diversified portfolio

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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

That is, the Sharpe ratios of the U.S. only and internationally diversified portfolios are identical, so alpha∗ is zero. P1: a/b c08 P2: c/d QC: e/f JWBT412-Marston T1: g December 8, 2010 17:51 150 Printer: Courier Westford PORTFOLIO DESIGN But what if emerging market stocks are included in the analysis? The MSCI Emerging Markets Index begins only in January 1990. In Table 8.1, a portfolio with both MSCI indexes, EAFE and Emerging Markets, is compared with a U.S.-only portfolio. The internationally diversified portfolio consists of MSCI EAFE alone before 1990. Beginning in 1990, MSCI EM has a one-third weight in the international index with MSCI EAFE having a two-thirds weight. The results are a little more satisfactory. The riskadjusted return on the internationally diversified portfolio is 0.3 percent above that of the U.S.

DIVERSIFICATION BENEFITS OF FOREIGN STOCK INVESTING A traditional argument in favor of diversification into foreign stocks was the relatively low correlation between foreign and domestic stocks. This low correlation meant that the risk of an internationally diversified portfolio could be lower than that of an all-U.S. portfolio. Over the period from 1970 (when the EAFE index begins) and 2009, for example, the correlation between EAFE and the S&P 500 index is only 0.60. The effects of this low correlation have often been illustrated using a horseshoe diagram like that found in Figure 5.8. The horseshoe shows various portfolios of U.S. and foreign stocks ranging from an all-S&P 500 portfolio (at the lower right end) to an all EAFE portfolio (at the higher right end). The powerful message of this chart is that diversified portfolios of foreign and domestic stocks have the dual benefit of lower risk and higher return. The horseshoe diagram was often used in the marketing materials of foreign stock mutual fund managers during the mid-1990s.

The first comparisons are for the period starting in 1970 when the EAFE index was introduced. There is an all-American portfolio consisting of 75 percent invested in the S&P 500 and 25 percent in the medium-term Treasury bond. The diversified portfolio replaces one third of the stock allocation, 25 percent of the whole portfolio, with foreign stocks. The portfolio containing EAFE has a higher return and lower standard deviation. So the Sharpe ratio is also higher at 0.41 as opposed to 0.37 for the all-American portfolio. That is not much of a difference, but it translates into 0.4 percent excess return for the diversified portfolio.12 The second set of portfolios is for a shorter period beginning in 1979. This set of portfolios replaces the S&P 500 with the Russell 3000 all-cap P1: a/b c05 P2: c/d QC: e/f JWBT412-Marston T1: g December 8, 2010 17:36 Printer: Courier Westford 87 Foreign Stocks TABLE 5.5 Performance of Portfolio with EAFE Added Portfolio A (1970–2009) Without EAFE 25% EAFE Portfolio B (1979–2009) Without EAFE 25% EAFE Geometric Average Arithmetic Average Standard Deviation Sharpe Ratio 9.7% 9.9% 10.0% 10.1% 12.0% 11.2% 0.37 0.41 11.0% 10.8% 11.2% 11.0% 12.2% 11.6% 0.47 0.47 Portfolio A: Portfolio without EAFE consists of 25 percent in medium-term U.S.

 

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

ASSET ALLOCATION IN TRADITIONAL AND ALTERNATIVE INVESTMENTS: A ROAD MAP A seminal study by Brinson, Hood, and Beebower (1986) demonstrated that as much as 93.6% of variation in returns in quarterly performance of professionally managed diversified portfolios could be explained by the mix of the asset classes (security selection explains the rest).5 Recent research however, has also shown, that while over 90% of the return volatility of a diversified portfolio through time is explained by its allocation to broad asset classes, a somewhat smaller portion of that portfolio’s total return over the same time period is explained by its allocation to various asset classes. Davis et. al (2007) have shown the portion of total returns on various portfolios that can be explained by their allocations to broad asset classes may vary depending on how actively a diversified portfolio is managed. Whatever the final number, these results indicate that asset allocation is a major determinant of any diversified portfolio’s risk-return profile and that any viable asset allocation program should include a wide range of potential asset classes.

For instance, if the current price of a 10-year zero-coupon Treasury security is .67, this means that for every $100 investment, $67 must be invested in Treasuries to protect the principal. The remaining $33 can be invested in the diversified portfolio. Such a strategy would be free of almost any risk and of course is not likely to provide a meaningful return either. Alternatively, the investor may be willing to take a small risk and use a CPPI structure to manage the risk. Using a moderate multiplier (e.g., m = 2), the investor can have a great deal of confidence that the bond floor will not be violated. In this case, the portfolio manager will invest the following amount in the diversified portfolio: 66 = 2 × (100 − 67 ) The remaining 34 will be invested in Treasuries. Suppose the bond floor increases to 70, the investment in Treasuries grows 36 and the investment in diversified portfolio grows to 73. The reallocation is determined as follows: 78 = 2 × (36 + 73 − 70) This means that the total investment in diversified portfolio should increase from 73 to 78.

As an alternative, the number of calculations can be significantly reduced if it is assumed that returns are driven by only one factor (e.g., the market portfolio). Note that this does not assume that CAPM holds. In other words, suppose we use a simple linear regression to estimate the beta of an asset with respect to a well diversified portfolio. Rit = α i + βi Rmt + eit The rate of return on the asset at time t is given by Rit, the rate of return on the diversified portfolio is given by Rmt, the intercept and the slope (beta) are given by αi and βi respectively. Finally, the error term for asset i is given by eit. Suppose we run the same regression for another asset, denoted asset j. If the error term for asset j is uncorrelated with the error term for asset i, then the covariance between the two assets is given by Cov (Ri , Rj ) = βi β jVar (Rm ) Notice that to estimate covariance between the two assets, we need an estimate of the variance of the market portfolio as well (Var(Rm)).

 

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

During most periods, so-called junk bonds (lower credit quality, higher-yielding bonds) have given investors a net rate of return two percentage points higher than the rate that could be earned on “investment-grade” bonds with high-quality credit ratings. In 2010 investment-grade bonds yielded about 6 percent, whereas “junk” bonds often yielded 8 percent. Thus, even if 2 percent of the lower-grade bonds defaulted on their interest and principal payments and produced a total loss, a diversified portfolio of low-quality bonds would still produce net returns comparable to those available from a high-quality bond portfolio. Thus, many investment advisers have recommended well-diversified portfolios of high-yield bonds as sensible investments. There is, however, another school of thought that advises investors to “just say no” to junk bonds. Most junk bonds have been issued as a result of a massive wave of corporate mergers, acquisitions, and leveraged (mainly debt-financed) buyouts. The junk-bond naysayers point out that lower credit bonds are most likely to be serviced in full only during good times in the economy.

BROADLY DIVERSIFIED PORTFOLIO OF MUTUAL FUNDS (WITH ANNUAL REBALANCING) VS. PORTFOLIO CONTAINING U.S. STOCKS ONLY Source: Vanguard and Morningstar. The first decade of the new millennium has been a most challenging time for investors. Even a broadly diversified Total Stock Market fund devoted solely to U.S. stocks lost money. But even in this horrible decade, following the timeless lessons I have espoused would have produced satisfactory results. The chart above shows that an investment in the VTSMX (the Vanguard Total Stock Market Fund) did not produce positive returns in the “lost” decade of the “naughties.” But suppose an investor diversified her portfolio with the approximate conservative percentages I suggested previously for the “aging Baby Boomers.” The diversified portfolio (annually rebalanced) produced a quite satisfactory return even during one of the worst decades investors have ever experienced.

There were many villains in this morality tale: the fee-obsessed underwriters who should have known better than to peddle all of the crap they brought to market; the research analysts who were the cheerleaders for the banking departments and who were eager to recommend Net stocks that could be pushed by commission-hungry brokers; corporate executives using “creative accounting” to inflate their profits. But it was the infectious greed of individual investors and their susceptibility to get-rich-quick schemes that allowed the bubble to expand. And yet the melody lingers on. I have a friend who built a modest investment stake into a small fortune with a diversified portfolio of bonds, real estate funds, and stock funds that owned a broad selection of blue-chip companies. But he was restless. At cocktail parties he kept running into people boasting about this Net stock that tripled or that telecom chipmaker that doubled. He wanted some of the action. Along came a stock called Boo.com, an Internet retailer that planned to sell with no discounts “urban chic clothing—that was so cool it wasn’t even cool yet.”

 

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

Exactly how you invest in each of these asset classes is of lesser importance than owning the asset classes themselves, although some ways are better and less expensive than others. 3 CHAPTER 1 4 What is you current investment policy? Consider the following two portfolio management strategies. Which one best describes you today? ● ● Plan A. Buy investments that I expect will perform well over the next few years. If an investment performs poorly or the prospects change, switch to another investment or go to cash and wait for a better opportunity. Plan B. Buy and hold different types of investments in a diversified portfolio regardless of their near-term prospects. If an investment performs poorly, buy more of that investment to put my portfolio back in balance. If you are like most investors, Plan A looks familiar. People tend to put their money into investments that they believe will lead to profitable results in the near term and sell those that do not perform. The goal of Plan A is to “do well,” which is not a quantifiable financial goal.

Examples of styles include growth and value stocks, large and small stocks, and investment-grade bonds and non-investment-grade bonds. Sectors can be of different types. Stocks can be divided by industry sectors, such as industrial stocks, technology stocks, bank stocks, and so on; or they can be geographically divided, such as Pacific Rim and European stocks. Bonds can be divided by issuer, such as mortgages, corporate bonds, and Treasury bonds. A well-diversified portfolio may hold several asset classes, categories, styles, and sectors. Successful investors study all asset classes and their various components in order to understand the differences among them. They estimate the long-term expectations of risk and return, and they study how the returns on one asset class may move in relation to other classes. Then they weigh the advantages and disadvantages of including each investment in their portfolio.

However, despite the October collapse, the market still stood in positive territory at the end of the month, and by year-end the S&P 500 was up a respectable 5.1 percent. No investor who had money in a diversified stock portfolio for the entire year in 1987 lost money, but that is not what people remember. We only remember how bad it felt to lose money on Black Monday. Everyone wants to earn a fair return on his or her investments after inflation and taxes. This will require risk and probably losing money on occasion. All the broadly diversified portfolios introduced in this book have inherent risk and will go down in value periodically. It would be nice to know when these losses will occur so that we can sell beforehand, but that is simply not possible. No one can predict with any consistency when the markets will go up or down. If a person tells you she has found the secret to the markets, she is either naive or she is trying to steal your money.

 

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

An investor would be better off allocating to multiple investments, each with the same expected average return, than to just one of those investments, not only because of lower risk (the well-understood rationale) but also because the lower volatility of the diversified portfolio will yield a higher compounded return. In fact, a diversified portfolio will often yield a higher compounded return than at least some of its components with returns above the portfolio average. The implication is that unless you are confident that you can pick a significantly above-average investment, you are better off with a diversified portfolio, even for return reasons alone, not to mention the risk-reduction benefits. The impact of volatility on compounding is one of the reasons why in Chapter 3 the past best-performing sector or fund yielded a lower cumulative return than the average (in addition to having much higher risk).

There is, in fact, no reason to assume that a largely similar portfolio, let alone the same portfolio, would have been chosen at the start of the pro forma period and subsequently maintained throughout the period without changes. Thus such pro forma results will be highly biased because, although the portfolio results are constructed from actual return data for the underlying funds, the composition of the portfolio itself is hypothetical. Another example of misleading pro forma numbers would be a manager who after trading a diversified portfolio decides to create a new specialized program that trades only one sector in the portfolio. One can safely assume that such a carve-out portfolio will be based on a market sector subset of the whole portfolio that has done particularly well. Once again, the pro forma results are based on actual returns, a factor that seems to lend credibility. What the investor may fail to realize, however, is that the returns represent a cherry-picked subset of a broader portfolio.

Even if individual hedge funds, on average, had the same return/risk characteristics as mutual funds or equity indexes, it would still be possible to create a portfolio with significantly better return/risk characteristics by utilizing hedge funds because of their heterogeneous nature. The fact that there are so many different types of hedge fund strategies, some with moderate to low correlation with each other, makes it possible to create a portfolio that has much greater diversification and hence lower risk. Consequently, a diversified portfolio of hedge funds has an intrinsic important advantage over traditional mutual fund investments simply because there are so many more tools to work with. Advantages of Incorporating Hedge Funds in a Portfolio There are two key reasons why a hedge fund allocation should be added to traditional long-only investment portfolios: 1. Hedge funds are a better-performing asset in return/risk terms.

 

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

M = minimum-risk portfolio. 15.6 illustrates, an index of managed futures returns is most strongly related to investment strategies focused on currencies, interest rates, and stocks. Commodities are in fourth place. One way of demonstrating that a commodity investment strategy is of benefit to a diversified portfolio of CTAs is to calculate how the Sharpe ratio (excess return divided by standard deviation) would change once the new investment is added to the portfolio. Table 15.7 shows how the addition of a particular commodity manager to three diversified portfolios increases the Sharpe ratio of each portfolio. The three diversified portfolios are represented by CTA indices provided by Daniel B. Stark & Co. Figure 15.8 illustrates another way of confirming that a futures trading program would be a diversifier for an existing investment in a basket of futures traders.

Systematic funds can be either trend followers or contrarian; in this case one was a systematic trend follower and the other was a systematic non-trend TABLE 10.3 Summary Statistics for Currency Portfolios 211 TABLE 10.4 Correlations for Currency Portfolios 212 RISK AND MANAGED FUTURES INVESTING follower. However, a pair where both funds were classified as systematic trend followers had a correlation of 0.47. As expected, the discretionary funds had low correlations. Given the diversity of the funds classified as currency, the correlation patterns of risk measures are along expected lines. Diversified Portfolios Table 10.5 presents the summary statistics for the diversified portfolios; Table 10.6 presents the correlations among the portfolios. For the period of our study, 107 diversified CTAs had complete data. One interesting result in the case of diversified CTAs is that no portfolios are perfectly correlated with each other. However, a majority of portfolios had high correlations, a few had moderate correlations, and none had low correlations.

Thirty-nine CTAs had complete data for the period of our study. Of these 5 were discretionary, 21 were systematic, 10 were trend based, and 3 were trend identifiers. Clearly the systematic or trend-based funds dominated the portfolios. The return patterns of these portfolios suggest that they have similar risk characteristics. The Interdependence of Managed Futures Risk Measures TABLE 10.5 Summary Statistics for Diversified Portfolios 213 214 TABLE 10.6 Correlations for Diversified Portfolios The Interdependence of Managed Futures Risk Measures TABLE 10.7 Summary Statistics for Financial Portfolios 215 216 TABLE 10.8 Correlations for Financial Portfolios The Interdependence of Managed Futures Risk Measures TABLE 10.9 Summary Statistics for Stock Portfolios 217 218 TABLE 10.10 Correlations for Stock Portfolios The Interdependence of Managed Futures Risk Measures 219 Stock Portfolios Table 10.9 presents the summary characteristics of the stock portfolios; Table 10.10 presents the correlations.

 

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

Only by regularly rebalancing portfolios to long-term targets do investors realize the results that correspond to the policy asset-allocation decision. SECURITY SELECTION Security selection plays a minor role in investment returns, because investors tend to hold broadly diversified portfolios that correlate reasonably strongly with the overall market. The high degree of association between investor security holdings and the market reduces the importance of security-specific influences, causing portfolio returns to mirror market returns. Consider the security selection alternative to the generally sensible investor behavior of holding broadly diversified portfolios. If an investor were to hold a single stock instead of a diverse portfolio of stocks, the idiosyncratic character of that particular security would drive equity portfolio performance. In the single-stock portfolio scenario, security selection plays a critical role in portfolio results.

I expected that Unconventional Success would resemble Pioneering Portfolio Management, adjusting only for differences between the resources and instruments available to institutions and to individuals. As I gathered information for my new book, the data clearly pointed to the failure of active management by profit-seeking mutual-fund managers to produce satisfactory results for individual investors. Following the evidence, I concluded that individuals fare best by constructing equity-oriented, broadly diversified portfolios without the active management component. Instead of pursuing ephemeral promises of market-beating strategies, individuals benefit from adopting the ironclad reality of market-mimicking portfolios managed by not-for-profit investment organizations. The colossal failure of the mutual-fund industry carries serious implications for society, particularly regarding retirement security for American workers.

The investment management world includes a very small number of not-for-profit money management firms, allowing investors the opportunity to invest with organizations devoted exclusively to fulfilling fiduciary obligations. Moreover, the market contains a number of attractively structured, passively managed investment alternatives, affording investors the opportunity to create equity-oriented, broadly diversified portfolios. In spite of the massive failure of the mutual-fund industry, investors willing to take an unconventional approach to portfolio management enjoy the opportunity to achieve financial success. David Swensen New Haven, Connecticut March 2005 OVERVIEW 1 Sources of Return Capital markets provide three tools for investors to employ in generating investment returns: asset allocation, market timing, and security selection.

 

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

After looking back at the performance of both groups of stocks, the conclusion was not what some had expected: “First, dividend yield does not have a consistent impact on expected return . . . second . . . expected return on the [higher yielding] portfolio, given its level of risk, will be lower than it might be with a better diversified portfolio.” Let me put this into plain English. A stock’s performance wasn’t determined by how much a corporation paid as a dividend, if it all. Sometimes higher dividend-paying stocks performed better, and other times they did not, compared to lower-paying stocks. There was not a clear pattern you could take to the bank. Their second point is critical. Trying to put together a high-yielding portfolio would get you a similar result to the broad market, but increase your risk. Why? You simply had a smaller, less diversified portfolio that in the end would have the same performance as a more diversified portfolio. Thus, you were wasting your time seeking dividend yield. Philip Morris, the CIA, and Time Travel It’s 2010 and you work for the CIA.

We provided a service otherwise known as the action that people couldn’t get with their retirement accounts. In order to gather more money under our control, the wholesaler suggested we start selling mutual funds. They were marketed as less risky because they invested in lots of stocks. But, we told him, we invested in lots of stocks too! He agreed, with a puzzled stare, but continued to extol the virtues of a diversified portfolio as defined by many funds, not many stocks. To be fair, a diversified portfolio for us was 5 to 10 stocks, which is still considered fairly focused. While we didn’t care or get it at the time, the bottom line was that his pitch was all about getting the safe money. Needless to say, we didn’t much care for what the funds did, as they all looked the same. Most of the charts showed a comparison of that fund’s performance with the S&P 500.

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.” To save you the hassle of going through the formulas, let me explain it this way: If you hold combinations of securities that don’t correlate, you can decrease your risk to the risk of a single asset.

 

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

Balance of payments: asset prices and currencies and foreign central banks’ creation of fiat money and foreign exchange reserves global imbalances government finance and quantitative easing and U.S. and foreign exchange reserves Banking sector: commercial banks, credit creation, and decline in liquidity reserves commercial banks’ credit structure current financial health of in Mitchell’s theory of business cycles New Great Depression scenarios and Bank of America Baruch, Bernard Bear Stearns Bernanke, Ben: global savings glut theory of on Milton Friedman policy responses to credit expansion and New Depression Bodin, Jean Bonds: in diversified portfolio effect of stimulus on quantitative easing and Bush, George W. Business cycles, theories of Business Cycles: The Problem and Its Setting (Mitchell) Capital adequacy ratio (CAR) Capitalism, evolution to credit-based, government-directed economic system China: fiat money creation and foreign exchange reserves New Great Depression scenarios and possibility of end to buying of U.S. debt Citibank Commercial banks. See Banking sector Commercial Paper Funding Facility (CPFF) Commodities: in diversified portfolio inflation and quantitative easing and regulation of derivatives market and Congressional Budget Office (CBO): budget outlook scenarios government debt estimates Construction sector, in Mitchell’s theory of business cycles Consumer price inflation Corporate sector: inflation and deflation’s effects on share of U.S. debt Corruption of Capitalism, The (Duncan) Credit creation and expansion: credit structure of U.S., 1945 and 2007 economic growth and essential to booms foreign causes transformation of U.S. economy by U.S. domestic causes “Crowding in” “Crowding out” Currencies, trade balances and Current account balances.

See Energy and energy prices Overproduction, in Mitchell’s theory of business cycles Paul, Ron People’s Bank of china (PBOC) Perot, Ross Primary dealer credit facility (PDCF) Private sector debt: contraction of effect of stimulus on Production incomes, in Mitchell’s theory of business cycles Profits: credit expansion’s effect on in Mitchell’s theory of business cycles Property rights, debt-deflation and Protectionism: inflation and New Great Depression scenarios and Purchasing Power of Money: Its Determination and Relation to Credit, Interest and Crises, The (Fisher) Quantitative easing: asset prices and balance of payments and beginning of QE1 QE2 QE3 Quantity theory of credit banking sector crisis and monetarism and principles of quantity theory of money contrasted uses of Quantity theory of money Rational investment option, for U.S. solar initiative example Reagan, Ronald Rental property, in diversified portfolio Republican Party Reserve requirements: asset-based securities and government-sponsored entities and commercial banks and current Roosevelt, Franklin D. Rothbard, Murray Russia Saving and investment, in Mitchell’s theory of business cycles Savings and loan companies, credit supply and Schumpeter, Joseph Schwartz, Anna Jacobson Solar initiative, proposed Spain Special Drawing Rights (SDRs) Special purpose vehicles (SPVs), credit creation and Status quo option, for U.S. Stocks: in diversified portfolio quantitative easing and Switzerland Taiwan Tariffs: inflation and New Great Depression scenarios and Tax revenues: credit expansion’s effect on during Great Depression New Great Depression consequences and Theory of Money and Credit, The (von Mises) Time deposits, commercial bank funding and Total credit market debt (TCMD): contraction of by economic sector foreign central banks’ creation of fiat money and foreign exchange reserves in 2011 likely for 2012 major categories of sectors and changing percentages of debt Trade, generally.

That will be no easy task, even for the experts. Those unable to devote all their time and energy to deciphering the kaleidoscopic changes in the politics and policies of Washington have the option of constructing a broadly diversified investment portfolio that would ensure significant wealth preservation regardless of whether the price level moves up or down. The following are five components of a diversified portfolio: 1. Commodities generally perform well in an inflationary environment and suffer in times of disinflation or deflation. Gold and silver benefit most from quantitative easing, which undermines public confidence in the national currency. 2. Stocks tend to rise (1) in a healthy economic environment, (2) when central banks create money and pump it into the financial markets (so long as they don’t cause too much inflation), (3) when the government runs a budget surplus and crowds in the private sector, and (4) when the trade deficit is larger than the budget deficit.

