset pricing model, central bank independence, Checklist Manifesto, corporate governance, credit crunch, Credit Default Swap, disintermediation, distributed generation, diversification, diversified portfolio, Emanuel Derman, Eugene Fama: efficient market hypothesis, experimental subject, financial innovation, illegal immigration, implied volatility, index fund, Long Term Capital Management, loss aversion, margin call, market clearing, market fundamentalism, market microstructure, money: store of value / unit of account / medium of exchange, moral hazard, natural language processing, open economy, pre–internet, quantitative trading / quantitative finance, random walk, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, road to serfdom, Robert Shiller, Robert Shiller, shareholder value, Sharpe ratio, special drawing rights, statistical arbitrage, stochastic volatility, The Myth of the Rational Market, too big to fail, transaction costs, value at risk, yield curve

Loosely speaking, that means however many stocks you add to your portfolio, you can’t get its standard deviation much below 40 percent (0.40 is the square root of 0.16) of the average standard deviation of the stocks in it. If you stick to large-capitalization U.S. stocks, the correlation is even higher. That also means that if you pick stocks at random you get 90 percent of the diversification benefit of holding the entire market by buying just 20 stocks. What it doesn’t say, but is true, is that if you pick stocks cleverly to have low or even negative correlation with each other, you can get the diversification benefit of the market with four to eight stocks. These are the kinds of portfolios we would expect investors to hold under IGT CAPM; and until MPT CAPM pushed investors to huge portfolios, typical portfolio sizes were eight to 40 stocks, even among professional managers. While in theory investors might have improved their Sharpe ratios slightly by holding more stocks, it’s quite possible that the additional transaction costs would have offset the benefit.

An investor considers investments, makes an allocation decision, and then moves on to the next decision. The portfolio is what results from this process. IGT is clearly a better description of the world. No investors used a top-down approach when Markowitz wrote. People have tried it since, inspired by what MPT said they should do, but it has never been popular or conspicuously successful. When it is used, it is generally only at the asset-class level rather than to select individual positions—that is, it is used to decide how much to allocate to each of stocks, bonds, real estate, commodities, and other assets, but not which stocks or which bonds to buy—and it is constrained tightly to force a result similar to preconceived ideas. IGT also seems to be a better description of investor thought processes. Investors focus on how much capital is at risk in a position, what the expected return is, and how much variance of return can be expected.

In the real world, with all investors doing the same thing, we saw consolidation of investment management services, with huge funds managed by huge fund management companies. In the IGT world, with every investor different, you would expect to see far more small funds and companies. Belief in MPT CAPM helped make the markets more efficient cross-sectionally; that is, returns on different asset classes over the same time periods aligned pretty well with their respective risk levels. But, at least arguably, MPT CAPM contributed toward prices diverging from fundamental value. Index fund investors don’t ask what something is worth; they want to hold it in proportion to its price. Among other things, it guarantees that they are overinvested in anything overpriced, and underinvested in anything underpriced.

 

pages: 302 words: 86,614

The Alpha Masters: Unlocking the Genius of the World's Top Hedge Funds by Maneet Ahuja, Myron Scholes, Mohamed El-Erian

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Asian financial crisis, asset allocation, asset-backed security, backtesting, Bernie Madoff, Bretton Woods, business process, call centre, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, Donald Trump, en.wikipedia.org, family office, fixed income, high net worth, interest rate derivative, Isaac Newton, Long Term Capital Management, Mark Zuckerberg, merger arbitrage, NetJets, oil shock, pattern recognition, Ponzi scheme, quantitative easing, quantitative trading / quantitative finance, Renaissance Technologies, risk-adjusted returns, risk/return, rolodex, short selling, Silicon Valley, South Sea Bubble, statistical model, Steve Jobs, systematic trading

For example, Bridgewater has never had a concentrated exposure to the U.S. dollar. It has always strived for diversification beyond what’s needed for liquidity. After the position has been weighted accordingly, the goal is to create an optimal beta portfolio of positions, know how they behave, how they’re structured, and how they’re priced. Then Bridgewater does that for every single position—the firm has about 100 uncorrelated alpha streams in its alpha portfolio at any given time. Perhaps the most important application of this portfolio engineering has nothing to do with the firm’s Pure Alpha strategy. In 1994, faced with his own portfolio management decisions, Dalio created the “All Weather portfolio”—a passive asset allocation that was designed to take full advantage of diversification. “In the mid-90s I started to accumulate some money that I wanted to use to establish a family trust, and for that trust I wanted the right asset allocation mix,” he recalls.

Its method is to take a value-added return from active management (alpha) minus the return from passively holding a portfolio (beta) and create optimal portfolios for each where clients specify their desired targeted level of risk. Bridgewater called its first optimal alpha strategy Pure Alpha, and it would be an integral step in the process for every investment made across the fund. So, toward the end of the 2006 Bridgewater sent letters to clients about the “constrained” nature of those alpha-generating strategies, which didn’t permit the firm to move freely among asset classes. Bridgewater announced that henceforth clients would use Pure Alpha in conjunction with its bond or currency accounts; those unwilling to make the transfer would be resigned within 12 months. Once among the largest traditional global bond and currency managers in the world, Bridgewater today uses Pure Alpha only in conjunction with its actively managed accounts. While some would find this risky, Dalio maintains it is a better way to manage money and reduce the risk of underperformance for clients and the firm.

When Loeb started Third Point, he had a strong background in high-yield credit, distressed debt, and risk arbitrage, but necessity pushed him to expand his areas of expertise. “We’ve never defined ourselves as one kind of firm,” he says, “and we’ve never really deviated from that kind of flexible approach. Instead, we’ve deepened our research process, and hired people who brought us expertise in different geographies, different industries, and different asset classes. Our philosophy is to be opportunistic all the way across the capital structure from debt to equity, across industries and different geographies. We invest wherever we see some kind of special situation element, an event that will either help create the investment opportunity or help to realize the opportunity.” In finding these opportunities, Loeb begins with an investment framework, a financial point of view that helps define patterns of events that have consistently produced outsized returns.

 

pages: 741 words: 179,454

Extreme Money: Masters of the Universe and the Cult of Risk by Satyajit Das

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affirmative action, Albert Einstein, algorithmic trading, Andy Kessler, Asian financial crisis, asset allocation, asset-backed security, bank run, banking crisis, banks create money, Basel III, Benoit Mandelbrot, Berlin Wall, Bernie Madoff, Big bang: deregulation of the City of London, Black Swan, Bonfire of the Vanities, bonus culture, Bretton Woods, BRICs, British Empire, capital asset pricing model, Carmen Reinhart, carried interest, Celtic Tiger, clean water, cognitive dissonance, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Daniel Kahneman / Amos Tversky, debt deflation, Deng Xiaoping, deskilling, discrete time, diversification, diversified portfolio, Doomsday Clock, Emanuel Derman, en.wikipedia.org, Eugene Fama: efficient market hypothesis, eurozone crisis, Fall of the Berlin Wall, financial independence, financial innovation, fixed income, full employment, global reserve currency, Goldman Sachs: Vampire Squid, Gordon Gekko, greed is good, happiness index / gross national happiness, haute cuisine, high net worth, Hyman Minsky, index fund, interest rate swap, invention of the wheel, invisible hand, Isaac Newton, job automation, Johann Wolfgang von Goethe, joint-stock company, Joseph Schumpeter, Kenneth Rogoff, Kevin Kelly, labour market flexibility, laissez-faire capitalism, load shedding, locking in a profit, Long Term Capital Management, Louis Bachelier, margin call, market bubble, market fundamentalism, Marshall McLuhan, Martin Wolf, merger arbitrage, Mikhail Gorbachev, Milgram experiment, Mont Pelerin Society, moral hazard, mortgage debt, mortgage tax deduction, mutually assured destruction, Naomi Klein, Network effects, new economy, Nick Leeson, Nixon shock, Northern Rock, nuclear winter, oil shock, Own Your Own Home, pets.com, Plutocrats, plutocrats, Ponzi scheme, price anchoring, price stability, profit maximization, quantitative easing, quantitative trading / quantitative finance, Ralph Nader, RAND corporation, random walk, Ray Kurzweil, regulatory arbitrage, rent control, rent-seeking, reserve currency, Richard Feynman, Richard Feynman, Richard Thaler, risk-adjusted returns, risk/return, road to serfdom, Robert Shiller, Robert Shiller, Rod Stewart played at Stephen Schwarzman birthday party, rolodex, Ronald Reagan, Ronald Reagan: Tear down this wall, savings glut, shareholder value, Sharpe ratio, short selling, Silicon Valley, six sigma, Slavoj Žižek, South Sea Bubble, special economic zone, statistical model, Stephen Hawking, Steve Jobs, The Chicago School, The Great Moderation, the market place, the medium is the message, The Myth of the Rational Market, The Nature of the Firm, The Predators' Ball, The Wealth of Nations by Adam Smith, Thorstein Veblen, too big to fail, trickle-down economics, Turing test, Upton Sinclair, value at risk, Yogi Berra, zero-coupon bond

As fund management evolved into a professionally managed business, increasing costs, especially of attracting investors and compliance, forced economies of scale. UBS Asset Management and Blackstone now manage trillions of dollars. As size made it difficult to enter and exit markets quickly without affecting prices, indexation or core-satellite approaches grew. Diversification encouraged new asset classes—emerging markets, currencies, commodities, infrastructure, insurance risk, and even fine arts. As long as the investment offered returns and did not move together with other asset classes held by the investor, adding them to a portfolio improved return with lower risk. The success of the unorthodox investment philosophy of David Swensen and the Yale Endowment showed the potential of hedge funds and private equity to generate alpha. Investment managers used derivatives to manage risk or create structured products.

Black remained equivocal about the replication approach: “Merton’s derivation relies on stricter assumptions, so I don’t think it’s really robust.”13 Slow and Quick Money Initially, the ideas did not find acceptance among practitioners. The professors could point to no practical experience or track record. Baron Rothschild once observed that only three people understood the meaning of money and none had very much of it.14 Diversification to reduce risk was contrary to the ethos of stock picking. While successfully managing the portfolios of an insurance company and the King’s College endowment, Keynes insisted that diversification was flawed: To suppose that safety...consists in having a small gamble in a large number of different [stocks] where I have no information...as compared with a substantial stake in a company where one’s information is adequate, strikes me as a travesty of investment policy.15 Mark Twain’s Pudd’nhead Wilson agreed: “Put all your eggs in one basket, and watch that basket.”

His remaining 24 percent stake was valued at almost $8 billion, placing him near Rupert Murdoch and Steve Jobs on the list of richest people. In 2006, Schwarzman earned $398 million, around double the combined pay of the five largest American investment bank CEOs. Amateur Hour A leaked internal memo written by Carlyle’s William Conway dated January 31, 2007 showed that that the boom was almost over: “most investors in most assets classes are not being paid for the risks being taken...the longer it lasts the worst it will be when it ends...if the excess liquidity ended tomorrow I would want as much flexibility as possible.”14 Shortly after the Blackstone IPO, U.S. subprime problems overflowed into a general credit crunch, and the debt markets ground to a halt. As the global recession affected earnings and cash flows, companies that had been leveraged up in buyouts found it difficult to meet debt repayments.

 

pages: 543 words: 157,991

All the Devils Are Here by Bethany McLean

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Asian financial crisis, asset-backed security, bank run, Black-Scholes formula, call centre, collateralized debt obligation, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, Exxon Valdez, fear of failure, financial innovation, fixed income, high net worth, Home mortgage interest deduction, interest rate swap, laissez-faire capitalism, Long Term Capital Management, margin call, market bubble, market fundamentalism, Maui Hawaii, moral hazard, mortgage debt, Northern Rock, Own Your Own Home, Ponzi scheme, quantitative trading / quantitative finance, race to the bottom, risk/return, Ronald Reagan, Rosa Parks, shareholder value, short selling, South Sea Bubble, statistical model, telemarketer, too big to fail, value at risk

In this, AIG-FP was following the evolution of the CDO business itself, which had gone from BISTRO—a CDO made up of one bank’s corporate loan portfolio—to CDOs that consisted of disparate corporate credits, to this new multisector CDO. Multisector CDOs were “highly diversified kitchen sinks,” as one FP trader put it, that included everything from student loans to credit card debt to prime commercial real estate mortgage-backed securities to a smattering of subprime residential mortgage-backed securities. The theory, as always, was that diversification would protect against losses; the different asset classes in a multisector CDO were supposed to be uncorrelated. A Yale economist named Gary Gorton was hired to work up the risk models, which showed—naturally!—that the possibility of losses reaching the super-senior tranches was so tiny as to be nearly nonexistent. To FP’s executives, wrapping the super-seniors felt like free money. The executive who marketed credit default swaps for AIG-FP was Al Frost.

He had been involved in structured finance seemingly forever; as a young lawyer in the 1980s, Adelson had worked on several of the early deals put together by Lew Ranieri and Larry Fink. Perhaps because of his long experience, he was always less willing to accept uncritically many of the arguments made for mortgage-backed securities. When underwriters began reducing their credit enhancements, claiming that the securities had proven themselves with their good performance, Adelson didn’t buy it. The fact that an asset class like housing had performed well in the past said nothing about how the same asset class was going to perform in the future, he believed. For a very long time, Moody’s backed Adelson, for which he would always be grateful. But his skepticism was out of sync with both the market and the new Moody’s. “My view wasn’t the most widely held one at Moody’s,” he says now. “You spend a lot of time doing soul-searching when you’re looking one way and everyone else is looking the other way.”

Having studied at the feet of Rubin, Summers, and Greenspan, it was perhaps inevitable that he would share their mind-set about the virtues of the market. As the guidance was being discussed within the government, there were bank supervisors who were arguing that the Fed needed to clamp down on both mortgage lending and commercial real estate practices, especially given the rapid growth of both asset classes since 2000. But there were, shall we say, alternate concerns, which were expressed by Geithner and others who shared his views. What would the effect be on the mortgage and housing market if the Fed were heavy-handed? What would the effect be on the bottom lines of banks? “The Fed slowed down the guidance,” says one person. “It was slowed down by internal debates about how far the regulators should go since most of the mortgages were sold into the market—and this guidance would replace investor risk appetites with regulatory standards.”

 

pages: 294 words: 82,438

Simple Rules: How to Thrive in a Complex World by Donald Sull, Kathleen M. Eisenhardt

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Affordable Care Act / Obamacare, Airbnb, asset allocation, Atul Gawande, barriers to entry, Basel III, Berlin Wall, carbon footprint, Checklist Manifesto, complexity theory, Craig Reynolds: boids flock, Credit Default Swap, Daniel Kahneman / Amos Tversky, diversification, en.wikipedia.org, European colonialism, Exxon Valdez, facts on the ground, Fall of the Berlin Wall, haute cuisine, invention of the printing press, Isaac Newton, Kickstarter, late fees, Lean Startup, Louis Pasteur, Lyft, Moneyball by Michael Lewis explains big data, Nate Silver, Network effects, obamacare, Paul Graham, performance metric, price anchoring, RAND corporation, risk/return, Saturday Night Live, sharing economy, Silicon Valley, Startup school, statistical model, Steve Jobs, TaskRabbit, The Signal and the Noise by Nate Silver, transportation-network company, two-sided market, Wall-E, web application, Y Combinator, Zipcar

. [>] According to this rule: Ran Duchin and Haim Levy, “Markowitz Versus the Talmudic Portfolio Diversification Strategies,” Journal of Portfolio Management 35, no. 2 (2009): 71–74. [>] This research ran: Jun Tu and Guofu Zhou, “Markowitz Meets Talmud: A Combination of Sophisticated and Naive Diversification Strategies,” Journal of Financial Economics 99, no. 1 (2011): 204–15. See table 6 for summary of tests of rules against real data sets. [>] The 1/N rule earned: Ibid. When provided with twenty years of data, the financial models did a bit better, beating the 1/N rule just over one-third of the time. [>] Other studies have run: Victor DeMiguel, Lorenzo Garlappi, and Raman Uppal, “Optimal Versus Naïve Diversification: How Inefficient Is the 1/N Portfolio Strategy,” Review of Financial Studies 22, no. 5 (2007): 1915–53; Victor DeMiguel et al., “A Generalized Approach to Portfolio Optimization: Improving Performance by Constraining Portfolio Norms,” Management Science 55, no. 5 (2009): 798–812; Michael Gallmeyer and Marcel Marekwica, “Heuristic Portfolio Trading Rules with Capital Gains Tax,” Social Science Research Network, May 18, 2013, http://ssrn.com/abstract=2172396. [>] Instead, as he later confessed: Jason Zweig, “Investing Experts Urge ‘Do as I Say, Not as I Do,’” Wall Street Journal, January 3, 2009. [>] When choosing a mate: Oliver M.

For all its theoretical elegance and widespread adoption, however, the Markowitz model has a problem: it cannot outperform a simple rule that originated in the Babylonian Talmud, written about fifteen hundred years ago. According to this rule of thumb, “a man should always place his money, one third in land, a third into merchandise, and keep a third in hand.” The general extension of this Talmudic advice is the 1/N principle, whereby total available funds are prioritized with equal ranking across the total number of asset classes. The 1/N rule ignores a lot of data and relationships that the Markowitz model captures, such as each asset’s historical returns, risk, and correlation with other asset classes. In fact, the 1/N rule ignores everything except for the number of investment alternatives under consideration. It is hard to imagine a simpler investment rule. And yet it works. One recent study of alternative investment approaches pitted the Markowitz model and three extensions of his approach against the 1/N rule, testing them on seven samples of data from the real world.

The returns from the complicated models, unimpressive as they are, still overstate the returns investors could expect in the real world, because they exclude the fees that asset managers might charge for active management. One surprising follower of the 1/N rule is Markowitz himself. While working at the Rand Corporation, Markowitz had to allocate his retirement fund across investment opportunities. According to his own theory, he should have calculated the correlations between different asset classes to draw an efficient frontier and rank the asset classes accordingly. Instead, as he later confessed to a financial journalist, he allocated his retirement funds evenly between stocks and bonds and called it a day. Prioritizing rules are particularly common in business settings, as we will discuss in chapter 5. They are especially powerful when applied to a bottleneck, an activity or decision that keeps individuals or organizations from reaching their objectives.

 

pages: 426 words: 115,150

Your Money or Your Life: 9 Steps to Transforming Your Relationship With Money and Achieving Financial Independence: Revised and Updated for the 21st Century by Vicki Robin, Joe Dominguez, Monique Tilford

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asset allocation, Buckminster Fuller, buy low sell high, credit crunch, disintermediation, diversification, diversified portfolio, fiat currency, financial independence, fudge factor, full employment, Gordon Gekko, high net worth, index card, index fund, job satisfaction, Menlo Park, Parkinson's law, passive income, passive investing, profit motive, Ralph Waldo Emerson, Richard Bolles, risk tolerance, Ronald Reagan, Silicon Valley, software patent, strikebreaker, Thorstein Veblen, Vanguard fund, zero-coupon bond

Best-selling author Larry Swedroe from his book, What Wall Street Doesn’t Want You to Know: “Regardless of the asset class [see below], use only index or passive asset class funds. Active management is a loser’s game. Diversify across many asset classes. This will reduce portfolio risk and probably increase returns as well.” Designing Your Own ʺENOUGH . . . AND THEN SOMEʺ FI3 Portfolio Your “portfolio” is a fancy way of saying the sum of your investments across “asset classes”—which simply means types of investment vehicles such as cash, bonds, stocks, real estate, foreign currency and commodities. Asset allocation is the art and science of distributing your nest egg across various classes to balance risk and reward. Instead of putting all your eggs in one basket, you are wisely limiting your market risk by spreading your money across various asset classes. This is a smart, sensible and time-tested strategy.

Instead you are looking for enough of a return to meet your short-term as well as long-term goals while taking as little risk as possible. That is why index funds, with their low fees and ability for diversification, can work well for the FI investment program. At its core, index fund investing means you are using an approach and strategy that seeks to track the investment returns of a specified stock or bond market benchmark or index. One of the most popular index funds today is the S&P 500 Index Fund, which attempts to replicate the investment results of this specific target index. There is no attempt to use traditional “active” money management or to make “bets” on individual stocks. Indexing is a passive investment approach emphasizing broad diversification and low portfolio trading activity. Low cost is a key advantage of index funds, leaving a larger share of the pie for investors, which is why this choice aligns well for your FI investment plan.

This is a smart, sensible and time-tested strategy. By using index funds, you can allocate your capital across various asset classes. This enables you to reduce volatility without giving up investment performance. Beyond Index Funds: The Simplest Kind of Mutual Fund— Lifestyle Funds The FI investment program was designed to be easy to implement as well as simple to manage. If, in addition to index funds, you were to choose only one new investment strategy that could mirror this approach, it would have to be investing in mutual funds known as “lifestyle funds.” This all-in-one concept seems uniquely designed for an FI investment plan because the management fees are low, the plan is simple to manage and it enables inexperienced investors to quickly establish a well-diversified portfolio that reduces market risk.

 

pages: 543 words: 147,357

Them And Us: Politics, Greed And Inequality - Why We Need A Fair Society by Will Hutton

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Andrei Shleifer, asset-backed security, bank run, banking crisis, Benoit Mandelbrot, Berlin Wall, Bernie Madoff, Big bang: deregulation of the City of London, Bretton Woods, capital controls, carbon footprint, Carmen Reinhart, Cass Sunstein, centre right, choice architecture, cloud computing, collective bargaining, conceptual framework, Corn Laws, corporate governance, credit crunch, Credit Default Swap, debt deflation, decarbonisation, Deng Xiaoping, discovery of DNA, discovery of the americas, discrete time, diversification, double helix, Edward Glaeser, financial deregulation, financial innovation, financial intermediation, first-past-the-post, floating exchange rates, Francis Fukuyama: the end of history, Frank Levy and Richard Murnane: The New Division of Labor, full employment, George Akerlof, Gini coefficient, global supply chain, Growth in a Time of Debt, Hyman Minsky, I think there is a world market for maybe five computers, income inequality, inflation targeting, interest rate swap, invisible hand, Isaac Newton, James Dyson, James Watt: steam engine, joint-stock company, Joseph Schumpeter, Kenneth Rogoff, knowledge economy, knowledge worker, labour market flexibility, Long Term Capital Management, Louis Pasteur, low-wage service sector, mandelbrot fractal, margin call, market fundamentalism, Martin Wolf, means of production, Mikhail Gorbachev, millennium bug, moral hazard, mortgage debt, new economy, Northern Rock, offshore financial centre, open economy, Plutocrats, plutocrats, price discrimination, private sector deleveraging, purchasing power parity, quantitative easing, race to the bottom, railway mania, random walk, rent-seeking, reserve currency, Richard Thaler, rising living standards, Robert Shiller, Robert Shiller, Ronald Reagan, Rory Sutherland, shareholder value, short selling, Silicon Valley, Skype, South Sea Bubble, Steve Jobs, The Market for Lemons, the market place, The Myth of the Rational Market, the payments system, the scientific method, The Wealth of Nations by Adam Smith, too big to fail, unpaid internship, value at risk, Washington Consensus, working poor, éminence grise

The fundamental conundrum lies in reconciling shareholders’ desire to have the ability to cash in their shares whenever they want with companies’ need to have consistent and committed owners over an extended period of time. There is no easy solution. However, Britain has certainly been far too biased in favour of total shareholder freedom. Our finanical sector has always stressed the importance of liquidity – of being able to realise assets quickly for cash. But over the 1990s and 2000s company shares became just another asset class that leveraged banks, hedge funds and investment houses held on a short-term basis for yield or capital gain before selling as soon as the anticipated profits had been made. The number of investors committed to long-term share ownership consistently fell as the number of short-term funds consistently rose. In 1990 foreigners and financial institutions like hedge funds held just 12.5 per cent of all British shares; by 2006, they owned 49.6 per cent.