 

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

Since you are planning on investing for the long-term (you are, aren't you?), reading a prospectus and understanding what you're investing in will be well worth the time and effort. We can't emphasize it enough: Read the fund's prospectus and understand what you re investing in! There are at least 10 advantages of investing in mutual funds: 1. Diversification. The costs involved in purchasing a diversified portfolio of individual stocks and bonds could be prohibitive for most investors. However, since each mutual fund invests in a large number of stocks, bonds, or both, you get instant diversification when you buy a mutual fund. 2. Professional management. Whether your fund is an index fund or an actively managed one, there are professional managers at the helm. 3. Low minimums. Although each mutual fund establishes its own minimum purchase requirements, you can actually purchase some mutual funds by promising to invest at little as $50 per month.

Finally, because of the wide selection of funds available, you can probably find a fund to fit just about any investment needs you might have. So, as we've seen, mutual funds have a lot to offer. We feel strongly that they should be the investment of choice for most individual investors. Funds of Funds In an attempt to simply investing, a recent trend has developed that allows investors to obtain a nicely diversified portfolio by choosing a single mutual fund that meets their desired asset allocation. These offerings invest in other mutual funds, normally from the same company, and usually include stock, bond, and money market mutual funds-thus the name funds of funds. Some of these funds maintain a fairly stable ratio of stocks, bonds, and cash at all times, so it's up to investors to switch to a more conservative fund as they get older and closer to retirement.

Chandan Sengupta, author of The Only Proven Road to Investment Success: "You should switch all your investments in stocks to index funds as soon as possible, after giving proper consideration to any tax consequences." William F. Sharpe, Nobel Laureate, STANCO 25 Professor of Finance, Emeritus, Stanford University Graduate School of Business and Chairman, Financial Engines, Inc.: "I love index funds." Rex Sinquefield, co-chairman of Dimensional Fund Advisors: "The only consistent superior performer is the market itself, and the only way to capture that superior consistency is to invest in a properly diversified portfolio of index funds." Larry E. Swedroe, author of The Successful Investor Today: "Despite the superior returns generated by passively managed funds, financial publications are dominated by forecasts from so-called gurus and the latest hot fund managers. I believe that there is a simple explanation for the misinformation: it's just not in the interests of the Wall Street establishment or the financial press to inform investors of the failure of active managers."

 

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

For example, government fixed income, including short-end rates, are a good way to diversify the equity risk premium. In fact, in the U.S., stocks and bonds have had pretty much the same return on risk for the last 80 years, during which time they have been uncorrelated, on average. A diversified portfolio would ideally have an equal risk allocation to stocks and bonds, which would suggest an allocation of about 20-80 stocks-bonds. International diversification is also very important. Within reasonable capacity constraints, I would suggest trying to equal weight most things by risk. Once you have a diversified portfolio with stocks and bonds, your next concern should be inflation. Over the long term all assets respond to inflation. However, over the short- to medium-term many of the assets traditionally included as inflation hedges are anything but.

The book became the bible of the real money world, and dog-eared copies can be found on the desks or bookshelves of most real money managers. Soon after its publication, investors from family offices to pensions and foundations began trying to emulate Yale by creating their own endowment-style portfolios. The “Yale Model” soon came to be known as the “Endowment Model” as the portfolio management style became pervasive among university endowment portfolios. The Endowment Model, as it was popularly interpreted, is a broadly diversified portfolio, though with a heavy equity orientation, which seeks to earn a premium for taking on illiquidity risk. The argument behind the equity and “equity-like” orientation is that stocks produce the highest returns over time. This fundamental concept has roots in the very foundations of capitalism: risky equity capital should earn more than less risky bonds. The argument for seeking out illiquidity risk comes from financial theory, which states that investors are paid a premium for assuming the risk of illiquid assets (you should be compensated for not being able to sell something when you want).

You could have had the right view but missed the move, or worse, got run over in the crisis. Views sometimes count very little, whereas good risk management always counts a lot. The top performers in 2008 were able to put on good risk-versus-reward bets at the right time, and had the liquidity to do so due to good risk management. The old style of risk management suggests establishing a “diversified” portfolio with different asset weightings based on risk tolerance and time profile, which does not really work in this environment. If you are 60 years old, you are theoretically supposed to increase your bond weighting. But if you did that at the beginning of 2009—decreased your equities and increased your bonds—you virtually committed suicide. And if the inflation hawks are right, this may prove to be a really bad trade for a long period, even if your timing is reasonably good.

 

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

If it returns, say, 10% in a given year, does it bother you that some of the stocks in it may have lost more than 80% of their value, as will happen to a few each year? Of course not. A globally diversified portfolio behaves the same way, except that the performance of each component is now more visible to you in the form of returns data in the daily paper and your quarterly statements. As an example, I’ve listed the returns for 1998, 1999, and 2000 for some of the most commonly used stock asset classes: This three-year sequence is a pretty typical one. Let’s start with 1998. In the first place, a diversified portfolio did reasonably well in that year. U.S. large stocks did the best, but REITs lost a lot of money. Many investors got discouraged that year and sold their REITs. They were soon sorry because by 2000, stock returns were generally poor and REITs were the only stock asset with superlative returns.

Treasury Inflation Protected Securities (TIPS) currently yield a 3.5% inflation-adjusted return. If you can live on 3.5% of your savings and you can shelter almost all of your retirement money in a Roth IRA (which does not require mandatory distributions after age 70 1/2), then you are guaranteed success for up to 30 years, which is the current maturity of the longest bond. For devout believers in the value of a well-diversified portfolio, this option is profoundly unappealing, as this is a poorly diversified portfolio—the financial equivalent of Eden’s snake. (Although it’s a very secure basket!) At a minimum, however, some commitment to TIPS in your sheltered accounts is probably not a bad idea. At the end of the day, you can never be completely certain that your retirement will be a financial success. Further, you are faced with a tradeoff between the amount of your nest egg you can spend each year and the probability of success—the less you spend, the more likely you are to succeed.

Another way of putting this is that rebalancing forces you to be a contrarian—someone who does the opposite of what everyone else is doing. Financial contrarians tend to be wealthier than folks who like to simply follow the crowd. This concept also reveals the major benefit of a diversified portfolio: the advantage of “making small bets with dry hands.” In poker, the player who is least concerned about the size of the pot has the advantage, because he is much less likely to lose his nerve than his opponents. If you have a properly diversified portfolio, you are in effect making many small bets, none of which should ruin you if they go bad. When the chips are down, it will not bother you too much to toss a few more coins into the pot when everyone around you is folding his hand. That’s how you win at poker, and that’s how you win the long game of investing.

 

pages: 425 words: 122,223

Capital Ideas: The Improbable Origins of Modern Wall Street by Peter L. Bernstein

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Albert Einstein, asset allocation, backtesting, Benoit Mandelbrot, Black-Scholes formula, Bonfire of the Vanities, Brownian motion, buy low sell high, capital asset pricing model, debt deflation, diversified portfolio, Eugene Fama: efficient market hypothesis, financial innovation, financial intermediation, fixed income, full employment, implied volatility, index arbitrage, index fund, interest rate swap, invisible hand, John von Neumann, Joseph Schumpeter, law of one price, linear programming, Louis Bachelier, mandelbrot fractal, martingale, means of production, new economy, New Journalism, profit maximization, Ralph Nader, RAND corporation, random walk, Richard Thaler, risk/return, Robert Shiller, Robert Shiller, Ronald Reagan, stochastic process, the market place, The Predators' Ball, the scientific method, The Wealth of Nations by Adam Smith, Thorstein Veblen, transaction costs, transfer pricing, zero-coupon bond

The analyst need only calculate the relationship of each of the securities to the dominant factor. If the price of a security is more volatile than the movements of the dominant factor, that security will make the portfolio more variable, and therefore more risky, than it would have been otherwise; if the price of the security is less volatile, it will make the portfolio less risky. In well-diversified portfolios, the simple average of these relationships will then serve as an estimate of the volatility of the portfolio as a whole. What is the “basic underlying factor” to which Sharpe refers? There is no doubt that individual stocks respond most directly to the stock market as a whole. About one-third of the variability of the average stock is simply a reflection of moves in the “index”—or “the most important single influence.”

I had never even set my fingers onto a computer keyboard until I attended a 1969 summer workshop at Harvard Business School. PCs with video screens were not yet a gleam in an inventor’s eye; we sat at terminals hooked into a mainframe located somewhere else and waited patiently while a clattering printer produced our results in hard copy. I now realize that we were using the computer to compose diversified portfolios, but I had little idea at the time of what that clattering was all about. ••• Only two analyses of any note had appeared during the twenty years following Cowles’s 1933 article, one in 1934 and the other long afterward in 1953. Neither paper was by an economist. The authors in each case were statisticians who used the data base of the financial markets to prove a point about statistical methods.

Profitable trading depends on imperfections, which develop only when other investors are slower than the swinger to receive information, draw erroneous conclusions from it, or delay acting on it. Gradual recognition and understanding of the facts is what makes for trends instead of bedlam. Professionals insist that they can win when they invest actively, as opposed to buying and holding a broadly diversified portfolio, because they can distinguish trends from noise and make better sense than amateurs out of new information. Moreover, because they are full-time players tuned in to all the smart brokers and analysts, professionals are confident that they can act fast enough to beat the others to the gun. Alexander contrasts this view with the view of the academics who hold that the best way to anticipate future price movements is to toss a coin.

 

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

One use for the model is to compare a mutual fund performance to three distinct risks factors and isolate how much of a fund’s return was due to these three factors and how much was due to the fund manager. Fama and French found that, on average, beta alone explained about 70 percent of a diversified portfolio’s performance. When they measured how much exposure that randomly created portfolios were influenced by the three risk factors of beta, size, and BtM, they could explain within about 95 percent accuracy how a diversified portfolio should have performed in relation to the stock market without knowing the actual return of the portfolio. All they needed to know was the amount in each risk factor. The results were a blow to active portfolio managers, who until this time touted their stock-picking prowess as the primary reason for generating alpha.

You’ll have to read other books for details on asset allocation recommendations and fund selection methods. Several books are highlighted within these chapters. Index Funds Make Most Active Funds Obsolete It wasn’t necessary for actively managed mutual funds to beat the market prior to the introduction of index funds because they were the only game in town. They were the only option available. Mutual fund companies fulfilled their obligation to investors by offering a broadly diversified portfolio of securities that individuals could not replicate on their own at the same cost. In this regard, actively managed funds were a good deal for investors. But that era has passed. Today, actively managed funds aren’t needed to gain broad diversification in an asset class. Index funds and ETFs perform that function much more efficiently. The costs are lower, diversification is broader, the transparency of fund holdings is superior, and the tax benefit from lower turnover helps investors whose accounts are subject to taxation.

For the small investor to make an intelligent selection from these—indeed, to pass an intelligent judgment on a single one—is ordinarily impossible. He lacks the ability, the facilities, the training, and the time essential to a proper investigation.3 The mutual fund system worked for the industry and for investors for many years because it was a win-win situation. Investors bought into a diversified portfolio of securities through mutual funds, and the fund companies didn’t need to be concerned about losing assets when their managers underperformed the markets because few people monitored the returns that closely. Passive Investing Makes Its Case The cozy relationship between Wall Street and Main Street lasted for several decades. Then, in the 1960s, a barrage of brash, young academics began to analyze mutual fund returns more closely and started asking tough questions.

 

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

The majority of rational investors are best off with a cheaply bought index tracker of world equities as their risky assets. It is a major evolution in the investing world that products tracking these indices are now readily available: just 15 years ago they were not. Some books on investing involve intricate arguments about why certain geographical areas or sectors of the equity markets will outperform and provide a safe haven for the investor. On the contrary, the most diversified portfolio you can find offers the greatest protection against regional declines. Also, since we are simply saying ‘buy the world’, the product is very simple and should be super cheap. Over the long run that will matter greatly. Someone willing to add a bit of complexity to the very simple portfolio of world equities and minimal-risk government bonds could add other government and corporate bonds (see Figure 3.2).

As an example, if you work in the property sector in the UK, own a house in London and stand to inherit a share of the family property business one day, you already have significant exposure to the UK economy and particularly the property sector. You may have a diversified rational portfolio with your investments, but you are still taking a large concentration risk in your overall economic life. If the UK property market went down the drain you would be in a rough spot, despite having done the right things in your investment portfolio. It could well be that the diversification benefits you gained from having a broadly diversified portfolio were dwarfed by the fact that the rest of your assets were so concentrated. You might be losing your job and any potential future job prospects, your house may decline in value and your inheritance be worth less, all for the same reason. As unpleasant as the plight of the UK investor would be in the above scenario, compare it to the situation of an investment portfolio composed exclusively of UK property stocks.

But in a case like that you can take solace from the fact that while this hurts you locally your rational portfolio is broadly diversified and perhaps not declining at the same time as everything else in your life is going wrong. There is no generalised way to reduce the concentration risk outlined above. If you find yourself with too great a concentration risk try to find ways to divest some of the assets that add to this risk and re-invest those in a more diversified portfolio like the rational one. Unfortunately many people only worry about these issues after misfortune has hit. Not just geography I had a friend who was a successful internet entrepreneur. He had made some money from selling his internet business and was now launching the next one. Because of the risk he perceived in his own business he did not invest too much of his money into the new venture.

 

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 are in no rush to immediately and radically alter your finances. You have the rest of your life to get your affairs in order; the time you take learning and planning will be time well-spent. 2. Acquire an appreciation of the nature of and fundamental relationship between risk and reward in the financial markets. 3. Learn about the risk/reward characteristics of various specific investment types. 4. Appreciate that diversified portfolios behave very differently than the individual assets in them, in much the same way that a cake tastes different from shortening, flour, butter, and sugar. This is called portfolio theory and is critical to your future success. 5. Estimate how much risk you can tolerate; then learn how to use portfolio theory to construct a portfolio tailored to produce the most return for that amount of risk. 6.

As we shall see, sticking by your asset allocation policy through thick and thin is much more important than picking the “best” allocation. Dealing with More Than Two Imperfectly Correlated Assets The above models have been quite useful for demonstrating the effect of diversification on risk and return of two similar assets (Example 2) and two different assets (Example 1) with zero correlation. Unfortunately, the above examples are no more than useful illustrations of the theoretical benefits of diversified portfolios. In the real world of investing, we must deal with mixes of dozens of asset types, each with a different return and risk. Even worse, the returns of these assets are only rarely completely uncorrelated. Worse still, the risks, returns, and correlations of these assets fluctuate considerably over time. In order to understand real portfolios, we shall require much more complex techniques.

In the words of a former president, we are in “deep doo-doo.” We can’t predict returns, SDs, and correlations accurately enough. If we could, we wouldn’t need the optimizer in the first place. And optimizing raw historical returns is a one-way ticket to the poor house. So, forget about getting the answer from a magic black box. We’ll have to look elsewhere for a coherent allocation strategy. More Bad News A well-diversified portfolio is not a free lunch. It does not come anywhere near eliminating risk; economic catastrophes do not respect national borders. The events of 1929–1932 and 1973–1974 involved all markets, and the damage varied only in degree among national markets. Markowitz mean-variance analysis tells us that if one asset has an SD of 20%, then two completely uncorrelated assets 72 The Intelligent Asset Allocator (zero correlation) will have an SD of 14.1%, and four mutually uncorrelated assets, an SD of 10%.

 

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

The fall in transactions costs suggests that the price of obtaining and maintaining a diversified portfolio of common stocks, which is necessary to replicate index returns, could have easily cost from 1 to 2 percent per year over much of the nineteenth and twentieth centuries. Because of these costs, investors in earlier years purchased fewer stocks than in an index and were less diversified, thereby assuming more risk than implied by stock indexes. Alternatively, if investors attempted to buy all the stocks, their real returns could have been as low as 5 percent per year after deducting transactions costs. The collapse of transactions costs over the past two decades means that stockholders can now acquire and hold a completely diversified portfolio at an extremely low cost.11 It has been well established that liquid securities—that is, those assets that can be sold quickly and at little cost on short notice in the public market—command a premium over illiquid securities.

Dimson, Marsh, and Staunton are saying that the results found in the United States have relevance to all investors in all countries. The superior performance of U.S. equities over the past two centuries is not a special case. Stocks have outperformed fixed-income assets in every country examined and often by an overwhelming margin. International studies have reinforced, not diminished, the case for equities. CONCLUSION: STOCKS FOR THE LONG RUN Over the past 200 years the compound annual real return on a diversified portfolio of common stock is nearly 7 percent in the United States, and it has displayed a remarkable constancy over time. The reasons for the persistence and long-term stability of stock returns are not well understood. Certainly the returns on stocks are dependent on the quantity and quality of capital, productivity, and the return to risk taking. But the ability to create value also springs from skillful management, a stable political system that respects property rights, and the capacity to provide value to consumers in a competitive environment.

CHAPTER 2 Risk, Return, and Portfolio Allocation FIGURE 25 2–1 Maximum and Minimum Real Holding Period Returns, 1802 through December 2006 It is very significant that stocks, in contrast to bonds or bills, have never delivered to investors a negative real return over periods of 17 years or more. Although it might appear to be riskier to accumulate wealth in stocks rather than in bonds over long periods of time, precisely the opposite is true: the safest long-term investment for the preservation of purchasing power has clearly been a diversified portfolio of equities. Some investors question whether holding periods of 10 or 20 or more years are relevant to their planning horizon. But one of the greatest mistakes that investors make is to underestimate their holding period. This is because many investors think about the holding periods of a particular stock, bond, or mutual fund. But the holding period that is relevant for portfolio allocation is the length of time the investors hold any stocks or bonds, no matter how many changes are made among the individual issues in their portfolio.

 

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

Harry said it was because it was too risky. You should instead look around for many positive expected return opportunities. Since this particular stock has the highest expected return, that means you’re going to average in lower expected return investments. Your portfolio expected return is the weighted average of your individual stock expected returns, so a diversified portfolio has to have a lower expected return than the 100 percent you can get with this one stock. But a diversified portfolio can have much lower risk than even the safest component. By spreading your money around, you might end up with a portfolio expected return of 10 percent, instead of the 100 percent you can get with one stock, but with much less probability of losing money. Instead of an 80 percent chance of losing all your money, you might have only a 20 percent chance of losing money at all, and only a tiny chance of losing more than 10 percent of your money.

You either avoid risk as much as practical, or you try to find as many risks as you can. You could, of course, put half your portfolio in bonds and the other half in diversified risky assets, but this still makes you a risk taker, seeking out as many risks as possible. You just run a low risk version of the strategy. There’s nothing that says a risk taker has to have a high-risk life. In practice, however, once investors take all the trouble to create a broadly diversified portfolio, or individuals learn to embrace risk, they tend to exploit the investment. It’s good that people make this choice young, because each route requires skills and life attitudes that would be fatal to acquire playing for adult stakes. Risk takers must enjoy the volatility of the ride, because that’s all there is. There is no destination. You never stop gambling. Risk avoiders must learn to endure volatility in order to get to the planned destination.

Table 5.2 Total Period Excess Returns of Optimal Investments in Selected Commodities, 1970 to 2010 The reason the portfolio of all seven commodities did so much better than the individual assets when we invested 100 percent of our money is not that diversification lowers risk and lower risk is good; it’s that it just happened to produce a portfolio with near the optimal amount of risk (we see in the last line of Table 5.2 that we can improve a little by keeping 14.3 percent of our money in low-risk bonds). Another very important point is that the average return on the individual investments is 32.9 percent, only a little less than the 35.5 percent from the portfolio, and it is achieved with much less average investment. An investor with even a little faith in her ability to pick the best commodity investment is not crazy to hold a single commodity rather than a diversified portfolio, as long as (and I emphasize how important this is) she knows how to size the bet correctly. Investors with no knowledge should always diversify but for active investors the best portfolio, in my opinion, is usually the one that can be sized most accurately, rather than the most diversified or highest Sharpe ratio or highest expected return one. Now, suppose you had a genie on New Year’s Eve 1969 who told you the portfolio of the seven commodities that would have the highest Sharpe ratio over the subsequent 40 years.

 

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

Take a look at the chart on page 74, which illustrates this point. 74 Your Broker or Advisor Is Keeping You from Being a Smart Im"eStor RISK RETURN COMPARISON (DitlI'Iri8l: 1911-2005) 11m _ • C*dI Yur lois AmgII AuuaJ II!ln • &1M SIKb 141M iIIJlIk ....... "" .,.. "" ... '" "' "" ,"' "" . . As you can see, if you invested in a diversified portfolio consisting of 100% stocks during the period 1977 to 2005, your average rerum would have been 1 1.7%. Your worst loss in any one calendar year would have been 15.1%. However, if you had a diversified portfolio invested in only 60% stocks and 40% bonds, your average rerum would have been 11.0%--only 0.7% less than the 100% stock portfolio. However, your worst loss in anyone year-instead of bei ng 15. 1% with the 100% stock portfolio-would have been only 6.2%. By moving from a portfolio that is 100% invested in stocks to one that is 60% invested in stocks and 40% invested in government bonds, it is possible to greatly reduce the downside risk while sacrificing only a modest amount of upside potential.

Bogle, Common Sense on Mutual Funds This step is the easy part. All we know about the srock and bond markets is that over time both will go up in value. As I have explained, no one can predict which stock or which bond will increase in value, or when it will increase. And no one wi ll know when or by how much the entire market will increase in value. Therefore, investors should own the entire market. By the «entire market," I mean a broadly diversified portfolio of investments in domestic and international markets. Let's take anomer look at (he chart on the following page that I showed you in Chapter 4. It tells you precisely which 180 The Real \vily Smart Im'estors Beat 95%or the "Pros- ETFs to select, and what percentage of your portfolio should be invested in each ETF, depending on the portfolio you have selected. COMPosmON OF FOUR MOOEl POIIIIOLIOS LOW IISI fUNaUME IS/$e:s CON ~ 1.'

 

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

But small-cap stocks offered the most intriguing choice: They delivered a much higher annual rate of return during the sample period—but with greater volatility. So, the question is straightforward: Do higher rates of return compensate an investor for the added risk? Arguably, systematic risk is the most important risk measure for investors who are considering the addition of an asset class to a diversified portfolio.3 According to the capital asset pricing model (CAPM), the only risk priced (that is, a risk that requires a higher rate of return) is risk correlated with the market. This is otherwise known as systematic risk, or market risk. Risk not correlated with the market is not priced because it can be diversified away. The CAPM offers a way to estimate systematic risk for different asset classes—what is known as beta.

CAPM Beta Jensen’s Alpha T-Statistics Sharpe Ratio Small Cap 1 5.64% 2.07 0.65 Large Cap 1 0.00% Growth 1.06 –1.46% 1.87 0.43 Value 0.93 0.81% 1.67 0.60 International 0.62 –1.27% 0.04 0.29 0.53 Strategic Asset Allocation Based On… Period Sharpe Ratio 0.66 0.03% 24.09 0.72 Yearly Sharpe Ratio 0.52 0.02% 24.58 0.63 Market Weights 0.54 0.1% 27 0.57 Comparing the Historical- and Market-Based Allocations As I pointed out in Chapter 1, “In Search of the Upside,” financial economics developments over the past three decades provide us with the necessary tools to develop risk-adjusted returns in a rigorous and systematic way. Arguably, systematic risk is the more important risk measure for investors who are considering adding an asset class to a diversified portfolio. According to the capital asset pricing model (CAPM), the only sort of risk priced (that is, risk requiring a higher rate-of-return) is systematic risk, which is correlated with the market. The CAPM offers a way to estimate systematic risk for different asset classes (that is, beta) as well as precisely measure the additional return (that is, alpha) provided by an asset class over that required to compensate for the systematic risk.

Second, and equally important, is the SAA would have significantly reduced the portfolio’s overall volatility while producing market-like returns. The numbers reported in the previous chapter in fact show the SAA’s great benefit, and the diversification produced by the strategy, are best described in risk reduction terms. But, the data nevertheless clearly show the SAA, as promised, delivers a diversified portfolio producing lower risk without sacrificing returns. That’s a good deal. But, if good in this case only means good enough, the good is the enemy of the best. The challenge now is to develop an allocation strategy that delivers even better risk-adjusted returns than the market SAA. The data reported in Chapter 2, “The Case for Cyclical Asset Allocation,” show for approximately 80 percent of the time during our 30-year sample period, the optimal size, style, location, and equity/fixed-income allocation was a corner solution (that is, a 90 percent or greater allocation to one of the choices).

 

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

No, seriously: Two-thirds of Americans are overweight or obese, and the average American is nearly $7,000 in debt. BECAUSE OF INFLATION, YOU’RE ACTUALLY LOSING MONEY EVERY DAY YOUR MONEY IS SITTING IN A BANK ACCOUNT. In 2008, when the global financial crisis really erupted in the stock market, the first thing many people did was pull their money out of the market. That’s almost always a bad move. They compounded one mistake—not having a diversified portfolio—with a second: buying high and selling low. For all the people who blamed the government, CEOs, and evil banks, had any of them read one personal finance book? And yet they expected to get ahead with their money? Let’s put the excuses aside. What if you could consciously decide how to spend your money, rather than say, “I guess that’s how much I spent last month”? What if you could build an automatic infrastructure that made all your accounts work together and automated your savings?

It’s very unfortunate that the very same people who are afraid of investing in the market right now are usually the same people who buy when prices are soaring. As Warren Buffett has said, investors should “be fearful when others are greedy and greedy when others are fearful.” For you, it’s different. You understand how investing works, so you can put a long-term perspective into practice. Yes, in theory it’s possible for you to lose all your money, but if you’ve bought different investments to create a balanced (or “diversified”) portfolio, you won’t. You’ll notice that your friends are concerned with the downside: “You could lose everything! How will you have time to learn to invest? There are so many sharks out there to take your money.” What about the downside of the money they’re losing every day by not investing? Ask your friends what the average return of the S&P 500 has been for the past seventy years. How much money would they have if they invested $10,000 today and didn’t touch it for ten years—or fifty years?

Okay, so index funds are clearly far superior to buying either individual stocks and bonds or mutual funds. With their low fees, they are a great choice if you want to create and control the exact makeup of your portfolio. But what if you’re one of those people who knows you’ll just never get around to doing the necessary research to figure out an appropriate asset allocation and which index funds to buy? Let’s be honest: Most people don’t want to construct a diversified portfolio, and they certainly don’t want to rebalance and monitor their funds, even if it’s just once a year. If you fall into this group, there is the option at the very top of the investment pyramid. It’s an investment option that’s drop-dead easy: lifecycle funds. Lifecycle Funds: Investing the Easy Way Whether you’re just arriving here direct from page 165, or you’ve read through the basics of investing and decided you want to take the easy way after all, no problem—lifecycle funds are the easiest investment choice you’ll ever need to make.

 

pages: 345 words: 86,394

Frequently Asked Questions in Quantitative Finance by Paul Wilmott

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Albert Einstein, asset allocation, Black-Scholes formula, Brownian motion, butterfly effect, capital asset pricing model, collateralized debt obligation, Credit Default Swap, credit default swaps / collateralized debt obligations, delta neutral, discrete time, diversified portfolio, Emanuel Derman, Eugene Fama: efficient market hypothesis, fixed income, fudge factor, implied volatility, incomplete markets, interest rate derivative, interest rate swap, iterative process, London Interbank Offered Rate, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, margin call, market bubble, martingale, Norbert Wiener, quantitative trading / quantitative finance, random walk, regulatory arbitrage, risk/return, Sharpe ratio, statistical arbitrage, statistical model, stochastic process, stochastic volatility, transaction costs, urban planning, value at risk, volatility arbitrage, volatility smile, Wiener process, yield curve, zero-coupon bond

Suppose that we think that five factors are sufficient to represent the economy. We can therefore decompose any portfolio into a linear combination of these five factors, plus some supposedly negligible stock-specific risks. If we are shown six diversified portfolios we can decompose each into the five random factors. Since there are more portfolios than factors we can find a relationship between (some of) these portfolios, effectively relating their values, otherwise there would be an arbitrage. Note that the arbitrage argument is an approximate one, relating diversified portfolios, on the assumption that the stock-specific risks are negligible compared with the factor risks. In practice we can choose the factors to be macro-economic or statistical. Here are some possible macro-economic variables. • an index level • GDP growth • an interest rate (or two) • a default spread on corporate bonds • an exchange rate Statistical variables come from an analysis of a covariance of asset returns.

However, if returns are expected to be normally distributed the semi variance will be statistically noisier than the variance because fewer data points are used in its calculation. Treynor Ratio The Treynor or Reward-to-variability Ratio is another Sharpe-like measure, but now the denominator is the systematic risk, measured by the portfolio’s beta, (see Capital Asset Pricing Model), instead of the total risk: In a well-diversified portfolio Sharpe and Treynor are similar, but Treynor is more relevant for less diversified portfolios or individual stocks. Information Ratio The Information ratio is a different type of performance measure in that it uses the idea of tracking error. The numerator is the return in excess of a benchmark again, but the denominator is the standard deviation of the differences between the portfolio returns and the benchmark returns, the tracking error.

Short Answer The Arbitrage Pricing Theory (APT) of Stephen Ross (1976) represents the returns on individual assets as a linear combination of multiple random factors. These random factors can be fundamental factors or statistical. For there to be no arbitrage opportunities there must be restrictions on the investment processes. Example Suppose that there are five dominant causes of randomness across investments. These five factors might be market as a whole, inflation, oil prices, etc. If you are asked to invest in six different, well diversified portfolios then either one of these portfolios will have approximately the same risk and return as a suitable combination of the other five, or there will be an arbitrage opportunity. Long Answer Modern Portfolio Theory represents each asset by its own random return and then links the returns on different assets via a correlation matrix. In the Capital Asset Pricing Model returns on individual assets are related to returns on the market as a whole together with an uncorrelated stock-specific random component.

 

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

His previous assignments have included working for the Corporate and Investment Bank in equity derivatives, where he performed diverse roles including senior profit and loss analysis, risk management and warrants trading. 1 Introduction In 2008 conventional private investor thinking was turned upside down following the ‘credit crunch’ and the ensuing stream of dismal revelations of imprudent bank lending, financial products based on the packaging of toxic debt and inadequate financial sector regulation. Previous conceptions of what were safe forms of investment and how diversified portfolios could be structured at acceptable levels of risk were tossed aside. High-net-worth individuals (HNWs) and others with significant capital assets, including pension pots, available for investment have had to rethink their investment strategies. Financial institutions and advisers were caught on the hop too and have had to tighten their investment analysis and due diligence routines. Bernard Medoff’s failed Ponzi scheme in New York demonstrated how reputable fund managers, in the UK as well as the United States, could be sucked into a quite simple scam through a lack of rigour in their investment selections.

Hedge fund strategies Long/short global equities By taking long and short positions in different stocks of the same market, a large part of the directional market risk can be removed. There are various return drivers, including sector selection, market capitalization positioning, stock selection, and how managers vary the total amount held in long and short positions. Funds may also use leverage, meaning that portfolios can range from riskier highly leveraged focused portfolios to more diversified portfolios with less or no leverage. Managers can add positions based upon top-down and/or bottom-up fundamentals or technicals. 26 BESTINVEST WEALTH MANAGEMENT SERVICE Investing shouldn’t be a numbers game Bestinvest has been providing investment counsel for over 20 years. We’ve been through five recessions, six Chancellors of the Exchequer, black Monday, black Wednesday and more than a fair share of bleak outlooks.

At the other end of the scale is pure direct investment, which tends to be simply of the one family-one building type transactions. This, with or without debt, gives the investor total ownership and control of his investment. Looking at each type of investment we can briefly summarize their characteristics as follows: ឣ Funds – Single or multiple funds. – Tend to be illiquid (unless one of the open-ended variety with short-based redemption periods). – Difficult for investor to see value of single assets. – Well-diversified portfolio. – Single or multiple strategy. – Access to established fund managers with excellent access and expertise to their marketplaces. – Reduced management risk at asset level. – Debt, if used, is accessed via the fund manager; thus the individual investor does not have to acquire his/her own debt. ឣ ឣ 62 REAL ESTATE AND FORESTRY ______________________________________________ Direct investment – Single property of a portfolio. – Tangible asset and perhaps a ‘trophy’. – Can be individually valued. – More liquid than many funds as the investor can decide when, or when not, to trade. – Possible portfolio concentration. – Risk due to single property market and strategy. – Management risks all down to the investor. – The investor will be responsible for managing the ownership process, including obtaining debt if required. – Most clients purchase as a long-term hold with debt whereby the income covers the debt service or ‘washes its face’ and where the client is not looking for income but more to capital growth and protection in the longer term.

 

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

Nicholas Founder and Chairman of HFR Group he global macro approach to investing attempts to generate outsized positive returns by making leveraged bets on price movements in equity, currency, interest rate, and commodity markets.The macro part of the name derives from managers’ attempts to use macroeconomic principles to identify dislocations in asset prices, while the global part suggests that such dislocations are sought anywhere in the world. The global macro hedge fund strategy has the widest mandate of all hedge fund strategies whereby managers have the ability to take positions in any market or instrument. Managers usually look to take positions that have limited downside risk and potentially large rewards, opting for either a concentrated risk-taking approach or a more diversified portfolio style of money management. Global macro trades are classified as either outright directional, where a manager bets on discrete price movements, such as long U.S. dollar index or short Japanese bonds, or relative value, where two similar assets are paired T 1 2 INSIDE THE HOUSE OF MONEY on the long and short sides to exploit a perceived relative mispricing, such as long emerging European equities versus short U.S. equities, or long 29year German Bunds versus short 30-year German Bunds.

I would say to think of it just like we did at CSFB when building the proprietary trading desk. You want to diversify. The simplest version is you want a carry trader, a fund that earns regular income; and you want a gamma trader, one that looks for the huge move.You want someone who’s going to make you the regular money when things are normal and quiet, and the guy who’s going to make you a lot of money when things really move. That’s how you develop a diversified portfolio. Not by diversifying through markets or by geographic regions but through how they trade. The great trades in global macro are when you combine carry with gamma.When a high yielding currency is cheap, for example, is when you can get tremendous outsized returns. THE RESEARCHER 129 Why do you think asset allocators find global macro the most difficult of the hedge fund strategies to understand?

It was an outstanding trade. 4.5 4.0 Getting a Bit Hairy Yield (%) 3.5 3.0 Position Entered at 3.4% Yield 2.5 2.0 Exit at Initial 1.5% Yield Target FIGURE 15.1 1997–2003 10-Year Treasury Inflation-Protected Securities (TIPS), Source: Bloomberg. 20 03 2 20 0 01 20 0 20 0 99 19 98 19 19 97 1.5 THE FIXED INCOME SPECIALISTS 319 Were you able to hold on to the position because you were running a broadly diversified portfolio? Gorton: Exactly. We had other trades on that were doing well. We also hung on to that trade for so long because it was so outstandingly good. I have never seen a yield curve that was as mispriced as the yen curve at that time. Other great trades over the years were curvature and conditional steepener type trades on the U.S. yield curve back in 2001 when nobody understood them. Now everyone understands them so there is not much juice left in it.

 

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

But, the fact remains that many people question the validity of this alternative investment vehicle that provides investors with access to the historically inaccessible world of hedge funds and their legendary managers. So, what is a fund of hedge funds? As the name implies, it is a fund that invests in other hedge funds. In creating and managing a portfolio of various hedge funds, a fund of hedge funds manager thematically blends together funds so as to maximize returns while minimizing risk. To do so, he must create a diversified portfolio that is composed of funds that exhibit low correlations with the overall market, experience solid performance, and have lower volatility. Thus, funds of hedge funds are the ultimate vehicle for investors who want to take advantage of the various benefits of hedge fund investing. If done properly, smaller investors—who historically do not have the sizable minimums required to get access to hall of fame hedge fund managers—allot their capital to this alternative asset, with the capital being stewarded judiciously to an able-minded group that is constantly and dynamically shifting the portfolio.

For example, for as little as $50,000 a Registered Investment Company (RIC) provides individuals with access through the same aggregation that a fund of funds provides. 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.

The investment object of an FOF can also vary significantly in terms of its volatility, return objective, and it’s correlation to various other asset classes. 2. How or why did you get started in the industry? My career began in the capital markets focused on sales and trading across currencies, interest rates, equities, and later derivatives. From that I migrated to structured investment products and then to CIO of an asset management business focused on globally diversified portfolios of stocks, bonds, and cash. Around that same time hedge funds were starting to become recognized investment alternatives with attractive risk adjusted returns and correlation characteristics. Therefore, I began to explore how to utilize them within a portfolio of traditional asset classes to create portfolios that would be more efficient. As a result I concluded that a multi manager multistrategy fund of funds would be the best solution to achieve the desired object of migrating a traditional portfolio toward the northwest quadrant of the efficient frontier. 3.

 

pages: 695 words: 194,693

Money Changes Everything: How Finance Made Civilization Possible by William N. Goetzmann

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Albert Einstein, Andrei Shleifer, asset allocation, asset-backed security, banking crisis, Benoit Mandelbrot, Black Swan, Black-Scholes formula, Bretton Woods, Brownian motion, capital asset pricing model, Cass Sunstein, collective bargaining, colonial exploitation, compound rate of return, conceptual framework, corporate governance, Credit Default Swap, David Ricardo: comparative advantage, debt deflation, delayed gratification, Detroit bankruptcy, disintermediation, diversified portfolio, double entry bookkeeping, Edmond Halley, en.wikipedia.org, equity premium, financial independence, financial innovation, financial intermediation, fixed income, frictionless, frictionless market, full employment, high net worth, income inequality, index fund, invention of the steam engine, invention of writing, invisible hand, James Watt: steam engine, joint-stock company, joint-stock limited liability company, laissez-faire capitalism, Louis Bachelier, mandelbrot fractal, market bubble, means of production, money: store of value / unit of account / medium of exchange, moral hazard, new economy, passive investing, Paul Lévy, Ponzi scheme, price stability, principal–agent problem, profit maximization, profit motive, quantitative trading / quantitative finance, random walk, Richard Thaler, Robert Shiller, Robert Shiller, shareholder value, short selling, South Sea Bubble, sovereign wealth fund, spice trade, stochastic process, the scientific method, The Wealth of Nations by Adam Smith, Thomas Malthus, time value of money, too big to fail, trade liberalization, trade route, transatlantic slave trade, transatlantic slave trade, tulip mania, wage slave

His graphs showed how each country’s bonds marched to a separate tune over the period: when one country went down, the others did not necessarily follow. Never mind the global crash of 1720. Lowenfeld concentrated on the recent past, the period of intense growth in the world markets. These data, once collected and studied, showed him that spreading investments internationally made the overall portfolio less risky. As a result, he reasoned, a truly diversified portfolio had to be spread over the entire world. And investors needed a convenient exchange to build such an ideal, modern diversified portfolio. Lowenfeld constructed a beautiful example using only railway securities. Bonds from one industry in a single country are usually highly correlated, but the Lowenfeld portfolio invested equally in ten railroad bonds from around the world: British, Canadian, German, Sardinian, Indian, Egyptian, American, Mexican, Argentinean, and Spanish; all with about the same yield.

Edgar Smith launched the Investors Management Company shortly before the publication of his landmark study. It offered its services on a strictly fee basis—eliminating some of the extreme conflicts of interest held by other firms. Unlike big Wall Street companies, Investors Management Company did not underwrite securities and then park the failures in their investment trusts. The firm offered two products: Fund A and Fund B. Both allowed investors to hold a diversified portfolio of common stock, formed chiefly according to the principles outlined in his book. Fund A planned to pay out 5% per year in dividends, which was the rate Smith figured was a sustainable yield based on historical analysis. Fund B allowed investors to plow back all dividends by reinvesting in more common stock shares. Smith not only demonstrated that stocks were a superior long-term investment; by launching his investment funds, he also offered Americans a vehicle to capitalize on his research.

Smith not only demonstrated that stocks were a superior long-term investment; by launching his investment funds, he also offered Americans a vehicle to capitalize on his research. Although the Investors Management Company Funds A and B were not the very first mutual funds in America, they were very prominent and immediately attracted imitators. Just as suddenly as Americans became infatuated with buying stocks, they fell in love with investment trusts. The simple idea of pooling investor money and buying a diversified portfolio of securities is a great one and is certainly not new. After all, the Dutch invented mutual funds every bit as sophisticated. The British model for American funds—including the famous Foreign and Colonial Government Trust—was widely acknowledged in the 1920s. Trusts were even referred to as a “British” style of investing. The American wrinkle was the emphasis on equity. Irving Fisher was also a big fan of investment trusts: the risks that … attach to [common stock] may be reduced, or insured against, by diversification … investment trusts and investment council tend to diminish the risk to the common stock investor.

 

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

This chapter will likely prove contentious, for I set down my own evaluations—flawed and subjective though they may be—of what I call the “Stewardship Quotient” for Vanguard and for three other fund managers. The Index Fund In 1975, I created the first index mutual fund, now known as Vanguard 500 Index Fund. Then, as now, I considered it the very paradigm of long-term investing, a fully diversified portfolio of U.S. stocks operated at high tax efficiency and rock-bottom costs, and designed to be held, well, “forever.” It is now the world’s largest equity mutual fund. In Chapter 6, I chronicle the Fund’s formation, its investment advantages, its minimal costs, and its remarkable record of performance achievement. It is these factors that underlie the growth of index funds to their dominant position in today’s mutual fund industry, holding 28 percent of total assets of equity funds.

It seems increasingly apparent, however, that the paradigm of long-term investing represented by the TIF and the paradigm of short-term speculation so often represented by the ETF are, in general, competing only at the margin for the capital of the same investors. The clash of the cultures in the index fund arena, then, is a clash between two very different philosophies. The first philosophy is buy and hold a widely diversified portfolio of stocks and bonds. The second is buy such a portfolio and sell at will, and do the same with narrow portfolios of, well, anything, including heavily levered portfolios through which bets are magnified. Seldom has the choice between investment and speculation been so starkly drawn. To be fair, we must make a distinction between the use of ETFs by individual investors and financial institutions.

I have earlier explored how mutual fund investors can do so more effectively by seeking out funds that already measure up to essential fiduciary principles, presenting in Chapter 5 a “stewardship quotient” checklist that investors can use to establish guidelines for their selection of a mutual fund family, and choosing among the mutual funds it supervises. Buy Broad Market Index Funds Another major positive step is focusing on index funds as the core of your portfolio. Owning an index fund is simply a decision to buy and hold a diversified portfolio of stocks representing the entire stock market, both U.S. and possibly non-U.S. companies. Such an index fund is the paradigm of long-term investing, and the antithesis of short-term speculation. That was my concept when I created the first index mutual fund way back in 1975, and the growth of indexing over the past 37 years has attested to its soundness—and then some!—over the decades that followed.

 

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

Correlation Correlation comparisons help to show that trend following is a legitimate style and demonstrate the similarity of performances Maryland-based Campbell and Co., a trend following managed futures firm with almost $3 billion in assets under management, has returned 17.65 percent since its inception in 1972, proving that performance can be sustainable over the long-term.26 The Millburn Diversified Portfolio has a 10 percent allocation which has historically exhibited superior performance characteristics coupled with an almost zero correlation of monthly returns to those of traditional investments. If an investor had invested 10 percent of his or her portfolio in the Millburn Diversified Portfolio from February 1977 through August 2003 he or she would have increased the return on his or her traditional portfolio by 73 basis points (a 6.2 percent increase) and decreased risk (as measured by standard deviation) by 0.26 of a percent (an 8.2 percent decrease). www.millburncorp.com 112 Trend Following (Updated Edition): Learn to Make Millions in Up or Down Markets among trend followers.

What Market Do You Buy or Sell at Any Time? One of the first decisions any trader makes is what to trade. Will you trade stocks? Currencies? Futures? Commodities? What markets will you choose? While some people might focus on limited, market-specific portfolios, such as currencies or bonds, others pursue a more widely diversified portfolio of markets. For example, The Adam, Harding, & Lueck (AHL) Diversified Program (the largest trend following fund in the world now run by Man Financial) trades a diversified portfolio of over 100 core markets on 36 exchanges. They trade stock indices, bonds, currencies, shortterm interest rates, and commodities (energy, metal, and agricultural contracts): CHART 10.1: AHL Portfolio Currencies: 24.3% Bonds: 19.8% Energies: 19.2% Stocks: 15.1% Interest rates: 8.5% Metals: 8.2% Agriculturals: 4.9% AHL does not have fundamental expertise in all of these markets.