Over the seven years to March 2008, global foreign currency reserves jumped by $4,900 billion, with China’s reserves alone up by $1,500 billion.19 Each of these elements contributed to the fiasco; and now all of them need to be unravelled if Britain and the world economy are to generate a sustained recovery. Banking is vital but dangerous The fundamental attribute of finance is its capacity to make money from money. Financiers have three avenues to riches that are not available to non-financial entrepreneurs: the laying off of risk through diversification; the extra capital gains to be won through leverage; and the capacity to borrow short and lend long. Economies need bankers to spread their risk, offer credit and confront the existential challenge of offering depositors their money back on demand while simultaneously lending it over the longer term. If banks are not prepared to do these things, the economy seizes up. But the temptation for bankers is to gamble in order to make fortunes – and generate huge costs if it all goes wrong.

But the temptation for bankers is to gamble in order to make fortunes – and generate huge costs if it all goes wrong. Central banking and regulation are societies’ two defences against this, but in the 2000s they were hoodwinked. One of the first principles of banking and insurance is that one default or pay-out can be safely absorbed as long as it occurs among many successful loans or insurance contracts. For diversification to work, though, the risks must be both genuinely spread and, as far as possible, independent of each other. Thus, for example, a prudent banker lends to both a manufacturer of umbrellas and a manufacturer of suntan oil: whatever the weather, at least one of the companies will prosper and pay back the loan with interest. This was the thinking that justified taking different tranches of debt from different classes of borrowers – some rock-solid, others very risky – and wrapping them up in a single security, the logic of the collateralised debt obligation (CDO).

 

pages: 289 words: 113,211

A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation by Richard Bookstaber

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affirmative action, Albert Einstein, asset allocation, backtesting, Black Swan, Black-Scholes formula, Bonfire of the Vanities, butterfly effect, commodity trading advisor, computer age, disintermediation, diversification, double entry bookkeeping, Edward Lorenz: Chaos theory, family office, financial innovation, fixed income, frictionless, frictionless market, George Akerlof, implied volatility, index arbitrage, Jeff Bezos, London Interbank Offered Rate, Long Term Capital Management, loose coupling, margin call, market bubble, market design, merger arbitrage, Mexican peso crisis / tequila crisis, moral hazard, new economy, Nick Leeson, oil shock, quantitative trading / quantitative finance, random walk, Renaissance Technologies, risk tolerance, risk/return, Robert Shiller, Robert Shiller, rolodex, Saturday Night Live, shareholder value, short selling, Silicon Valley, statistical arbitrage, The Market for Lemons, time value of money, too big to fail, transaction costs, tulip mania, uranium enrichment, yield curve, zero-coupon bond

The problem with this sort of classification, based as it is strictly on the trading style or strategy type, is that it has to be revised over time as new strategies emerge and existing ones fail. An alternative classification matrix, which I developed in 2001, attempts to overcome this problem, but in so doing reveals the existential issue for hedge funds.1 This approach classifies hedge funds by five characteristics: 1. Asset class. The broadest category, it defines the market in which the fund operates. These include fixed income, equities, currencies, and commodities. There can also be a “multiclass” to capture “none or some of the above,” and this specifically includes global macro funds. 245 ccc_demon_243-254_ch11.qxd 2/13/07 A DEMON 1:47 PM OF Page 246 OUR OWN DESIGN 2. Direction. As the name implies, the direction of the manager’s activity in the asset: long, short, long/short, and neutral.

If this is an effective categorization framework for hedge funds/alternative investments, what is the categorization framework for the alternative to this al- 246 ccc_demon_243-254_ch11.qxd 2/13/07 1:47 PM Page 247 HEDGE FUND EXISTENTIAL ternative? The answer is, there is none. This categorization for hedge funds actually is a categorization for all investment strategies. After all, what investment strategy is not typified by some direction (especially since “neutral” is one choice), operating on some general asset class, and focused on some geographic region? The same question arises when we consider hedge funds as a subject of study and research. I know of at least two institutes that are focused on the study of alternative investments. One is at the London School of Business, the other at the University of Massachusetts, Amherst. There are also several journals that focus on hedge funds and alternative investments.

A 1-percent-and-20-percent fee structure leads to the same ballpark return for the hedge fund manager as a 100-basis-point fee will for the manager of a larger but unlevered long-only fund. WILL HEDGE FUNDS TAKE OVER THE INVESTMENT WORLD? Hedge funds are the unconstrained version of traditional investment funds in that they do not have restrictions on shorting, levering, or expanding to innovative asset classes. They can do everything a traditional manager can do and then some. Because of this, hedge funds should dom- 252 ccc_demon_243-254_ch11.qxd 2/13/07 1:47 PM Page 253 HEDGE FUND EXISTENTIAL inate the traditional funds in generating returns. Looking at it another way, any traditional investment manager who finds himself passing up an opportunity to improve returns because he cannot get short exposure, cannot lever his exposure to a trade idea, or cannot take on a promising position because it lies outside of his allowable universe will be left behind by an equally talented counterpart who is following an identical investment method in a hedge fund.

 

pages: 246 words: 74,341

Financial Fiasco: How America's Infatuation With Homeownership and Easy Money Created the Economic Crisis by Johan Norberg

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accounting loophole / creative accounting, bank run, banking crisis, Bernie Madoff, Black Swan, capital controls, central bank independence, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, David Brooks, diversification, financial deregulation, financial innovation, helicopter parent, Home mortgage interest deduction, housing crisis, Howard Zinn, Hyman Minsky, Isaac Newton, Joseph Schumpeter, Long Term Capital Management, market bubble, Martin Wolf, Mexican peso crisis / tequila crisis, millennium bug, moral hazard, mortgage tax deduction, Naomi Klein, new economy, Northern Rock, Own Your Own Home, price stability, Ronald Reagan, savings glut, short selling, Silicon Valley, South Sea Bubble, The Wealth of Nations by Adam Smith, too big to fail

Their point is that nothing is more dangerous than good times because they encourage investors to borrow more and take bigger risks. If things look good, they are going to get worse. "Investors said, `I don't want to be in equities anymore, and I'm not getting any return in my bond positions,"' explains a financier who is the author of many financial innovations: "Two things happened. They took more and more leverage, and they reached for riskier asset classes. Give me yield, give me leverage, give me return."" It's the Deficit, Stupid U.S. households were not alone in opening wide their pocketbooks and bankbooks: The U.S. government did the same. By 2002, the Bush administration had turned a $127 billion surplus into a $158 billion deficit. This was not only the effect of the general economic downturn but also the result of conscious policy choices.

Moody's, which used to be a bit sulky in its outward behavior, suddenly began to spend a lot of time with its customers on numerous golfing trips and karaoke nights. The number one growth industry at that time was the securitization of mortgages. Moody's held out for a long time, sticking to its principle that no CDO consisting solely of mortgages could get a top rating since there was too little diversification of risk-a national fall in home prices would have a devastating effect on its value. But other rating agencies were making out like bandits by awarding top grades to such securities, even though some of the people working there were already suspicious. One S&P employee warned in an internal e-mail that the CDO market they were creating was a "monster," concluding, "Let's hope we are all wealthy and retired by the time this house of cards falters."26 The CEO of Moody's explained the development much later at an internal meeting: "It was a slippery slope.

One S&P employee warned in an internal e-mail that the CDO market they were creating was a "monster," concluding, "Let's hope we are all wealthy and retired by the time this house of cards falters."26 The CEO of Moody's explained the development much later at an internal meeting: "It was a slippery slope. What happened in 2004 and 2005 with respect to subordinated tranches [the riskiest bits of CDOs] is that our competition, Fitch and S&P, went nuts. Everything was investment grade."27 The conservative rating agency must have felt an overwhelming temptation to go a little crazy itself: Moody's abandoned its diversification requirement in 2004 and started bringing out its Aaa stamp when customers came calling with mortgage-backed securities. From a business point of view, this was exactly the right thing to do. A single rating assignment could earn the company more than $200,000, and it did not have to take more than a day and could sometimes be done in a few hours. Moody's became one of the world's most profitable businesses, and various kinds of securitization accounted for more than 40 percent of the company's sales in 2005.28 The potential profits were huge because good ratings were what created the necessary conditions for the securitization industry in the mortgage market-the possibility to shake a bunch of risky mortgages until they were rated as a risk-free investment.

 

pages: 237 words: 50,758

Obliquity: Why Our Goals Are Best Achieved Indirectly by John Kay

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Andrew Wiles, Asian financial crisis, Berlin Wall, bonus culture, British Empire, business process, Cass Sunstein, computer age, credit crunch, Daniel Kahneman / Amos Tversky, discounted cash flows, discovery of penicillin, diversification, Donald Trump, Fall of the Berlin Wall, financial innovation, Gordon Gekko, greed is good, invention of the telephone, invisible hand, Jane Jacobs, Long Term Capital Management, Louis Pasteur, market fundamentalism, Nash equilibrium, pattern recognition, purchasing power parity, RAND corporation, regulatory arbitrage, shareholder value, Simon Singh, Steve Jobs, The Death and Life of Great American Cities, The Predators' Ball, The Wealth of Nations by Adam Smith, ultimatum game, urban planning, value at risk

In the first decade of the twenty-first century banks persuaded themselves that risk management could be treated as a problem that was closed, determinate and calculable—like working out when the bus will arrive. We, and they, learned that they were wrong. The most widely used template in the banking industry was called “value at risk” (VAR) and elaborated by JPMorgan. The bank published the details and subsequently spun off a business, RiskMetrics, which promotes it still.2 These risk models are based on analysis of the volatility of individual assets or asset classes and—crucially—on correlations, the relationships among the behaviors of different assets. The standard assumptions of most value-at-risk models are that the dispersion of investment returns follows the normal distribution, the bell curve that characterizes so many natural and social phenomena, and that future correlations will reproduce past ones. The assumption of normal distribution of returns seems to work well in times that are, well, normal.

The reason is not ignorance of what good management practice should be. . . . To a degree incomprehensible to Americans, Saint-Gobain must move through a veritable jungle of blood ties and corporate ties while carrying the dead weight of dozens of intra-company empires and three centuries of tradition.”6 History has not served Dr. H. Igor Ansoff well. TRW, Singer and Litton all pursued similar strategies of poorly managed diversification that subsequently fell apart. Litton’s legendary reputation survived the publication of Dr. Ansoff’s work by less than a year. Singer and Litton are no longer independent companies and TRW is, once again, an automotive parts supplier of modest scale and ambition. Saint-Gobain, by contrast, is one of the most successful industrial companies in France and globally, with two hundred thousand employees worldwide.7 As Dr.

Welfare is something which is always changing its opportunities and demands—because human nature and general circumstances are always changing.”1 Marks and his colleagues had a rather general vision of the business they wanted to build but were constantly adaptive in decision making. Their chief method of market research was to put goods on the shelves and see if they sold. Or not: Most of the company’s diversifications failed, with one unexpected success—a food department. As a result, from the 1950s to the 1990s, fear of Marks & Spencer was at the front of the mind of every other UK retailer. But like ICI and Boeing, Marks & Spencer would sacrifice that status during the rationalist 1990s in the—ultimately unsuccessful—pursuit of growth in earnings per share.2 As at ICI and Boeing, the oblique approach built shareholder value and the direct approach destroyed it.

 

pages: 304 words: 22,886

Nudge: Improving Decisions About Health, Wealth, and Happiness by Richard H. Thaler, Cass R. Sunstein

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Al Roth, Albert Einstein, asset allocation, availability heuristic, call centre, Cass Sunstein, choice architecture, continuous integration, Daniel Kahneman / Amos Tversky, desegregation, diversification, diversified portfolio, endowment effect, equity premium, feminist movement, framing effect, full employment, George Akerlof, index fund, invisible hand, late fees, libertarian paternalism, loss aversion, Mahatma Gandhi, Mason jar, medical malpractice, medical residency, mental accounting, meta analysis, meta-analysis, Milgram experiment, pension reform, presumed consent, profit maximization, rent-seeking, Richard Thaler, risk tolerance, Robert Shiller, Robert Shiller, Saturday Night Live, school choice, school vouchers, transaction costs, Vanguard fund, Zipcar

Rules of Thumb Even the most sophisticated investors can sometimes find the decision about how to invest their money daunting, and they resort to NAÏVE INVESTING simple rules of thumb. Take the example of the financial economist and Nobel laureate Harry Markowitz, one of the founders of modern portfolio theory. When asked about how he allocated his retirement account, he confessed: “I should have computed the historic covariances of the asset classes and drawn an efficient frontier. Instead . . . I split my contributions fifty-fifty between bonds and equities.”2 Markowitz was not alone. In the mid-1980s most educators had a defined-contribution pension plan provided by a company that goes by its initials, tiaa-cref. At that time the plan had only two options—tiaa, which invests in fixed-income securities such as bonds, and cref, which invests mostly in stocks.

But we can nonetheless learn a lot by comparing the portfolios people actively constructed with the default fund on dimensions that sensible investors should value—such as fees, risk, and performance. To make a long story short, the active choosers didn’t do so great. The default fund appears to have been chosen with some care (see Table 9.1). The asset allocation is 65 percent foreign (that is, non-Swedish) stocks, 17 percent Swedish stocks, 10 percent fixed-income securities (bonds), 4 percent hedge funds, and 4 percent private equity. Across all asset classes, 60 percent of the funds are managed passively, meaning that the portfolio managers are simply buying an index of stocks and not trying to beat the market. One good thing about index funds is that they are cheap. The fees they charge investors are much lower than those charged by funds that try to beat the market. These low fees for the index funds helped keep *In fact, the percentage of active choosers has declined steadily, from 17.6 percent in 2001, the first year after the launch. 149 150 MONEY Table 9.1 Comparison of the default fund and the mean actively chosen portfolio Asset allocation Default (%) Mean actively chosen portfolio (%) Equities Sweden Americas Europe Asia Fixed-income securities (bonds) Hedge funds Private equity 82 17 35 20 10 10 4 4 96.2 48.2 23.1 18.2 6.7 3.8 0 0 Indexed 60 4.1 Fee Returns for the first three years Returns through July 2007 0.17 29.9 21.5 0.77 39.6 5.1 Note: The table compares the default fund and the mean actively chosen portfolio.

AARP, 161–62, 163–64 ABBA, Gold: Greatest Hits, 194 “above average” effect, 32, 224 Abu Ghraib prison, 245 accessibility, 25 accountability, in schools, 200 acid deposition program, 187–88 acid rain, 187–88 air conditioners, filters for, 234 air pollution, 183, 184–85, 186, 188 alcohol abuse, 67–68, 234–35 Ambient Orb, 194 American dream, 135 American Express, 35 anchoring and adjustment, 23–24 angels, 235 annual percentage rate (APR), 133, 137 anonymity, 57 arbitrage opportunity, 51 arousal, power of, 42 asbestos, warnings about, 189 Asch, Solomon, 56–59 aspects, elimination by, 95 asset allocation, 34–35, 118–28; company stock, 125–28; diversification heuristic, 123; and loss aversion, 120–21; and market timing, 121–22; mutual funds, 119; and rates of return, 123; and risk toler- ance, 124–25; rules of thumb for, 122– 25; stocks and bonds, 118, 119–20 asymmetric paternalism, 72n, 249–51 ATM cards, 88 attention, lack of, 35 Attila the Hun, 23–24 Austria, organ donations in, 178–79 autokinetic effect, 57 automatic pilot, 43 Automatic System, 19–22; and Doers, 42; mindless choosing by, 43–44; and priming, 69–71; and risk, 25; in Stroop test, 82; and temptation, 42 Automatic Tax Return, 230–31 automobiles: buying, 98–99, 138; catalytic converters for, 184; emissions from, 184, 186; fuel economy standards for, 191–92, 192, 193; gas tank caps, 88–89; user-friendly, 88; Zipcar rentals, 99n autopsies, corneas removed in, 177 availability bias, 24–26, 67 Ayres, Ian, 231–32 “back to zero” option, 12–13 Barrera, Ramiro, 163 basketball: “hot hands” in, 30, 31; “streak shooting,” 30 283 284 INDEX behavior: dynamically inconsistent, 41; risk-related, 7, 25, 32–33 Benartzi, Shlomo, 112, 124, 127 Bennett, Robert, 14 Bettinger, Eric, 141 Big Blue, 6 birth control pills, 89 Bismarck, Otto von, 105 boomerang effect, 68 borrowing, 132; see also credit markets Boston, school system in, 203–5 Boston Research Group, 126 brain, functioning of, 19–22 Brandeis, Louis, 240 brand switching, 64–65 Breman, Anna, 229 broadcast programming, 55 Burke, Edmund, 238n Bush, George H.

 

pages: 364 words: 101,286

The Misbehavior of Markets by Benoit Mandelbrot

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Albert Einstein, asset allocation, Augustin-Louis Cauchy, Benoit Mandelbrot, Big bang: deregulation of the City of London, Black-Scholes formula, British Empire, Brownian motion, buy low sell high, capital asset pricing model, carbon-based life, discounted cash flows, diversification, double helix, Edward Lorenz: Chaos theory, Elliott wave, equity premium, Eugene Fama: efficient market hypothesis, Fellow of the Royal Society, full employment, Georg Cantor, Henri Poincaré, implied volatility, index fund, informal economy, invisible hand, John von Neumann, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, market bubble, market microstructure, new economy, paper trading, passive investing, Paul Lévy, Plutocrats, plutocrats, price mechanism, quantitative trading / quantitative finance, Ralph Nelson Elliott, RAND corporation, random walk, risk tolerance, Robert Shiller, Robert Shiller, short selling, statistical arbitrage, statistical model, Steve Ballmer, stochastic volatility, transfer pricing, value at risk, volatility smile

The same reasoning—that people instinctively understand the market is very risky—helps explain why so much of the world’s wealth remains in safe cash, rather than in anything riskier. The Wall Street mantra is asset allocation: Deciding how to divide your portfolio among cash, bonds, stocks, and other asset classes is far more important than the specific stocks or bonds you pick. A typical broker’s recommendation, based on Markowitz-Sharpe portfolio theory, is 25 percent cash, 30 percent bonds, and 45 percent stocks. But, according to a study by the Organization for Economic Cooperation and Development, most people do not think that way. Japanese households keep 53 percent of their financial assets in cash, and barely 8 percent in shares (the balance is in other asset classes). Europeans keep 28 percent in cash, 13 percent in shares. For Americans, it is 13 percent cash and 33 percent stocks. Unlike a broker, most investors do not care about “average” returns.

It argued that, to estimate a stock’s value, you start by forecasting how much in dividends it will pay; then adjust the prediction for inflation, foregone interest, and other factors that make the forecast uncertain. A straightforward rule. But surely, Markowitz thought to himself, real investors do not think that way. They do not look only at their potential profit; if they did, most people would buy just one stock, their best pick, and wait for the winnings to roll in. Instead, people also think about diversification. They judge how risky a stock is, how much its price bounces around compared to other stocks. They think about risk as well as reward, fear as well as greed. They buy many stocks, not one. They build portfolios. “Don’t put all your eggs in one basket”: It was an idea as old as investing itself. Even Shakespeare knew it, as Markowitz later recalled:…I thank my fortune for it, My ventures are not in one bottom trusted, Nor to one place; nor is my whole estate Upon the fortune of this present year; Therefore my merchandise makes me not sad.

They help plan the trades, build the portfolios, and, most important, avoid risking too much money at a time. He and some colleagues published some information about it in a 1998 scholarly paper; they called it “tail chiseling”: Under conventional portfolio theory, based on all the old assumptions of Brownian motion in prices, you build a portfolio by laboriously calculating how all the assets in a portfolio vary against each other; good diversification would mean some stocks zig when others zag. But Bouchaud’s method takes it as given that prices exhibit long-term dependence, have fat tails, and scale by a power law. He focuses, then, only on the odds for a crash—sharp, catastrophic price drops. After all, it is not small declines that wipe an investor out, it is the crashes. So their scaling formula minimizes the odds of too many of the assets in a portfolio crashing at the same time.

 

pages: 311 words: 99,699

Fool's Gold: How the Bold Dream of a Small Tribe at J.P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe by Gillian Tett

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accounting loophole / creative accounting, asset-backed security, bank run, banking crisis, Black-Scholes formula, Bretton Woods, business climate, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, easy for humans, difficult for computers, financial innovation, fixed income, housing crisis, interest rate derivative, interest rate swap, locking in a profit, Long Term Capital Management, McMansion, mortgage debt, North Sea oil, Northern Rock, Renaissance Technologies, risk tolerance, Robert Shiller, Robert Shiller, short selling, sovereign wealth fund, statistical model, The Great Moderation, too big to fail, value at risk, yield curve

But by the autumn of 2007, it had become clear that this diversification theory wasn’t working in the subprime mortgage world. Defaults were rising in all regions. The problem of cash flow was particularly vexing for those managing what had become an especially popular type of CDO during 2005 and 2006, those known as “mezzanine CDO of ABS.” These were made up out of only mezzanine notes—or those rated around BBB. Bankers liked to claim that there was still a high level of diversification in these structures because the mezzanine notes were linked to the loans of a vast pool of different households. In practice, though, because they were all in the mezzanine tranche, they would all be hit by default losses at once. Any “diversification” was an illusion. For all of these reasons, the ratings agencies felt forced to continue slashing ratings.

Credit Suisse, the once-dull Swiss group, grabbed DLJ, another American broker. The industry was rapidly adjusting to a new reality that banks needed to be big and offer a full range of services in order to compete at all. As institutions merged, financial activity broke through long-standing barriers. The art of trading corporate bonds had always been siloed off from the business of extending loans and underwriting equities. Now investors began hopping across assets classes, not to mention national borders, with abandon. Aggressive and high-risk hedge funds exploded onto the scene, some growing so large that they were competing in earnest with the new banking behemoths. The financial world was becoming “flat,” morphing into one seething, interlinked arena for increasingly free and fierce competition. Those playing in this twenty-first-century domain of unfettered cyberfinance knew these changes carried risks.

However, as Basel’s BIS noted at the time, the “striking feature of financial market behavior” in the twenty-first century was “the low level of price volatility over a wide range of financial assets and markets.” The prices of almost all assets were rising, while the cost of borrowing was flat or falling. One troubling result, policy makers feared, was an increasing correlation among the prices of many different asset classes, which would mean that a downturn would also be widespread. Most policy makers and bankers had never seen such eerily calm markets in their careers, and they were uncertain and divided about what—if anything—they should do. At one end of the intellectual spectrum stood senior American officials, who mostly assumed that the pattern was benign. In January 2006, Ben Bernanke, an esteemed academic economist, took over at the Fed from Greenspan.