A bold trader placing large bets feels pressure—or heat—from the volatility of the portfolio. A hot portfolio keeps more at risk than does a cold one. Portfolio heat seems to be associated with personality preference; bold traders prefer and are able to take more heat, while more conservative traders generally avoid the circumstances that give rise to heat. In portfolio management, we call the distributed bet size the heat of the portfolio. A diversified portfolio risking 2 percent on each of five instruments has a total heat of 10 percent, as does a portfolio risking 5 percent on each of two instruments.”16 Chauncy DiLaura, a student of Seykota’s, adds to the explanation, “There has to be some governor so I don’t end up with a whole lot of risk. The size of the bet is small around 2 percent.” Seykota calls his risk-adjusted equity “core equity” and the risk tolerance percentage “heat.”

 

pages: 415 words: 125,089

Against the Gods: The Remarkable Story of Risk by Peter L. Bernstein

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Albert Einstein, Andrew Wiles, Antoine Gombaud: Chevalier de Méré, Big bang: deregulation of the City of London, Bretton Woods, buttonwood tree, capital asset pricing model, cognitive dissonance, Daniel Kahneman / Amos Tversky, diversified portfolio, double entry bookkeeping, Edmond Halley, Edward Lloyd's coffeehouse, endowment effect, experimental economics, fear of failure, Fellow of the Royal Society, Fermat's Last Theorem, financial deregulation, financial innovation, full employment, index fund, invention of movable type, Isaac Newton, John Nash: game theory, John von Neumann, linear programming, loss aversion, Louis Bachelier, mental accounting, moral hazard, Nash equilibrium, probability theory / Blaise Pascal / Pierre de Fermat, random walk, Richard Thaler, Robert Shiller, Robert Shiller, spectrum auction, statistical model, The Bell Curve by Richard Herrnstein and Charles Murray, The Wealth of Nations by Adam Smith, trade route, transaction costs, tulip mania, Vanguard fund

As Poincare had pointed out, the behavior of a system that consists of only a few parts that interact strongly will be unpredictable. With such a system you can make a fortune or lose your shirt with one big bet. In a diversified portfolio, by contrast, some assets will be rising in price even when other assets are falling in price; at the very least, the rates of return among the assets will differ. The use of diversification to reduce volatility appeals to everyone's natural risk-averse preference for certain rather than uncertain outcomes. Most investors choose the lower expected return on a diversified portfolio instead of betting the ranch, even when the riskier bet might have a chance of generating a larger payoff-if it pans out. Although Markowitz never mentions game theory, there is a close resemblance between diversification and von Neumann's games of strategy.

"The basic element in my view of the good society," he wrote, "is the centrality of others.... These principles imply a general commitment to freedom.... Improving economic status and opportunity ... is a basic component of increasing freedom. `9 But the fear of loss sometimes constrains our choices. That is why Arrow applauds insurance and risk-sharing devices like commodity futures contracts and public markets for stocks and bonds. Such facilities encourage investors to hold diversified portfolios instead of putting all their eggs in one basket. Arrow warns, however, that a society in which no one fears the consequences of risk-taking may provide fertile ground for antisocial behavior. For example, the availability of deposit insurance to the depositors of savings and loan associations in the 1980s gave the owners a chance to win big if things went right and to lose little if things went wrong.

In this case, one player is the investor and the other player is the stock market-a powerful opponent indeed and secretive about its intentions. Playing to win against such an opponent is likely to be a sure recipe for losing. By making the best of a bad bargain-by diversifying instead of striving to make a killing-the investor at least maximizes the probability of survival. The mathematics of diversification helps to explain its attraction. While the return on a diversified portfolio will be equal to the average of the rates of return on its individual holdings, its volatility will be less than the average volatility of its individual holdings. This means that diversification is a kind of free lunch at which you can combine a group of risky securities with high expected returns into a relatively low-risk portfolio, so long as you minimize the covariances, or correlations, among the returns of the individual securities.

 

pages: 287 words: 81,970

The Dollar Meltdown: Surviving the Coming Currency Crisis With Gold, Oil, and Other Unconventional Investments by Charles Goyette

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bank run, banking crisis, Ben Bernanke: helicopter money, Berlin Wall, Bernie Madoff, Bretton Woods, British Empire, Buckminster Fuller, California gold rush, currency manipulation / currency intervention, Deng Xiaoping, diversified portfolio, Elliott wave, fiat currency, fixed income, Fractional reserve banking, housing crisis, If something cannot go on forever, it will stop, index fund, Lao Tzu, margin call, market bubble, McMansion, money: store of value / unit of account / medium of exchange, mortgage debt, oil shock, peak oil, pushing on a string, reserve currency, rising living standards, road to serfdom, Ronald Reagan, Saturday Night Live, short selling, Silicon Valley, transaction costs

If you own a hardware store in a farming community and expect to do well as agricultural commodities rise, you might wish to deemphasize that component of the recommended investments, diversifying by adding more weight to another. If you spend a lot of time behind the wheel and your cost of living will rise sharply as energy prices climb, you may want to hedge that risk by allocating more to the energy component of your portfolio. Someone with a small amount of money may invest the entire amount in gold coins, while an experienced investor with an already diversified portfolio will act on one or two specific recommendations that represent special profit opportunities. Even so, I do recommend that you allot your investments among the four categories to the extent you are able. The four categories represent investments in enduring monetary vehicles (although gold and silver each merit a separate chapter, think of them both as part of this category), in the world’s preeminent form of energy, in the basics of life, and in financial conditions that unfold over time.

This averaging can dampen some of the technical disparities that occur in the market. USL’s expense ratio is a little higher than USO’s, 0.60 percent. Read the prospectus, available at the same site, unitedstatesoilfund.com, before investing. Because of the political risk it is hard to recommend direct oil investments in much of the world now. Direct investments in kleptocracies like Mexico and Russia are out of the question except as small parts of well-diversified portfolios. Canada is another story. Canada is a rule-of-law nation that operates a fiscal surplus and a balance of trade surplus. It has the world’s second-largest proved reserves and is the United States’ largest supplier of oil. Canadian Royalty Trusts oil and natural gas producers deserve a mention in this section because of their advantageous structure. Royalty trust units trade like stocks and have been prized for their dividends.

Baytex Energy Trust (Toronto Stock Exchange symbol: BTE.UN; New York Stock Exchange symbol: BTE), an oil and gas investment trust with producing properties in Alberta, British Columbia, and Saskatchewan, produces over 40,000 barrels of oil equivalent per day, weighted about 60 percent to heavy oil. Consult the company’s Web site before investing, baytex.ab.ca, for regulatory filings and more information. Enerplus Resources Fund Trust (Toronto Stock Exchange symbol: ERF.UN; New York Stock Exchange symbol: ERF) is an oil and gas income trust with a diversified portfolio of crude oil and natural gas assets located in western Canada and the United States. Production expectations for 2009 are 91,000 barrels of oil equivalent a day: 58 percent natural gas, 42 percent crude oil and natural gas liquids. Read investor information and regulatory filings before investing at enerplus. com. Penn West Energy Trust (Toronto Stock Exchange symbol: PWT .UN; New York Stock Exchange symbol: PWE) is the largest conventional oil and natural gas producing income trust in North America, producing more than 190,000 barrels of oil equivalent a day from a portfolio of assets across the Western Canadian Sedimentary Basin.

 

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

This is probably because anyone who can convince people to let them manage their money would prefer to claim higher fees for doing so, and would not want clients to allocate money to an index-fund product that might charge a mere 0.2 per cent per year or less. There is more money to be made from active management or convincing people to invest in more fancy products like hedge funds or private equity. The above is highly unsexy as it does not claim to be able to beat the market or be particularly brilliant at financial analysis. 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.

A simple calculation shows that buying rolling three-month put options on the S&P500 at 8 per cent out-of-the-money would only have been profitable over the past 20 years if you had ceased buying options when the implied standard deviation of the option was above 23 per cent – not a great result considering the markets were frequently down a lot during this period. Above that implied volatility threshold the options were simply too expensive for it to be a consistently profitable strategy. There is probably an argument to be made that investors who are comfortable trading options could benefit from buying deep out-of-the-money put options on the market when implied volatilities are low and thus be protected against shock events in their diversified portfolio at a manageable cost, but it is clearly not a strategy for everyone. In summary, for those without edge (and that would be most people) we probably have to accept that most our financial investments will correlate in a downturn and we should adjust our risk appetite accordingly. Summary If we have only bought general indices on stocks and bonds, we have not paid anyone a ton of money to be smart about beating the markets (since we don’t think it can consistently be done, after fees).

Consequently, our portfolio is cheaply constructed. Our portfolio consists of a series of index futures, ETFs, and broad indices of corporate and government bonds. Over a five-to-ten-year time horizon, the low cost of the portfolio alone should cause us to outperform the active managers, who are weighed down both by fees and by investing in a narrower subset of the market than our broadly diversified portfolio. A few summarising thoughts: If you accept that market direction can’t be consistently predicted, you should not try to do so or pay anyone a lot of money for trying to do this on your behalf. If you accept active management, you implicitly accept the corresponding high fees and expenses. This section has focused a great deal on being able to achieve a strong portfolio construction at very low costs.

 

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

We had a list of about 30 or 40 of these indicators that we investigated. As part of this project, one of the researchers looked at stocks that were most up and stocks that were most down during the recent past. He found that the stocks that were most up tended to underperform the market in the next period, while the stocks that were most down tended to outperform the market. That finding led to a strategy of buying a diversified portfolio of the most down stocks and selling a diversified portfolio of the most up stocks. We called that strategy MUD for most up, most down. My friend UCI mathematician William F. Donoghue used to joke, little realizing how close he was to a deep truth, “Thorp, my advice is to buy low and sell high.” We found that this market neutral strategy had about a 20 percent annual return before costs. It had fairly high risk because the two sides did not track as closely as we would have liked.

In fact, he calls the potential improvement in return/risk through the addition of uncorrelated assets the “Holy Grail of investing.” He states that return/risk can be improved by as much as a factor of 5 to 1 if the assets in the portfolio are truly independent. Most people tend to focus on correlation as a primary tool for determining the relative dependence or independence of two assets. Dalio believes that correlation can be a misleading statistic and poorly suited as a tool for constructing a diversified portfolio. The crux of the problem is that correlations between assets are highly variable and critically dependent on prevailing circumstances. For example, typically, gold and bonds are inversely related because inflation (current or expected) will be bullish for gold and negative for bonds (because higher inflation normally implies higher interest rates). In the early phases of a deleveraging cycle, however, both gold and bonds can move higher together, as aggressive monetary easing will reduce interest rates (i.e., increase bond prices), while at the same time enhancing longer-term concerns over currency depreciation, which will increase gold prices.

., increase bond prices), while at the same time enhancing longer-term concerns over currency depreciation, which will increase gold prices. In this type of environment, gold and bonds can be positively correlated, which is exactly opposite their normal relationship. Instead of using correlation as a measure of dependence between positions, Dalio focuses on the underlying drivers that are expected to affect those positions. Drivers are the cause; correlations are the consequence. In order to ensure a diversified portfolio, it is necessary to select assets that have different drivers. By determining the future drivers that are likely to impact each market, a forward-looking approach, Dalio can more accurately assess which positions are likely to move in the same direction or inversely—for example, anticipate when gold and bonds are likely to move in the same direction and when they are likely to move in opposite directions.

 

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

., traditional beta exposures for which a HF fee is charged). Thus the goal of HF beta investing is to create a portfolio of alternative betas, while leaving out traditional ones. Capturing HF betas requires skill, both in defining them (identifying smart strategies: inclusion, weighing, rebalancing) and in implementing them cost-effectively and with effective risk management. With HF betas we can structure a diversified portfolio with an especially attractive reward-to-risk ratio (e.g., combining value and momentum strategies that both have a positive alpha but that are often negatively correlated to each other). Truly original proprietary strategies have a special premium in today’s competitive environment where fears of being in overcrowded trades are not unreasonable. Both HF replication and HF beta strategies try to capture (some of) the predictable part of HF industry returns.

Diversification does imply dilution away from the strongest signals; to balance this we give higher weights to the highest yielding and lowest yielding currencies. Over my full sample, an undiversified first–tenth trade (i.e., buying the single highest yielding and shorting the lowest yielding currency) gave a moderately higher excess return (8%) but much higher volatility (16%), resulting in an SR of 0.51—compared with the base case 6%/10%/0.61 noted above. In the other extreme, a diversified portfolio that buys equal amounts of the highest yielding five currencies and that shorts the lowest yielding five currencies earned 4% with a low 7% volatility, resulting in an SR of 0.62. Thus, in risk-adjusted terms, diversification across signals is somewhat more beneficial than exploiting the strongest signal. Ranking model vs. pairwise carry trading. Many studies analyze a diversified basket of USD pairs instead of a ranking model.

• Momentum strategies can be traded on a single asset (trend following) or across assets (long–short trading). One can use many types of momentum signals (past returns, moving averages, breakout, consistency, etc.) and various lookback window lengths (to capture shorter and longer trends). • For single commodities, the SR of trend-following strategies is typically between 0.0 and 0.5. For a diversified portfolio of them, the SR is between 0.5 and 1.0—at the higher end if volatility weighting is used. However, actual CTAs (commodity trading advisors) rarely have as good SRs as these simulated strategies. • Momentum patterns likely reflect behavioral factors—investor underreaction to news and overreaction to recent returns (extrapolating past returns). Rational risk-based explanations are less compelling, but I highlight a link between commodity inventories and momentum

 

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

When financial theorists warn against ‘home bias’, they mean the tendency for investors to keep their money in assets produced by their own country. But the real home bias is the tendency to invest nearly all our wealth in our own homes. Housing, after all, represents two thirds of the typical US household’s portfolio, and a higher proportion in other countries.75 From Buckinghamshire to Bolivia, the key to financial security should be a properly diversified portfolio of assets. 76 To acquire that we are well advised to borrow in anticipation of future earnings. But we should not be lured into staking everything on a highly leveraged play on the far from risk-free property market. There has to be a sustainable spread between borrowing costs and returns on investment, and a sustainable balance between debt and income. These rules, needless to say, do not apply exclusively to households.

Not that this pile of debt scared them. Their mathematical models said there was next to no risk involved. For one thing, they were simultaneously pursuing multiple, uncorrelated trading strategies: around a hundred of them, with a total of 7,600 different positions.82 One might go wrong, or even two. But all these different bets just could not go wrong simultaneously. That was the beauty of a diversified portfolio - another key insight of modern financial theory, which had been formalized by Harry M. Markowitz, a Chicago-trained economist at the Rand Corporation, in the early 1950s, and further developed in William Sharpe’s Capital Asset Pricing Model (CAPM).83 Long-Term made money by exploiting price discrepancies in multiple markets: in the fixed-rate residential mortgage market; in the US, Japanese and European government bond markets; in the more complex market for interest rate swapsbf - anywhere, in fact, where their models spotted a pricing anomaly, whereby two fundamentally identical assets or options had fractionally different prices.

advertising 196 Afghanistan 6 Africa: aid to 307 British investment in 293 China and 338-9 gold trade 25 slaves from 23 African-American people 249-50 ‘Africas within’ 13 age see pensions agriculture: East-West comparison 285 finance and 2 forward and future contracts 226 ‘improvements’ 235 and migration 110 rising and declining prices 53 and risk 184 Agtmael, Antoine van 288 Aguilera, Jaime Roldós 310-11 aid: conditions on 307 limited usefulness 307 and microfinance 279 to developing countries 274 Aldrich-Vreeland Act 301 Algeria 32 Allende, Salvador 212-13 Allison, Graham 223 All State insurance company 181-2 Al Qaeda 223 Alsace 144 Amboyna 130 American Civil War 91-7 American Dream Downpayment Act 267 American Home Mortgage 272 Americas, conquest of 285 Amsterdam 127 as financial centre 74-5 Amsterdam Exchange Bank (Wisselbank) 48-9 anarchists 17 Andersen (Arthur) 173 Andhra Pradesh 280 Angell, Norman 297 Angola 2 annuities 73-4 anthrax 223 anti-Darwinians 356 Antipodes 293 anti-Semitism 38 Antwerp 52 Applegarth, Adam 7 Arab: mathematics 32 oil 26 Arab-Israeli war 308 arbitrage 83 Argentina 98 British investment in 294 currencies 114 default crisis 110 Enron and 171 inflation 3 past prosperity 3 stock market 125 aristocracy 89 ARMs see mortgages, adjustable-rate arms/defence industry 298 . see also technological innovation art markets 6 Asia: aid and international investment 287 Asian crisis (1997-8) 10 and credit crunch 283 dependence on exports to US 10 dollar pegs 300 European trade 26 industrial growth and commodity prices 10 low-wage economies, production by 116 savings glut 336 sovereign wealth funds 9 asset-backed securities 6 and sub-prime mortgages 9 assets: asset markets 163 need for diversified portfolio 262 new types 353 asymmetric information 122 Atahuallpa 20 Australasia 52 Australia 233 Austria/Austro-Hungarian empire 90 bonds 86 currency collapses 107 and First World War 101 autarky 303 automobiles 160 Avignon 43 Babylonia see Mesopotamia Baer (Julius) bank 322 Bagehot, Walter 55 Baghdad 176 Bahamas see Lyford Cay Bailey, A. H. 198 Bailey, David 196n. balance sheets 44 Balducci, Timothy 181-2n.

 

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Beyond the Random Walk: A Guide to Stock Market Anomalies and Low Risk Investing by Vijay Singal

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Andrei Shleifer, asset allocation, capital asset pricing model, correlation coefficient, cross-subsidies, Daniel Kahneman / Amos Tversky, diversified portfolio, endowment effect, index arbitrage, index fund, locking in a profit, Long Term Capital Management, loss aversion, margin call, market friction, market microstructure, mental accounting, merger arbitrage, new economy, prediction markets, price stability, profit motive, random walk, Richard Thaler, risk-adjusted returns, risk/return, Sharpe ratio, short selling, transaction costs, Vanguard fund

If the fund companies revise their rules for pricing, then the gains due to timing will disappear. The foregoing discussion assumes that a valid explanation exists for each anomaly. That is not always the case. There are anomalies, such as the home bias, for which no reasonable explanation exists. Home bias is the tendency of investors to underweight foreign stocks compared to an optimally diversified portfolio. In other cases, the explanation, though supported by empirical evidence, may be incorrect. Whenever explanations are either false or unavailable, the anomaly is likely to disappear without any warning. ANOMALIES MAY BE ARBITRAGED AWAY BY TRADING If markets are efficient and investors are rational, then the more popular this book becomes, the greater the chance that people will trade on these anomalies until they are no longer profitable.

A simple and commonly used measure of the riskreturn trade-off is the Sharpe ratio.2 The ratio is calculated as: 81 82 Beyond the Random Walk Portfolio return – Return on Treasury bills Standard deviation of portfolio return The Sharpe ratios are reported below based on the average shortterm interest rate and annual returns for two trading strategies and three indexes over the May 1989–April 1999 period. 6-month estimation period, 12-month holding, 3 industries 0.58 12-month estimation period, 12-month holding, 3 industries 0.86 S&P 500 holding return 0.86 Wilshire 5000 holding return 0.78 Russell 2000 holding return 0.35 Sector fund trading strategies do not outperform the S&P 500 after accounting for risk. However, the trading strategies are generally superior when compared with other mutual funds, and other indexes. If only the beta risk (or systematic risk) is considered (assuming the sector funds are held in an otherwise well-diversified portfolio), the sector fund trading strategies are superior, in general, to almost all other mutual funds, including the S&P 500 index funds. All of the data presented in this section for Fidelity sector funds are based on long holding periods. Later in this chapter we will see that Fidelity sector funds perform quite well over shorter holding periods. Those results are similar to the results reported earlier in this section.

The challenge in diversifying risk is to find stocks that have a correlation of less than +1. However, if you own only one stock, such as the stock of the company you work for, it is easy to find other stocks that are not well correlated with that stock. Adding more stocks to that one stock will certainly reduce risk. It is estimated that you must invest in thirty to forty randomly picked stocks to get a reasonably diversified portfolio. Did you know that a typical individual invests in less than ten stocks? How many different stocks does your portfolio have? Correlation and risk are important for all financial decisions. For example, you protect your house and car against loss through insurance. Insurance has a negative correlation with your assets. Insurance pays off when your assets are destroyed but pays nothing if your assets are not destroyed.

 

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

The purpose of the CAPM is to deduce how to price risky assets when the market is in equilibrium. To derive the CAPM, we consider the conditions under which a risky asset may be added to an already well diversified portfolio. The conditions depend on the systematic risk of the asset, also called the undiversifiable risk of the asset since it cannot be diversified away by holding a large portfolio of different risky assets. We also need to know the risk free rate of return and the expected return on the market portfolio. Then we ask: given the systematic risk of an asset, what should its expected excess return be to justify its addition to our well diversified portfolio?21 The CAPM is based on a concept of market equilibrium in which the expected excess return on any single risky asset is proportional to the expected excess return on the market portfolio.

So if an estimated coefficient is insignificantly different from 0 then its explanatory variable can be excluded from the regression model. The estimated model can be used to: • predict or forecast values of the dependent variable using scenarios on the independent variables; • test an economic or financial theory; • estimate the quantities of financial assets to buy or sell when forming a diversified portfolio, a hedged portfolio or when implementing a trading strategy. The outline of this chapter is as follows. Section I.4.2 introduces the simplest possible linear regression model, i.e. one with just one explanatory variable. We describe the best method to estimate the model parameters when certain assumptions hold. This is called ordinary least squares (OLS) estimation. Then we explain how to test some simple hypotheses in the simple linear model.

It is the excess of the expected return on an asset (or more generally on an investment portfolio) over the risk free rate divided by the standard deviation of the asset returns distribution, i.e. ER − Rf (I.6.56) = where ER and are the forecasted expected return and standard deviation of the asset or portfolio’s returns. Suppose we forecast an alpha for a risky asset in the CAPM framework (I.6.47) and that this alpha is positive. Then we may wish to add this asset to our well diversified portfolio, but the CAPM does not tell us how much of this asset we should buy. If our holding is too large this will affect the diversification of our portfolio. The asset has a non-zero specific risk , so if we add too much of the asset this will produce a specific risk of the portfolio that is also non-zero. A risk adjusted performance measure associated with abnormal returns in the CAPM framework was proposed by Treynor (1965).

 

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

Business risks are partly attributable to the specifics of a particular business and partly related to the prosperity of the general economy. The CAPM describes them as specific risk and market risk respectively. Specific risk arises when a badly managed business loses share to its competitors, or a major project suffers from cost overruns. A well-diversified portfolio will accumulate a variety of specific risks. (CAPM implies that the lower risk achieved by constructing such a portfolio will be reflected in lower returns: I recommend readers to ignore this advice and build a diversified portfolio anyway.) Market risk is usually measured by β, which measures the correlation between the value of a particular stock and the movement of general share price indexes. I will return to this Greek alphabet soup in Chapter 7. But selecting uncorrelated investments is not easy.

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. A conservative investor – like me – can invest in very risky things so long as the investment is part of a well-diversified portfolio. Correlation is the statistical term for the extent to which two distinct variables – such as the values of Apple shares and those of long-term bonds – move together. 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.

Taken as a whole, although some particular hedge funds have been very successful, the hedge fund industry has been very profitable for hedge fund managers, but not for their investors.8 Diversification by financial intermediaries is nevertheless valuable and cheaper for investors. This was the initially persuasive rationale for pooled investment funds, which enabled small investors to take shares in a diversified fund which they could not possibly have built for themselves. A simple, lazy and therefore inexpensive way of constructing a diversified portfolio is simply to buy all the available stocks. In the 1970s computers made it easy for intermediaries to offer funds that held a proportionate share of every security. Academic research around the efficient market hypothesis – which encouraged scepticism about the reality of manager skill – led to the creation of the first index, or passive, funds. Within a few years passive funds, which simply held all the shares in the Standard & Poor’s or other index, had captured a growing share of the market for intermediation, not just in stock markets but also among bond and even property investors.

 

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

When we analyze the risk versus return of cash, bonds, stocks, and alternatives, it has been shown that a properly diversified portfolio that includes these asset classes can minimize risk without sacrificing return. For example, in Exhibit 9.3, Investment Growth Based on Rates of Return 1980 to 2011, you can clearly see that if you invest 20 percent of your portfolio in stocks and 80 percent in bonds (rather than 100 percent in bonds), that can result in less risk with a higher return. The general rule of investing states the higher the risk, the higher the potential rate of return. This Nobel-prizewinning discovery by Harry Markowitz was able to show that with a properly diversified portfolio that included both stocks and bonds, it was actually possible to increase your rate of return and, at the same time, lower the risk of the overall portfolio.

Company- or industry-specific risk occurs when an event affects only a specific company or industry—for example, if accounting irregularities are discovered during a particular company’s financial statement audit, the value of investment in that company is likely to decrease. These types of events can have a significant effect on a company’s value as well as the confidence investors can place with its management. By far, this is the strongest reason for a well-diversified portfolio and why you should never keep all your eggs in one basket. Stocks, Bonds, Mutual Funds, and Exchange-Traded Funds The most efficient and popular way to invest is by purchasing individual stocks, bonds, mutual funds, and exchange-traded funds (ETFs). Therefore, I believe that it is essential that I provide you with a description of each of these investment vehicles. Stocks1 A stock represents a fractional ownership interest in a corporation.

This includes growth stocks, growth mutual funds, growth ETFs, and growth alternative investments. These investment vehicles may provide the potential for returns that could exceed inflation over the long term. Of course, these growth-oriented investment vehicles also come with a greater risk than other types of investments. As you select your asset allocation model based on your risk tolerance level, never forget that smart investors always focus on a well-diversified portfolio. Taking on too much risk or taking on too little risk can both be equally damaging to your financial success. You must find your own perfect balance in determining your own risk-reward ratio. When investing, you must always consider the tax consequences of your investment when determining your true rate of return. Here are just a few examples of how taxes affect investments: • If you hold an investment for more than a year, you will have the added advantage of long-term capital gains treatment.

 

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

For instance, many of the corporate events that event-driven hedge fund managers trade on are associated with demand pressure. When a merger has been announced, the target stock jumps up on the announcement, but if the merger deal falls apart, the price will drop back down. Due to this event risk, many mutual funds and other investors sell the target stock, leading to downward pressure on the stock price. In this case, merger arbitrage hedge funds provide liquidity by buying a diversified portfolio of such merger targets. The merger arbitrage hedge funds can therefore be viewed as selling insurance against the event risk that the merger falls apart. Just as insurance companies profit from selling protection against your house burning down, merger arbitrage hedge funds profit from selling insurance against a merger deal failing. Another source of demand pressure is that some investors want to hedge various risks.

Safety can be measured using stock returns and fundamental accounting variables, or both. The standard return-based measure is the market beta, measuring the systematic risk that the stock price will go down when the market is also down. Some equity investors also look at a stock’s total volatility (or even its idiosyncratic volatility). The beta is relevant for measuring the contribution to risk in a very well-diversified portfolio, while the stock’s total volatility is the risk of holding the stock in a concentrated portfolio. Fundamental risk measures are designed to estimate the risk of declining future profits, for instance, by considering the past variation in profitability. Payout and Management Quality A fourth class of quality measures focuses on how shareholder-friendly the firm is and how well managed it is.

The size of each position is chosen to target an annualized volatility of 40% for that asset.6 Specifically, the number of dollars bought/sold of instrument s at time t is 40%/ so that the time series momentum (TSMOM) strategy realizes the following return during the next week: Here, is the ex ante annualized volatility for each instrument, estimated as an exponentially weighted average of past squared returns. This constant-volatility position-sizing methodology is useful for several reasons: First, it enables us to aggregate the different assets into a diversified portfolio that is not overly dependent on the riskier assets—this is important given the large dispersion in volatility among the assets we trade. Second, this methodology keeps the risk of each asset stable over time, so that the strategy’s performance is not overly dependent on what happens during times of high risk. Third, the methodology minimizes the risk of data mining given that it does not use any free parameters or optimization in choosing the position sizes.

 

Investment: A History by Norton Reamer, Jesse Downing

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Albert Einstein, algorithmic trading, asset allocation, backtesting, banking crisis, Berlin Wall, Bernie Madoff, Brownian motion, buttonwood tree, California gold rush, capital asset pricing model, Carmen Reinhart, carried interest, colonial rule, credit crunch, Credit Default Swap, Daniel Kahneman / Amos Tversky, debt deflation, discounted cash flows, diversified portfolio, equity premium, estate planning, Eugene Fama: efficient market hypothesis, Fall of the Berlin Wall, family office, Fellow of the Royal Society, financial innovation, fixed income, Gordon Gekko, Henri Poincaré, high net worth, index fund, interest rate swap, invention of the telegraph, James Hargreaves, James Watt: steam engine, joint-stock company, Kenneth Rogoff, labor-force participation, land tenure, London Interbank Offered Rate, Long Term Capital Management, loss aversion, Louis Bachelier, margin call, means of production, Menlo Park, merger arbitrage, moral hazard, mortgage debt, Network effects, new economy, Nick Leeson, Own Your Own Home, pension reform, Ponzi scheme, price mechanism, principal–agent problem, profit maximization, quantitative easing, RAND corporation, random walk, Renaissance Technologies, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, Sand Hill Road, Sharpe ratio, short selling, Silicon Valley, South Sea Bubble, sovereign wealth fund, spinning jenny, statistical arbitrage, technology bubble, The Wealth of Nations by Adam Smith, time value of money, too big to fail, transaction costs, underbanked, Vanguard fund, working poor, yield curve

Alternatives (a class of investments that includes hedge funds, private equity, and venture capital) tend to be high-fee, relatively exclusive, and often institutionally oriented products. Index funds and ETFs, by contrast, are low fee, typically involve passive and rules-based ownership, and are available for retail investors and institutions alike. Debates have raged over the relative superiority of these as well as the ability to combine the two classes in a diversified portfolio. Few examinations, however, have sought to uncover their respective historical developments to unlock meaning and their possible futures. This chapter aims to do precisely that, unearthing the origins and evolution of these investment vehicles. More New Investment Forms 257 ALTERNATIVE INVESTMENTS: HEDGE FUNDS, PRIVATE EQUITY, AND VENTURE CAPITAL The realm of alternative investments is vast and includes not just hedge funds, private equity, and venture capital but also commodities, real estate, and infrastructure.

Actual investable commodities indices are far more recent, coming into existence in 1991 with the Goldman Sachs 282 Investment: A History Commodity Index (S&P GSCI) and later in 1998 with the Dow Jones UBS Commodity Index.48 Commodities and natural resources investments include both traditional futures and collateralized commodity futures, as well as direct holdings of physical assets such as gold and other natural resources. Mineral rights and the licensing of revenue streams are also examples of real-world commodities and natural resources investments in the alternatives space. Commodity investments are an attractive way to diversify portfolios because they often have high returns and low correlations to equities and other liquid investable assets.49 timber, agriculture, and farmland The Employee Retirement Income Security Act of 1974 was a major catalyst for investment in timberland, since pension funds now had the ability to move into new and more esoteric asset classes.50 Since the mid-1980s, institutional assets invested in timber have grown dramatically, from $1 billion to more than $50 billion.51 Asset returns were strong through the 1980s to the 1990s, resting in part on Japanese demand and pricing.

Over the period from 1994 to 1996, some 91 percent of managed funds underperformed their index fund counterparts within US equities—a victory for the vehicle that was once derided as a recipe for mediocrity.58 Today there exist nearly 300 distinct stock and bond index mutual funds in the United States and over 1,000 American passive ETFs, and the world of investment has come a very long way toward not only accepting index funds as a fixture of investing but also fully embracing the power of indexing as one component of a strategy to outperform the market in terms of risk-adjusted return.59 The first index funds were meant for passive investors who simply wanted a small piece of the larger pie of the equity markets. Modern index funds, however, cater not only to passive investors who are looking for a broadly diversified portfolio of securities but also to active investors who want to enhance their portfolio returns by investing in particular asset classes through indexing. For instance, there are index funds that specialize in timberland investment, leveraged index funds that attempt to double or triple the return of a common stock index such as the S&P 500 on a daily basis, and index funds that specialize in commodities.

 

pages: 219 words: 15,438

The Essays of Warren Buffett: Lessons for Corporate America by Warren E. Buffett, Lawrence A. Cunningham

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compound rate of return, corporate governance, Dissolution of the Soviet Union, diversified portfolio, dividend-yielding stocks, fixed income, index fund, invisible hand, large denomination, low cost carrier, oil shock, passive investing, price stability, Ronald Reagan, the market place, transaction costs, Yogi Berra, zero-coupon bond

According to this view, you will do 12 CARDOZO LAW REVIEW [Vol. 19:1 better by randomly selecting a group of stocks for a portfolio by throwing darts at the stock tables than by thinking about whether individual investment opportunities make sense. One of modern finance theory's main tenets is modern portfolio theory. It says that you can eliminate the peculiar risk of any security by holding a diversified portfolio-that is, it formalizes the folk slogan "don't put all your eggs in one basket." The risk that is left over is the only risk for which investors will be compensated, the story goes. This leftover risk can be measured by a simple mathematical term-called beta-that shows how volatile the security is compared to the market. Beta measures this volatility risk well for securities that trade on efficient markets, where information about publicly traded securities is swiftly and accurately incorporated into prices.

A strategy of financial and mental concentration may reduce risk by raising both the intensity of an investor's thinking about a business and the comfort level he must have with its fundamental characteristics before buying it. The fashion of beta, according to Buffett, suffers from inattention to "a fundamental principle: It is better to be approximately right than precisely wrong." Long-term investment success depends not on studying betas and maintaining a diversified portfolio, but on recognizing that as an investor, one is the owner of a business. Reconfiguring a portfolio by buying and selling stocks to accommodate the desired beta-risk profile defeats long-term investment success. Such "flitting from flower to flower" imposes huge transaction costs in the forms of spreads, fees and commissions, not to mention taxes. Buffett jokes that calling someone who trades actively in the market an investor "is like calling someone who repeatedly engages in one-night stands a romantic."

(Many of the bonds that financed the purchase were sold to now-failed savings and loan associations; as a taxpayer, you are picking up the tab for this folly.) All of this seems impossible now. When these misdeeds were done, however, dagger-selling investment bankers pointed to the "scholarly" research of academics, which reported that over the years the higher interest rates received from low-grade bonds had more than compensated for their higher rate of default. Thus, said the friendly salesmen, a diversified portfolio of junk bonds would produce greater net returns than would a portfolio of high~grade bonds. (Beware of past-performance "proofs" in finance: If history books were the key to riches, the Forbes 400 would consist of librarians.) There was a flaw in the salesmen's logic-one that a first-year student in statistics is taught to recognize. An assumption was being made that the universe of newly-minted junk bonds was identical to the universe of low-grade fallen angels and that, therefore, the default experience of the latter group was meaningful in predicting the default experience of the new issues.

 

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

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. Investing in more securities will yield further diversification benefits, but to a drastically smaller degree. Further diversification benefits can be gained by investing in foreign securities because they tend to be less closely correlated with domestic investments. For example, an economic downturn in the U.S. economy may not affect Japan’s economy; therefore, Japanese investments could do well when domestic investments perform poorly.

Mutual funds are operated by money managers, who actively manage a fund’s assets in an attempt to produce positive returns for the fund’s investors. A mutual fund’s portfolio strategy is structured and maintained to match the investment objectives stated in its prospectus. Investopedia explains Mutual Fund Mutual funds are popular because they give small investors access to professionally managed, diversified portfolios of stocks, bonds, and other securities that would be quite difficult (if not impossible) for investors to replicate on their own with a small amount of money. Each shareholder participates proportionally in the gain or loss of the fund. Mutual fund units, or shares, are issued and typically can be purchased or redeemed as needed at the fund’s current net asset value (NAV) per share, which sometimes is expressed as NAVPS.

Passive investors purchase investments with the intention of long-term appreciation and thus have limited portfolio turnover. Index fund investing, in which shares in the fund simply mirror an index, is a form of passive investing. Investopedia explains Passive Investing Also known as a buy-and-hold or couch potato strategy, passive investing requires good initial research, patience, and a well-diversified portfolio. Unlike active investors, passive investors buy a security and typically do not actively attempt to profit from short-term price fluctuations. Passive investors instead rely on their belief that in the long term the investment will be profitable. Related Terms: • Diversification • Index • Mutual Fund • Exchange-Traded Fund • Index Fund Payback Period What Does Payback Period Mean? The length of time it takes to recover the cost of an investment.

 

Trend Commandments: Trading for Exceptional Returns by Michael W. Covel

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Albert Einstein, Bernie Madoff, Black Swan, commodity trading advisor, correlation coefficient, delayed gratification, diversified portfolio, en.wikipedia.org, Eugene Fama: efficient market hypothesis, family office, full employment, Lao Tzu, Long Term Capital Management, market bubble, market microstructure, Mikhail Gorbachev, moral hazard, Nick Leeson, oil shock, Ponzi scheme, prediction markets, quantitative trading / quantitative finance, random walk, Sharpe ratio, systematic trading, the scientific method, transaction costs, tulip mania, upwardly mobile, Y2K

There should be als, and energies. excellent performance You do not need to know the for the vast majority of markets.1 market’s name. They are all the same when you look at price data only. If they are all the same, then an opportunistic strategy that is ready to go when a trend starts can make you serious money. That’s how the fortunes discussed in the earlier chapter “Show Me the Money” were made. The following is an example of a diversified portfolio that you could use as a starting point for assembling your own portfolio (with the exchanges listed where markets are traded): British Pound (CME; www.cmegroup.com) Canadian Dollar (CME) Euro (CME) Swiss Franc (CME) Japanese Yen (CME) Australian Dollar (CME) Mexican Peso (CME) Eurodollar (CME) Euribor (NYSE LIFFE; www.euronext.com) Aussie Bank Bills (ASX; www.asx.com.au) U.S. 10-Year Note (CME) U.S. 30-Year Bond (CME) 66 Tre n d C o m m a n d m e n t s Canadian Gov’t.

., 223 Commodities Corporation, 69 D commodity trading advisors (CTAs), defined, 11 decisions, immediacy of, 131-132 The Complete TurtleTrader (Covel), 199 compounding, importance of, 22-23 degrees, worth of, 123 delay in decision-making, avoiding, 131-132 Dennis, Richard, 199 computers, role in trend following, 87-88 “Determining Optimal Risk” (Druz and Seykota), 62 consistency, 139 diversified portfolios, example of, 65-67 Contact (film), 4 contradictions in market predictions, 175-178 Donahue, Phil, 113 Donchian, Richard, 230-231, 239 Index Dow Theory, 225-226 fat tails, 137 Dow, Charles H., 225 Faulkner, Charles, 59 drawdowns, 69-70 Field, Jacob, 226 Druz, David, 18, 62 50 Cent, 166 Duchovny, David, 211 financial bubbles, irrational behavior in, 25-26 Dunn, Bill, 15-16, 195 Dunnigan, William, 229-230, 239 E Economic Bill of Rights, 114 economic philosophy, assumptions in, 25 economy, effect on presidential approval ratings, 181-182 Edwards, Robert D., 226 Efficient-Markets Hypothesis, 101-102 Elizabeth II (queen of England), 47 Elliott, R.

 

pages: 240 words: 60,660

Models. Behaving. Badly.: Why Confusing Illusion With Reality Can Lead to Disaster, on Wall Street and in Life by Emanuel Derman

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Albert Einstein, Asian financial crisis, Augustin-Louis Cauchy, Black-Scholes formula, British Empire, Brownian motion, capital asset pricing model, Cepheid variable, crony capitalism, diversified portfolio, Douglas Hofstadter, Emanuel Derman, Eugene Fama: efficient market hypothesis, Henri Poincaré, Isaac Newton, law of one price, Mikhail Gorbachev, quantitative trading / quantitative finance, random walk, Richard Feynman, Richard Feynman, riskless arbitrage, savings glut, Schrödinger's Cat, Sharpe ratio, stochastic volatility, the scientific method, washing machines reduced drudgery, yield curve

Idiosyncratic risk is avoidable: it can be diminished by diversification, the assembly of a portfolio of many stocks whose idiosyncratic risks are unrelated and therefore tend to cancel each other out. (This tendency to cancel is similar to the tendency of independent random up and down stock price moves in Figure 5.2 to cancel, so that the idiosyncratic risk of a portfolio of n stocks grows only as fast as Vn.) All that afflicts a stock in a (theoretically) diversified portfolio of many stocks is therefore the market risk it carries. CAPM characterizes each stock’s unavoidable market risk by a statistic, β (beta), the ratio of its individual market risk to the risk of the entire market. The β of each stock describes its tendency to herd with the crowd, and different stocks have different measurable betas.13 The greater the beta of a stock, the more it responds to a market move.

It is a sign of the political power of models that commercial websites publish the value of beta, a parameter in a model that doesn’t work that well, but not the more fundamental and model-neutral volatility statistic σ. But CAPM has had a beneficial impact, having being responsible for introducing into finance as metaphors the notion of alpha and beta. Alpha and beta represent the sources of return. Beta refers to the return earned for simply entering the market dumbly. Getting beta is easy: all you have to do is buy a diversified portfolio of stocks without worrying about their individual attributes. Alpha, in contrast, represents skill, the return generated by being smarter than the hordes, by picking better-than-average stocks, or picking ordinary stocks at the right time, as with Apple in the example above. Inspired by CAPM, investors now ask themselves whether their manager is providing merely dumb beta or smart alpha.

 

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%

But this is probably not true at all levels: as we move down the list into the $1–10 billion range (and according to Forbes, several hundred new fortunes appear in this range somewhere in the world almost every year), or even more into the $10–$100 million range, it is likely that many inherited fortunes are held in diversified portfolios, in which case they are difficult for journalists to detect (especially since the individuals involved are generally far less eager to be known publicly than entrepreneurs are). Because of this straightforward statistical bias, wealth rankings inevitably tend to underestimate the size of inherited fortunes. Some magazines, such as Challenges in France, state openly that their goal is simply to catalog so-called business-related fortunes, that is, fortunes consisting primarily of the stock of a particular company. Diversified portfolios do not interest them. The problem is that it is difficult to find out what their definition of a “business-related fortune” is.

We nevertheless lack the distance needed to be certain about this last point. We cannot rule out the possibility that the pure return on capital will rise to higher levels over the next few decades, especially in view of the growing international competition for capital and the equally increasing sophistication of financial markets and institutions in generating high yields from complex, diversified portfolios. In any case, this virtual stability of the pure return on capital over the very long run (or more likely this slight decrease of about one-quarter to one-fifth, from 4–5 percent in the eighteenth and nineteenth centuries to 3–4 percent today) is a fact of major importance for this study. In order to put these figures in perspective, recall first of all that the traditional rate of conversion from capital to rent in the eighteenth and nineteenth centuries, for the most common and least risky forms of capital (typically land and public debt) was generally on the order of 5 percent a year: the value of a capital asset was estimated to be equal to twenty years of the annual income yielded by that asset.

When growth is slow, it is almost inevitable that this return on capital is significantly higher than the growth rate, which automatically bestows outsized importance on inequalities of wealth accumulated in the past. This logical contradiction cannot be resolved by a dose of additional competition. Rent is not an imperfection in the market: it is rather the consequence of a “pure and perfect” market for capital, as economists understand it: a capital market in which each owner of capital, including the least capable of heirs, can obtain the highest possible yield on the most diversified portfolio that can be assembled in the national or global economy. To be sure, there is something astonishing about the notion that capital yields rent, or income that the owner of capital obtains without working. There is something in this notion that is an affront to common sense and that has in fact perturbed any number of civilizations, which have responded in various ways, not always benign, ranging from the prohibition of usury to Soviet-style communism.