 

pages: 346 words: 102,625

Early Retirement Extreme by Jacob Lund Fisker

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8-hour work day, active transport: walking or cycling, barriers to entry, clean water, Community Supported Agriculture, delayed gratification, discounted cash flows, diversification, don't be evil, dumpster diving, financial independence, game design, index fund, invention of the steam engine, inventory management, loose coupling, market bubble, McMansion, passive income, peak oil, place-making, Ponzi scheme, psychological pricing, the scientific method, time value of money, transaction costs, wage slave, working poor

This is unlike most people where one skill completely dominates all others--for example, one may be paid $25,000/year for one activity (one's job) but less than $25/year for one's next highest source of income, which is very likely to be the interest from a savings account. With proper diversification, if one income-generating module fails, it doesn't cause shockwaves through the rest of the system because the external coupling to other modules is weak. In addition, if the external couplings connect to different modules, rather than connecting to the same module, this lack of centralization protects the system from disruptions and cascading failures. Furthermore, the wider the diversification, the greater the likelihood of taking advantage of opportunities in the unique environment you reside in, or which you may find yourself residing in due to changing circumstances--this is the quintessence of adaptability.

The same goes for retirement savings, which are essentially a very big fund intended to last from retirement until death. The cash flow when working more than one job. If each job can cover expenses, the diversification provides security. This may also be thought of as working one job and having multiple clients. A person, particularly a nonsalaried working man, may have several sources of income, either in the form of multiple clients or serial contracts in which case the cash flow looks like this figure. Due to the unsteady nature of his income, the working man will likely rely on savings in between jobs. Since periods without work are a way of life, "emergency fund" is hardly the right term, but the principle is the same. Having more than one income stream provides more security due to diversification. Of course, a working man can go into debt as well, and a salary man can take on side jobs. The complete picture for many people will thus look more like this figure.

Then after a decade of trending stock markets, which moved up no matter what people owned, it was decided that the managers weren't needed and index funds came into fashion--why do you need a manager if markets go up all on their own? At that point nobody wanted to own gold. In the past 10 years the market has been in a trading range and now gold is more expensive than ever, so who knows what the future will bring? My suggestion is not to presume that one can pick an asset class and then stick with it forever. Despite this, there are a few established principles in the art of investing. Reward is often correlated with risk, where risk can either be quantified as volatility or qualified as uncertainty (lack of knowledge). This means that the higher the return rate, the higher the risk of loss of capital. Another principle, however, says that risk is more related to skill and knowledge.

 

pages: 430 words: 140,405

A Colossal Failure of Common Sense: The Inside Story of the Collapse of Lehman Brothers by Lawrence G. Mcdonald, Patrick Robinson

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asset-backed security, bank run, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, cuban missile crisis, diversification, fixed income, high net worth, hiring and firing, if you build it, they will come, London Interbank Offered Rate, Long Term Capital Management, margin call, moral hazard, mortgage debt, naked short selling, new economy, Ronald Reagan, short selling, sovereign wealth fund, value at risk

The task of the investment bank was to examine, investigate, and arrive at a yes or no that would not mislead their clients. I’d seen those beady-eyed analyst guys operate at close quarters, and I had enormous faith in them. With my courage high, I straightened up to sell these convertible bonds that had been given the green light from Merrill Lynch. I’d already noticed this type of bond was beginning to outperform on a risk-adjusted basis every other kind of asset class, even residential property and gold. I also sensed the coming high-tech revolution, and I had visions of being carried directly into Wall Street on a wave of flying electronic sparks, flickering screens, and cyberspace mysticism. I was not that far wrong, either. But first I needed to establish a business within the confines of Merrill Lynch in Hyannis. The work was not that difficult, and I cruised through the first few months, building a client list, selling the bonds, selling what equities I considered appropriate, and rekindling old friendships.

There was a brief silence before the chief administrative officer, David Goldfarb, stepped up to the plate on behalf of Lehman Brothers to reply to Guy’s question. It was not what you might describe as a perfectly straightforward answer. Indeed, David’s opening sentence was as close to unadulterated gibberish as anything I’ve ever heard: “You know, again, our mortgage platform in the U.S. as well as in Europe and Asia is predicated on a diversified set of products and a diversified set of regions, and with that diversification it has led to, you know, resiliency overall. As Chris [Chris O’Meara, the recently appointed CFO of Lehman] mentioned in his formal remarks, the overall securitization volume is slightly down; however, there was a slight mix shift this quarter, more going toward Europe; our small lending platform basically had a couple of large securitizations.” Note the words that mattered: “the overall securitization volume is slightly down.”

Again, Lehman was slicing them up and packaging them, getting them rated AAA, and selling the bonds to banks, hedge funds, and sovereign wealth funds all over the world. Instead of the vast army of struggling homeowners, this derivative, the CMBS, offered the backing of major corporations in the form of cash flow paid by rents to those who owned the buildings. And so far as Dick and Joe were concerned, this was perfect: a hedge against the residential real estate, a safe diversification. Except that in the current global asset bubble, no one was diversified, nothing was safe. They simply did not understand that Lehman was concentrated, that commercial real estate was equally as vulnerable as residential property. Just another top-of-the market illusion of solidarity. Christine Daley understood this, understood we were heading for trouble. And now she was leaving. The rest of us were caught in a trap, because Lehman had us in golden handcuffs.

 

pages: 471 words: 124,585

The Ascent of Money: A Financial History of the World by Niall Ferguson

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Admiral Zheng, Andrei Shleifer, Asian financial crisis, asset allocation, asset-backed security, Atahualpa, bank run, banking crisis, banks create money, Black Swan, Black-Scholes formula, Bonfire of the Vanities, Bretton Woods, BRICs, British Empire, capital asset pricing model, capital controls, Carmen Reinhart, Cass Sunstein, central bank independence, collateralized debt obligation, colonial exploitation, Corn Laws, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, currency peg, Daniel Kahneman / Amos Tversky, deglobalization, diversification, diversified portfolio, double entry bookkeeping, Edmond Halley, Edward Glaeser, Edward Lloyd's coffeehouse, financial innovation, financial intermediation, fixed income, floating exchange rates, Fractional reserve banking, Francisco Pizarro, full employment, German hyperinflation, Hernando de Soto, high net worth, hindsight bias, Home mortgage interest deduction, Hyman Minsky, income inequality, interest rate swap, Isaac Newton, iterative process, joint-stock company, joint-stock limited liability company, Joseph Schumpeter, Kenneth Rogoff, knowledge economy, labour mobility, London Interbank Offered Rate, Long Term Capital Management, market bubble, market fundamentalism, means of production, Mikhail Gorbachev, money: store of value / unit of account / medium of exchange, moral hazard, mortgage debt, mortgage tax deduction, Naomi Klein, Nick Leeson, Northern Rock, pension reform, price anchoring, price stability, principal–agent problem, probability theory / Blaise Pascal / Pierre de Fermat, profit motive, quantitative hedge fund, RAND corporation, random walk, rent control, rent-seeking, reserve currency, Richard Thaler, Robert Shiller, Robert Shiller, Ronald Reagan, savings glut, seigniorage, short selling, Silicon Valley, South Sea Bubble, sovereign wealth fund, spice trade, structural adjustment programs, technology bubble, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, Thomas Malthus, Thorstein Veblen, too big to fail, transaction costs, value at risk, Washington Consensus, Yom Kippur War

And people who wanted to take out a mortgage after the market move would find themselves paying at least 0.41 per cent a year (in market parlance, 41 basis points) more. In the words of Bill Gross, who runs the world’s largest bond fund at the Pacific Investment Management Company (PIMCO), ‘bond markets have power because they’re the fundamental base for all markets. The cost of credit, the interest rate [on a benchmark bond], ultimately determines the value of stocks, homes, all asset classes.’ From a politician’s point of view, the bond market is powerful partly because it passes a daily judgement on the credibility of every government’s fiscal and monetary policies. But its real power lies in its ability to punish a government with higher borrowing costs. Even an upward move of half a percentage point can hurt a government that is running a deficit, adding higher debt service to its already high expenditures.

Where once they were the preserve of ‘high net worth’ individuals and investment banks, hedge funds are now attracting growing numbers of pension funds and university endowments.102 This trend is all the more striking given that the attrition rate remains high; only a quarter of the 600 funds reporting in 1996 still existed at the end of 2004. In 2006, 717 ceased to trade; in the first nine months of 2007, 409.103 It is not widely recognized that large numbers of hedge funds simply fizzle out, having failed to meet investors’ expectations. The obvious explanation for this hedge fund population explosion is that they perform relatively well as an asset class, with relatively low volatility and low correlation to other investment vehicles. But the returns on hedge funds, according to Hedge Fund Research, have been falling, from 18 per cent in the 1990s to just 7.5 per cent between 2000 and 2006. Moreover, there is increasing scepticism that hedge fund returns truly reflect ‘alpha’ (skill of asset management) as opposed to ‘beta’ (general market movements that could be captured with an appropriate mix of indices).104 An alternative explanation is that, while they exist, hedge funds enrich their managers in a uniquely alluring way.

Chimerica To many, financial history is just so much water under the bridge - ancient history, like the history of imperial China. Markets have short memories. Many young traders today did not even experience the Asian crisis of 1997-8. Those who went into finance after 2000 lived through seven heady years. Stock markets the world over boomed. So did bond markets, commodity markets and derivatives markets. In fact, so did all asset classes - not to mention those that benefit when bonuses are big, from vintage Bordeaux to luxury yachts. But these boom years were also mystery years, when markets soared at a time of rising short-term interest rates, glaring trade imbalances and soaring political risk, particularly in the economically crucial, oil-exporting regions of the world. The key to this seeming paradox lay in China.108 Chongqing, on the undulating banks of the mighty earth-brown River Yangtze, is deep in the heart of the Middle Kingdom, over a thousand miles from the coastal enterprise zones most Westerners visit.

 

pages: 381 words: 101,559

Currency Wars: The Making of the Next Gobal Crisis by James Rickards

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Asian financial crisis, bank run, Benoit Mandelbrot, Berlin Wall, Big bang: deregulation of the City of London, Black Swan, borderless world, Bretton Woods, BRICs, British Empire, business climate, capital controls, Carmen Reinhart, Cass Sunstein, collateralized debt obligation, complexity theory, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, currency peg, Daniel Kahneman / Amos Tversky, Deng Xiaoping, diversification, diversified portfolio, Fall of the Berlin Wall, family office, financial innovation, floating exchange rates, full employment, game design, German hyperinflation, Gini coefficient, global rebalancing, global reserve currency, high net worth, income inequality, interest rate derivative, Kenneth Rogoff, labour mobility, laissez-faire capitalism, liquidity trap, Long Term Capital Management, mandelbrot fractal, margin call, market bubble, Mexican peso crisis / tequila crisis, money: store of value / unit of account / medium of exchange, Network effects, New Journalism, Nixon shock, offshore financial centre, oil shock, open economy, paradox of thrift, price mechanism, price stability, private sector deleveraging, quantitative easing, race to the bottom, RAND corporation, rent-seeking, reserve currency, Ronald Reagan, sovereign wealth fund, special drawing rights, special economic zone, The Myth of the Rational Market, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, Thomas Kuhn: the structure of scientific revolutions, time value of money, too big to fail, value at risk, War on Poverty, Washington Consensus

Therefore, to revive the economy, the Fed needs to change mass behavior, which inevitably involves the arts of deception, manipulation and propaganda. To increase velocity, the Fed must instill in the public either euphoria from the wealth effect or fear of inflation. The idea of the wealth effect is that consumers will spend more freely if they feel more prosperous. The favored route to a wealth effect is an increase in asset values. For this purpose, the Fed’s preferred asset classes are stock prices and home prices, because they are widely known and closely watched. After falling sharply from a peak in mid-2006, home prices stabilized during late 2009 and rose slightly in early 2010 due to the policy intervention of the first-time home buyer’s tax credit. By late 2010, that program was discontinued and home prices began to decline again. By early 2011, home prices nationwide had returned to the levels of mid-2003 and seemed headed for further declines.

Multiple Reserve Currencies A country’s reserves are something like an individual’s savings account. An individual can have current income from a job and have various forms of debt, yet still maintain some savings for future use or a rainy day. These savings can be invested in stocks and commodities or just left in the bank. A country has the same choices with its reserves. It can use a sovereign wealth fund to invest in stocks or other asset classes, or it can keep a portion in liquid instruments or gold. The liquid instruments can involve bonds denominated in a number of different currencies, each called a reserve currency, because countries use them to invest and diversify their reserves. Since Bretton Woods in 1944, the dollar has been by far the leading reserve currency; however, it has never been the sole reserve currency. The IMF maintains a global database showing the composition of official reserves, including U.S. dollars, euros, pounds sterling, yen and Swiss francs.

Each player could participate as much or as little as she liked while the entire stream-of-consciousness digital scroll was preserved for future evaluation by Pentagon planners. The China brief was predictably boring given the proclivities of the team and my failure to excite much interest in gold-backed currency. We meekly accepted the scripted Russia-Japan energy deal but made some comment about accelerating China’s efforts to increase energy diversification. Russia went next. The brief started with some happy talk about continuing to work with China on a joint venture pipeline, but then veered into the announcement about demanding gold-backed currency for future energy shipments. An official summary of the war game prepared much later referred to this move as “aggressive” and “threatening,” but the immediate response was more in keeping with the absurd style of Dr.

 

pages: 413 words: 117,782

What Happened to Goldman Sachs: An Insider's Story of Organizational Drift and Its Unintended Consequences by Steven G. Mandis

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algorithmic trading, Berlin Wall, bonus culture, BRICs, business process, collapse of Lehman Brothers, collateralized debt obligation, complexity theory, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, disintermediation, diversification, Emanuel Derman, financial innovation, fixed income, friendly fire, Goldman Sachs: Vampire Squid, high net worth, housing crisis, London Whale, Long Term Capital Management, merger arbitrage, new economy, passive investing, performance metric, risk tolerance, Ronald Reagan, Saturday Night Live, shareholder value, short selling, sovereign wealth fund, The Nature of the Firm, too big to fail, value at risk

While discussing Goldman’s success with me, a widely respected consultant, who has experience working with many firms, explained that Goldman is exceptionally good at looking at overall risk and firmwide risk and understanding the aggregate size of the risk and correlations across the firm. He believes that Goldman had so many different proprietary desks in so many different asset classes with so many different correlations that it benefits from a diversification effect. When the corporate credit or equities businesses are doing poorly, then foreign exchange or interest rate businesses may be doing well. No other bank had invested as much in sophisticated, computer-driven quantitative systems to reveal the signals. And several senior people had the expertise to read the signals, ask the right questions, and then react.5 Goldman was the only firm that had so many risk experts in the highest levels of management.

None of the three most senior executives sold shares, but about 160 former partners did, selling over $2 million on average, while eleven sold more than $20 million. No nonpartner employees were allowed to sell shares before the first vesting period, three years after the IPO. 2 I remember a partner sheepishly telling me he decided to sell the maximum he was allowed to in the special offering for “diversification reasons,” almost seeking or expecting some sort of understanding or reassurance that it was ok. At the time a group of my peers discussed that the partners who retired before the IPO did not have the “diversification” option and that the current employees did not have the option to sell after one year. And based on conversations with those more senior to me at the time, some of my peers were certainly not the only ones who were questioning the timing of the sales. One interviewee mentioned to me that it was eerily similar to the 1994 partners “bailing out.”

Goldman promotes the person responsible for business selection and conflict clearance to the management committee. No other firm has someone this senior serving in this kind of position. The SEC fines Goldman $40 million for allegedly trying to pump up the prices of IPOs. Goldman pays the fine without admitting or denying wrongdoing. Peter Weinberg, son of Jimmy Weinberg and nephew of John L. Weinberg, leaves Goldman and cofounds a competing firm the next year. In a push to pool knowledge across asset classes, Goldman merges its corporate bond and credit area with its equity counterparts (O). Goldman reportedly changes its compensation policy in sales and trading areas to be more quantitative and transparent (O, C). 2006: Invited, along with four other investment banks, to make a pitch to defend BAA against a possible take-over, Goldman proposes buying a chunk of BAA itself, in what sounds to BAA like another take-over bid.

 

pages: 422 words: 113,830

Bad Money: Reckless Finance, Failed Politics, and the Global Crisis of American Capitalism by Kevin Phillips

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algorithmic trading, asset-backed security, bank run, banking crisis, Bernie Madoff, Black Swan, Bretton Woods, BRICs, British Empire, collateralized debt obligation, computer age, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, currency peg, diversification, Doha Development Round, energy security, financial deregulation, financial innovation, fixed income, Francis Fukuyama: the end of history, George Gilder, housing crisis, Hyman Minsky, imperial preference, income inequality, index arbitrage, index fund, interest rate derivative, interest rate swap, Joseph Schumpeter, Kenneth Rogoff, large denomination, Long Term Capital Management, market bubble, Martin Wolf, Menlo Park, mobile money, Monroe Doctrine, moral hazard, mortgage debt, new economy, oil shale / tar sands, oil shock, peak oil, Plutocrats, plutocrats, Ponzi scheme, profit maximization, Renaissance Technologies, reserve currency, risk tolerance, risk/return, Robert Shiller, Robert Shiller, Ronald Reagan, shareholder value, short selling, sovereign wealth fund, The Chicago School, Thomas Malthus, too big to fail, trade route

Petersburg Stock Exchange. 65 In light of government signals that Russian companies should trade through the exchange, Western analysts assumed that Putin’s unspoken goal was to see 10 to 20 percent of world oil and gas trade—some of it in Europe—become ruble-denominated. In the meantime, observers disagreed on which tactics—diversification of central bank reserves, depegging from the dollar, or repricing oil to be paid for with a broader currency mix—held the biggest threat for the greenback or for the overall interests of the United States. Several experts partially exonerated central bank diversification sales, blaming “real money” managers (pension funds, insurance companies, and corporate treasurers) or funds. Mansoor Mohi-uddin, head of foreign-exchange strategy at UBS, suggested that the main threats “come not from central banks but real money or sovereign wealth funds fueled by very high oil prices selling the dollar aggressively.”66 Without some kind of currency magic, the fireworks were just beginning.

This connection helps to amplify a vital corollary, widely discussed during the late-summer credit panic debate. Yale economist Robert Shiller, fearful that in some parts of the United States home prices could fall by as much as 50 percent, emphasized the usual prominence of housing slumps leading into U.S. recessions.22 Merrill Lynch chief economist David Rosenberg, predicting a nationwide fall in housing prices of 15 or even 20 percent, explained a double underpinning. By 2007, a $23 trillion asset class was involved, and “there is nothing on the planet as big as that.” Moreover, he said, “there has never been a real estate deflation in this country that failed to end in a destabilizing recession.” 23 Martin Feldstein, president of the National Bureau of Economic Research, which declares and measures recessions in the United States, told the important August 31 conference sponsored by the Kansas City Federal Reserve Bank that the sort of collapse already visible in new home construction had been “ a precursor to eight of the past 10 recessions,” so that there was “a significant risk of a very serious downturn.”24 Speaking at the same conference, Professor Edward Leamer, of UCLA’s Anderson School of Management, set out his own theory, that the U.S. economy was guided not by a business cycle but by a consumer cycle particularly driven by housing.

By mid-2007, in turn, five of the ten markets projected by Moody’s Economy.com to undergo the largest peak-to-bottom home price declines were in California—Stockton, Modesto, Fresno, Oxnard-Ventura, and Sacramento.26 If anything, the earlier explosive growth shown in the figure hinted at the possibility of a decline of a related magnitude. FIGURE 4.4 The Tripling of California Home Prices, 1995-2006 Source: California Association of Realtors. But back in 2000-2001, as the NASDAQ stock market bubble was bursting, an appreciation of housing’s enormous national weight—besides being a $20 trillion asset class, it was also the principal wealth repository for most American families—may well have spurred a new strategy on the part of the Federal Reserve Board and the President’s Working Group on Financial Markets. Several specific motivations have been bandied about. First, the Working Group logically went into high gear to stimulate the U.S. economy after 9/11. Also, there was the belief, attributed to Greenspan in particular, that home-price inflation could be tapped to stimulate the larger national economy by homeowners who raised spendable dollars through refinancing.

 

pages: 225 words: 11,355

Financial Market Meltdown: Everything You Need to Know to Understand and Survive the Global Credit Crisis by Kevin Mellyn

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asset-backed security, bank run, banking crisis, Bernie Madoff, bonus culture, Bretton Woods, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, cuban missile crisis, disintermediation, diversification, fiat currency, financial deregulation, financial innovation, financial intermediation, fixed income, Francis Fukuyama: the end of history, global reserve currency, Home mortgage interest deduction, Isaac Newton, joint-stock company, liquidity trap, London Interbank Offered Rate, margin call, market clearing, moral hazard, mortgage tax deduction, Northern Rock, offshore financial centre, paradox of thrift, pattern recognition, pension reform, pets.com, Plutocrats, plutocrats, Ponzi scheme, profit maximization, pushing on a string, reserve currency, risk tolerance, risk-adjusted returns, road to serfdom, Ronald Reagan, shareholder value, Silicon Valley, South Sea Bubble, statistical model, The Great Moderation, the payments system, too big to fail, value at risk, very high income, War on Poverty, Y2K, yield curve

The problem is that really rich people often get that way by having all their eggs in one basket (think of Bill Gates) or a few big 51 52 FINANCIAL MARKET MELTDOWN holdings in which they have some clout over management (think Warren Buffett). So diversification may actually reduce your upside. In a real, full-bore market panic like the Fall of 2008, almost all stocks and classes of stock tank, so diversification offers little if any shelter. IRRATIONAL MARKETS Sometimes it’s better to be lucky than to be good. The stock market is not rational. You have probably seen data and charts produced by financial advisors showing that equities have outperformed bonds by a significant margin over the last century or more. From this, you might conclude they represent a fundamentally better ‘‘asset class’’ for growing your money. What you are not told is that over that period most of the total growth in the value of stock market took place on a handful of days.

But the bond could still be a lousy investment if your money could have grown more over 20 years if it were invested in something else. Bond Trading That is why the real profits in the bond markets (and the real losses) come from trading bonds. Bonds of all sorts, mostly issued by governments and their agencies, are by far the biggest pool of financial instruments in most national financial markets and in the world as a whole. In finance-speak, bonds are by far the biggest ‘‘asset class.’’ They are the epitome of a ‘‘contract in a box’’ because they are a simple, fixed-interest contract of debt. Only the name of the issuer, their rating, the tenor, the currency, and the coupon need to be specified for any bond issued in any country to find a market price. They are easy to trade precisely because the players in the bond market need so little specific information. 45 46 FINANCIAL MARKET MELTDOWN The motive behind all the trading in the bond market is simple.

 

pages: 466 words: 127,728

The Death of Money: The Coming Collapse of the International Monetary System by James Rickards

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Affordable Care Act / Obamacare, Asian financial crisis, asset allocation, Ayatollah Khomeini, bank run, banking crisis, Ben Bernanke: helicopter money, bitcoin, Black Swan, Bretton Woods, BRICs, business climate, capital controls, Carmen Reinhart, central bank independence, centre right, collateralized debt obligation, collective bargaining, complexity theory, computer age, credit crunch, currency peg, David Graeber, debt deflation, Deng Xiaoping, diversification, Edward Snowden, eurozone crisis, fiat currency, financial innovation, financial intermediation, financial repression, Flash crash, floating exchange rates, forward guidance, George Akerlof, global reserve currency, global supply chain, Growth in a Time of Debt, income inequality, inflation targeting, invisible hand, jitney, Kenneth Rogoff, labor-force participation, labour mobility, Lao Tzu, liquidationism / Banker’s doctrine / the Treasury view, liquidity trap, Long Term Capital Management, mandelbrot fractal, margin call, market bubble, market clearing, market design, money: store of value / unit of account / medium of exchange, mutually assured destruction, obamacare, offshore financial centre, oil shale / tar sands, open economy, Plutocrats, plutocrats, Ponzi scheme, price stability, quantitative easing, RAND corporation, reserve currency, risk-adjusted returns, Rod Stewart played at Stephen Schwarzman birthday party, Ronald Reagan, Satoshi Nakamoto, Silicon Valley, Silicon Valley startup, Skype, sovereign wealth fund, special drawing rights, Stuxnet, The Market for Lemons, Thomas Kuhn: the structure of scientific revolutions, Thomas L Friedman, too big to fail, trade route, uranium enrichment, Washington Consensus, working-age population, yield curve

If these data then guide the next dose of policy, the central banker has entered a wilderness of mirrors in which false signals induce policy, which induces more false signals and more policy manipulation and so on, in a feedback loop that diverges further from reality until it crashes against a steel wall of data that cannot easily be manipulated, such as real income and output. A case in point is the so-called wealth effect. The idea is straightforward. Two asset classes—stocks and housing—represent most of the wealth of the American people. The wealth represented by stocks is highly visible; Americans receive their 401(k) account statements monthly, and they can check particular stock prices in real time if they so choose. Housing prices are less transparent, but anecdotal evidence gathered from real estate listings and water-cooler chatter is sufficient for Americans to have a sense of their home values.