 

Early Retirement Guide: 40 is the new 65 by Manish Thakur

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Airbnb, diversified portfolio, financial independence, index fund, Lyft, passive income, passive investing, risk tolerance, Robert Shiller, Robert Shiller, time value of money, Vanguard fund, Zipcar

There's no hard and fast answer for this since some individuals are very entrepreneurial and want to actively manage where their dollars are put to work, and some individuals are already booked solid and want a more passive approach. The key to this is to simply get started. This section will give you 90% of the knowledge and resources to get started investing today. Invest in an adequately diversified portfolio of low cost passive investments and hold for the long term. That sentence holds all the secrets and techniques needed to invest and thrive. Don't spend a dime on finance gurus and conferences that will teach you "the 5 key techniques to earning millions on stocks" or "the secret to how I made $65,000 in a month." When first starting out in investing, it's understandable to look for a secret to consistently making money with investments.

 

pages: 670 words: 194,502

The Intelligent Investor (Collins Business Essentials) by Benjamin Graham, Jason Zweig

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accounting loophole / creative accounting, air freight, Andrei Shleifer, asset allocation, buy low sell high, capital asset pricing model, corporate governance, Daniel Kahneman / Amos Tversky, diversified portfolio, Eugene Fama: efficient market hypothesis, hiring and firing, index fund, Isaac Newton, Long Term Capital Management, market bubble, merger arbitrage, new economy, passive investing, price stability, Ralph Waldo Emerson, Richard Thaler, risk tolerance, Robert Shiller, Robert Shiller, Ronald Reagan, shareholder value, sharing economy, short selling, Silicon Valley, South Sea Bubble, Steve Jobs, the market place, transaction costs, tulip mania, VA Linux, Vanguard fund, Y2K, Yogi Berra

I think Graham, ever the conservative, would split the difference between the lowest and highest past returns and project that over the next decade stocks will earn roughly 6% annually, or 4% after inflation. (Interestingly, that projection matches the estimate we got earlier when we added together real growth, inflationary growth, and speculative growth.) Compared to the 1990s, 6% is chicken feed. But it’s a whisker better than the gains that bonds are likely to produce—and reason enough for most investors to hang on to stocks as part of a diversified portfolio. But there is a second lesson in Graham’s approach. The only thing you can be confident of while forecasting future stock returns is that you will probably turn out to be wrong. The only indisputable truth that the past teaches us is that the future will always surprise us—always! And the corollary to that law of financial history is that the markets will most brutally surprise the very people who are most certain that their views about the future are right.

Unlike traditional brokers or mutual funds that won’t let you in the door for less than $2,000 or $3,000, these online firms have no minimum account balances and are tailor-made for beginning investors who want to put fledgling portfolios on autopilot. To be sure, a transaction fee of $4 takes a monstrous 8% bite out of a $50 monthly investment—but if that’s all the money you can spare, then these microinvesting sites are the only game in town for building a diversified portfolio. You can also buy individual stocks straight from the issuing companies. In 1994, the U.S. Securities and Exchange Commission loosened the handcuffs it had long ago clamped onto the direct sale of stocks to the public. Hundreds of companies responded by creating Internet-based programs allowing investors to buy shares without going through a broker. Some helpful online sources of information on buying stocks directly include www.dripcentral.com, www.netstock direct.com (an affiliate of Sharebuilder), and www.stockpower.com.

I hereby declare my refusal to let a herd of strangers make my financial decisions for me. I further make a solemn commitment never to invest because the stock market has gone up, and never to sell because it has gone down. Instead, I will invest $______.00 per month, every month, through an automatic investment plan or “dollar-cost averaging program,” into the following mutual fund(s) or diversified portfolio(s): _________________________________, _________________________________, _________________________________. I will also invest additional amounts whenever I can afford to spare the cash (and can afford to lose it in the short run). I hereby declare that I will hold each of these investments continually through at least the following date (which must be a minimum of 10 years after the date of this contact): _________________ _____, 20__.

 

pages: 295 words: 66,824

A Mathematician Plays the Stock Market by John Allen Paulos

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Benoit Mandelbrot, Black-Scholes formula, Brownian motion, business climate, butterfly effect, capital asset pricing model, correlation coefficient, correlation does not imply causation, Daniel Kahneman / Amos Tversky, diversified portfolio, Donald Trump, double entry bookkeeping, Elliott wave, endowment effect, Erdős number, Eugene Fama: efficient market hypothesis, four colour theorem, George Gilder, global village, greed is good, index fund, invisible hand, Isaac Newton, John Nash: game theory, Long Term Capital Management, loss aversion, Louis Bachelier, mandelbrot fractal, margin call, mental accounting, Nash equilibrium, Network effects, passive investing, Paul Erdős, Ponzi scheme, price anchoring, Ralph Nelson Elliott, random walk, Richard Thaler, Robert Shiller, Robert Shiller, short selling, six sigma, Stephen Hawking, transaction costs, ultimatum game, Vanguard fund, Yogi Berra

Likewise, if C is the number of classes skipped during the year by a randomly selected student in a large lecture and S is his score on the final exam, then the variance of (C + S) is smaller than the variance of C plus the variance of S. Students who miss a lot of classes generally (although certainly not always) achieve a lower score, so the extremes of the sum, number of classes missed plus exam scores, are going to be considerably less than they would be if number of classes missed and exam scores did not have a negative covariance. When choosing stocks for a diversified portfolio, investors, as noted, generally look for negative covariances. They want to own equities like the Hatfield and the McCoy stocks and not like WCOM, say, and some other telecommunications stock. With three or more stocks in a portfolio, one uses the stocks’ weights in the portfolio as well as the definitions just discussed to compute the portfolio’s variance and standard deviation. (The algebra is tedious, but easy.)

Brian auditors Aumann, Robert availability error average values compared with distribution of incomes risk as variance from averages average return compared with median return average value compared with distribution of incomes buy-sell rules and outguessing average guess risk as variance from average value averaging down Bachelier, Louis Bak, Per Barabasi, Albert-Lazló Bartiromo, Maria bear markets investor self-descriptions and shorting and distorting strategy in Benford, Frank Benford’s Law applying to corporate fraud background of frequent occurrence of numbers governed by Bernoulli, Daniel Beta (B) values causes of variations in comparing market against individual stocks or funds strengths and weaknesses of technique for finding volatility and Big Bang billiards, as example of nonlinear system binary system biorhythm theory Black, Fischer Black-Scholes option formula blackjack strategies Blackledge, Todd “blow up,” investor blue chip companies, P/E ratio of Bogle, John bonds Greenspan’s impact on bond market history of stocks outperforming will not necessarily continue to be outperformed by stocks Bonds, Barry bookkeeping. see accounting practices bottom-line investing Brock, William brokers. see stock brokers Buffett, Warren bull markets investor self-descriptions and pump and dump strategy in Butterfly Economics (Ormerod) “butterfly effect,” of nonlinear systems buy-sell rules buying on the margin. see also margin investments calendar effects call options. see also stock options covering how they work selling strategies valuation tools campaign contributions Capital Asset Pricing Model capital gains vs. dividends Central Limit Theorem CEOs arrogance of benefits in manipulating stock prices remuneration compared with that of average employee volatility due to malfeasance of chain letters Chaitin, Gregory chance. see also whim trading strategies and as undeniable factor in market chaos theory. see also nonlinear systems charity Clayman, Michelle cognitive illusions availability error confirmation bias heuristics rules of thumb for saving time mental accounts status quo bias Cohen, Abby Joseph coin flipping common knowledge accounting scandals and definition and importance to investors dynamic with private knowledge insider trading and parable illustrating private information becoming companies/corporations adjusting results to meet expectations applying Benford’s Law to corporate fraud comparing corporate and personal accounting financial health and P/E ratio of blue chips competition vs. cooperation, prisoner’s dilemma complexity changing over time horizon of sequences (mathematics) of trading strategies compound interest as basis of wealth doubling time and formulas for future value and present value and confirmation bias definition of investments reflecting stock-picking and connectedness. see also networks European market causing reaction on Wall Street interactions based on whim interactions between technical traders and value traders irrational interactions between traders Wolfram model of interactions between traders Consumer Confidence Index (CCI) contrarian investing dogs of the Dow measures of excellence and rate of return and cooperation vs. competition, prisoner’s dilemma correlation coefficient. see also statistical correlations counter-intuitive investment counterproductive behavior, psychology of covariance calculation of portfolio diversification based on portfolio volatility and stock selection and Cramer, James crowd following or not herd-like nature of price movements dart throwing, stock-picking contest in the Wall Street Journal data mining illustrated by online chatrooms moving averages and survivorship bias and trading strategies and DeBondt, Werner Deciding What’s News (Gans) decimalization reforms decision making minimizing regret selling WCOM depression of derivatives trading, Enron despair and guilt over market losses deviation from the mean. see also mean value covariance standard deviation (d) variance dice, probability and Digex discounting process, present value of future money distribution of incomes distribution of wealth dynamic of concentration UN report on diversified portfolios. see stock portfolios, diversifying dividends earnings and proposals benefitting returns from Dodd, David dogs of the Dow strategy “dominance” principle, game theory dot com IPOs, as a pyramid scheme double-bottom trend reversal “double-dip” recession double entry bookkeeping doubling time, compound interest and Dow dogs of the Dow strategy percentages of gains and losses e (exponential growth) compound interest and higher mathematics and earnings anchoring effect and complications with determination of inflating (WCOM) P/E ratio and stock valuation and East, Steven H.

 

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

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.

While individual investors account for 27 percent of the average company’s shareholders, they tend to be more passive than institutional investors in exercising their responsibilities and rights. Individuals vote the proxies for just 29 percent of their shares, while institutions vote 90 percent of theirs.72 One reason is that individuals are daunted by the complexity of voting. The information is often convoluted, and the process time consuming. If you own a diversified portfolio of individual stocks, you may have to do it twenty or thirty times or more. But technology has made it possible for individuals to vote their preferences without the need for individual review of each proxy. “Advance Voting Instructions” (AVI) allow investors to vote automatically with or against management, or with a well-known third party such as the giant pension fund CalPERS, or with the recommendations of a proxy voting agency.

 

pages: 507 words: 145,878

Predator's Ball by Connie Bruck

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diversified portfolio, financial independence, fixed income, mortgage debt, offshore financial centre, paper trading, profit maximization, The Predators' Ball, yield management, Yogi Berra, zero-coupon bond

There were the players who had turned nondescript or failing financial companies into dazzling success stories, based on the yield of the bonds that Milken offered them. And there were the money managers—people who ran investment portfolios for thrift institutions, insurance companies, public and private pension funds, mutual funds, offshore banks, college endowments, high-yield funds. Many of them had been converted into believers by Milken back in the seventies, when he had begun tirelessly preaching an esoteric gospel: that in a diversified portfolio of high-yield bonds, otherwise known as “junk” bonds, the reward outweighs the risk. This was a proven theory, well documented by academician W. Braddock Hickman in his enormous multivolume tome Corporate Bond Quality and Investor Experience, published in the fifties. All that remained, for everyone to make money, more money probably than they had ever imagined, was to put theory into practice.

It was a powerful disincentive to taking any secrets from Milken’s operation to a rival firm. OVER THE NEXT several years, Milken began to cultivate a group of increasingly satisfied customers. There were a handful of institutions, like Massachusetts Mutual, and discount-bond mutual funds, including Keystone B4, Lord Abbott Bond Debenture, and National Bond Fund. These tended to play the market according to Hickman, going for the yield over time in large, diversified portfolios. There was also David Solomon, of First Investors Fund for Income, known as FIFI. FIFI was converting its high-grade-bond fund (with bonds that had suffered in the recession) to a high-yield fund in 1973, at about the time that Solomon was employed to manage it. According to former members of Milken’s group, Milken soon took Solomon in hand, and the returns on Solomon’s portfolio showed the effect.

The firm was embarked on what Joseph would later describe as its “high-value-added” course: as the years went on, Drexel would charge ever more astonishing fees for doing what no one else could do. Milken had his stable of clients, but if this market was to thrive it would need a much broader base. Milken and Joseph quickly determined, however, that they would not distribute the bonds through Drexel’s retail system. Milken followed the old Hickman credo on diversification. The retail customers with their small holdings would not have diversified portfolios, and without diversification Milken was convinced he would ultimately kill his clients. The way to reach those retail buyers, Milken and Joseph decided, was to invent high-yield-bond funds, where the portfolio would be diversified. First Investors Fund for Income (FIFI) had been operating essentially as a high-yield-bond fund since Milken began tutoring David Solomon, in the midseventies.

 

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

In particular, those who are required to take the employer’s match in the form of company stock allocate 29 percent of their discretionary contributions—that is, the money they have control over—to company stock. By contrast, those who have the option, but not the requirement, to take the employer’s match in the form of company stock allocate only 18 percent of their own funds to company stock.10 How risky is it to hold the shares of a single stock rather than a diversified portfolio? According to estimates by the economist Lisa Meulbroek (2002), a dollar in company stock is worth less than half the value of a dollar in a mutual fund! In other words, when firms foist company stock onto their employees, it is like paying them fifty cents on the dollar. The upshot is that, in general, workers would be much better off with a diversified mutual fund than with company stock.

First, even if firms recognize that company stock is not so great for employees, they do not want all or most employees to sell their stock at once, for fear that such sales will lower the stock’s price. Second, firms do not want to be signaling that they think their stock is a bad investment. The Sell More Tomorrow plan gives employees the option to sell off their shares gradually over a period of time (say, three years), with the proceeds directed into a diversified portfolio. The program could be done on either an opt-in or opt-out basis. NAÏVE INVESTING Nudges Through better choice architecture, plans can help their participants on many dimensions. Attention to choice architecture has become increasingly important over the years because plans have greatly increased the number of options they offer, making it even harder for people to choose well. Defaults Historically, most defined-contribution plans did not have a default option.

 

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

Central banks were not well equipped to do this because they lacked the investment staff and portfolio managers needed to select stocks, commodities, private equity, real estate and hedge funds, which were the key to higher returns. So the sovereign wealth funds began to emerge to better manage these investments; the earliest SWFs were created some decades ago, but most have come into being in the past ten years, with their government sponsors giving them enormous allocations from their central bank reserves with a mandate to build diversified portfolios of investments from around the world. In their basic form, sovereign wealth funds do make economic sense. Most assets are invested professionally and contain no hidden political agenda, but this is not always the case. Some purchases are vanity projects, such as Middle Eastern investments in the McLaren, Aston Martin and Ferrari Formula 1 racing teams, while other investments are far more politically and economically consequential.

Financial Economics At about the same time that Paul Samuelson and others were developing their Keynesian theories, another group of economists were developing a theory of capital markets. From the faculties of Yale, MIT and the University of Chicago came a torrent of carefully reasoned academic papers by future Nobel Prize winners such as Harry Markowitz, Merton Miller, William Sharpe and James Tobin. Their papers, published in the 1950s and 1960s, argued that investors cannot beat the market on a consistent basis and that a diversified portfolio that broadly tracks the market will produce the best results over time. A decade later, a younger generation of academics, including Myron Scholes, Robert C. Merton (son of famed sociologist Robert K. Merton) and Fischer Black, came forward with new theories on the pricing of options, opening the door to the explosive growth of financial futures and other derivatives contracts ever since.

 

pages: 261 words: 103,244

Economists and the Powerful by Norbert Haring, Norbert H. Ring, Niall Douglas

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accounting loophole / creative accounting, Affordable Care Act / Obamacare, Albert Einstein, asset allocation, bank run, barriers to entry, Basel III, Bernie Madoff, British Empire, central bank independence, collective bargaining, commodity trading advisor, corporate governance, credit crunch, Credit Default Swap, David Ricardo: comparative advantage, diversified portfolio, financial deregulation, George Akerlof, illegal immigration, income inequality, inflation targeting, Jean Tirole, job satisfaction, Joseph Schumpeter, knowledge worker, labour market flexibility, law of one price, Long Term Capital Management, low skilled workers, market bubble, market clearing, market fundamentalism, means of production, minimum wage unemployment, moral hazard, new economy, obamacare, open economy, pension reform, Ponzi scheme, price stability, principal–agent problem, profit maximization, purchasing power parity, Renaissance Technologies, rolodex, Sergey Aleynikov, shareholder value, short selling, Steve Jobs, The Chicago School, the payments system, The Wealth of Nations by Adam Smith, too big to fail, transaction costs, ultimatum game, union organizing, working-age population, World Values Survey

Individual investors have less information and skill than institutional investors. They are therefore at a disadvantage if they trade with institutional investors. Thus the standard recommendation of economically disinterested advisors is to refrain from frequent trading, especially as it is well known that 80 percent of individual investors lose on average, which interestingly is the same ratio for gambling (Barber et al. 2004). Investors should buy and hold diversified portfolios, 56 ECONOMISTS AND THE POWERFUL such as low-cost mutual or index tracking funds. Instead, they trade actively, trying to pick the winners or trying to time the market by disinvesting when they think prospects are bad and investing again when they think prospects are good. It is hard to overemphasize how costly this is – and how beneficial to the institutional counterparties of these uninformed traders.

In the US, the big prize for a money management firm running a family of mutual funds is to become trustee of a corporate 401(k) retirement plan. If such firms face a tradeoff between increasing their chances of becoming (and remaining) trustee and making the optimal investment choices for their clients, the profit-maximizing choice is simple. They do the bidding of MONEY IS POWER 57 the company that has the power to name the trustee. The retirement savers would benefit from having a diversified portfolio. In particular, they should not be overinvested in the stock of their employer since they already face the risk of low income or job loss if their employer should fare badly. However, the company has an interest in having its stock price pumped up by increasing demand. In addition, it is very convenient for the top management of the companies involved to have a large share of their stock in the hands of fund managers who want to curry favor with them.

 

pages: 311 words: 17,232

Living in a Material World: The Commodity Connection by Kevin Morrison

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barriers to entry, Berlin Wall, carbon footprint, clean water, commodity trading advisor, diversified portfolio, Doha Development Round, Elon Musk, energy security, European colonialism, flex fuel, food miles, Hernando de Soto, Hugh Fearnley-Whittingstall, hydrogen economy, Long Term Capital Management, new economy, North Sea oil, oil rush, oil shale / tar sands, oil shock, out of africa, peak oil, price mechanism, Ronald Coase, Ronald Reagan, Silicon Valley, sovereign wealth fund, the payments system, The Wealth of Nations by Adam Smith, trade liberalization, transaction costs, uranium enrichment, young professional

Fund returns had taken a nose dive after a vast number of investors had piled their money into over-valued technology companies; highly leveraged telecom and dot com companies that were running out of cash. The academic theory of portfolio diversification has actually been around since the 1950s, when Harry Markowitz developed the modern portfolio theory, which essentially highlighted the need to build a diversified portfolio. At that time though, Markowitz was still mainly focused on bonds and equities. The theory took another step in the early 1980s when Dr John Lintner of Harvard University concluded in his study that, ‘The combined portfolios of stocks, after including judicious investments in managed futures accounts, show substantially less risk, at every possible level of expected return, than portfolios of stocks (or stocks and bonds) alone’ (Lintner, 1983).

Governments will be ready to act if there are extreme price moves, such as those seen in the 1970s, which were followed by a wave of price controls and subsidies. Speculators were blamed for driving down agriculture prices in the late 19th century and increasing commodity prices in the early 21st century. Neither accusation was correct; prices reflect the nature of supply and demand. With greater focus on commodities from an economic and political point, they will continue to form part of a diversified portfolio as new commodity investment products are launched in more markets. Like any market though, commodities will reach a point where prices are excessive when compared to the underlying supply and demand. A good signal of that is when there is too much attention on commodities on television, the internet and in newspapers. This concentration can lead to a bubble, as seen with the dot com experience.

 

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

It might not resonate as much as it did a decade ago (Tigrent, after all, admits that revenues dropped significantly between 2009 and 2010 before they ceased reporting their numbers altogether as competitive pressures ranging from other wealth seminars to the ongoing recession led the company to drop the price of their classes), but there are still many people who believe in the magic of what Kiyosaki is promoting. Kiyosaki gets at a truth that more reputable people in the financial services world have trouble grasping: many people don’t believe the stock market is capable of doing what other financial advisers claim. “Invest your money for the long term in a well diversified portfolio of mutual funds? Send it straight to Wall Street so that they can pay their brokers $10 million a year in bonuses? I mean, how stupid does a person have to be?” he said in a recent Time magazine interview. Knowing what we do about the state of the American retirement system, he has a point, if not the solution. Kiyosaki’s not howling at you for being in debt like Suze Orman, Dave Ramsey, and David Bach are.

that people could short stocks on a margin account: Chuck Jaffe, “Stupid Investment of the Week: Dads (or Moms) Won’t Get Rich from This Book’s Advice,” Market Watch, October 9, 2009, http://articles.marketwatch.com/2009-10-09/investing/30745209_1_vibrant-online-community-financial-education-conspiracy-theories.to quote from the press release announcing the deal: “Infomercial Company to Modify Business Practices, Reimburse Dissatisfied Customers, Attorney General Bill McCollum,” News Release, January 10, 2008, http://myfloridalegal.com/newsrel.nsf/newsreleases/BB082469E432ABD6852573CC0054A7C3. In a 2003 interview with Smart Money: Eleanor Laise, “Karma Chameleon,” Smart Money, February, 2003. “Invest your money for the long term in a well-diversified portfolio”: “10 Questions for ‘Rich Dad, Poor Dad’ Author Robert Kiyosaki—Video—TIME.com”, http://www.time.com/time/video/player/0,32068,28344410001_1908587,00.html. “The problem I sense today,” as he writes in Rich Dad, Poor Dad: Kiyosaki and Lechter, Rich Dad, Poor Dad, 55. “I didn’t want to be a millionaire, but owning a little wedge of real estate”: Carol Lloyd, “Rich House, Poor House,” San Francisco Chronicle, July 22, 2005, http://www.sfgate.com/cgi-bin/article.cgi?

 

pages: 408 words: 85,118

Python for Finance by Yuxing Yan

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asset-backed security, business intelligence, capital asset pricing model, constrained optimization, correlation coefficient, distributed generation, diversified portfolio, implied volatility, market microstructure, P = NP, p-value, quantitative trading / quantitative finance, Sharpe ratio, time value of money, value at risk, volatility smile

First, we have to know how to retrieve historical price data from Yahoo! Finance. Number of stocks and portfolio risk We know that when we increase the number of stocks in a portfolio, we would diversify away firm-specific risk. However, how many stocks do we need to diversify away from most of the firm-specific risk? Statman (1987) argues that we need at least 30 stocks. The title of his paper is How Many Stocks Make a Diversified Portfolio? in the Journal of Financial Quantitative Analysis. Based on his relationship between n (number of stocks) and the ratio of the portfolio standard deviation to the standard deviation of a single stock, we have the graph showing the relationship between the two. The values in the following table are from Statman (1987) where n is the number of stocks in a portfolio, V S is the standard deviation of the annual portfolio returns, and V is the average of the standard deviation of a one-stock portfolio: n VS VS V n VS VS V 1 49.236 1.00 45 20.316 0.41 2 37.358 0.76 50 20.203 0.41 4 29.687 0.60 75 19.860 0.40 6 26.643 0.54 100 19.686 0.40 [ 142 ] Chapter 7 n VS VS V n VS VS V 8 24.983 0.51 200 19.432 0.39 10 23.932 0.49 300 19.336 0.39 12 23.204 0.47 400 19.292 0.39 14 22.670 0.46 500 19.265 0.39 16 22.261 0.45 600 19.347 0.39 18 21.939 0.45 700 19.233 0.39 20 21.677 0.44 800 19.224 0.39 25 21.196 0.43 900 19.217 0.39 30 20.870 0.42 1000 19.211 0.39 35 20.634 0.42 f 19.158 0.39 40 20.456 0.42 The following is our program: from matplotlib.pyplot import * n=[1,2,4,6,8,10,12,14,16,18,20,25,30,35,40,45,50,75,100,200,300,400,500,6 00,700,800,900,1000] port_sigma=[0.49236,0.37358,0.29687,0.26643,0.24983,0.23932,0.23204, 0.22670,0.22261,0.21939,0.21677,0.21196,0.20870,0.20634,0.20456,0.20316,0 .20203,0.19860,0.19686,0.19432,0.19336,0.19292,0.19265,0.19347,0.19233,0. 19224,0.19217,0.19211,0.19158] xlim(0,50) ylim(0.1,0.4) hlines(0.19217, 0, 50, colors='r', linestyles='dashed') annotate('', xy=(5, 0.19), xycoords = 'data',xytext = (5, 0.28), textcoords = 'data',arrowprops = {'arrowstyle':'<->'}) annotate('', xy=(30, 0.19), xycoords = 'data',xytext = (30, 0.1), textcoords = 'data',arrowprops = {'arrowstyle':'<->'}) annotate('Total portfolio risk', xy=(5,0.3),xytext=(25,0.35), arrowprops=dict(facecolor='black',shrink=0.02)) figtext(0.15,0.4,"Diversiable risk") figtext(0.65,0.25,"Nondiversifiable risk") plot(n[0:17],port_sigma[0:17]) [ 143 ] Visual Finance via Matplotlib title("Relationship between n and portfolio risk") xlabel("Number of stocks in a portfolio") ylabel("Ratio of Portfolio std to std of one stock") show() In the preceding code, the values for n, that is, the number of stocks in a portfolio, and port_swigma, that is, the portfolio standard deviation, are from Statman (1987).

Which pair of stocks is more closely associated with each other among IBM, DELL, and WMT? Show the evidence. You can use the latest five-year data from Yahoo! Finance to support your arguments. 11. What is the Capital Market Line? How do we visualize this concept? 12. What is the Security Market Line? How do we visualize this concept? 13. Could you find empirical evidence to support or dispute the argument made by Statman (1987) that a well-diversifiable portfolio should at least be holding 30 stocks? 14. Construct an efficient frontier with the use of ten stocks from Yahoo! Finance. You can use either monthly or daily data. 15. How do we show the relationship between risk and returns? 16. What is the correlation between the US stock market and the Canadian stock market? What is the relationship between the US stock market and the Japanese stock market?

 

pages: 151 words: 38,153

With Liberty and Dividends for All: How to Save Our Middle Class When Jobs Don't Pay Enough by Peter Barnes

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Alfred Russel Wallace, banks create money, Buckminster Fuller, collective bargaining, David Ricardo: comparative advantage, declining real wages, deindustrialization, diversified portfolio, en.wikipedia.org, Fractional reserve banking, full employment, hydraulic fracturing, income inequality, Jaron Lanier, John Maynard Keynes: Economic Possibilities for our Grandchildren, Joseph Schumpeter, land reform, Mark Zuckerberg, Network effects, oil shale / tar sands, profit maximization, quantitative easing, rent-seeking, Ronald Coase, Ronald Reagan, Silicon Valley, sovereign wealth fund, the map is not the territory, The Spirit Level, The Wealth of Nations by Adam Smith, Thorstein Veblen, transaction costs, Tyler Cowen: Great Stagnation, Upton Sinclair, winner-take-all economy

Employee stock ownership plans are a step in this direction, and Kelso’s breakthrough was to create a way to finance them (through trusts that buy stock on credit) and get them favorable tax treatment. ESOPs, however, have two limitations: they’re limited to workers in companies that choose to adopt them, and they suffer from the fact that putting all one’s eggs in a single company’s stock isn’t as safe as putting them in a diversified portfolio. A larger leap toward broad stock ownership would be a plan that covered everyone and included stock in a broad assortment of companies.6 Just such a plan was proposed in 2007 by Dwight Murphey, a follower of free-market economist Ludwig von Mises. Unlike many conservatives, who blame the poor themselves and government programs for poverty, Murphey acknowledges that most modern poverty is due to a lack of jobs that pay well.

 

pages: 892 words: 91,000

Valuation: Measuring and Managing the Value of Companies by Tim Koller, McKinsey, Company Inc., Marc Goedhart, David Wessels, Barbara Schwimmer, Franziska Manoury

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air freight, barriers to entry, Basel III, BRICs, business climate, business process, capital asset pricing model, capital controls, cloud computing, compound rate of return, conceptual framework, corporate governance, corporate social responsibility, credit crunch, Credit Default Swap, discounted cash flows, distributed generation, diversified portfolio, energy security, equity premium, index fund, iterative process, Long Term Capital Management, market bubble, market friction, meta analysis, meta-analysis, new economy, p-value, performance metric, Ponzi scheme, price anchoring, purchasing power parity, quantitative easing, risk/return, Robert Shiller, Robert Shiller, shareholder value, six sigma, sovereign wealth fund, speech recognition, technology bubble, time value of money, too big to fail, transaction costs, transfer pricing, value at risk, yield curve, zero-coupon bond

This section provides our fundamental assumptions, background on the important issues, and a practical way to estimate the components of the cost of capital. General Guidelines Our analysis adopts the perspective of a global investor—either a multinational company or an international investor with a diversified portfolio. Of course, some emerging markets are not yet well integrated with the global market, and local investors may face barriers to investing outside their home market. As a result, local investors cannot always hold well-diversified portfolios, and their cost of capital may be considerably different from that of a global investor. Unfortunately, there is no established framework for estimating the capital cost for local investors. Furthermore, as long as international investors have access to local investment opportunities, local prices will be based on an international cost of capital.

Woolridge, “Some New Evidence That Spinoffs Create Value,” Journal of Applied Corporate Finance 7 (1994): 100–107. 566 CORPORATE PORTFOLIO STRATEGY management believed that the challenges and opportunities of the two businesses were different enough that they would be better managed as separate companies. THE MYTH OF DIVERSIFICATION A perennial question in corporate strategy is whether companies should hold a diversified portfolio of businesses. The idea seemed to be discredited in the 1970s, yet some executives still say things like “It’s the third leg of the stool that makes a company stable.” Our perspective is that diversification is intrinsically neither good nor bad; which it is depends on whether the parent company adds more value to the businesses it owns than any other potential owner could, making it the best owner of those businesses in the circumstances.

What are some impediments to matching the best potential owner to a business? 4. Provide examples of how the best owner of a business has changed over time. Give reasons for these changes. 5. Explain how and why the best owner of a business might change over time. 6. What are the steps involved in constructing a portfolio? Discuss potential hurdles in executing the analytic approach. 7. Should a company operate a diversified portfolio of businesses? What are the arguments for and against? 8. What are the benefits to society when a business is owned by its best owner? 26 Performance Management The overall value that a company creates is the sum of the outcomes of innumerable business decisions that its managers and staff take at every level, from choosing when to open the door to customers to deciding whether to acquire a new business.

 

Debtor Nation: The History of America in Red Ink (Politics and Society in Modern America) by Louis Hyman

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asset-backed security, bank run, barriers to entry, Bretton Woods, card file, central bank independence, computer age, corporate governance, credit crunch, declining real wages, deindustrialization, diversified portfolio, financial independence, financial innovation, Gini coefficient, Home mortgage interest deduction, housing crisis, income inequality, invisible hand, late fees, London Interbank Offered Rate, market fundamentalism, means of production, mortgage debt, mortgage tax deduction, p-value, pattern recognition, profit maximization, profit motive, risk/return, Ronald Reagan, Silicon Valley, statistical model, technology bubble, the built environment, transaction costs, union organizing, white flight, women in the workforce, working poor

Splitting FNMA into two organizations—FNMA and GNMA—would cordon off the welfare programs from the market programs, and privatization would take the welfare expenses, to a large 228 CHAPTER SEVEN degree, off the federal budget because mortgages bought and sold would not look like a government expense on the accounting sheets, enabling the expansion of federal mortgage lending. Only the subsidies to GNMA, and not the total mortgages bought, would go on the books as a federal expense.26 Mortgage-backed securities initially came in two forms: the “modified pass-through” security and the “bond-like” security. Both forms gave the investor a claim on the monthly principal and interest payments of a large, diversified portfolio of mortgages. Both forms rendered the investor’s connection to the underlying assets completely anonymous and secondhand. The differences between them initially irked the mortgage banking industry, however. The pass-through security delivered the real monthly principal and interest payments of the portfolio, minus a servicing fee, to the investor. The bond-like security provided a steady, even payment of principal and interest to the investor.

FHLMC developed a national computer network called AMMINET to provide up-to-the-minute information on mortgage-backed security trades and issues, creating a real national “market” with national information.37 By 1972, FHLMC, with established procedures for credit evaluation, loan documents, appraisals, mortgage insurance, and mortgage originators, began to issue completely conventionally backed, mortgage-backed securities—creating the first national conventional mortgage market. More than just standardization, however, conventional mortgages could be traded because they were issued through mortgage-backed securities and not the old assignment system of the 1950s. While the FHA mortgage reduced investors’ risk by homogenizing standards, the FHLMC reduced risk by heterogeneous diversification. The mortgage-backed security came with a pre-diversified portfolio for a given interest rate, so that the investor did not need to cherry-pick mortgages across regions and neighborhoods. The risk of one bad loan could be diluted across many good loans in a mortgage-backed security’s underlying portfolio. Mortgage portfolios backing the securities brought enough diversification, it was believed, to overwhelm any outlying bad loan. For investors who would never see the property, such risk-reduction was essential. 232 CHAPTER SEVEN FHLMC substituted risk-reducing portfolio diversification for risk-eliminating federal guarantees.

Investors wanted the reassurance that the unlimited tax-collecting resources of the federal government stood behind the securities, even if, legally, there was not an unlimited backstop. While GNMA and FNMA announced in their publications that the “full faith” of the U.S. government stood behind their issues, the reality fell far short of the promise— but for investors, it was close enough. Dangling promises, diversified portfolios, and foreclosable houses convinced many investors. The mortgage-backed security had come into its own and quickly began to define how mortgage funds flowed in the United States. By 1973, FHLMC was buying three times as many conventional mortgages as federally insured mortgages—nearly $1 billion in conventional mortgages.40 The next year, 1974, FHLMC further doubled its conventional mortgage activity to nearly $2 billion and shrunk its purchases of federally insured mortgages to $261 million.41 This rapid expansion into an uninsured market was made possible through FHLMC’s assiduous mimicry of the debt instruments of GNMA and FNMA, which continued through 1972 to deal primarily in federally insured mortgages.

 

pages: 264 words: 115,489

Take the money and run: sovereign wealth funds and the demise of American prosperity by Eric Curt Anderson

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asset allocation, banking crisis, Bretton Woods, business continuity plan, business intelligence, business process, collective bargaining, corporate governance, credit crunch, currency manipulation / currency intervention, currency peg, diversified portfolio, floating exchange rates, housing crisis, index fund, Kenneth Rogoff, open economy, passive investing, profit maximization, profit motive, random walk, reserve currency, risk tolerance, risk-adjusted returns, risk/return, Ronald Reagan, sovereign wealth fund, the market place, The Wealth of Nations by Adam Smith, too big to fail, Vanguard fund

These funds should instead be invested in a manner intended to maximize returns and minimize opportunity costs.146 Summers’ advice should come as a blunt warning for those charged with forging the United States’ future fiscal policies. Foreign central bankers are preparing to search for greener pastures—to sink their funds in a manner that will no longer subsidize interest rates for U.S. consumers. In Summers’ words: . . . the typical central bank portfolio (consisting of 0–3 years dollar-denominated Treasuries) would have earned about 1% in real terms, over the last 60 years. In contrast, a diversified portfolio of stocks and bonds, similar to a typical pension portfolio (60% stocks/40% bonds) would have earned a real return of approximately 6% and a portfolio invested entirely in stocks has earned in excess of 7%.147 Given this insight, it is time to rethink those dismissive statements about government bureaucrats being capable of “only” managing to earn returns of 8%. Few investors I know would exchange this return for the 1% apparently to be won from more “careful” investment in U.S.

As listed in the letter, these principles are: • To operate for the public good, generating long-term, attractive returns for the prosperity of the people of Abu Dhabi • To operate as strictly individual entities, making independent, commercially driven investment decisions • To follow meticulously all of the laws, regulations, and rules of the countries and exchanges in which investments are made • To meet all disclosure requirements of relevant government and regulatory bodies in countries in which they invest • To maximize risk-adjusted returns, relative to well-established market indices • To recruit and retain world-class financial professionals either as in-house or external managers • To invest with a long-term perspective • To invest in a well-diversified portfolio across asset classes, geographies, and sectors • To maintain appropriate standards of governance and accountability12 The letter closed by noting Abu Dhabi realized its investments “are good for the global economy—providing increased liquidity, injecting capital for growth, expanding market access, creating jobs, and encouraging a common interest and commitment to mutual prosperity.”13 Quite clearly, the authors had been reading through U.S.

 

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

That, along with the natural sensibilities of a borscht belt comic, made me a popular alternative to the yield curve guys. Given the 20-minute rule for these talks, none of them were as voluminous as this chapter. Still, this is not intended in any way to be a complete history of market technology, but rather an easily digestible introduction. I occasionally still do these talks on what remains of greater Wall Street. I am also open to weddings, quinceañeras, and bar mitzvahs, since we all need diversified portfolios these days. Looking into the workings of modern securities markets is like looking under the hood of a Prius hybrid car. There are so many complex and obscure parts it’s hard to discern what’s going on. If you look under the hood of an auto from a simpler era, for example a ’64 Mustang, you can see the parts and what they do, and have a better chance at understanding their complex modern replacements.

Trading is the implementation of investment ideas, and poor implementation can negate the potential value of any idea.7 Putting the Pieces Together This business of analyzing all the stocks all the time and controlling trading costs produces a lot of information, including investment signals, trading costs, and liquidity constraints. We need to put them all together in a portfolio of balanced, prudent bets to enhance the index return, and to adjust the portfolio periodically. This is where the idea of portfolio optimization comes in. Behind the math and the Nobel Prizes,8 portfolio optimization is about trading off risk and reward to produce a diversified portfolio. Thirty years ago, this was considered a crackpot idea. In Capital Ideas (Free Press, 1993), Peter L. Bernstein includes a story of young Bill Sharpe wandering Wall Street in the 1960s, trying to shake loose enough computer time to run a small optimization. Most people thought he was a crackpot. In 1990 Crackpot Bill shared the Nobel Prize in economics, and optimization is used in the management of trillions of dollars in assets around the world.9 If someone utterly and completely believed in a forecast that a stock would spike up, that investor would hold a one-stock portfolio.

 

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

Senior note holders take a smack only if the DAS_C10.QXD 5/3/07 7:59 PM Page 287 9 C re d i t w h e re c re d i t i s d u e – f u n w i t h C D S a n d C D O 287 losses on the underlying loans are above the equity and mezzanine amounts. The mezzanine and equity investors receive a high return in return for accepting the higher risk. This is tranching. CDO tranching is the black art of dissimulation. Investors are told that they are getting access to a ‘diversified’ portfolio of credit risk and are promised highly customized credit risk. It’s all very clever ‘spin’. The portfolio on which the CDO is based is generally ‘diversified’. For example, a $1,000 million portfolio might be made up of 100 loans of $10 million each. Each loan is to a different entity; the portfolio is diversified; if you buy the senior notes then you are also diversified. Unfortunately, if you buy the mezzanine or equity then you have a problem.

There were capital guaranteed hedge fund investments – you couldn’t lose your principal although you may end up earning nothing on your investment for ten years. AI gained traction. Many ordinary investors were now paying several layers of fees: there was the fee to their mutual fund, there was a fee to the DAS_Z01.QXP 8/11/06 2:10 PM Page 309 Epilogue 309 FoF manager, then there was the hedge fund manager’s fee. The idea of a diversified portfolio of hedge funds didn’t make sense, all the diversification did was to average out the returns. The idea of a capital guaranteed hedge fund was a contradiction in terms. You either were willing to take the risk or not. Dealers loved hedge funds. Investment banks helped set them up, invested in them and traded with them. A whole new service developed – ‘prime brokerage’. This combined settling and clearing hedge fund trades, execution services and (the most lucrative) lending money to hedge funds against the value of securities that the fund had.

 

pages: 416 words: 39,022

Asset and Risk Management: Risk Oriented Finance by Louis Esch, Robert Kieffer, Thierry Lopez

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asset allocation, Brownian motion, business continuity plan, business process, capital asset pricing model, computer age, corporate governance, discrete time, diversified portfolio, implied volatility, index fund, interest rate derivative, iterative process, P = NP, p-value, random walk, risk/return, shareholder value, statistical model, stochastic process, transaction costs, value at risk, Wiener process, yield curve, zero-coupon bond

The first two indicators are based on the market straight-line equation and the CAPM equation respectively; the third is a variation on the second. 3.3.3.2 Sharpe index The market straight-line equation is: EP = RF + EM − RF · σP σM which can be rewritten as follows: EM − RF EP − RF = σP σM This relation expresses that the excess return (compared to the risk-free rate), standardised by the standard deviation, is (in equilibrium) identical to a well-diversified portfolio and for the market. The term Sharpe index is given to the expression SIP = EP − RF σP which in practice is compared to the equivalent expression calculated for a market representative index. Example Let us take the data used for the simple Sharpe index model (Section 3.2.4): E1 = 0.05 σ1 = 0.10 ρ12 = 0.3 E2 = 0.08 σ2 = 0.12 ρ13 = 0.1 E3 = 0.10 σ3 = 0.15 ρ23 = 0.4 Let us then consider the specific portfolio relative to the value λ = 0.010 for the risk parameter.

This will give βP = 0.9774. The Treynor index for this portfolio is therefore obtained by: TI P = 0.0758 − 0.03 = 0.0469 0.9774 meanwhile, the index relative to the index is TI I = 0.04 − 0.03 = 0.0100 1 This will lead to the same conclusion. 3.3.3.4 Jensen index According to the reasoning in the Treynor index, we have EP − RF = βP (EM − RF ). This relation being relative (in equilibrium) for a well-diversified portfolio, a portfolio P will present an excess of return in relation to the market if there is a number αP > 0 so that: EP − RF = αP + βP (EM − RF ). The Jensen index, JI P = α̂, is the estimator for the constant term of the regression: EP ,t − RF,t = α + β (EI,t − RF,t ). For this, the variable to be explained (explanatory) is the excess of return of portfolio in relation to the risk-free rate (excess of return of market representative index).

 

pages: 386 words: 122,595

Naked Economics: Undressing the Dismal Science (Fully Revised and Updated) by Charles Wheelan

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affirmative action, Albert Einstein, Andrei Shleifer, barriers to entry, Berlin Wall, Bernie Madoff, Bretton Woods, capital controls, Cass Sunstein, central bank independence, clean water, collapse of Lehman Brothers, congestion charging, Credit Default Swap, crony capitalism, currency manipulation / currency intervention, Daniel Kahneman / Amos Tversky, David Brooks, demographic transition, diversified portfolio, Doha Development Round, Exxon Valdez, financial innovation, floating exchange rates, George Akerlof, Gini coefficient, Gordon Gekko, greed is good, happiness index / gross national happiness, Hernando de Soto, income inequality, index fund, interest rate swap, invisible hand, job automation, Joseph Schumpeter, Kenneth Rogoff, libertarian paternalism, low skilled workers, lump of labour, Malacca Straits, market bubble, microcredit, money: store of value / unit of account / medium of exchange, Network effects, new economy, open economy, presumed consent, price discrimination, price stability, principal–agent problem, profit maximization, profit motive, purchasing power parity, race to the bottom, RAND corporation, random walk, rent control, Richard Thaler, rising living standards, Robert Gordon, Robert Shiller, Robert Shiller, Ronald Coase, Ronald Reagan, school vouchers, Silicon Valley, Silicon Valley startup, South China Sea, Steve Jobs, The Market for Lemons, The Wealth of Nations by Adam Smith, Thomas L Friedman, Thomas Malthus, transaction costs, transcontinental railway, trickle-down economics, urban sprawl, Washington Consensus, Yogi Berra, young professional

If there had been a disruption serious enough to cancel the World Cup, the investors lose some or all of their money, which is used instead to compensate the World Football Federation for the lost revenue. The beauty of these products lies in the way they spread risk. The party selling the bonds avoids ruin by sharing the costs of a natural disaster or a terrorist attack with a broad group of investors, each of whom has a diversified portfolio and will therefore take a relatively small hit even if something truly awful happens. Indeed, one role of the financial markets is to allow us to spread our eggs around generously. I must recount one of those inane experiences that can happen only in high school. Some expert in adolescent behavior at my high school decided that students would be less likely to become teen parents if they realized how much responsibility it required.