The low interest rates offered by the banks, a type of financial repression also practiced in the United States, make Chinese savers susceptible to higher-yielding investments. Foreign markets are mostly off-limits because of capital controls, and China’s own stock markets have proved highly volatile, performing poorly in recent years. China’s bond markets remain immature. Instead, Chinese savers have been attracted by two asset classes—real estate and structured products. The bubble in Chinese property markets, especially apartments and condos, is well known, but not every Chinese saver is positioned to participate in that market. For them, the banking system has devised trust structures and “wealth management products” (WMPs). A WMP is a pool or fund in which investors buy small units. The pool then takes the aggregate proceeds and invests in higher-yielding assets.

A rapid price rise from the $1,500-per-ounce level to the $2,500-per-ounce level will not be a bubble but rather a sign that a physical buying panic has commenced and that official shorting operations are not producing the desired dampening effect. Conversely, if gold moves to the $800-per-ounce level or lower, this is a good sign of severe deflation, potentially devastating to leveraged investors in all asset classes. Gold’s continued acquisition by central banks. Purchases by China in particular are a second sign of the dollar’s demise. The announcement by China in late 2014 or early 2015 that it has acquired over 4,000 tonnes of gold will be a landmark in this larger trend and a harbinger of inflation. IMF governance reforms. This third sign will mean larger voting power for China, and U.S. legislation to convert committed U.S. lines of credit into so-called quotas at the IMF.

 

pages: 497 words: 144,283

Connectography: Mapping the Future of Global Civilization by Parag Khanna

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1919 Motor Transport Corps convoy, 2013 Report for America's Infrastructure - American Society of Civil Engineers - 19 March 2013, 3D printing, 9 dash line, additive manufacturing, Admiral Zheng, affirmative action, agricultural Revolution, Airbnb, Albert Einstein, amateurs talk tactics, professionals talk logistics, Amazon Mechanical Turk, Asian financial crisis, asset allocation, autonomous vehicles, banking crisis, Basel III, Berlin Wall, bitcoin, Black Swan, blockchain, borderless world, Boycotts of Israel, Branko Milanovic, BRICs, British Empire, business intelligence, call centre, capital controls, charter city, clean water, cloud computing, collateralized debt obligation, complexity theory, corporate governance, corporate social responsibility, credit crunch, crony capitalism, crowdsourcing, cryptocurrency, cuban missile crisis, data is the new oil, David Ricardo: comparative advantage, deglobalization, deindustrialization, dematerialisation, Deng Xiaoping, Detroit bankruptcy, diversification, Doha Development Round, edge city, Edward Snowden, Elon Musk, energy security, ethereum blockchain, European colonialism, eurozone crisis, failed state, Fall of the Berlin Wall, family office, Ferguson, Missouri, financial innovation, financial repression, forward guidance, global supply chain, global value chain, global village, Google Earth, Hernando de Soto, high net worth, Hyperloop, ice-free Arctic, if you build it, they will come, illegal immigration, income inequality, income per capita, industrial robot, informal economy, Infrastructure as a Service, interest rate swap, Internet of things, Isaac Newton, Jane Jacobs, Jaron Lanier, John von Neumann, Julian Assange, Just-in-time delivery, Kevin Kelly, Khyber Pass, Kibera, Kickstarter, labour market flexibility, labour mobility, LNG terminal, low cost carrier, manufacturing employment, mass affluent, megacity, Mercator projection, microcredit, mittelstand, Monroe Doctrine, mutually assured destruction, New Economic Geography, new economy, New Urbanism, offshore financial centre, oil rush, oil shale / tar sands, oil shock, openstreetmap, out of africa, Panamax, Peace of Westphalia, peak oil, Peter Thiel, Plutocrats, plutocrats, post-oil, post-Panamax, private military company, purchasing power parity, QWERTY keyboard, race to the bottom, Rana Plaza, rent-seeking, reserve currency, Robert Gordon, Robert Shiller, Robert Shiller, Ronald Coase, Scramble for Africa, Second Machine Age, sharing economy, Shenzhen was a fishing village, Silicon Valley, Silicon Valley startup, six sigma, Skype, smart cities, Smart Cities: Big Data, Civic Hackers, and the Quest for a New Utopia, South China Sea, South Sea Bubble, sovereign wealth fund, special economic zone, spice trade, Stuxnet, supply-chain management, sustainable-tourism, TaskRabbit, telepresence, the built environment, Tim Cook: Apple, trade route, transaction costs, UNCLOS, uranium enrichment, urban planning, urban sprawl, WikiLeaks, young professional, zero day

The next growth wave will come from cost savings from low commodities prices and low interest rates enabling investment from continents of legacy infrastructure such as North America to regions seeking to harness their human masses such as Southeast Asia. Now is the time both to build markets and to connect them. Connectivity is the most important asset class of the twenty-first century. For investors looking to capitalize on cheap credit and to commit assets to the real economy rather than phony financial derivatives, there is nothing more concrete than infrastructure. Infrastructure is an asset class capable of generating higher returns than fixed income and less volatility than equities. Though it requires debt in the short term, there is no long-term growth without it. The benefits of investing in infrastructure are immeasurable, creating flow opportunities that enhance mobility, boost productivity, and spur social transformation.

The more all these players invest in each other and co-invest with each other, the harder it becomes to disentangle them. A new terminology is emerging to describe massive yet diffuse entities such as BlackRock, whose $4.5 trillion in assets come from a globally diversified base: They are now called “alternative asset management conglomerates” or “diversified financial institutions” that manage pools of permanent capital they can invest across any asset class such as government debt in emerging markets. They constantly scan markets for trophy real estate assets, underpriced equities, fee-generating infrastructure such as airports and toll roads, or technology start-ups. By making direct investments in foreign countries and establishing joint ventures, global asset managers become one with local partners, getting around investment restrictions to receive better treatment.

From the Chesapeake Bay to villages in Namibia and Finland, when societies abandon habitats they have polluted, resilient Mother Nature claims them back, gradually revitalizing their ecosystems. While the world rural population is in absolute decline, some Western countries are witnessing a mild amount of de-urbanization. In America, several thousand eco-conscious youth (including many college graduates) have returned to farming (not just marijuana), injecting life into otherwise defunct towns. Indeed, agriculture is one of the best performing asset classes in terms of both operational cash yields and asset appreciation. Japan’s elderly farmers have been joined by some urban youth as well, who bring essential new mechanization technologies to keep agricultural output strong as the world’s oldest country drifts into the sunset. A noble organic food movement has also demonstrated how natural planting of diverse crops at smaller scale can produce high-quality yields.

 

pages: 358 words: 106,729

Fault Lines: How Hidden Fractures Still Threaten the World Economy by Raghuram Rajan

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accounting loophole / creative accounting, Andrei Shleifer, Asian financial crisis, asset-backed security, bank run, barriers to entry, Bernie Madoff, Bretton Woods, business climate, Clayton Christensen, clean water, collapse of Lehman Brothers, collateralized debt obligation, colonial rule, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, currency manipulation / currency intervention, diversification, Edward Glaeser, financial innovation, floating exchange rates, full employment, global supply chain, Goldman Sachs: Vampire Squid, illegal immigration, implied volatility, income inequality, index fund, interest rate swap, Joseph Schumpeter, Kenneth Rogoff, knowledge worker, labor-force participation, Long Term Capital Management, market bubble, Martin Wolf, medical malpractice, microcredit, moral hazard, new economy, Northern Rock, offshore financial centre, open economy, price stability, profit motive, Real Time Gross Settlement, Richard Florida, Richard Thaler, risk tolerance, Robert Shiller, Robert Shiller, Ronald Reagan, school vouchers, short selling, sovereign wealth fund, The Great Moderation, the payments system, The Wealth of Nations by Adam Smith, too big to fail, upwardly mobile, Vanguard fund, women in the workforce, World Values Survey

Some smart traders in a number of banks understood and grew increasingly concerned by the risks that were being taken by the units creating and holding asset-backed securities. At Lehman, for example, fixed-income traders started selling these securities short, even while the real estate and mortgage unit loaded up on them.5 Clearly, any unit that is focused on creating and holding a certain kind of asset is naturally reluctant to declare an end to the boom it has ridden. The unit’s size, power, and reputation become too closely related to the asset class, and its head becomes an interested booster. For Lehman’s mortgage unit to declare an end to the mortgage boom would have been to sign its own death warrant. But knowing that those close to the action may become unreliable in assessing the associated risks, a firm’s risk managers should step in to curtail further investment. In many firms they did not, and it is important to understand why. Risk managers should adjust every unit’s returns down for the risk it takes, reducing perverse incentives to take risk.

The German dentist would not be able to lend directly, because she would incur extremely high costs in investigating the Vegas borrower’s creditworthiness, making the loan conform to all local legal requirements, collecting payments, and intervening in case of default. Moreover, any individual subprime homebuyer would have a high propensity to default, certainly higher than the level of risk with which a conservative private investor would be comfortable. This is where the sophisticated U.S. financial sector stepped in. Securitization dealt with many of these concerns. If the mortgage was packaged together with mortgages from other areas, diversification would reduce the risk. Furthermore, the riskiest claims against the package could be sold to those who had the capacity to evaluate them and had an appetite for the risk, while the safest, AAA-rated portions could be sold directly to the foreign dentist or her bank. The U.S. financial sector thus bridged the gap between an overconsuming and overstimulated United States and an underconsuming, understimulated rest of the world.

Suppose further that the investment bank structuring the deal issues two securities against the package—a junior security with face value of $1 that bears the brunt of losses until they exceed $1, and a senior security that bears losses after that. The senior security suffers losses only if both mortgages default. If mortgage defaults occur independently (that is, they are uncorrelated), then the senior security defaults only 1 percent of the time. This is the magic of combining diversification with tranching the liabilities—that is, creating securities of different seniority. Put a sufficient number of subprime mortgages together from different parts of the country and from different originators, issue different tranches of securities against them, and it is indeed possible to convert a substantial quantity of the subprime frogs into AAA-rated princes, provided the correlation between mortgage defaults is low.

 

pages: 355 words: 92,571

Capitalism: Money, Morals and Markets by John Plender

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Andrei Shleifer, asset-backed security, bank run, Berlin Wall, Big bang: deregulation of the City of London, Black Swan, bonus culture, Bretton Woods, business climate, Capital in the Twenty-First Century by Thomas Piketty, central bank independence, collapse of Lehman Brothers, collective bargaining, computer age, Corn Laws, corporate governance, credit crunch, Credit Default Swap, David Ricardo: comparative advantage, deindustrialization, Deng Xiaoping, discovery of the americas, diversification, Eugene Fama: efficient market hypothesis, eurozone crisis, failed state, Fall of the Berlin Wall, fiat currency, financial innovation, financial intermediation, Fractional reserve banking, full employment, Gordon Gekko, greed is good, Hyman Minsky, income inequality, inflation targeting, invention of the wheel, invisible hand, Isaac Newton, James Watt: steam engine, Johann Wolfgang von Goethe, John Maynard Keynes: Economic Possibilities for our Grandchildren, joint-stock company, Joseph Schumpeter, labour market flexibility, London Interbank Offered Rate, London Whale, Long Term Capital Management, manufacturing employment, Mark Zuckerberg, market bubble, market fundamentalism, means of production, Menlo Park, moral hazard, moveable type in China, Nick Leeson, Northern Rock, Occupy movement, offshore financial centre, paradox of thrift, Plutocrats, plutocrats, price stability, principal–agent problem, profit motive, quantitative easing, railway mania, regulatory arbitrage, Richard Thaler, rising living standards, risk-adjusted returns, Robert Gordon, Robert Shiller, Robert Shiller, Ronald Reagan, savings glut, shareholder value, short selling, Silicon Valley, South Sea Bubble, spice trade, Steve Jobs, technology bubble, The Chicago School, The Great Moderation, the map is not the territory, The Wealth of Nations by Adam Smith, Thorstein Veblen, time value of money, too big to fail, tulip mania, Upton Sinclair, We are the 99%, Wolfgang Streeck

Easy money, the growing demand for food in emerging markets such as China and India, instability in oil-producing countries in the Middle East, extreme weather conditions and subsidies for ethanol may have been more powerful influences on prices than speculation when President Sarkozy was sounding off. That said, there is a growing body of evidence that financial speculation is causing extreme price movements as investment banks and pension funds treat commodities as a specific asset class that supposedly offers the benefits of diversification. These movements may also be exacerbated by the activities of high-frequency traders, who use computerised algorithms to analyse market data and trade frenetically in milliseconds or even microseconds. There is also an arguable case against short selling in banking when confidence is fragile, because a collapsing share price may encourage a run on the deposits of a solvent bank, thereby precipitating its collapse.

This contributes to inequality both inside companies and in society at large, leading to the kinds of discontent and alienation expressed by the Occupy movement across America in 2011 and 2012, along with similar protests around the world. It is possible to put a case that manufacturing can shrink too far if international specialisation causes economies to suffer from a lack of diversity. That was the case with Britain, which was seriously under-diversified when the credit crunch struck in 2007. Back then, it derived more than 9 per cent of GDP from financial services. Yet it is also possible to suffer from a lack of diversification by dint of excessive exposure to manufacturing, as was the case with Germany at the same time. The Germans’ over-reliance on exports to drive economic growth meant that the collapse in world trade after the bankruptcy of Lehman Brothers in 2008 resulted in a greater percentage loss of output than in the US, which was the epicentre of the financial crisis. Despite these caveats, the conclusion has to be that the decline in manufacturing in so many Western countries is not a catastrophe.

Wilson) 1, 2 Alberti, Leon Battista 1 Alessandri, Piergiorgio 1 Allen, Maurice 1 Ambassadors, The (Henry James) 1 Americans for Tax Reform 1 Anatomy of Change-Alley (Daniel Defoe) 1 Angell, Norman 1 Anglosphere 1, 2 Arab Spring 1 Aramaic 1 arbitrage 1 Argentina 1 Aristotle 1, 2, 3, 4, 5, 6, 7, 8, 9 art 1 Asian Tiger economies 1 Atlas Shrugged (Ayn Rand) 1 Austen, Jane 1 Austrian school 1 aviation 1 Babbitt (Sinclair Lewis) 1 Bair, Sheila 1 Balloon Dog (Orange) (sculpture) 1 Balzac 1 Bank for International Settlements 1, 2, 3, 4, 5, 6 Bank of England 1, 2, 3, 4, 5 bank runs 1 bankers 1, 2 bankruptcy laws 1, 2 Banks, Joseph 1 Banksy 1 Barbon, Nicholas 1, 2, 3 Bardi family 1 Barings 1 Baruch, Bernard 1, 2 base metal, transmutation into gold 1 Basel regulatory regime 1, 2, 3 Baudelaire, Charles 1 Baum, Frank 1 behavioural finance 1 Belgium 1, 2 Bell, Alexander Graham 1 Benjamin, Walter 1 Bernanke, Ben 1, 2, 3 Bi Sheng 1 Bible 1 bimetallism 1 Bismarck, Otto von 1 Black Monday (1987) 1 black swans 1 Blake William 1, 2, 3 Bloch, Marcel 1 Bloomsbury group 1, 2 Boccaccio 1 bond market 1 bonus culture 1 Bootle, Roger 1 Boston Tea Party 1 Boswell, James 1 Boulton, Matthew 1 Bowra, Maurice 1 Brandeis, Louis 1 Bretton Woods conference 1 British Land (property company) 1 British Rail pension fund 1 Brookhart, Smith 1, 2 Brunner, Karl 1 Bryan, William Jennings 1 Bubble Act (Britain 1720) 1 bubbles 1, 2, 3 Buchanan, James 1 Buffett, Warren 1, 2, 3 Buiter, Willem 1 Burdett, Francis 1 van Buren, Martin 1 Burke, Edmund 1, 2 Burns, Robert 1 Bush, George W. 1, 2 Butler, Samuel 1 Candide (Voltaire) 1 Carlyle, Thomas 1, 2, 3 Carnegie, Andrew 1 Carville, James 1 cash nexus 1 Cash Nexus, The (Niall Ferguson) 1 Cassel, Ernest 1, 2 Catholic Church 1, 2, 3 Cecchetti, Stephen 1 Centre for the Study of Capital Market Dysfunctionality, (London School of Economics) 1 central bankers 1 Cervantes 1 Chamberlain, Joseph 1 Chancellor, Edward 1 Chapter 11 bankruptcy 1 Charles I of England 1, 2 Charles II of England 1 Chaucer 1 Cheney, Dick 1 Chernow, Ron 1 Chicago school 1, 2 Child & Co. 1 China 1, 2 American dependence on 1, 2 industrialisation 1, 2, 3 manufacturing 1 paper currency 1 Christianity 1, 2, 3, 4, 5 Churchill, Winston 1 Cicero 1, 2 Citizens United case 1 Cleveland, Grover 1 Clyde, Lord (British judge) 1 Cobden, Richard 1, 2, 3, 4 Coggan, Philip 1 Cohen, Steven 1 Colbert, Jean-Baptiste 1, 2 Cold War 1 Columbus, Christopher 1 commodity futures 1 Companies Act (Britain 1862) 1 Condition of the Working Class in England (Engels) 1 Confucianism 1, 2, 3 conquistadores 1 Constitution of Liberty, The (Friedrich Hayek) 1 Coolidge, Calvin 1, 2, 3 Cooper, Robert 1 copyright 1 Cort, Cornelis 1 Cosimo the Elder 1 crash of 1907 1 crash of 1929 1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11 creative destruction 1, 2 credit crunch (2007) 1, 2, 3 cum privilegio 1 Cyprus 1, 2 Dale, Richard 1, 2 Dante 1 Darwin, Erasmus 1 Das Kapital (Karl Marx) 1 Dassault, Marcel 1 Daunton, Martin 1 Davenant, Charles 1, 2, 3 Davies, Howard 1 debt 1 debt slavery 1 Decameron (Boccaccio) 1 Defoe, Daniel 1, 2, 3, 4, 5, 6, 7, 8 Dell, Michael 1 Deng Xiaoping 1, 2 derivatives 1 Deserted Village, The (Oliver Goldsmith) 1, 2, 3 Devil Take the Hindmost (Edward Chancellor) 1 Dickens, Charles 1, 2, 3, 4, 5, 6, 7, 8, 9 portentously named companies 1 Die Juden und das Wirtschaftsleben (Werner Sombart) 1 A Discourse of Trade (Nicholas Barbon) 1 Ding Gang 1 direct taxes 1, 2 Discorsi (Machiavelli) 1 diversification 1 Dodd–Frank Act (US 2010) 1, 2, 3 ‘dog and frisbee’ speech 1 dot.com bubble 1, 2, 3, 4 Drayton, Harley 1 Dumas, Charles 1, 2 Dürer, Albrecht 1 Duret, Théodore 1, 2 Dutch East India Company 1 Duttweiler, Gottlieb 1 Dye, Tony 1 East of Eden (film version) 1 Economic Consequences of the Peace (Keynes) 1, 2 Edison, Thomas 1, 2 efficient market hypothesis 1 electricity 1 Eliot, T.

 

pages: 435 words: 127,403

Panderer to Power by Frederick Sheehan

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Asian financial crisis, asset-backed security, bank run, banking crisis, Bretton Woods, British Empire, call centre, central bank independence, collateralized debt obligation, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, deindustrialization, diversification, financial deregulation, financial innovation, full employment, inflation targeting, interest rate swap, inventory management, Isaac Newton, Long Term Capital Management, margin call, market bubble, McMansion, Menlo Park, mortgage debt, new economy, Northern Rock, oil shock, place-making, Ponzi scheme, price stability, reserve currency, rising living standards, rolodex, Ronald Reagan, Sand Hill Road, savings glut, shareholder value, Silicon Valley, Silicon Valley startup, South Sea Bubble, supply-chain management, supply-chain management software, The Great Moderation, too big to fail, transaction costs, trickle-down economics, VA Linux, Y2K, Yom Kippur War

That’ll Be $250,000 . . .”New York Post, February 9, 2006. 301 criticism: “I was beginning to feel quite comfortable that I was fully back to the anonymity I was seeking.”4 He was also well paid for his private advice. Deutsche Bank, Pimco, the worlds largest bond manager, and John Paulson, a hedge fund manager who profited magnificantly from the real estate crash, all hired Greenspan as an advisor. THE PEAK All asset classes were inflating. This worldwide credit bubble developed after the stock market crash in 2000. Now, stock markets around the world, and also bonds, commodities, and art (of all periods), were rising.5 As markets rose and credit spreads shrank, there seemed to be one explanation: liquidity. This is a word with several meanings. Probably most timely was that practically anything was tradeable. Houses and dining-room sets were securitized, as were trees and art.

Houses and dining-room sets were securitized, as were trees and art. Of course, there had to be a willing buyer and there was no shortage of purchasers for the most dubious of assets. (Home-equity loans was bundled and sold. They were backed by rising house prices. Thus, the word liquidity: assets flowed like a river after a monsoon. In 2005, U.S. house prices stalled. In 2006, prices fell. “Illiquidity” followed. Many of the other asset classes (if not all the others) were supported by the higher level of collateral and credit that spilled back from elevating house prices. When house prices peaked, so did the collateral. But credit kept rising. Banks and brokerages borrowed to lend. By 2007, brokerage firms were leveraged at 30:1 and 40:1. (At 40:1 leverage, the firm becomes insolvent if the prices of its assets fall more than 2.5 percent.)

greenspan’s history lesson In his 1966 essay “Gold and Economic Freedom,” Greenspan dramatized (maybe overdramatized) an earlier period when the Federal Reserve paid little attention to asset prices: “When business in the United States underwent a mild contraction in 1927, the Federal Reserve created [excessive] paper reserves.… The excess credit which the Fed pumped into the economy spilled over into the stock market—triggering a fantastic speculative boom.… As a result, the American economy collapsed.… The world economies plunged into the Great Depression of the 1930’s.” Money pouring into speculation in the 1920s went not only into the stock market, it also went into an asset class that probably received more speculative funds than the stock market: real estate. Speculative real estate lending then bore a sickening resemblance to the present. But by the late 1920s, New York banks lent to commercial builders long after they should have stopped. The city’s office space rose 92 percent in the last half of the 1920s and by another 56 percent after the stock market crash.13 One notable growth story was the Bank of United States.

 

pages: 566 words: 155,428

After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead by Alan S. Blinder

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Affordable Care Act / Obamacare, asset-backed security, bank run, banking crisis, banks create money, Carmen Reinhart, central bank independence, collapse of Lehman Brothers, collateralized debt obligation, conceptual framework, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, Detroit bankruptcy, diversification, double entry bookkeeping, eurozone crisis, facts on the ground, financial innovation, fixed income, friendly fire, full employment, hiring and firing, housing crisis, Hyman Minsky, illegal immigration, inflation targeting, interest rate swap, Isaac Newton, Kenneth Rogoff, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, market bubble, market clearing, market fundamentalism, McMansion, moral hazard, naked short selling, new economy, Nick Leeson, Northern Rock, Occupy movement, offshore financial centre, price mechanism, quantitative easing, Ralph Waldo Emerson, Robert Shiller, Robert Shiller, Ronald Reagan, shareholder value, short selling, South Sea Bubble, statistical model, the payments system, time value of money, too big to fail, working-age population, yield curve, Yogi Berra

Unfortunately, when the house-price bubble burst, neither type of diversification worked as advertised. Why not? First, when the national housing bubble burst, home prices actually did fall almost everywhere—an “impossible” event that had not occurred since the Great Depression. In fairness, few observers anticipated this virtually unprecedented collapse. (True confession: I was not one of them.) For decades, Americans had witnessed periodic housing bubbles, which blew up and popped in particular parts of the country. But when home prices fell in, say, Boston, they kept rising in, say, Los Angeles—and vice versa. The period after 2006 was different. House prices fell all over the map, undermining the trumpeted gains from geographical diversification. That was a forgivable error. The proverbial hundred-year flood actually happened.

First, the mortgage twins were allowed to operate with extremely high leverage and under a pretty light regulatory regime. At the end of 2007, as the housing crash was gathering steam, Fannie and Freddie were leveraged about 75 to 1. Yes, that meant that a mere 1.4 percent loss on their assets would have left both of them insolvent. Second, by charter, Fannie and Freddie were not allowed to diversify into other asset classes. Mortgages, mortgage guarantees, and mortgage-related securities constituted roughly 100 percent of their earning assets. In some sense, these three were the same assets in different guises. Thus, in words that no one ever used, Fannie and Freddie were actually designed to fail if the proverbial 100-year flood ever swallowed up the housing market. When it did so after 2006, Fannie and Freddie were doomed.

One “bad apple” can make the whole group guilty until proven innocent, with unsettling results on financial markets and, much more important, on economies. Some aspects of financial contagion are rational. If a bank fails, that may leave its counterparties holding the (empty) bag—as happened with Lehman Brothers and was feared in the cases of Bear Stearns and AIG. If the prices of a certain asset class (e.g., houses, stocks, or subprime mortgages) plummet, the resulting capital losses may imperil a large number of institutions. Those linkages are obvious. Other bases for rational contagion are less so. For example, in 2008 a number of big Wall Street firms operated with the same business model as Bear Stearns’: combining high leverage with heavy reliance on very short-term debt. When the model failed for Bear, that called into question the safety of Lehman Brothers, Merrill Lynch, Goldman Sachs, and Morgan Stanley.

 

pages: 935 words: 267,358

Capital in the Twenty-First Century by Thomas Piketty

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accounting loophole / creative accounting, Asian financial crisis, banking crisis, banks create money, Berlin Wall, Branko Milanovic, British Empire, capital controls, Capital in the Twenty-First Century by Thomas Piketty, carbon footprint, central bank independence, collapse of Lehman Brothers, conceptual framework, corporate governance, correlation coefficient, David Ricardo: comparative advantage, demographic transition, distributed generation, diversification, diversified portfolio, European colonialism, eurozone crisis, Fall of the Berlin Wall, financial intermediation, full employment, German hyperinflation, Gini coefficient, high net worth, Honoré de Balzac, immigration reform, income inequality, income per capita, index card, inflation targeting, informal economy, invention of the steam engine, invisible hand, joint-stock company, Joseph Schumpeter, market bubble, means of production, mortgage debt, mortgage tax deduction, new economy, New Urbanism, offshore financial centre, open economy, pension reform, purchasing power parity, race to the bottom, randomized controlled trial, refrigerator car, regulatory arbitrage, rent control, rent-seeking, Robert Gordon, Ronald Reagan, Simon Kuznets, sovereign wealth fund, Steve Jobs, The Nature of the Firm, the payments system, The Wealth of Nations by Adam Smith, Thomas Malthus, Thorstein Veblen, trade liberalization, very high income, We are the 99%

Furthermore, property taxes in some countries (such as the United States) rely on fairly sophisticated assessment procedures with automatic adjustment to changing market values, procedures that ought to be generalized and extended to other asset classes. In some European countries (including France, Switzerland, Spain, and until recently Germany and Sweden), there are also progressive taxes on total wealth. Superficially, these taxes are closer in spirit to the ideal capital tax I am proposing. In practice, however, they are often riddled with exemptions. Many asset classes are left out, while others are assessed at arbitrary values having nothing to do with their market value. That is why several countries have moved to eliminate such taxes. it is important to heed the lessons of these various experiences in order to design an appropriate capital tax for the century ahead.

When comparing very different societies and periods, we must avoid trying to sum everything up with a single figure, for example “the standard of living in society A is ten times higher than in society B.” When growth attains levels such as these, the notion of per capita output is far more abstract than that of population, which at least corresponds to a tangible reality (it is much easier to count people than to count goods and services). Economic development begins with the diversification of ways of life and types of goods and services produced and consumed. It is thus a multidimensional process whose very nature makes it impossible to sum up properly with a single monetary index. Take the wealthy countries as an example. In Western Europe, North America, and Japan, average per capita income increased from barely 100 euros per month in 1700 to more than 2,500 euros per month in 2012, a more than twentyfold increase.10 The increase in productivity, or output per hour worked, was even greater, because each person’s average working time decreased dramatically: as the developed countries grew wealthier, they decided to work less in order to allow for more free time (the work day grew shorter, vacations grew longer, and so on).11 Much of this spectacular growth occurred in the twentieth century.

Over a period of thirty to sixty years, there are significant differences between a growth rate of 0.1 percent per year (3 percent per generation), 1 percent per year (35 percent per generation), or 3 percent per year (143 percent per generation). It is only when growth statistics are compiled over very long periods leading to multiplications by huge factors that the numbers lose a part of their significance and become relatively abstract and arbitrary quantities. Growth: A Diversification of Lifestyles To conclude this discussion, consider the case of services, where diversity is probably the most extreme. In theory, things are fairly clear: productivity growth in the service sector has been less rapid, so that purchasing power expressed in terms of services has increased much less. As a typical case—a “pure” service benefiting from no major technological innovation over the centuries—one often takes the example of barbers: a haircut takes just as long now as it did a century ago, so that the price of a haircut has increased by the same factor as the barber’s pay, which has itself progressed at the same rate as the average wage and average income (to a first approximation).

 

pages: 669 words: 210,153

Tools of Titans: The Tactics, Routines, and Habits of Billionaires, Icons, and World-Class Performers by Timothy Ferriss

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Airbnb, artificial general intelligence, asset allocation, Atul Gawande, augmented reality, back-to-the-land, Bernie Madoff, Bertrand Russell: In Praise of Idleness, Black Swan, blue-collar work, Buckminster Fuller, business process, Cal Newport, call centre, Checklist Manifesto, cognitive bias, cognitive dissonance, Colonization of Mars, Columbine, correlation does not imply causation, David Brooks, David Graeber, diversification, diversified portfolio, Donald Trump, effective altruism, Elon Musk, fault tolerance, fear of failure, Firefox, follow your passion, future of work, Google X / Alphabet X, Howard Zinn, Hugh Fearnley-Whittingstall, Jeff Bezos, job satisfaction, Johann Wolfgang von Goethe, Kevin Kelly, Kickstarter, Lao Tzu, life extension, Mahatma Gandhi, Mark Zuckerberg, Mason jar, Menlo Park, Mikhail Gorbachev, Nicholas Carr, optical character recognition, PageRank, passive income, pattern recognition, Paul Graham, Peter H. Diamandis: Planetary Resources, Peter Singer: altruism, Peter Thiel, phenotype, post scarcity, premature optimization, QWERTY keyboard, Ralph Waldo Emerson, Ray Kurzweil, recommendation engine, rent-seeking, Richard Feynman, Richard Feynman, risk tolerance, Ronald Reagan, sharing economy, side project, Silicon Valley, skunkworks, Skype, Snapchat, social graph, software as a service, software is eating the world, stem cell, Stephen Hawking, Steve Jobs, Stewart Brand, superintelligent machines, Tesla Model S, The Wisdom of Crowds, Thomas L Friedman, Wall-E, Washington Consensus, Whole Earth Catalog, Y Combinator

As legendary hedge fund manager Ray Dalio told Tony Robbins (page 210): “It’s almost certain that whatever you’re going to put your money in, there will come a day when you will lose 50% to 70%.” It pays to remember that if you lose 50%, you need a subsequent 100% return to get back to where you started. That math is tough. So, how to de-risk your portfolio? Many investors “rebalance” across asset classes to maintain certain ratios (e.g., X% in bonds, Y% in stocks, Z% in commodities, etc.). If one asset class jumps, they liquidate a part of it and buy more of lower performing classes. There are pros and cons to this, but it’s common practice. From 2007 to 2009, during the Real-World MBA that taught me to angel invest (page 250), less than 15% of my liquid assets were in startups. But most startups are illiquid. I commonly can’t sell shares until 7 to 12 years after I invest, at least for my big winners to date.

This bodily reaction—an involuntary half-chuckle, a rush of adrenaline, a surge of endorphins, a sharp change of emotions, etc.—can act as a metal detector for good material. It takes practice, but it works. On Diversification for Stress Management The below came from me asking, “What advice would you give your 30-year-old self?”: “My 30-year-old self wouldn’t have access to medical marijuana, so I’d have a limited canvas with which to paint. I’ve always made it a top priority since I was a teenager—and had tons of stress-related medical problems—to make that job one: to learn how to not have stress. I would consider myself a world champion at avoiding stress at this point in dozens of different ways. A lot of it is just how you look at the world, but most of it is really the process of diversification. I’m not going to worry about losing one friend if I have a hundred, but if I have two friends I’m really going to be worried.

They all agree asset allocation is the single most important investment decision.” In Money: Master the Game, Ray Dalio elaborated for Tony: “When people think they’ve got a balanced portfolio, stocks are three times more volatile than bonds. So when you’re 50/50, you’re really 90/10. You really are massively at risk, and that’s why when the markets go down, you get eaten alive. . . . Whatever asset class you invest in, I promise you, in your lifetime, it will drop no less than 50% and more likely 70% at some point. That is why you absolutely must diversify.” Contribution: “And the last one that I found: almost all of them were real givers, not just givers on the surface . . . but really passionate about giving. . . . It was really real.” TF: One great example is the Robin Hood Foundation, conceived of by Paul Tudor Jones, which fights poverty in New York City

 

pages: 586 words: 159,901

Wall Street: How It Works And for Whom by Doug Henwood

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accounting loophole / creative accounting, affirmative action, Andrei Shleifer, asset allocation, asset-backed security, bank run, banking crisis, barriers to entry, borderless world, Bretton Woods, British Empire, capital asset pricing model, capital controls, central bank independence, corporate governance, correlation coefficient, correlation does not imply causation, credit crunch, currency manipulation / currency intervention, David Ricardo: comparative advantage, debt deflation, declining real wages, deindustrialization, dematerialisation, diversification, diversified portfolio, Donald Trump, equity premium, Eugene Fama: efficient market hypothesis, experimental subject, facts on the ground, financial deregulation, financial innovation, Financial Instability Hypothesis, floating exchange rates, full employment, George Akerlof, George Gilder, hiring and firing, Hyman Minsky, implied volatility, index arbitrage, index fund, interest rate swap, Internet Archive, invisible hand, Isaac Newton, joint-stock company, Joseph Schumpeter, kremlinology, labor-force participation, late capitalism, law of one price, liquidationism / Banker’s doctrine / the Treasury view, London Interbank Offered Rate, Louis Bachelier, market bubble, Mexican peso crisis / tequila crisis, microcredit, minimum wage unemployment, moral hazard, mortgage debt, mortgage tax deduction, oil shock, payday loans, pension reform, Plutocrats, plutocrats, price mechanism, price stability, prisoner's dilemma, profit maximization, Ralph Nader, random walk, reserve currency, Richard Thaler, risk tolerance, Robert Gordon, Robert Shiller, Robert Shiller, shareholder value, short selling, Slavoj Žižek, South Sea Bubble, The Market for Lemons, The Nature of the Firm, The Predators' Ball, The Wealth of Nations by Adam Smith, transaction costs, transcontinental railway, women in the workforce, yield curve, zero-coupon bond

It used to be that the buying and selling of foreign exchange (a/k/a forex or FX) was an intermediate process, a step between, say, liquidating a U.S. Treasury bond and buying shares of Matsushita in its place, or between a multinational corporation's taking its profits in German marks and shipping them back to headquarters in London. Now, however, hedge funds, pension funds, and other institutional investors have increasingly been treating foreign exchange as an asset class in itself, separate from any underlying stock or bond (Bank for International Settlements 1993, p. 7). That means that trading in money itself, rather than monetary claims on underlying real assets, is now one of the most fashionable strategies available to big-time plungers. Trade in foreign currencies is ancient — and not only in coins and bills, but in financial exotica. As Marcello de Cecco (1992a) noted, Aristote- WALL STREET lian," Christian, and Islamic restrictions on usury prompted clever forex transactions, so priced and structured as to allow the furtive bearing of interest.

The less restricted have an array of choices to make: financial assets vs. real commodities, domestic vs. foreign assets, if foreign then Latin American vs. African, stocks vs. bonds, various kinds of stocks (by industrial sector, by size of underlying company, by various financial measures like price/earnings ratios) or bonds (government vs. corporate, high-quality corporate vs. low-, long-term vs. short-), and so on. Over the very long term stocks greatly outperform any other asset class, but most people don't care about the long term; they want to be in today's hot sector, the day after tomorrow be damned. While stocks do outperform over the very long term, it's not really clear why; their performance can't be explained by most conventional financial models (Mehra and Prescott 1985; Siegel 1992). This is known as the equity premium puzzle in the trade. Many ingenious attempts have been made to solve the puzzle — like "nonaddictive habit formation" (Shrikhande 1996), whatever that means — but none have done so definitively.

Instead, the game is to play the cycle and the microcycle. Wall Street apologists might point to attempts to ride emerging long-term trends — biotech, the Internet — with both great risk and promise, but the Street is often wrong about these things; they're far more passions of the moment than ENSEMBLE they are serious, detached prognostications. Talk of structural transformations is often just part of the sales rhetoric, a way to hawk a fresh asset class or defend a favored old one. Few people pay as much attention to the business cycle as Wall Streeters — understandable, given the chart patterns around cyclical turning points. But understanding the cycle isn't enough; it's also tempting to catch deviations from the cycle — "growth recesssions," "soft landings," and the like. Great effort goes into predicting important numbers; meaningless factoids like "in four of the last five Aprils, employment came in under the consensus" circulate, assertions that are often wrong, but are nonetheless believed and solemnly repeated.

 

pages: 402 words: 110,972

Nerds on Wall Street: Math, Machines and Wired Markets by David J. Leinweber

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AI winter, algorithmic trading, asset allocation, banking crisis, barriers to entry, Big bang: deregulation of the City of London, butterfly effect, buttonwood tree, buy low sell high, capital asset pricing model, citizen journalism, collateralized debt obligation, corporate governance, Craig Reynolds: boids flock, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Danny Hillis, demand response, disintermediation, distributed generation, diversification, diversified portfolio, Emanuel Derman, en.wikipedia.org, experimental economics, financial innovation, Gordon Gekko, implied volatility, index arbitrage, index fund, information retrieval, Internet Archive, John Nash: game theory, Khan Academy, load shedding, Long Term Capital Management, Machine translation of "The spirit is willing, but the flesh is weak." to Russian and back, market fragmentation, market microstructure, Mars Rover, moral hazard, mutually assured destruction, natural language processing, Network effects, optical character recognition, paper trading, passive investing, pez dispenser, phenotype, prediction markets, quantitative hedge fund, quantitative trading / quantitative finance, QWERTY keyboard, RAND corporation, random walk, Ray Kurzweil, Renaissance Technologies, Richard Stallman, risk tolerance, risk-adjusted returns, risk/return, Ronald Reagan, semantic web, Sharpe ratio, short selling, Silicon Valley, Small Order Execution System, smart grid, smart meter, social web, South Sea Bubble, statistical arbitrage, statistical model, Steve Jobs, Steven Levy, Tacoma Narrows Bridge, the scientific method, The Wisdom of Crowds, time value of money, too big to fail, transaction costs, Turing machine, Upton Sinclair, value at risk, Vernor Vinge, yield curve, Yogi Berra

Structural Ideas for the Economic Rescue 309 A Capital Market for Home Equity Fractional Interest Securities The HEFI security represents a passive investor interest in a home— just as a share of stock represents a passive investment in a company. Institutional investors such as pension and endowment funds would be interested in HEFIs to achieve diversification beyond stocks and bonds. The single-family, owner-occupied (SFOO) equity asset class is as large as the entire U.S. stock market, around $10 trillion. To be properly diversified, institutional investors should hold about as much in the SFOO equity asset class as they do in stocks. Institutional investors acknowledge interest in these assets. Right now there is no practical way for institutional investors to invest in SFOO equity; HEFIs and a HEFI trading market would change this unhappy situation by creating a practical way for them to take part in this market.

In 1992, I had joined First Quadrant, an institutional investment management firm3 that applied quantitative forecasting techniques to a variety of investment strategies. Figure 8.3 revisits the idea of maximizing predictability introduced in Chapter 5 and is a high-level perspective on maximizing predictability in finance.4 To expand on the previous discussion, the key point is that there are three central decisions to make in financial prediction: 1. What to predict. You can choose to predict the returns to an asset class, such as a broad market or industry group, an exchange rate, interest rates, or returns to individual securities of many types. Financial and Economic Data WHAT we predict WITH Figure 8.3 Prediction Method Returns, Spreads HOW we predict WHAT we predict Maximizing Predictability: Three Places to Look Perils and Pr omise of Evolutionary Computation on Wall Str eet 191 There is also money to be made by predicting the return differences (spreads) between individual securities or groups of securities.

A manager who was way up one year, down the next, flat in the third, and showed generally erratic performance would be considered riskier than a steady (if much less exciting) performer. For example, a manager who outperformed the S&P index by between 2 percent and 3 percent year in and year out, with very little variation from year to year, would have a much better information ratio than another manager with the same average +2.5 percent performance, but with large differences from year to year. The diversification provided by the larger numbers of stocks in the portfolios of quantitatively managed funds often results in a higher information ratio than their traditionally managed counterparts. A Gentle Intr oduction to Computerized Investing 117 What Do Quantitative Managers Do? What are these people with the computers doing if they haven’t gone and kicked the tires and had lunch with the CEO? This is a good question.

 

pages: 215 words: 55,212

The Mesh: Why the Future of Business Is Sharing by Lisa Gansky

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Airbnb, Amazon Mechanical Turk, Amazon Web Services, banking crisis, barriers to entry, carbon footprint, cloud computing, credit crunch, crowdsourcing, diversification, Firefox, Google Earth, Internet of things, Kickstarter, late fees, Network effects, new economy, peer-to-peer lending, recommendation engine, RFID, Richard Florida, Richard Thaler, ride hailing / ride sharing, sharing economy, Silicon Valley, smart grid, social web, software as a service, TaskRabbit, the built environment, walkable city, yield management, young professional, Zipcar

It is one of the many thriving p2p financial ventures, including the first of such marketplaces, Zopa, which is based in the U.K. and has expanded to Italy and Japan. All facilitate individual loans and offer significantly higher rates of return than traditional banks. In a recent article, American Banker, a notable trade journal, acknowledged this advantage in recommending p2p lending as a compelling asset class for diversification of investment portfolios. Other p2p financial companies, such as Lending Club, SmartyPig, BigCarrot, GreenNote, Kisskissbankbank, auxmoney, and smava, have entered the field, often focused on a particular geography or type of customer. The p2p funding tree is growing fast. The company will direct him to crafters with llama wool products, including those who raise llamas and spin and hand dye their own wool.

 

pages: 289 words: 77,532

The Secret Club That Runs the World: Inside the Fraternity of Commodity Traders by Kate Kelly

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Bakken shale, bank run, Credit Default Swap, diversification, fixed income, Gordon Gekko, index fund, locking in a profit, London Interbank Offered Rate, Long Term Capital Management, margin call, paper trading, peak oil, Ponzi scheme, risk tolerance, Ronald Reagan, side project, Silicon Valley, sovereign wealth fund, supply-chain management, the market place

Glancing around the room, Currie noted that the collective assets under management were the lowest they had been in the decade or so that commodity-focused hedge funds had even existed. No wonder, he thought, when the average commodity fund that year was on track to lose almost 3 percent. In fairness, Currie thought it wasn’t all the managers’ fault. “It’s not so much that the commodities story itself is over,” he said after the London meeting, “as it is that the other asset classes,” or groups of investment instruments, like stocks or bonds, “have a better outlook.” Currie had prepared a chart showing that the era of cash, oil, and gold as favored trades had effectively ended. Despite the commodity supercycle, a theory still being thrown around at the time that argued for a protracted period of high commodity prices, he felt that the potential for returns was now far better in stocks.

Daniel Rosenbaum/The New York Times/Redux Xstrata CEO Mick Davis (center) walking out of the November 2012 shareholder meeting in Zug, Switzerland, at which his company’s $70 billion takeover by Glencore was finally approved. Brett Olsher, the Goldman banker who tried to bring order to a raucous merger process, is on the left, and Bill Vereker, the Nomura banking chief who advised Xstrata’s independent shareholders, is on the right. Bloomberg/Getty Images Jeff Currie, Goldman’s chief commodities analyst, realized at a fall 2012 meeting of London hedge-fund managers that the popularity of his asset class had finally fizzled. Goldman Sachs ACKNOWLEDGMENTS What you have just read is the result of a three-year undertaking that was made possible by an array of sources, associates, and friends who are too many in number to name here. The shortlist follows. My job at CNBC introduced me to the commodities world with stories on key players in natural gas, agriculture, and crude-oil trading.

Salesmen for the GSCI and other commodity indexes argued that their products were an important way to diversify investment portfolios. An array of new securities that traded like stocks but tracked precious metals like gold and silver had made commodity investing easier for regular people than ever before, and the commodity market’s inexorable upward movement meant that they’d be crazy not to buy in. “Wall Street did a nice job of marketing the value of having the diversification of commodities in your portfolio,” says Jeff Scott, chief investment officer of the $74 billion financial firm Wurts & Associates. “I don’t mean that sarcastically. And there is value to having certain commodities in your portfolio. Unfortunately, the return composition changed.” In other words, at a certain point the money wagon stopped rolling along. Until 2008, there were plenty of reasons to like commodities, most important of which was the torrid pace of demand in India and China.

 

The Future of Money by Bernard Lietaer

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agricultural Revolution, banks create money, barriers to entry, Bretton Woods, clean water, complexity theory, dematerialisation, discounted cash flows, diversification, fiat currency, financial deregulation, financial innovation, floating exchange rates, full employment, George Gilder, German hyperinflation, global reserve currency, Golden Gate Park, Howard Rheingold, informal economy, invention of the telephone, invention of writing, Lao Tzu, Mahatma Gandhi, means of production, microcredit, money: store of value / unit of account / medium of exchange, Norbert Wiener, North Sea oil, offshore financial centre, pattern recognition, post-industrial society, price stability, reserve currency, Ronald Reagan, seigniorage, Silicon Valley, South Sea Bubble, the market place, the payments system, trade route, transaction costs, trickle-down economics, working poor

Capitalism’s central nervous system It is insufficient to look at currencies as just another asset class. A country's currency is indeed also much more. It plays the role of the central nervous system that commands the values of all asset classes in that country. This becomes clearer when we look at how all the other three traditional asset classes are affected directly by what happens to money. We have seen already that bonds are an attractive investment only to the extent that the currency in which they are denominated keeps its value (i.e. when inflation is low or falling). It is also well known that stock prices fall when interest rates rise, and interest rates tend to shoot up when a currency gets into trouble. The last asset class, real estate, presents a more complex situation. On the one side, real estate is the best protection available against inflation.

The purchasing power of US$ 100 is just over US$24.72; and Pound 100, Pound 12.57, and so on. Sometimes inflation can get really out of hand, with devastating consequences for the societies, which experience them (see sidebar). Managing savings intelligently therefore boils down to allocating cash between the three classical major asset classes: real estate, bonds, and stocks. Over the past decade, another major asset class has appeared that is of particular interest to us: currencies. A few words about the changing role of each asset class over time puts this development into perspective. Real Estate From the beginning of the Agricultural Revolution until last century, real estate, particularly land, was the dominant form of savings available in the world. The wealth of individuals could usually be evaluated by the quality and the size of the real estate they had accumulated.

So holding positions in currencies by themselves has become a logical extension. It has now become a significant factor in most professional investors' portfolios. Something extraordinary has been happening over the past decade: the currency market has become the biggest single market in the world. Foreign exchange transactions purchases and sales of currencies) today dwarf the trading volume of all other asset classes, even of the entire global economy. As a result, currency markets are becoming vitally important to almost everyone for the first time in recorded history - although it is probable that the majority of people are still quite unaware of this. If you have travelled anywhere abroad, you have dealt in the foreign exchange market. You went to a bank or money exchange office and exchanged your little bits of paper against more exotic-looking local bits of paper.

 

pages: 459 words: 118,959

Confidence Game: How a Hedge Fund Manager Called Wall Street's Bluff by Christine S. Richard

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Asian financial crisis, asset-backed security, banking crisis, Bernie Madoff, cognitive dissonance, collateralized debt obligation, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, Donald Trump, family office, financial innovation, fixed income, forensic accounting, glass ceiling, Long Term Capital Management, market bubble, moral hazard, Ponzi scheme, profit motive, short selling, statistical model, white flight

This disastrous outcome was the result of a basic flaw in the assumptions used to securitize mortgages. Credit-rating companies insisted on diversification: a range of loan originators and servicers, wide geographical distribution, and various loan sizes. Ideally, the diversity protected investors from being exposed to loans that would all come under pressure for the same reason. What the credit-rating companies had overlooked was the time frame, or the so-called vintage, in which the loans were made. Vintage turned out to be the single most important factor in the performance of many loans. Loans made in 2006 and 2007 were made to people who borrowed as much as they could to purchase houses they couldn’t afford when prices were peaking. The credit-rating companies and bond insurers mistakenly assumed that even more diversification was created when mortgage-backed securities were pooled into CDOs.

By the time Ackman met with Mark Gold, who oversaw MBIA’s structured finance business, it was nearly 7 p.m. The fund manager from Neuberger Berman was long gone, and the building was nearly deserted on that summer evening. Ackman talked with Gold about the company’s business of guaranteeing collateralized-debt obligations (CDOs), a business that Budnick described as “booming.” CDOs were Wall Street’s favorite new asset class. The securities are built out of pools of securities rather than pools of loans. Otherwise, CDOs work on the same waterfall principle as simpler asset-backed bonds. MBIA was backing lots of CDOs at what it called “super-senior levels,” the most senior or highest levels of a CDO securitization. These super-senior exposures were considered better than triple-A because they had a greater cushion to absorb losses than what the rating companies believed was necessary to achieve triple-A performance.

 

pages: 524 words: 143,993

The Shifts and the Shocks: What We've Learned--And Have Still to Learn--From the Financial Crisis by Martin Wolf

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air freight, anti-communist, Asian financial crisis, asset allocation, asset-backed security, balance sheet recession, bank run, banking crisis, banks create money, Basel III, Ben Bernanke: helicopter money, Berlin Wall, Black Swan, bonus culture, Bretton Woods, call centre, capital asset pricing model, capital controls, Capital in the Twenty-First Century by Thomas Piketty, Carmen Reinhart, central bank independence, collateralized debt obligation, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, currency peg, debt deflation, deglobalization, Deng Xiaoping, diversification, double entry bookkeeping, en.wikipedia.org, Erik Brynjolfsson, Eugene Fama: efficient market hypothesis, eurozone crisis, Fall of the Berlin Wall, fiat currency, financial deregulation, financial innovation, financial repression, floating exchange rates, forward guidance, Fractional reserve banking, full employment, global rebalancing, global reserve currency, Growth in a Time of Debt, Hyman Minsky, income inequality, inflation targeting, invisible hand, Joseph Schumpeter, Kenneth Rogoff, labour market flexibility, labour mobility, liquidationism / Banker’s doctrine / the Treasury view, liquidity trap, Long Term Capital Management, margin call, market bubble, market clearing, market fragmentation, Martin Wolf, Mexican peso crisis / tequila crisis, moral hazard, mortgage debt, new economy, North Sea oil, Northern Rock, open economy, paradox of thrift, price stability, private sector deleveraging, purchasing power parity, pushing on a string, quantitative easing, Real Time Gross Settlement, regulatory arbitrage, reserve currency, Richard Feynman, Richard Feynman, risk-adjusted returns, risk/return, road to serfdom, Robert Gordon, Robert Shiller, Robert Shiller, Ronald Reagan, savings glut, Second Machine Age, secular stagnation, shareholder value, short selling, sovereign wealth fund, special drawing rights, The Chicago School, The Great Moderation, The Market for Lemons, the market place, The Myth of the Rational Market, the payments system, The Wealth of Nations by Adam Smith, too big to fail, Tyler Cowen: Great Stagnation, very high income, winner-take-all economy

If the U.S. government had not chosen this policy path – fostering the growth of a bubble of unprecedented size and an equally unprecedented number of weak and high-risk residential mortgages – the great financial crisis of 2008 would never have occurred.65 It is certainly possible to accept that enthusiastic government promotion of home ownership and, in particular, the GSEs, played some role. But the view that this was the principal cause is entirely unconvincing, for four reasons.66 First, Keith Hennessey, Douglas Holtz-Eakin and Bill Thomas, also Republican nominees to the Financial Crisis Inquiry Commission, note, in their own dissenting comment: The report largely ignores the credit bubble beyond housing. Credit spreads declined not just for housing, but also for other asset classes like commercial real estate. This tells us to look to the credit bubble as an essential cause of the U.S. housing bubble. It also tells us that problems with U.S. housing policy or markets do not by themselves explain the U.S. housing bubble. There were housing bubbles in the United Kingdom, Spain, Australia, France and Ireland, some more pronounced than in the United States. Some nations with housing bubbles relied little on American-style mortgage securitization.

Between 1970 and 1989, the median annual growth of emerging economies was only 1.5 per cent; between 1990 and 2007, it reached 3.4 per cent.10 Between 1970 and 1989, the median growth rate of low-income countries had been a calamitous minus 0.1 per cent; in the subsequent period, it reached 1.5 per cent – low, but still a huge improvement.11 The variability of growth also fell substantially between the two periods.12 An optimistic view is that the ability of many emerging and developing countries to cope with the biggest financial crisis since the 1930s reflects improvements in policies and changes in economies, particularly diversification of the composition and direction of trade, of the sources of inflows of capital and of their entire economies. A pessimistic view is that recent growth has been supported by capital inflows, strong credit growth, booming commodity markets and, in the crucial case of China, an unsustainable growth of poor-quality investment. All this, pessimists note, is becoming far more challenging. Optimists have evidence on their side.13 Something has indeed changed for the better.

The aims of these proposals were to help insulate domestic retail banking from external financial shocks, facilitate resolution of a banking group in difficulty, and make it more credible that the government would not back trading activities. At the same time, the Commission rejected the idea of a full split, rather than a ring fence, arguing that the diversity of businesses within a large group and the diversification of their assets might improve stability in a crisis. The UK government subsequently brought in legislation in line with the Commission’s proposals, with the strong support of the Parliamentary Commission on Banking Standards. The Banking Reform Act based on these proposals was passed into law in late 2013. The ICB’s recommendations were a response to the worrying fact that before the crisis the assets of the UK’s banking sector amounted to five times the country’s GDP, largely because of the huge scale of its globally active banks.

 

pages: 288 words: 16,556

Finance and the Good Society by Robert J. Shiller

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bank run, banking crisis, barriers to entry, Bernie Madoff, capital asset pricing model, capital controls, Carmen Reinhart, Cass Sunstein, cognitive dissonance, collateralized debt obligation, collective bargaining, computer age, corporate governance, Daniel Kahneman / Amos Tversky, Deng Xiaoping, diversification, diversified portfolio, Donald Trump, Edward Glaeser, eurozone crisis, experimental economics, financial innovation, full employment, fundamental attribution error, George Akerlof, income inequality, invisible hand, joint-stock company, Joseph Schumpeter, Kenneth Rogoff, land reform, loss aversion, Louis Bachelier, Mahatma Gandhi, Mark Zuckerberg, market bubble, market design, means of production, microcredit, moral hazard, mortgage debt, Occupy movement, passive investing, Ponzi scheme, prediction markets, profit maximization, quantitative easing, random walk, regulatory arbitrage, Richard Thaler, road to serfdom, Robert Shiller, Robert Shiller, Ronald Reagan, self-driving car, shareholder value, Sharpe ratio, short selling, Simon Kuznets, Skype, Steven Pinker, telemarketer, The Market for Lemons, The Wealth of Nations by Adam Smith, Thorstein Veblen, too big to fail, Vanguard fund, young professional, Zipcar

Imagine that the banks are virtually identical, and that both have lent out about as much money as the regulators allow them to, given their current capital. Suppose they each package part of their mortgages into AAA securities and swap the securities with one another: each thus holds mortgages that the other originated—in the new, securitized form. You might think that nothing essential has changed. But think again. Because capital requirements are based on risk-weighted assets, and because the securities fall into a di erent asset class than the underlying mortgages, the e ect is to loosen regulation and allow the banks to lend more. You might ask, how could regulators be so stupid as not to see the potential for disaster here? They were not stupid. But they were operating on the assumption that the rating agencies were infallible—an assumption that they did not feel it was within their purview to examine, as they did not regulate the rating agencies.

This 14.2% is based on a geometric average of gross returns, as it should be. 7. Chevalier and Ellison (1999). 8. Li et al. (2008). 9. That is, among the individuals inducted into the army between 1982 and 2001, those who had higher IQ scores had higher Sharpe ratios for their 2000 portfolios, controlling for other factors, re ecting greater exposure to small-cap and value stocks and better diversification. Grinblatt et al. (2011). 10. Kat and Menexe (2003). 11. Kaplan and Schoar (2005). 12. Berk and Green (2004). 13. Bogle (2009): 47. 14. Levine (1997). 15. French (2008). 16. Goetzmann et al. (2002). 17. Dugan et al. (2002). 18. Dugan (2005). 19. Acharya et al. (2010). 20. Kaufman (2005): 313. 21. Bernasek (2010): 48. Chapter 3. Bankers 1. Diamond and Dybvig (1983) lay out the issue of bank runs as a problem of multiple equilibria in a model of banks as creators of liquidity, thereby providing both a clear rationale for the existence of banks and an understanding of their vulnerabilities. 2. http://fraser.stlouisfed.org/publications/bms/issue/61/download/130/section10.p Table 130. 3.

See also financial institutions investment managers: choosing, 29; compensation, 28, 32–34; competition among, 30–32; deceptive games, 34–36; definition of, 27; fees, 28, 34; integrity, 35, 36–37; intelligence, 31; performance, 28–29, 30–32, 34–35; personal portfolios, 28; public hostility toward, 28; regulation of, 35–36; responsibilities, 27–28, 225; risks taken, 34, 35; social benefits, 36; trustees, 119–20; university endowments, 31. See also mutual funds investments: broadening ownership, 214–15; diversification, 28, 29; foreign direct, 229; liquidity, 144; moral hazard, 40–41 investors: information available to, 41–42; institutional, 25, 43; limited liability, 174–75; in mutual funds, 29; venture capital firms, 24–25 Iowa Electronic Markets, 61 IPOs. See initial public offerings Islamic law, 157 Israel, lawyers in, 82, 83 Ives, Charles, 136 Ives & Myrick, 136 Japan: accounting regulators, 101; lawyers, 83; mortgage securitization, 245n6 (Chapter 5) Jayachandran, Seema, 158 Jayadev, Arjun, 12 Jewish law, 83, 157 JOBS Act, 48 John Muir & Co., 137–38 Joseph, Jane E., 140 Jung, Jeeman, 185–86 Kahneman, Daniel, 160, 161 Kaplan, Steven N., 31 Kat, Harry, 31 Kaufman, Henry, 36 Keloharju, Matti, 31 Kelso, Louis O., 215–16 Kendall, Maurice, 169 Keynes, John Maynard, 169, 172 kidney transplants, market for, 69–70 kiva.org, 44 Kleiner, Morris M., 95 Koons, Jeff, 136–37 Korobov, Vladimir, 166, 193 Kranton, Rachel E., 215 Kremer, Michael, 71, 158 Krueger, Alan B., 95 Kuznets, Simon, 94 labor unions.

 

pages: 464 words: 117,495

The New Trading for a Living: Psychology, Discipline, Trading Tools and Systems, Risk Control, Trade Management by Alexander Elder

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additive manufacturing, Atul Gawande, backtesting, Benoit Mandelbrot, buy low sell high, Checklist Manifesto, deliberate practice, diversification, Elliott wave, endowment effect, loss aversion, mandelbrot fractal, margin call, offshore financial centre, paper trading, Ponzi scheme, price stability, psychological pricing, quantitative easing, random walk, risk tolerance, short selling, South Sea Bubble, systematic trading, The Wisdom of Crowds, transaction costs, transfer pricing, traveling salesman, tulip mania

Mini-contracts trade during the same hours as regular contracts and closely track their prices. Their commissions are similar to those for regular contracts, taking a proportionately bigger bite from each trade. Their slippage tends to be bigger due to lower volumes. The exceptions are stock index futures, where mini contracts have higher volumes than regular ones. ■ 47. Forex The currency market is the largest asset class in the world by trading volume, with a turnover of over $4 trillion per day. Currencies trade around the clock—from 20:15 GMT on Sunday to 22 GMT on Friday, stopping only on weekends. While some currency trades serve the hedging needs of importers and exporters, most transactions are speculative. The United States is the only country in the world where most people don't think much about currencies.

Analysts who researched legal insider trading found that insider buying or selling was meaningful only if more than three executives or large stockholders bought or sold within a month. These actions reveal that something very positive or negative is about to happen. A stock is likely to rise if three insiders buy in one month and to fall if three insiders sell within a month. Clusters of insider buying tend to have a better predictive value than clusters of selling. That's because insiders are willing to sell a stock for many reasons (diversification, buying a second home, sending a kid to college) but they are willing to buy for one main reason—they expect their company's stock to go up. Short Interest While the numbers of futures and options contracts held long and short is equal by definition, in the stock market there is always a huge disparity between the two camps. Most people, including professional fund managers, buy stocks, but very few sell them short.

Not according to the 6% Rule because his account is already exposed to a combined risk of 6% in stocks B, C, and D (there is no longer a risk in stock A). He may not buy stock E. A few days later, stock B hits its stop. Stock E still looks attractive. May he buy it? No, since he already lost 2% on stock B and has a 4% exposure to risk in stocks C and D. Adding another position at this time would expose him to more than 6% risk per month. Three open trades isn't a lot of diversification. If you wish to make more trades, set your risk per trade at less than 2%. For example, if you risk only 1% of your account equity on any trade, you may open up to six positions before maxing out at the 6% limit. In trading a large account, I use the 6% Rule but tighten the 2% Rule to well under 1%. The 6% Rule allows you to increase your trading size when you're on a winning streak but makes you stop trading early in a losing streak.

 

pages: 500 words: 145,005

Misbehaving: The Making of Behavioral Economics by Richard H. Thaler

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Albert Einstein, Amazon Mechanical Turk, Andrei Shleifer, Apple's 1984 Super Bowl advert, Atul Gawande, Berlin Wall, Bernie Madoff, Black-Scholes formula, capital asset pricing model, Cass Sunstein, Checklist Manifesto, choice architecture, clean water, cognitive dissonance, conceptual framework, constrained optimization, Daniel Kahneman / Amos Tversky, delayed gratification, diversification, diversified portfolio, Edward Glaeser, endowment effect, equity premium, Eugene Fama: efficient market hypothesis, experimental economics, Fall of the Berlin Wall, George Akerlof, hindsight bias, Home mortgage interest deduction, impulse control, index fund, invisible hand, Jean Tirole, John Nash: game theory, John von Neumann, late fees, law of one price, libertarian paternalism, Long Term Capital Management, loss aversion, market clearing, Mason jar, mental accounting, meta analysis, meta-analysis, More Guns, Less Crime, mortgage debt, Nash equilibrium, Nate Silver, New Journalism, nudge unit, payday loans, Ponzi scheme, presumed consent, pre–internet, principal–agent problem, prisoner's dilemma, profit maximization, random walk, randomized controlled trial, Richard Thaler, Robert Shiller, Robert Shiller, Ronald Coase, Silicon Valley, South Sea Bubble, statistical model, Steve Jobs, technology bubble, The Chicago School, The Myth of the Rational Market, The Signal and the Noise by Nate Silver, The Wealth of Nations by Adam Smith, Thomas Kuhn: the structure of scientific revolutions, transaction costs, ultimatum game, Walter Mischel

. ________________ * For a long time foundations and endowments operated in the same way, which was to leave the principal alone and spend the “income,” tending to push them to hold bonds and stocks that paid large dividends. Gradually this practice was recognized as silly, and these organizations adopted a more sensible rule, such as to spend a given percentage (say 5%) of a three-year moving average of the value of the endowment, allowing them to choose investments based on their long-term potential rather than their cash payouts. This change in policy allowed endowments to invest in new asset classes such as venture capital funds, which often do not pay any returns for many years. 18 Anomalies An important aspect of Thomas Kuhn’s model of scientific revolutions, which came up at the end of the Chicago conference, is that paradigms change only once experts believe there are a large number of anomalies that are not explained by the current paradigm. A few scattered unexplained facts are not enough to upend the conventional wisdom.

If you form a portfolio composed of a bunch of highly risky stocks whose prices bounce around a lot, the portfolio itself will not be especially risky if the price movements of each of the component stocks are independent of one another, because then the movements will on average cancel out. But if the returns on the stocks are positively correlated, meaning they tend to go up and down together, then a portfolio of volatile stocks remains pretty risky; the benefits of diversification conferred by holding a portfolio of the stocks are not as great. In this way, according to the CAPM, the correct measure of the riskiness of a stock is simply its correlation with the rest of the market, a measure that is called “beta.”† Roughly speaking, if a stock has a beta of 1.0, then its movements are proportional to the overall market. If a stock has a beta of 2.0, then when the market goes up or down by 10% the individual stock will (on average) go up or down by 20%.

Journal of Experimental Psychology 101, no. 1: 16. Lintner, John. 1956. “Distribution of Incomes of Corporations Among Dividends, Retained Earnings, and Taxes.” American Economic Review 46, no. 2: 97–113. ———. 1965a. “The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets.” Review of Economics and Statistics 47, no. 1: 13–37. ———. 1965b. “Security Prices, Risk, and Maximal Gains from Diversification.” Journal of Finance 20, no. 4: 587–615. List, John A. 2011. “The Market for Charitable Giving.” Journal of Economic Perspectives 25, no. 2: 157–80. Loewenstein, George. 1992. “The Fall and Rise of Psychological Explanations in the Economics of Intertemporal Choice.” In George Loewenstein and Jon Elster, eds., Choice Over Time,. 3–34. New York: Russell Sage Foundation. ———, and Drazen Prelec. 1992.

 

pages: 515 words: 132,295

Makers and Takers: The Rise of Finance and the Fall of American Business by Rana Foroohar

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3D printing, accounting loophole / creative accounting, additive manufacturing, Airbnb, algorithmic trading, Asian financial crisis, asset allocation, bank run, Basel III, bonus culture, Bretton Woods, British Empire, call centre, Capital in the Twenty-First Century by Thomas Piketty, Carmen Reinhart, carried interest, centralized clearinghouse, clean water, collateralized debt obligation, corporate governance, corporate social responsibility, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, crowdsourcing, David Graeber, deskilling, Detroit bankruptcy, diversification, Double Irish / Dutch Sandwich, Emanuel Derman, Eugene Fama: efficient market hypothesis, financial deregulation, financial intermediation, Frederick Winslow Taylor, George Akerlof, gig economy, Goldman Sachs: Vampire Squid, Gordon Gekko, greed is good, High speed trading, Home mortgage interest deduction, housing crisis, Howard Rheingold, Hyman Minsky, income inequality, index fund, interest rate derivative, interest rate swap, Internet of things, invisible hand, joint-stock company, joint-stock limited liability company, Kenneth Rogoff, knowledge economy, labor-force participation, labour mobility, London Whale, Long Term Capital Management, manufacturing employment, market design, Martin Wolf, moral hazard, mortgage debt, mortgage tax deduction, new economy, non-tariff barriers, offshore financial centre, oil shock, passive investing, pensions crisis, Ponzi scheme, principal–agent problem, quantitative easing, quantitative trading / quantitative finance, race to the bottom, Ralph Nader, Rana Plaza, RAND corporation, random walk, rent control, Robert Shiller, Robert Shiller, Ronald Reagan, Second Machine Age, shareholder value, sharing economy, Silicon Valley, Silicon Valley startup, Snapchat, sovereign wealth fund, Steve Jobs, technology bubble, The Chicago School, The Spirit Level, The Wealth of Nations by Adam Smith, Tim Cook: Apple, Tobin tax, too big to fail, trickle-down economics, Tyler Cowen: Great Stagnation, Vanguard fund

Goldman Sachs can technically own farmland, for example, and trade the grain grown on it. Although Wall Street has long bought and sold commodities futures and swaps, the combination of purely financial trading and ownership of physical commodities was a trend that began to accelerate around 2000, thanks to deregulation and a torrent of pension money that began to flow into commodities as an asset class. Only financial institutions have this ability to both make the market and be the market—to trade the products they own, hoarding or even manipulating them if they like, to raise or lower prices at will. They are the fox in the henhouse—except they also designed and built the henhouse, and they get to butcher the hens, and sell the eggs if they want. This unique market position does more than enable them to push food prices so high that people go hungry.

Andrea Gabor, The Capitalist Philosophers: The Geniuses of Modern Business—Their Lives, Times, and Ideas (New York: Times Business, 2000), 135. 26. John A. Byrne, The Whiz Kids: The Founding Fathers of American Business—and the Legacy They Left Us (New York: Doubleday, 1993), 36. 27. Ibid., 50; Abraham Zaleznik, “The Education of Robert S. McNamara, Secretary of Defense, 1961–1968,” Revue Française de Gestion 6, no. 159 (2005). 28. David R. Jardini, “Out of the Blue Yonder: The RAND Corporation’s Diversification into Social Welfare Research, 1946–1968” (PhD diss., Carnegie Mellon University, 1996); Gabor, The Capitalist Philosophers, 136. 29. E. J. Barlow, “Preliminary Proposal for Air Defense Study,” RAND Archives D(L)-816-2, October 1950, quoted in Jardini, “Out of the Blue Yonder,” 67. 30. Halberstam, The Best and the Brightest, 229–30. 31. Byrne, The Whiz Kids, 175. 32. David Halberstam, The Reckoning (New York: William Morrow, 1986), 207. 33.

John C. Bogle, “Big Money in Boston: The Commercialization of the Mutual Fund Industry,” Journal of Portfolio Management 40, no. 4 (2013): 135. 12. Knut A. Rostad, ed., The Man in the Arena: Vanguard Founder John C. Bogle and His Lifelong Battle to Serve Investors First (Hoboken, NJ: Wiley, 2013), 124–25. 13. Bogle, The Clash of the Cultures, 111. 14. Ian Ayres and Quinn Curtis, “Beyond Diversification: The Pervasive Problem of Excessive Fees and ‘Dominated Funds’ in 401(k) Plans,” Yale Law Journal 124, no. 5 (March 2015): 1501. 15. Bogle, “Big Money in Boston,” 142. 16. Author interview with John Shaw Sedgwick, the son of R. Minturn Sedgwick, for this book. 17. R. Minturn Sedgwick, “The Record of Conventional Investment Management: Is There Not a Better Way?” Financial Analysts Journal 29, no. 4 (July–August 1973): 41–44. 18.

 

pages: 523 words: 143,139

Algorithms to Live By: The Computer Science of Human Decisions by Brian Christian, Tom Griffiths

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4chan, Ada Lovelace, Alan Turing: On Computable Numbers, with an Application to the Entscheidungsproblem, Albert Einstein, algorithmic trading, anthropic principle, asset allocation, autonomous vehicles, Berlin Wall, Bill Duvall, bitcoin, Community Supported Agriculture, complexity theory, constrained optimization, cosmological principle, cryptocurrency, Danny Hillis, delayed gratification, dematerialisation, diversification, double helix, Elon Musk, fault tolerance, Fellow of the Royal Society, Firefox, first-price auction, Flash crash, Frederick Winslow Taylor, George Akerlof, global supply chain, Google Chrome, Henri Poincaré, information retrieval, Internet Archive, Jeff Bezos, John Nash: game theory, John von Neumann, knapsack problem, Lao Tzu, linear programming, martingale, Nash equilibrium, natural language processing, NP-complete, P = NP, packet switching, prediction markets, race to the bottom, RAND corporation, RFC: Request For Comment, Robert X Cringely, sealed-bid auction, second-price auction, self-driving car, Silicon Valley, Skype, sorting algorithm, spectrum auction, Steve Jobs, stochastic process, Thomas Malthus, traveling salesman, Turing machine, urban planning, Vickrey auction, Walter Mischel, Y Combinator

The Upside of Heuristics The economist Harry Markowitz won the 1990 Nobel Prize in Economics for developing modern portfolio theory: his groundbreaking “mean-variance portfolio optimization” showed how an investor could make an optimal allocation among various funds and assets to maximize returns at a given level of risk. So when it came time to invest his own retirement savings, it seems like Markowitz should have been the one person perfectly equipped for the job. What did he decide to do? I should have computed the historical covariances of the asset classes and drawn an efficient frontier. Instead, I visualized my grief if the stock market went way up and I wasn’t in it—or if it went way down and I was completely in it. My intention was to minimize my future regret. So I split my contributions fifty-fifty between bonds and equities. Why in the world would he do that? The story of the Nobel Prize winner and his investment strategy could be presented as an example of human irrationality: faced with the complexity of real life, he abandoned the rational model and followed a simple heuristic.

brains try to minimize the number of neurons: Using this neurally inspired strategy (known as “sparse coding”), researchers have developed artificial neurons that have properties similar to those found in the visual cortex. See Olshausen and Field, “Emergence of Simple-Cell Receptive Field Properties.” groundbreaking “mean-variance portfolio optimization”: The work for which Markowitz was awarded the Nobel Prize appears in his paper “Portfolio Selection” and his book Portfolio Selection: Efficient Diversification of Investments. “I split my contributions fifty-fifty”: Harry Markowitz, as quoted in Jason Zweig, “How the Big Brains Invest at TIAA–CREF,” Money 27(1): 114, January 1998. “less information, computation, and time”: Gigerenzer and Brighton, “Homo Heuristicus.” more than quadrupled from the mid-1990s to 2013: From Soyfoods Association of North America, “Sales and Trends,” http://www.soyfoods.org/soy-products/sales-and-trends, which in turn cites research “conducted by Katahdin Ventures.”

“Optimal Persistence Policies.” Operations Research 8 (1960): 362–380. Malthus, Thomas Robert. An Essay on the Principle of Population. London: J. Johnson, 1798. Marcus, Gary. Kluge: The Haphazard Evolution of the Human Mind. New York: Houghton Mifflin Harcourt, 2009. Markowitz, Harry. “Portfolio Selection.” Journal of Finance 7, no. 1 (1952): 77–91. ______. Portfolio Selection: Efficient Diversification of Investments. New York: Wiley, 1959. Martin, Thomas Commerford. “Counting a Nation by Electricity.” Electrical Engineer 12, no. 184 (1891): 521–530. McCall, John. “Economics of Information and Job Search.” Quarterly Journal of Economics 84 (1970): 113–126. McGrayne, Sharon Bertsch. The Theory That Would Not Die: How Bayes’ Rule Cracked the Enigma Code, Hunted Down Russian Submarines, & Emerged Triumphant from Two Centuries of Controversy.

 

pages: 397 words: 112,034

What's Next?: Unconventional Wisdom on the Future of the World Economy by David Hale, Lyric Hughes Hale

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affirmative action, Asian financial crisis, asset-backed security, bank run, banking crisis, Basel III, Berlin Wall, Black Swan, Bretton Woods, capital controls, Cass Sunstein, central bank independence, cognitive bias, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, corporate social responsibility, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, currency peg, Daniel Kahneman / Amos Tversky, debt deflation, declining real wages, deindustrialization, diversification, energy security, Erik Brynjolfsson, Fall of the Berlin Wall, financial innovation, floating exchange rates, full employment, Gini coefficient, global reserve currency, global village, high net worth, Home mortgage interest deduction, housing crisis, index fund, inflation targeting, invisible hand, Just-in-time delivery, Kenneth Rogoff, labour market flexibility, labour mobility, Long Term Capital Management, Mahatma Gandhi, Martin Wolf, Mexican peso crisis / tequila crisis, Mikhail Gorbachev, money: store of value / unit of account / medium of exchange, mortgage tax deduction, Network effects, new economy, Nicholas Carr, oil shale / tar sands, oil shock, open economy, passive investing, payday loans, peak oil, Ponzi scheme, post-oil, price stability, private sector deleveraging, purchasing power parity, quantitative easing, race to the bottom, regulatory arbitrage, rent-seeking, reserve currency, Richard Thaler, risk/return, Robert Shiller, Robert Shiller, Ronald Reagan, sovereign wealth fund, special drawing rights, technology bubble, The Great Moderation, Thomas Kuhn: the structure of scientific revolutions, Tobin tax, too big to fail, total factor productivity, trade liberalization, Washington Consensus, women in the workforce, yield curve

Again, this “contango” may reflect the markets’ capacity to price a worrisome combination of accelerated field depletion, geopolitical turmoil, and self-inflicted political constraints in key producer countries, or it may merely illustrate the irrelevance of “future prices” in predicting the future price of oil. While the near-term economic horizon is currently dominated by an uneven economic recovery process and a reduced appetite for commodities as an asset class, a longer-term time horizon is needed to make sense of market behaviors that fail to be fully determined by the present supply-demand balance. Let us reflect, therefore, on what has been learned since the financial crisis of 2008–2009 regarding the longer-term market determinants. We shall begin with the move toward a post-oil economy that some think could be imposed by geological limits—“peak oil” and the assumed twilight in the desert1—or by concerns for climate change.

Paper Barrels The forecasts above assume that the speculative demand for oil will not get out of hand one way or another. Demand for “paper barrels” will continue to exercise an autonomous influence on oil prices. In the recent past, this took the form of massive investments in the futures markets in pursuit of large-scale gains as oil, and commodities more generally, turned into a major asset class for hedge fund and other investment fund portfolio managers. The sum of open interests on the NYMEX and ICE futures market jumped from 950,000 contracts (equivalent to just under 1 billion barrels of oil) in 2004 to 2.7 million contracts (2.7 billion barrels of oil) in 2008. According to LCM Research, adding exchange-traded options and futures contracts to the latter figure represents no less than seven billion barrels of oil.

In particular, oil recently became a major instrument in efforts to hedge against a fall in the dollar. As observed by LCM Research, the spike in oil prices of late October 2009—during which time oil prices crossed what had been for five months a firm upper limit of $75—can only be explained by the weakening in what had been a negative relationship between gold and the dollar and by the role that oil played, at least for a few months, as “an asset class of choice for dollar refugees.”41 If sustained for a long enough period, a significant weakening of the dollar could test not only this emerging coupling of currencies and oil markets, but possibly the manner in which Saudi Arabia defines what is presently an upper limit of $80 for the range of acceptable oil prices. Altogether, many trends will converge to significantly change the parameters behind the “sweet spot” that oil markets found in late 2009 and that it still enjoyed in the summer of 2010.

 

pages: 344 words: 94,332

The 100-Year Life: Living and Working in an Age of Longevity by Lynda Gratton, Andrew Scott

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3D printing, Airbnb, carbon footprint, Clayton Christensen, collapse of Lehman Brothers, crowdsourcing, delayed gratification, diversification, Downton Abbey, Erik Brynjolfsson, falling living standards, financial independence, first square of the chessboard, first square of the chessboard / second half of the chessboard, future of work, gender pay gap, gig economy, Google Glasses, indoor plumbing, information retrieval, Isaac Newton, job satisfaction, low skilled workers, Lyft, Network effects, New Economic Geography, pattern recognition, pension reform, Peter Thiel, Ray Kurzweil, Richard Florida, Richard Thaler, Second Machine Age, sharing economy, side project, Silicon Valley, smart cities, Stephen Hawking, Steve Jobs, women in the workforce, young professional

A longer second stage of relentless work will result in too much depletion of important intangible assets and, over time, a run-down in productive assets. The run-down in vitality assets brings to mind the curse of Ondine and an exhausted and zombie-like existence driven by money. A longer third stage of retirement may sound attractive, but can only be supported by significant financial accumulation and savings in the second stage, and could even turn into tedium if not managed properly. 3. A new asset class: Transformational assets If achieving a balance of tangible and intangible assets over a 100-year life within a three-stage model is challenging, then a natural consequence is the emergence of a multi-stage life. We cannot know exactly what this multi-stage life will look like, but there are some broad predictions we can make. It is likely that the first stage of education will last longer. This will give people more time to acquire and accumulate the intangible assets that will act as a buffer for a longer second stage.

To avoid knowledge stocks hitting zero, fitness and motivation disappearing, and friends and family disconnecting, most people will want to split their career into various stages, each with its own character and purpose. Technological innovations and sectoral shifts will bring flux, and being able to refresh and reskill at more points than Jack will become crucial. So if a multi-stage life is the way to achieve balance between tangibles and intangibles, then it will require the development of a new asset class. We call these transformational assets and they reflect the capacity and motivation to successfully achieve change and transitions. What sort of transitions will you face? Some transitions will be forced upon you by external circumstances: your skills could become technologically obsolete or the business you work for could close. There will also be those that you will have to initiate: you have to leave a job to go into full-time education, or transition from an exploration phase to a high-powered corporate role.

It is clear to us that lengthening time horizons and more periods of income fluctuation will result in major changes in how the financial sector works and in the products it offers. Take mortgage products, for example: a longer working life means that mortgage repayments can be spread out, but the fluctuations in this longer life require a measure of flexibility in contribution payments. A longer life also creates more time in which to take risks and more time to recover if these go wrong. This means that portfolio diversification and risk taking will alter with a longer life, and this will inevitably result in major structural changes in the industry. Focus on the costs Like any industry where consumers know a lot less than producers, it’s easy for consumers to make financial decisions they will look back on and regret. This is particularly the case in savings products, where there are financial intermediaries who require some form of cut or payment.

 

Griftopia: Bubble Machines, Vampire Squids, and the Long Con That Is Breaking America by Matt Taibbi

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affirmative action, Affordable Care Act / Obamacare, Bernie Sanders, Bretton Woods, carried interest, clean water, collateralized debt obligation, collective bargaining, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, David Brooks, desegregation, diversification, diversified portfolio, Donald Trump, financial innovation, Goldman Sachs: Vampire Squid, Gordon Gekko, greed is good, illegal immigration, interest rate swap, laissez-faire capitalism, London Interbank Offered Rate, Long Term Capital Management, margin call, market bubble, medical malpractice, moral hazard, mortgage debt, obamacare, passive investing, Ponzi scheme, prediction markets, quantitative easing, reserve currency, Ronald Reagan, Sergey Aleynikov, short selling, sovereign wealth fund, too big to fail, trickle-down economics, Y2K, Yom Kippur War

The Prudent Investor Act was something of a financial version of the Clear Skies Act or the Healthy Forests Restoration Act, a sweeping deregulatory action with a cheerily Orwellian name that actually meant close to the opposite of what it sounded like. The rule now said that there was no one-size-fits-all industry standard of prudence and that trusts were not only not barred from investing in certain asset classes, they were actually duty bound to diversify as much as possible. “It made diversification a presumptive responsibility” of the trust manager, Langbein said proudly, adding, “It abolished all categoric prohibitions on investment types.” This revolution in institutional investment laws on the state level coincided with similar actions on the federal level—including yet another series of very quiet changes to the rules in 2003 by the CFTC, which for the first time allowed pension funds (which are regulated not by the states but by the federal government) to invest in, among other things, commodity futures.

Whereas once upon a time you had to be accredited to trade commodities, there were now all sorts of ways that outsiders could get into the market. Coupled with the new interpretation of prudence—this notion that institutional investors not only could diversify into other types of investments, but should or had to—there was suddenly a huge inpouring of money into the commodity futures market. “Once upon a time, you had to be an accredited investor, and commodities weren’t considered an asset class,” says Pat McHugh, a trader in natural gas futures who has spent upwards of twenty years watching changes in the market. “Now all of a sudden commodities, it was like it was something you had to have.” Now, with all these changes, the massive pools of money sitting around in funds like CalPERS (the California state employees pension funds) and other state-run pension plans were fair game for the salesmen of banks like Goldman Sachs looking to pitch this exciting new class of investment as a way of complying with what Langbein, the Yalie professor, called the “powerful duty to diversify broadly.”

 

pages: 444 words: 86,565

Investment Banking: Valuation, Leveraged Buyouts, and Mergers and Acquisitions by Joshua Rosenbaum, Joshua Pearl, Joseph R. Perella

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asset allocation, asset-backed security, bank run, barriers to entry, capital asset pricing model, collateralized debt obligation, corporate governance, credit crunch, discounted cash flows, diversification, fixed income, London Interbank Offered Rate, performance metric, shareholder value, sovereign wealth fund, technology bubble, time value of money, transaction costs, yield curve

Regardless, D&A is explicitly disclosed in the cash flow statement as well as the notes to a company’s financial statements. As D&A is a non-cash expense, it is added back to EBIAT in the calculation of FCF (see Exhibit 3.4). Hence, while D&A decreases a company’s reported earnings, it does not decrease its FCF. Depreciation Depreciation expenses are typically scheduled over several years corresponding to the useful life of each of the company’s respective asset classes. The straight-line depreciation method assumes a uniform depreciation expense over the estimated useful life of an asset. For example, an asset purchased for $100 million that is determined to have a ten-year useful life would be assumed to have an annual depreciation expense of $10 million per year for ten years. Most other depreciation methods fall under the category of accelerated depreciation, which assumes that an asset loses most of its value in the early years of its life (i.e., the asset is depreciated on an accelerated schedule allowing for greater deductions earlier on).

Systematic risk is the risk related to the overall market, which is also known as nondiversifiable risk. A company’s level of systematic risk depends on the covariance of its share price with movements in the overall market, as measured by its beta (β) (discussed later in this section). By contrast, unsystematic or “specific” risk is company- or sector-specific and can be avoided through diversification. Hence, equity investors are not compensated for it (in the form of a premium). As a general rule, the smaller the company and the more specified its product offering, the higher its unsystematic risk. The formula for the calculation of CAPM is shown in Exhibit 3.15. EXHIBIT 3.15 Calculation of CAPM where: rf = risk-free rate βL = levered beta rm = expected return on the market rm - rf = market risk premium Risk-Free Rate (rf) The risk-free rate is the expected rate of return obtained by investing in a “riskless” security.

 

pages: 375 words: 105,067

Pound Foolish: Exposing the Dark Side of the Personal Finance Industry by Helaine Olen

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asset allocation, Bernie Madoff, Cass Sunstein, Credit Default Swap, David Brooks, delayed gratification, diversification, diversified portfolio, Donald Trump, Elliott wave, en.wikipedia.org, estate planning, financial innovation, Flash crash, game design, greed is good, high net worth, impulse control, income inequality, index fund, London Whale, Mark Zuckerberg, mortgage debt, oil shock, payday loans, pension reform, Ponzi scheme, quantitative easing, Ralph Nader, RAND corporation, random walk, Richard Thaler, Ronald Reagan, Saturday Night Live, too big to fail, transaction costs, Unsafe at Any Speed, upwardly mobile, Vanguard fund, wage slave, women in the workforce, working poor, éminence grise

They believe the stuff we are telling them.” Quinn was right. All too many of us thrilled to stock tips and swooned at sensible strategies for using dollar-cost averaging to invest in everything from the latest hot tech company to sensible no-load mutual funds. We believed it when experts told us we too could become the millionaire next door if we saved and invested just right, whether that was the right mix of asset classes and stock picks or the perfect undervalued house that, with a fresh coat of paint and a couple of other inexpensive fixes, could be quickly flipped at a profit. But it all came down to the same thing. Buy stocks! Buy houses! Buy and hold, my friends! Time the markets! Seize the financial day! But the ability of the vast majority of people to seize the financial day was increasingly constrained by a third trend: our salaries were not, for the most part, keeping up with the rest of the economy.

We got so into extreme couponing: Lauren Liggett: Paul Kegan, “Extreme Couponing: Student Saves $300 a month,” Money, July 20, 2011, http://money.cnn.com/2011/07/18/magazines/moneymag/extreme_couponing.moneymag/index.htm. Mikelann Valterra: http://www.seattlemoneycoach.com; author interview. It’s the sort of mindset: John Pelletier, “College Grads: Think About Your Retirement Now,” MarketWatch, April 16, 2012, http://articles.marketwatch.com/2012-04-16/finance/31345646_1_retirement-fund-switch-jobs-investment-diversification. Saundra Davis, financial coach: author interview. http://www.sagemoney.org/index.php?option=com_content&view=article&id=94&Itemid=53. There are efforts like the Family Independence: David Bornstein, “Out of Poverty, Family Style,” New York Times, July 14, 2011, http://opinionator.blogs.nytimes.com/2011/07/14/out-of-poverty-family-style. Underearners Anonymous: Genevieve Smith, “In Recovery: Twelve Steps to Prosperity,” Harper’s, June 2012; http://underearnersanonymous.org; also author interview with the founder of Underearners Anonymous.

 

pages: 829 words: 186,976

The Signal and the Noise: Why So Many Predictions Fail-But Some Don't by Nate Silver

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airport security, availability heuristic, Benoit Mandelbrot, Berlin Wall, Bernie Madoff, big-box store, Black Swan, Broken windows theory, Carmen Reinhart, Claude Shannon: information theory, Climategate, Climatic Research Unit, cognitive dissonance, collapse of Lehman Brothers, collateralized debt obligation, complexity theory, computer age, correlation does not imply causation, Credit Default Swap, credit default swaps / collateralized debt obligations, cuban missile crisis, Daniel Kahneman / Amos Tversky, diversification, Donald Trump, Edmond Halley, Edward Lorenz: Chaos theory, en.wikipedia.org, equity premium, Eugene Fama: efficient market hypothesis, everywhere but in the productivity statistics, fear of failure, Fellow of the Royal Society, Freestyle chess, fudge factor, George Akerlof, haute cuisine, Henri Poincaré, high batting average, housing crisis, income per capita, index fund, Internet Archive, invention of the printing press, invisible hand, Isaac Newton, James Watt: steam engine, John Nash: game theory, John von Neumann, Kenneth Rogoff, knowledge economy, locking in a profit, Loma Prieta earthquake, market bubble, Mikhail Gorbachev, Moneyball by Michael Lewis explains big data, Monroe Doctrine, mortgage debt, Nate Silver, new economy, Norbert Wiener, PageRank, pattern recognition, pets.com, prediction markets, Productivity paradox, random walk, Richard Thaler, Robert Shiller, Robert Shiller, Rodney Brooks, Ronald Reagan, Saturday Night Live, savings glut, security theater, short selling, Skype, statistical model, Steven Pinker, The Great Moderation, The Market for Lemons, the scientific method, The Signal and the Noise by Nate Silver, The Wisdom of Crowds, Thomas Kuhn: the structure of scientific revolutions, too big to fail, transaction costs, transfer pricing, University of East Anglia, Watson beat the top human players on Jeopardy!, wikimedia commons

The other 10 percent of the time, the noise traders dominate—and they can go a little haywire.97 One way to look at this is that markets are usually very right but occasionally very wrong. This, incidentally, is another reason why bubbles are hard to pop in the real world. There might be a terrific opportunity to short a bubble or long a panic once every fifteen or twenty years when one comes along in your asset class. But it’s very hard to make a steady career out of that, doing nothing for years at a time. The Two-Track Market Some theorists have proposed that we should think of the stock market as constituting two processes in one.98 There is the signal track, the stock market of the 1950s that we read about in textbooks. This is the market that prevails in the long run, with investors making relatively few trades, and prices well tied down to fundamentals.

In this scenario, your risks are well diversified: if a carpenter in Cleveland defaults on his mortgage, this will have no bearing on whether a dentist in Denver does. Under this scenario, the risk of losing your bet would be exceptionally small—the equivalent of rolling snake eyes five times in a row. Specifically, it would be 5 percent taken to the fifth power, which is just one chance in 3,200,000. This supposed miracle of diversification is how the ratings agencies claimed that a group of subprime mortgages that had just a B+ credit rating on average38—which would ordinarily imply39 more than a 20 percent chance of default40—had almost no chance of defaulting when pooled together. The other extreme is to assume that the mortgages, instead of being entirely independent of one another, will all behave exactly alike. That is, either all five mortgages will default or none will.

., 185–88, 254–55 Council of Economic Advisers, 40 Council on Foreign Relations, 435 Cramton, Steven, 292–93 creativity, 287–88, 289, 290, 291, 311 credit bubble, 68, 196 credit default option (CDO), 20–21, 21, 22, 24, 25, 26–30, 36, 43, 462 tranches of, 26–28, 28 credit default swap, 36 credit markets, 19 Crist, Charlie, 33 Cronkite, Walter, 207–8 Crowley, Monica, 48–49, 467 crystal methamphetamine, 221 Cuban Missile Crisis, 419, 433 Curb Your Enthusiasm, 111 cyclones, see hurricanes Czechoslovakia, 52 Daily Kos, 60 Damon, Matt, 317 Dark Winter, 437 Darwin, Charles, 375 data: in baseball, 79–80, 84 Big, 9–12, 197, 250, 253, 264, 289, 447, 452 distribution of, 164, 165 in economics, 80, 185, 193–94 in frequentism, 253 overfitting of, 163–71, 166, 168–71, 185, 191, 452n, 478 Pareto principle and, 313 data mining, 298 Daum, Robert, 224, 227, 229 David, Larry, 111 Davis, Ricky, 239, 257 De Bernardinis, Bernardo, 143 debt crisis, European, 198 Deep Blue, 10, 266, 268, 292, 493–94 bug in, 283, 285, 286, 288–89 creation of, 283–85 Kasparov’s final games against, 282–83 Kasparov’s first game against, 268, 270–79, 271, 274, 275, 276, 278 Kasparov’s second game against, 279–82, 280 rook moved for no apparent purpose by, 277–79, 278, 288 Deep Thought, 268, 284 default, 20–21, 22, 27–29, 184 defense, 90, 92, 106 Defense Department, U.S., terrorism prevention by, 273 defensive range, 96 de Groot, Adriaan, 272 Denver, Colo., 150 Denver Post, 176 depth, breadth vs., 271–73 determinism, 112, 113, 241, 242, 249, 448 Detroit Tigers, 77, 88, 94 difference engine, 263 Discover, 160 discrimination, calibration vs., 474 disease, see infectious disease diversification, 27 “Divine Benevolence” (Bayes), 241, 242 Djokovic, Novak, 496 Dodger Stadium, 79 Dokhoian, Yuri, 282 Domodedovo Airport, 440 dot-com boom, 346–48, 361 Dow Jones Industrial Average, 37, 339, 340, 343, 498, 503 Doyle, Arthur Conan, 307 Drake equation, 488 Druckenmiller, Stanley, 356 Dukakis, Michael, 68 Duke University, 359 Dutch book, 256n Dwan, Tom, 308–11, 313, 315, 318, 324, 328 dynamic systems, 16, 118, 120, 194 E*Trade, 339, 363, 498 earthquake forecasting, 149–54, 230 computers in, 289 failure of, 7, 11, 143, 147–49, 158–61, 168–71, 174, 249, 253, 346, 389 overfitting and, 168–71, 185 short-term, 174 time-dependent, 154 earthquakes, 16, 142–75, 476, 512 aftershocks to, 154, 161, 174, 476–77 in Anchorage, 149 causes of, 162 distribution across time and space of, 154–57, 155, 427 foreshocks to, 144, 154, 155–57, 476 Great Sumatra, 161, 171 in Haiti, 147n, 155–56, 156, 224 in Japan, 154, 155, 168–71, 172 in L’Aquila, 142–44, 148, 154–55, 157, 173 Lisbon, 145 list of deadliest, 147 Loma Prieta, 160 magnitude vs. frequency of, 151–53, 152, 153, 368n, 427, 432, 437–38, 441 near Reno, 156–57, 157 in New Zealand, 174 earthquake swarm, 143n, 173 Earth System Science Center, 408 East Germany, 52 eBay, 353 Ecclesiastes, 459 economic data, noise in, 193–94, 198 economic growth, 6, 6, 186n economic progress, 7, 112, 243 economics, predictions in, 33, 176–77, 230 actual GDP vs., 191–93, 192, 193, 194 Big Data and, 197 computers in, 289 consensus vs. individual, 197–98, 335 context ignored in, 43 an ever-changing economy, 189–93 economics, predictions in (Cont.)

 

pages: 374 words: 114,600

The Quants by Scott Patterson

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Albert Einstein, asset allocation, automated trading system, Benoit Mandelbrot, Bernie Madoff, Bernie Sanders, Black Swan, Black-Scholes formula, Bonfire of the Vanities, Brownian motion, buttonwood tree, buy low sell high, capital asset pricing model, centralized clearinghouse, Claude Shannon: information theory, cloud computing, collapse of Lehman Brothers, collateralized debt obligation, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, Donald Trump, Doomsday Clock, Emanuel Derman, Eugene Fama: efficient market hypothesis, fixed income, Gordon Gekko, greed is good, Haight Ashbury, index fund, invention of the telegraph, invisible hand, Isaac Newton, job automation, John Nash: game theory, law of one price, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, margin call, merger arbitrage, NetJets, new economy, offshore financial centre, Paul Lévy, Ponzi scheme, quantitative hedge fund, quantitative trading / quantitative finance, race to the bottom, random walk, Renaissance Technologies, risk-adjusted returns, Rod Stewart played at Stephen Schwarzman birthday party, Ronald Reagan, Sergey Aleynikov, short selling, South Sea Bubble, speech recognition, statistical arbitrage, The Chicago School, The Great Moderation, The Predators' Ball, too big to fail, transaction costs, value at risk, volatility smile, yield curve, éminence grise

In the five years since it had been up and running, Midas had delivered $1 billion in net income to Morgan, in the process making everyone at PDT rich beyond their wildest dreams. In the coming years, it would only get better, making everyone even richer. Especially Peter Muller. ASNESS When Cliff Asness took a full-time job at Goldman in late 1994, he wasn’t sure what his job was supposed to be. He was given the task of building quantitative models to forecast returns on multiple asset classes, a broad mandate. Essentially, Goldman was taking a gamble on the young phenom from Chicago, trying to see if his ivory tower schooling would pay off in the real world. Goldman had made one of its first wagers on book smarts with Fischer Black in the 1980s. By the early 1990s, it was the go-to bank for bright mathletes from universities around the country. Asness called his fledgling operation Quantitative Research Group.

If the selling had continued—which likely would have happened if Goldman Sachs hadn’t bailed out its GEO fund—the results could have been catastrophic, not only for the quants but for everyday investors, as the sell-off spilled into other sectors of the market. Just as the implosion of the mortgage market triggered a cascading meltdown in quant funds, the losses by imploded quant funds could have bled into other asset classes, a crazed rush to zero that could have put the entire financial system in peril. The most terrifying aspect of the meltdown, however, was that it revealed hidden linkages in the Money Grid that no one had been aware of before. A collapse in the subprime mortgage market triggered margin calls in hedge funds, forcing them to unwind positions in stocks. The dominoes started falling, hitting other quant hedge funds and forcing them to unwind positions in everything from currencies to futures contracts to options in markets around the world.

Deutsche Bank was also a big player in the securitization market, buying mortgage loans from lenders, packaging those loans into securities, then slicing and dicing them into different pieces to peddle to investors around the world. One reason why banks engage in securitization is to spread around risk like jelly on toast. Instead of lumping the jelly on one small piece of the toast, leaving all the reward (or risk that it falls off the toast) for one bite, it’s evenly distributed, making for lots more tasty bites—and, through the quant magic of diversification (spreading the jelly), less risk. If an investor buys a single subprime mortgage worth $250,000, that investor bears the entire risk if that mortgage goes into default, certainly possible given the fact that subprime mortgages usually go to the least creditworthy borrowers. But if a thousand subprime mortgages, each worth about $250,000, were pooled together and turned into a single security with a collective value of $250 million, the security could be divided into some number of shares.

 

pages: 448 words: 142,946

Sacred Economics: Money, Gift, and Society in the Age of Transition by Charles Eisenstein

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Albert Einstein, back-to-the-land, bank run, Bernie Madoff, big-box store, Bretton Woods, capital controls, clean water, collateralized debt obligation, credit crunch, David Ricardo: comparative advantage, debt deflation, deindustrialization, delayed gratification, disintermediation, diversification, fiat currency, financial independence, financial intermediation, floating exchange rates, Fractional reserve banking, full employment, global supply chain, happiness index / gross national happiness, hydraulic fracturing, informal economy, invisible hand, Jane Jacobs, land tenure, Lao Tzu, liquidity trap, lump of labour, McMansion, means of production, money: store of value / unit of account / medium of exchange, moral hazard, mortgage debt, new economy, oil shale / tar sands, Own Your Own Home, peak oil, phenotype, Ponzi scheme, profit motive, quantitative easing, race to the bottom, Scramble for Africa, special drawing rights, spinning jenny, technoutopianism, the built environment, Thomas Malthus, too big to fail

I won’t offer definitions here—you can look them up yourself—except for the most relevant, the zero-risk interest premium. That is equivalent to the rate on short-term U.S. government securities (T-bills), which have essentially zero risk and full liquidity. One might say that there is risk here too, but if things unravel to the point where the U.S. government is incapable of printing money, then no asset class would be safe. 5. The new means of keeping interest rates above growth is the Fed’s new power to offer interest on bank reserves. Currently at near zero, the Fed plans to raise these rates when the economy starts growing (see, e.g., Keister and McAndrews, “Why Are Banks Holding So Many Excess Reserves?”). This will ensure that any new wealth created through economic growth will accrue to the banks and bondholders who benefited from the Fed’s liquidity facility giveaways. 6.

In times of extreme crisis, governments typically confiscate private gold holdings—Hitler, Lenin, and Roosevelt all did so. If even the government falls apart, then people with guns will come and take your gold or any other store of wealth. I sometimes read the financial website Zero Hedge for its remarkable insight into the pretenses and machinations of the financial power elite. In that website’s dim view, no asset class except physical gold and other physical commodities is safe today. I agree with its logic as far as it goes, but it does not go far enough. If the system breaks down to the point of hyperinflation, then the institution of property—as much a social convention as money is—will break down too. In times of social turmoil, I can’t imagine anything more dangerous than possessing a few hundred ounces of gold.

I will not mince words: in this book I am calling for economic degrowth, a shrinking of the economy, a recession that will last decades or centuries. Obviously, the word “recession” has negative connotations today, though it really just means a time of receding. I am most emphatically not saying that we must make some sacrifices to our quality of life for the good of the planet. Rather, we need but reduce the role of money. If our future includes a diversification in the modes of human sharing, then economic growth no longer has the same meaning it has today. We don’t need to become more altruistic and self-sacrificing, forgoing our own benefit for the good of others. How tightly we hold to the equation of money and self-interest! But it shall be so no longer. Let me illustrate by way of some examples how we can all become richer through the shrinkage of the money realm.

 

pages: 421 words: 128,094

King of Capital: The Remarkable Rise, Fall, and Rise Again of Steve Schwarzman and Blackstone by David Carey; John E. Morris; John Morris

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asset allocation, banking crisis, Bonfire of the Vanities, carried interest, collateralized debt obligation, corporate governance, credit crunch, diversification, diversified portfolio, fixed income, Gordon Gekko, margin call, Menlo Park, mortgage debt, new economy, Northern Rock, risk tolerance, Rod Stewart played at Stephen Schwarzman birthday party, Sand Hill Road, sealed-bid auction, Silicon Valley, sovereign wealth fund, The Predators' Ball, éminence grise

Returns on most of the megabuyouts that epitomized the boom times are therefore likely to be dismal. Many industry insiders predicted that, collectively, private equity funds raised in the mid-2000s would not break even, performing even worse than funds raised at the end of the 1990s that were invested during the last market high. The push by some firms like Apollo, KKR, and Carlyle to diversify away from LBOs into other asset classes by launching business development companies and publicly traded debt funds also proved calamitous. A $900 million mortgage debt fund that Carlyle raised on the Amsterdam exchange, shortly after KKR launched its $5 billion equity fund, was leveraged with more than $22 billion of debt and capsized in 2008 when its lenders issued margin calls and seized all its assets. It was a complete wipeout.

It emerged with most of its capital intact while commercial and investment banks were hobbled by astronomical losses on mortgage products and derivatives. The buyout funds raised in 2005 to 2007 may end up delivering disappointing returns, just as many funds raised at the peaks of the market at the end of the eighties and nineties did. But the real test for private equity will be how it performs as an asset class against other investments. Notwithstanding the risks of leverage and the private equity–backed companies that went under, private equity funds have beaten the overall average returns at major pension funds over the last three, five, and ten years. For pension managers who need to make up for losses in stocks and real estate in 2007 to 2009, private equity will seem very tempting. Even without new contributions, though, private equity firms have roughly $500 billion in their coffers at a time when other institutions are struggling to raise capital.

At RCA Corporation, once just a radio and TV maker and the owner of the NBC broadcasting networks, CEO Robert Sarnoff added the Hertz rental car system; Banquet frozen foods; and Random House, the book publisher. Each of the great conglomerates—Litton Industries, Textron, Teledyne, and Gulf and Western Industries—had its own eclectic mix, but the modus operandi was the same: Buy, buy, buy. Size and diversity became grail-like goals. Unlike companies that grow big by acquiring competitors or suppliers to achieve economies of scale, the rationale for conglomerates was diversification. If one business had a bad year or was in a cyclical slump, others would compensate. At bottom, however, the conglomerate was a numbers game. In the 1960s, conglomerates’ stocks sometimes traded at multiples of forty times earnings—far above the historical average for public companies. They used their overvalued stock and some merger arithmetic to inflate their earnings per share, which is a key measure for investors.

 

pages: 393 words: 115,263

Planet Ponzi by Mitch Feierstein

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Affordable Care Act / Obamacare, Albert Einstein, Asian financial crisis, asset-backed security, bank run, banking crisis, barriers to entry, Bernie Madoff, centre right, collapse of Lehman Brothers, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Daniel Kahneman / Amos Tversky, disintermediation, diversification, Donald Trump, energy security, eurozone crisis, financial innovation, financial intermediation, Flash crash, floating exchange rates, frictionless, frictionless market, high net worth, High speed trading, illegal immigration, income inequality, interest rate swap, invention of agriculture, Long Term Capital Management, moral hazard, mortgage debt, Northern Rock, obamacare, offshore financial centre, oil shock, pensions crisis, Plutocrats, plutocrats, Ponzi scheme, price anchoring, price stability, purchasing power parity, quantitative easing, risk tolerance, Robert Shiller, Robert Shiller, Ronald Reagan, too big to fail, trickle-down economics, value at risk, yield curve

Jefferson Smith would have been baffled by the idea of risk quantification. As far as he was concerned, the amount of money he had at risk was the amount he’d lent to Joe Schmoe minus the amount that Joe had repaid. The only risk to which Jefferson Smith was exposed was that some idiot in the office might not be able to do simple arithmetic. The situation is utterly different today. For all that securities are designed to be tradable‌—‌a commoditized asset class using largely standardized legal language, conferring the same rights no matter which investor owns the security‌—‌they oftentimes don’t trade much at all. Sometimes that doesn’t matter too much. If you own an A-rated corporate bond, and you’ve done your homework and reckon that the A-rating is appropriate for the borrower in question, you can get a pretty good idea of the price your bond will trade at simply by looking at the prices at which other A-rated bonds are traded today.

A currency is likely to appreciate in value if its government operates sound finances and sound money; if it has a strong economy with good growth prospects, a strong and stable housing market, and perhaps especially if it has abundant natural resources. Those things are not, alas, true of very many countries today, but exceptions do exist: Canada and the Scandinavian states, for example. A natural diversification for American investors would be to switch some US dollar assets into Canadian dollars. North of the border, you have a government with sound money, untroubled banks, and huge natural resources. That’s a wonderful recipe for a steadily appreciating currency. The Australian and New Zealand dollars look attractive for similar reasons. Hong Kong dollars and the Brazilian real also offer strong possibilities for currency gains.

 

pages: 424 words: 121,425

How the Other Half Banks: Exclusion, Exploitation, and the Threat to Democracy by Mehrsa Baradaran

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access to a mobile phone, affirmative action, asset-backed security, bank run, banking crisis, banks create money, barriers to entry, British Empire, call centre, Capital in the Twenty-First Century by Thomas Piketty, cashless society, credit crunch, David Graeber, disintermediation, diversification, failed state, fiat currency, financial innovation, financial intermediation, Goldman Sachs: Vampire Squid, housing crisis, income inequality, Internet Archive, invisible hand, Kickstarter, M-Pesa, McMansion, microcredit, mobile money, moral hazard, mortgage debt, new economy, Own Your Own Home, payday loans, peer-to-peer lending, price discrimination, profit maximization, profit motive, quantitative easing, race to the bottom, rent-seeking, Ronald Reagan, Ronald Reagan: Tear down this wall, savings glut, the built environment, the payments system, too big to fail, trade route, transaction costs, unbanked and underbanked, underbanked, union organizing, white flight, working poor

The data is clear on this: “More than 84 percent of the subprime mortgages in 2006 were issued by private lending institutions.”81 The Turner Report, the most comprehensive review of the financial crisis, as well as most other serious analyses of the causes of the crisis, start the economic story with the problem of a “savings glut.” Put simply, the U.S. markets became flooded by foreign money seeking a high return on investment. While these funds would usually have bought up U.S. Treasury bonds, the large demand for them lowered Treasury yields and the pool of money flowed toward Wall Street, seeking a better return. The next safest asset class after U.S. treasuries was asset-backed securities, or home mortgages. Wall Street banks, trying to meet investor demand, sold and resold as many of these securities as they could through bundling and creating new “structured products,” but the demand was practically insatiable. So they originated more mortgage loans. But the pool of qualified borrowers was limited, leading them to seek higher and higher risk borrowers and creating a massive subprime market.

Reflecting the historical understanding that banks serve the public, most laws affecting banks had a requirement written into them that bank supervisors deciding on bank-related issues should only allow an action if it benefits the public. However, the question of whether a certain bank action would benefit the public morphed into an inquiry about bank profitability. For example, the Federal Reserve approved another case because of the public benefit of “[providing] Applicant greater resources for expansion and greater flexibility for diversification of business activities … [which would] allow Applicant to continue to compete effectively with other large Rhode Island financial organizations.”108 Bank “efficiency” and “profits” slowly became the proxy for “public benefit.” Additionally, the banks themselves underwent a coinciding cultural shift from acting as caretakers or fiduciaries for their customers to exploiting them. A former Goldman Sachs executive director explained this new culture that was rewarded, not by protecting customers, but by making money off of their ignorance.

 

pages: 819 words: 181,185

Derivatives Markets by David Goldenberg

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Black-Scholes formula, Brownian motion, capital asset pricing model, commodity trading advisor, compound rate of return, conceptual framework, Credit Default Swap, discounted cash flows, discrete time, diversification, diversified portfolio, en.wikipedia.org, financial innovation, fudge factor, implied volatility, incomplete markets, interest rate derivative, interest rate swap, law of one price, locking in a profit, London Interbank Offered Rate, Louis Bachelier, margin call, market microstructure, martingale, Norbert Wiener, price mechanism, random walk, reserve currency, risk/return, riskless arbitrage, Sharpe ratio, short selling, stochastic process, stochastic volatility, time value of money, transaction costs, volatility smile, Wiener process, Y2K, yield curve, zero-coupon bond

Short Positions Anticipated Sell, therefore Long P0 Time 0, Now Anticipated Buy, therefore Short P0 Time 0, Now Price Worry P1 Time 1, The Future Price Worry P1 Time 1, The Future HEDGING, BASIS RISK, AND SPREADING 165 6.1 HEDGING AS PORTFOLIO THEORY You are a mutual fund manager, which means that you manage a diversified portfolio. However, even after diversifying, market volatility remains. You don’t want to jump around between asset classes attempting to execute a risky and questionably profitable market timing strategy. We will call this the Wall Street Journal strategy. Instead, you want to maintain your position in the portfolio, but you also want to protect it against adverse price movements. The basic alternatives available to you are described in Figure 6.2. FIGURE 6.2 Synthetic Treasury Bill vs. Actual MUTUAL FUND TREASURY BILLS (NATURAL) HEDGE VEHICLE = STOCK INDEX FUTURES OF THE APPROPRIATE MATURITY The difference between the left-hand side and the right-hand side of Figure 6.2 is that in order to get to the right-hand side you have to liquidate part or all of your mutual funds, and invest the proceeds in US Treasury bills.

This has the positive effect of diversifying away some of the avoidable risk of individual stocks. However, we also know from portfolio analysis that there are limits to diversification. You can’t diversify away the non-diversifiable (market) risks of your portfolio. We also know that the maximum effect of diversification occurs when we add perfectly negatively correlated assets to our portfolio. So, the alternative ways to hedge your position are: 420 OPTIONS 1. (Naive) Diversification: add securities to form a portfolio with BAC. This gets you the diversification effect. 2. Synthetically create negative correlation: find another type of security that is highly positively correlated with BAC stock and short it! Under 2., candidate hedging vehicles include standard plain vanilla call options on BAC. There are many choices, varying by maturity and exercise price. One could also use forward contracts, or liquid futures contracts on BAC to hedge.

 

pages: 823 words: 220,581

Debunking Economics - Revised, Expanded and Integrated Edition: The Naked Emperor Dethroned? by Steve Keen

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accounting loophole / creative accounting, banking crisis, banks create money, barriers to entry, Benoit Mandelbrot, Big bang: deregulation of the City of London, Black Swan, Bonfire of the Vanities, butterfly effect, capital asset pricing model, cellular automata, central bank independence, citizen journalism, clockwork universe, collective bargaining, complexity theory, correlation coefficient, credit crunch, David Ricardo: comparative advantage, debt deflation, diversification, double entry bookkeeping, en.wikipedia.org, Eugene Fama: efficient market hypothesis, experimental subject, Financial Instability Hypothesis, Fractional reserve banking, full employment, Henri Poincaré, housing crisis, Hyman Minsky, income inequality, invisible hand, iterative process, John von Neumann, laissez-faire capitalism, liquidity trap, Long Term Capital Management, mandelbrot fractal, margin call, market bubble, market clearing, market microstructure, means of production, minimum wage unemployment, open economy, place-making, Ponzi scheme, profit maximization, quantitative easing, RAND corporation, random walk, risk tolerance, risk/return, Robert Shiller, Robert Shiller, Ronald Coase, Schrödinger's Cat, scientific mainstream, seigniorage, six sigma, South Sea Bubble, stochastic process, The Great Moderation, The Wealth of Nations by Adam Smith, Thorstein Veblen, time value of money, total factor productivity, tulip mania, wage slave

It therefore faces a ‘soft budget constraint’: to expand its operations, all it has to do is to persuade borrowers (firms and households) to borrow more money, and its income will grow – as will the level of debt. This growth in bank income and debt is in turn dependent on the willingness of borrowers to incur debt. If this is based solely on their income, then the ‘hard budget constraint’ that households and firms face will put a limit on the amount of debt they will take on. If, however, a Ponzi scheme develops in some asset class – so that people are willing to borrow money in the expectation of future capital gain – then the amount of borrowing will no longer be constrained by incomes. While capital gains are made, the borrowers also operate with a soft budget constraint: any deficiency of revenue over costs can be covered by selling an asset whose price has been inflated by the increase in leverage. Initially banks – after they have forgotten the previous crisis – will be willing to fund this process, since it increases their incomes.

At this time, his confidence in the soundness of the American economy was complete’ (Barber 1997). 9 Barber observed that among the other reasons was the fact that ‘In the 1930s, his insistence on the urgency of “quick fix” solutions generated frictions between Fisher and other professional economists’ (ibid.). 10 Almost 90 percent of the over 1,200 citations of Fisher in academic journals from 1956 were references to his pre-Great Depression works (Feher 1999). 11 Strictly speaking, this was supposed to be anything in which one could invest, but practically the theory was applied as if the investments were restricted to shares. 12 Since diversification reduces risk, all investments along this edge must be portfolios rather than i