Yale President Richard Levin told the Wall Street Journal, “We made huge excess returns on the way up. When it’s all over and things stabilize I think we’ll find the overall long-run performance [of the endowment] is better than if we didn’t.”12 I suspect he’s right, but that doesn’t necessarily make it a wise strategy for my mother-in-law. Diversify. When I teach finance, I like to have my students flip coins. It is the best way to make certain points. Here is one of them: A well-diversified portfolio will significantly lower the risk of serious losses without lowering your expected return. Let’s turn to the coins. Suppose the return on the $100,000 you have tucked away in a 401(k) depends on the flip of a coin: Heads, it quadruples in value; tails, you lose everything. The average outcome of this exercise is very good. (Your expected return is 100 percent.)* The problem, of course, is that the downside is unacceptably bad.

 

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

“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. “This enlightened process has created a tremendous new market for securities that in times past would have gone begging,” Fisher wrote. “It constitutes a permanent reason why this plateau [of stock prices] will not sink again to the level of former years except for extraordinary cause.”32 THROUGHOUT THE 1920S BOOM, ROGER Babson kept staring at his Babsoncharts and William Peter Hamilton at his Dow charts.

“Rational men, when they buy stocks and bonds, would never pay more than the present worth of the expected future dividends,” Williams wrote, “…nor could they pay less, assuming perfect competition, with all traders equally well informed.”15 The book was thus a guide to valuing stocks on the basis of projected future dividends, much as Irving Fisher had outlined back in 1906. Williams left out the second part of Fisher’s valuation equation: uncertainty. “No buyer considers all securities equally attractive at their present market prices whatever these prices happen to be,” Williams wrote in the first page of the book, “on the contrary, he seeks ‘the best at the price.’” Markowitz was dubious. Graham and Dodd exhorted their readers to hold a diversified portfolio, although they didn’t go deeply into the hows or whys. As he read further in The Theory of Investment Value, Markowitz saw that even Williams assumed that investors would own many securities. Someone who was truly out to buy only “the best at the price” would only buy one stock—the best one. Yet only fools did that. “Clearly, investors diversify to avoid risk,” Markowitz said. “What was missing from Williams’s analysis was the notion of the risk of the portfolio as a whole.”

 

pages: 207 words: 52,716

Capitalism 3.0: A Guide to Reclaiming the Commons by Peter Barnes

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Albert Einstein, car-free, clean water, collective bargaining, corporate governance, corporate personhood, corporate social responsibility, dark matter, diversified portfolio, en.wikipedia.org, hypertext link, Isaac Newton, James Watt: steam engine, jitney, new economy, patent troll, profit maximization, Ronald Coase, telemarketer, The Wealth of Nations by Adam Smith, transaction costs, War on Poverty, Yogi Berra

Let’s say we required publicly traded companies to deposit 1 percent of their shares each year in the American Permanent Fund for ten years—reaching a total of 10 percent of their shares. This would be our price not just for using a regulated stock exchange, but also for all the other privileges (limited liability, perpetual life, copyrights and patents, and so on) that we currently bestow on private corporations for free. 108 | A SOLUTION In due time, the American Permanent Fund would have a diversified portfolio worth several trillion dollars. Like its Alaskan counterpart, it would pay equal yearly dividends to everyone. As the stock market rose and fell, so would everyone’s dividend checks. A rising tide would lift all boats. America would truly be an “ownership society.” A Children’s Opportunity Trust Not long ago, while researching historic documents for this book, I stumbled across this sentence in the Northwest Ordinance of 1787: “[T]he estates, both of resident and nonresident proprietors in the said territory, dying intestate, shall descent to, and be distributed among their children, and the descendants of a deceased child, in equal parts.”

 

pages: 221 words: 61,146

The Crowded Universe: The Search for Living Planets by Alan Boss

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Albert Einstein, Dava Sobel, diversified portfolio, full employment, if you build it, they will come, Kuiper Belt, Mars Rover, Pluto: dwarf planet, Silicon Valley, wikimedia commons

Even such a mini-me Planet Finder would face a rough battle to win approval in the ongoing donnybrook over the NASA science budget. Jon Morse, Stern’s new director of SMD’s Astrophysics Division, pointed out that the Navigator Program could at best hope to compete for a new mission in the next decade that would cost no more than $600 million, a sum considerably less than what was needed to finish SIM, much less get started on TPF-C and TPF-I. Morse called for a “diversified portfolio” for Navigator, a plan that would begin with relatively modest precursor missions rather than with flagship-class missions such as SIM and the TPFs. The Webb Telescope was scheduled to launch in 2013, and the next flagship mission would be a new X-ray observatory that would fly in 2020, according to Morse. At that rate, TPF might have to wait until 2028 to fly, two decades later than Dan Goldin had planned in 1998.

 

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

Differences in economic fundamentals between developed and developing countries also provide support for the diversification argument. Emerging-market debt also benefits from high oil prices. Although oil price shocks may induce a global economic recession (recent oil price heights have so far defied this assumption), the counter-cyclicality of emerging-market debt – the fact that oil-producing countries may fare well when oil prices rise – means emerging-market assets can help protect a more diversified portfolio. There is an additional factor that can drive demand for the bonds of well-run African countries. Very often, international investors have restrictions on what they can and cannot buy for their portfolios. For example, some pension funds are only allowed to buy securities (stocks or bonds) which are included in approved lists (indices) drawn up by rating agencies or investment banks (for example, the J.

 

pages: 222 words: 70,559

The Oil Factor: Protect Yourself-and Profit-from the Coming Energy Crisis by Stephen Leeb, Donna Leeb

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Buckminster Fuller, diversified portfolio, fixed income, hydrogen economy, income per capita, index fund, mortgage debt, North Sea oil, oil shale / tar sands, oil shock, peak oil, profit motive, reserve currency, rising living standards, Ronald Reagan, shareholder value, Silicon Valley, Vanguard fund, Yom Kippur War, zero-coupon bond

All in all, if they are likely to be somewhat less exciting than some of our other recommendations, they offer a solid blend of growth, inflation protection, safety, and income. One of our favorite REITs is Apartment Investment and Management, which concentrates on buying and managing multifamily apartment complexes. It is geographically diverse, with interests in nearly every state. Another top pick is Duke Realty, which has a diversified portfolio of properties rented to a wide range of businesses, including those in manufacturing, retailing, wholesale trade, and professional services. It also owns or controls substantial acreage ready for development. In addition, it provides, on a fee basis, a variety of services to tenants at properties owned by others. Three Special Stocks Like a Barnum and Bailey circus where there is excitement in more than one ring at a time, even a world where a lot of the action revolves around energy shortages and rising energy prices will contain other trends with investment potential.

 

pages: 322 words: 77,341

I.O.U.: Why Everyone Owes Everyone and No One Can Pay by John Lanchester

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asset-backed security, bank run, banking crisis, Berlin Wall, Bernie Madoff, Big bang: deregulation of the City of London, Black-Scholes formula, Celtic Tiger, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Daniel Kahneman / Amos Tversky, diversified portfolio, double entry bookkeeping, Exxon Valdez, Fall of the Berlin Wall, financial deregulation, financial innovation, fixed income, George Akerlof, greed is good, hindsight bias, housing crisis, Hyman Minsky, interest rate swap, invisible hand, Jane Jacobs, John Maynard Keynes: Economic Possibilities for our Grandchildren, laissez-faire capitalism, liquidity trap, Long Term Capital Management, loss aversion, Martin Wolf, mortgage debt, mortgage tax deduction, mutually assured destruction, new economy, Nick Leeson, Northern Rock, Own Your Own Home, Ponzi scheme, quantitative easing, reserve currency, risk-adjusted returns, Robert Shiller, Robert Shiller, Ronald Reagan, shareholder value, South Sea Bubble, statistical model, The Great Moderation, the payments system, too big to fail, tulip mania, value at risk

If a portfolio is completely invested in the company that sells umbrellas, it will have strong performance during the rainy season but poor performance when the weather is sunny. The reverse occurs if the portfolio is invested only in the sunscreen company, the alternative investment: the portfolio will be high performance when the sun is out but will tank when clouds roll in. To minimize the weather-dependent risk in the example portfolio, the investment should be split between the companies. With this diversified portfolio, returns are decent no matter the weather, rather than alternating between excellent and terrible.” What the pros do is a sophisticated version of that.5 I’ve mentioned Myron Scholes and Fischer Black’s 1973 paper as the moment when the derivatives market underwent its modernist revolution. In share investing, the equivalent moment was the 1952 publication in the Journal of Finance of a paper called “Portfolio Selection” by Harry Markowitz, a twenty-five-year-old graduate student at the University of Chicago.

 

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

So the platforms have developed various tools for automatically parceling investors’ money out to different borrowers in different risk categories. Selling loans to investors as securitizations is another way of ensuring diversification. The upshot is that, in small but significant ways, the platforms are evolving to be more bank-like. The platforms are already doing their own credit analysis. They are already providing diversified portfolios for investors to fund. Some have provisioning funds that, in effect, mimic the role of equity by protecting lenders from defaults. RateSetter, one of the British platforms, is even carrying out a mild version of maturity transformation by allowing investors to loan money for shorter periods than the loans that are being funded. Some in the industry already float the possibility of having a current account attached to their lending platforms, perhaps even of having deposit insurance extended to them.

 

The Armchair Economist: Economics and Everyday Life by Steven E. Landsburg

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Albert Einstein, Arthur Eddington, diversified portfolio, first-price auction, German hyperinflation, Golden Gate Park, invisible hand, means of production, price discrimination, profit maximization, Ralph Nader, random walk, Ronald Coase, sealed-bid auction, second-price auction, second-price sealed-bid, statistical model, the scientific method, Unsafe at Any Speed

On the other hand, those are precisely the occasions when the stock of American Home Maintenance Services rises, and the strategic investor might want to add a few shares of American to his portfolio as a form of earthquake insurance. If asset prices behave as economists believe they do, most investors should focus not on picking the right assets but on constructing the right portfolios. The question "Is Consolidated Umbrella a good buy?" is meaningless except in the context of an existing portfolio. In conjunction with General Picnic Baskets, Consolidated can compose a well-diversified portfolio. In conjunction with International Raincoats, Consolidated composes a portfolio with a lot of unnecessary risk, courting disaster if the sun comes out. To earn large rewards, you must accept risk. (This is a moral that runs at large, extending beyond the world of high finance.) The trick is to accept no more risk than is necessary. The method 192 HOW MARKETS WORK is to diversify, by recognizing assets that tend to move in opposition and by using this information judiciously.

 

pages: 305 words: 69,216

A Failure of Capitalism: The Crisis of '08 and the Descent Into Depression by Richard A. Posner

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Andrei Shleifer, banking crisis, Bernie Madoff, collateralized debt obligation, collective bargaining, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, debt deflation, diversified portfolio, equity premium, financial deregulation, financial intermediation, Home mortgage interest deduction, illegal immigration, laissez-faire capitalism, Long Term Capital Management, market bubble, moral hazard, mortgage debt, oil shock, Ponzi scheme, price stability, profit maximization, race to the bottom, reserve currency, risk tolerance, risk/return, Robert Shiller, Robert Shiller, savings glut, shareholder value, short selling, statistical model, too big to fail, transaction costs, very high income

Given discounting to present value and the fact that by virtue of the principle of limited liability the creditors of a bankrupt corporation cannot go after the personal assets of the corporation's owners or managers, events that are catastrophic to a corporation if they occur but are highly unlikely to occur, and therefore if they do occur are likely to occur in the distant future, will not influence the corporation's behavior. A bankruptcy is not the end of the world for a company's executives, or even for its shareholders if they have a diversified portfolio of stocks and other assets. But a cascade of bank bankruptcies can be a disaster for a nation. The more leveraged a bank's (or other financial company's) capital structure is, the greater the risk of insolvency. Whether bank insolvencies, even if they precipitate a stock market crash, will trigger a depression thus depends on how widespread the insolvencies are, how deep the decline in the stock market is, and—of critical, but until the depression was upon us of neglected, importance—how much savings people have.

 

pages: 270 words: 79,180

The Middleman Economy: How Brokers, Agents, Dealers, and Everyday Matchmakers Create Value and Profit by Marina Krakovsky

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Affordable Care Act / Obamacare, Airbnb, Al Roth, Black Swan, buy low sell high, Credit Default Swap, cross-subsidies, crowdsourcing, disintermediation, diversified portfolio, experimental economics, George Akerlof, Goldman Sachs: Vampire Squid, income inequality, index fund, Jean Tirole, Lean Startup, Lyft, Mark Zuckerberg, market microstructure, Martin Wolf, McMansion, Menlo Park, moral hazard, multi-sided market, Network effects, patent troll, Paul Graham, Peter Thiel, pez dispenser, ride hailing / ride sharing, Sand Hill Road, sharing economy, Silicon Valley, social graph, supply-chain management, TaskRabbit, The Market for Lemons, too big to fail, trade route, transaction costs, two-sided market, Uber for X, ultimatum game, Y Combinator

One way to think about both the Certifier and Enforcer roles is that they protect buyers from risk. But that’s not all there is to managing risk for your trading partners, and the next chapter explores more broadly how middlemen can play the role of Risk Bearer without exposing themselves to unnecessary risks. 4 THE RISK BEARER Reducing Uncertainty THE ROLE: From banks and insurance companies to wholesalers, some companies earn a premium for bearing risk. By building diversified portfolios, they’re better able to weather volatility than their trading partners. The same principle holds true for nonobvious middlemen, from gallerists and venture capitalists to Internet platforms that deliver on-demand services: all are better able than their trading partners to bear risk. One key to being an admirable Risk Bearer: being able to discern internal from external risk, avoiding the former risk while embracing the latter.

 

pages: 251 words: 76,128

Borrow: The American Way of Debt by Louis Hyman

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asset-backed security, barriers to entry, big-box store, cashless society, collateralized debt obligation, credit crunch, deindustrialization, deskilling, diversified portfolio, financial innovation, Ford paid five dollars a day, Home mortgage interest deduction, housing crisis, income inequality, market bubble, McMansion, mortgage debt, mortgage tax deduction, Network effects, new economy, Plutocrats, plutocrats, price stability, Ronald Reagan, statistical model, technology bubble, transaction costs, women in the workforce

Securitization would be most important for all small and midsize companies, where the real growth potential in the economy resides. Many businesses fail, as many mortgages are foreclosed, but through risk management and federal standards, the bonds could handle that possibility. With good information, rating those companies would be more accurate and transparent. Unlike private credit-rating agencies, the bureau’s future would not depend on giving businesses a good review. With a diversified portfolio of business investments, risks for investors would go down. Business investment wouldn’t be the province of a few millionaires and their private equity; it could be done by average Joes with their pension funds. How much better would the world be if workers’ pension funds were invested in activities that produced jobs instead of McMansions? Regulation doesn’t need to tell firms what to do, but it does need to provide the transparency for investors to act wisely and to help markets make technological transitions when there is a great deal of change.

 

pages: 840 words: 202,245

Age of Greed: The Triumph of Finance and the Decline of America, 1970 to the Present by Jeff Madrick

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accounting loophole / creative accounting, Asian financial crisis, bank run, Bretton Woods, capital controls, collapse of Lehman Brothers, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, desegregation, disintermediation, diversified portfolio, Donald Trump, financial deregulation, fixed income, floating exchange rates, Frederick Winslow Taylor, full employment, George Akerlof, Hyman Minsky, income inequality, index fund, inflation targeting, inventory management, invisible hand, laissez-faire capitalism, locking in a profit, Long Term Capital Management, market bubble, minimum wage unemployment, Mont Pelerin Society, moral hazard, mortgage debt, new economy, North Sea oil, Northern Rock, oil shock, price stability, quantitative easing, Ralph Nader, rent control, road to serfdom, Robert Shiller, Robert Shiller, Ronald Coase, Ronald Reagan, Ronald Reagan: Tear down this wall, shareholder value, short selling, Silicon Valley, Simon Kuznets, technology bubble, Telecommunications Act of 1996, The Chicago School, The Great Moderation, too big to fail, union organizing, V2 rocket, value at risk, Vanguard fund, War on Poverty, Washington Consensus, Y2K, Yom Kippur War

Braddock Hickman, analyzed returns on corporate bonds issued between 1900 and 1943 and found that an investor who bought a highly diversified selection of these bonds and held them for the long run would earn a higher return than an investor who bought investment grade bonds only. In fact, Milken may have misinterpreted (or misrepresented) the study. The strategy depended on buying large numbers of differing bonds, building a well-diversified portfolio, not picking a handful of potential winners, which was Milken’s objective. But Milken, whether he understood the full implications of the study or not, was emboldened by the research. It is interesting that Wall Street accepted Milken’s interpretation that financial markets were inefficient when it was profitable to do so; when it gave CEOs outsize stock options based on the stock price of the company, Wall Street generally argued that markets were so efficient the stock price truly reflected the long-term value of the company.

Anthony Plath, “Financing Takeovers: Junk Bonds and Leveraged Buyouts,” Managerial Finance 17, no. 1 (February 1993). 3 “THE FIRST THING YOU NOTICED”: Author conversation with Martin Siegel, 1985. 4 IN FACT, MILKEN MAY HAVE MISINTERPRETED: Riskier assets should return a higher yield over time on average or they would not be bought at all; the higher yield justifies the risk. The problem is that an investor cannot know which companies will perform well and which will not, and will often lose a lot of money if invested in only a handful of companies, one or two of which may go bankrupt. A large, diversified portfolio likely reduces the penalties of choosing the wrong bonds, however, because the high yields offered by all the bonds more than compensate for the small handful of big losers. The same principle holds for a portfolio of stocks. The average return on stocks should be higher over time; but owning any individual stock is riskier. 5 HE THEN WENT EAST: Howard Rudnitsky, Allan Sloan, Richard L.

 

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

Markowitz was restating Antonio, in William Shakespeare’s Merchant of Venice: “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.” Despite Friedman’s grumbling, Markowitz received his Ph.D. Building on Markowitz’s work, in the 1960s, Jack Treynor, William Sharpe, John Lintner, and Jan Mossin developed the capital asset pricing model (CAPM). The CAPM calculated a theoretically appropriate required rate of return for assets, such as an individual security or a portfolio. Where an asset is added to a well-diversified portfolio, the additional return required is related to the risk unique to that security, which cannot be diversified away. The CAPM is one of modern finance’s iconic equations: E[Ri] = Rf + Beta [E[Rm] – Rf] where: E[Ri] is the expected return on the asset. Rf is the risk-free rate of interest on government bonds. Beta is the sensitivity of the asset returns to market returns. E[Rm] is the expected return of the market.

If three loans defaulted in the portfolio, then the investor would lose only $0.36 million (loss of $120,000 per company (60 percent of $200,000) times 3). In contrast, where they invested in the CDO equity, for the same three losses the investor loses $20 million. For the same event (three defaults), the investor’s loss is 56 times greater where they purchase the equity rather than investing in a diversified portfolio ($20 million versus $0.36 million). This is known as embedded loss leverage. Linked in a dizzy spiral of debt as their modus operandi merged, banks and the inhabitants of the shadow banking sector (ABS issuers, CDO issuers, conduits, SIVs, hedge funds, reinsurers and monoline insurers) increasingly resembled each other. In a case of rinse and repeat and then repeat again, at each stage the risk was redistilled and concentrated.

 

pages: 598 words: 169,194

Bernie Madoff, the Wizard of Lies: Inside the Infamous $65 Billion Swindle by Diana B. Henriques

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accounting loophole / creative accounting, airport security, Albert Einstein, banking crisis, Bernie Madoff, British Empire, centralized clearinghouse, collapse of Lehman Brothers, diversified portfolio, Donald Trump, dumpster diving, financial deregulation, forensic accounting, Gordon Gekko, index fund, locking in a profit, mail merge, merger arbitrage, Plutocrats, plutocrats, Ponzi scheme, Potemkin village, random walk, Renaissance Technologies, riskless arbitrage, Ronald Reagan, short selling, Small Order Execution System, sovereign wealth fund, too big to fail, transaction costs, traveling salesman

By the time Cohmad was formed, Bernie Madoff’s reported strategy for producing those profits was changing—a shift that had begun in 1980, when his biggest clients pressed him (in his recounting) to “offer them another form of trading that would produce long-term capital gains rather than the short-term capital gains of arbitrage.” The tax shelters of the 1970s were cracking, US income tax rates seemed high, and his wealthiest clients wanted to reduce their tax bills. He claimed that he offered them a new strategy: “a diversified portfolio of equities hedged as necessary” with various kinds of short sales. In a letter from prison, Madoff insisted that he cautioned his clients that the stocks in their portfolios would have to be held long enough to qualify for the capital gains tax break and, “more importantly, that the stock market would have to go up during the holding period, which was certainly difficult to predict.” Still, he said, “a number of the wealthy clients chose to do this strategy—the Levy, Picower, Chais and Shapiro families most importantly.”

Many of Anchor’s clients were small family or individual “hedge funds”, with names such as the “John Doe Hedge Fund” and the “Jane Doe IRA Hedge Fund”. A few were union or professional pension plans. At its peak, when Anchor Holdings supposedly had more than $12 million in assets, its largest individual account was under $750,000, and its smallest was a Roth individual retirement account worth just $3,224.43. Anchor Holdings invested these modest nest eggs in another hedge fund, which invested all its assets in an apparently diversified portfolio of international hedge funds. That portfolio consisted of the Primeo fund, the Santa Clara fund, and four other hedge funds—every single one of which was invested exclusively with Madoff. Believing they had avoided the risk of putting all their eggs in one basket, these small investors had actually handed their savings over to one man: Bernie Madoff. It is no wonder that some members of the US Congress were demanding that the SEC increase its attention to the hedge fund industry’s incursions into the middle class.

 

pages: 706 words: 206,202

Den of Thieves by James B. Stewart

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discounted cash flows, diversified portfolio, fudge factor, George Gilder, index arbitrage, Internet Archive, margin call, Ponzi scheme, rolodex, Ronald Reagan, shareholder value, South Sea Bubble, The Predators' Ball, walking around money, zero-coupon bond

He used his findings to persuade investors to gamble on high-yielding securities that Milken believed would make their payments and were, as a result, undervalued. Some of Milken's prospects were also potential corporate clients for Drexel. Insurance companies with large pools of assets were especially eager to invest profitably. Joseph went along with Milken on countless visits to spread the gospel of high-yield. At each stop, Milken ran through his arguments: The bond market was too risk-averse; a well-diversified portfolio would provide a better return; liquidity was growing as more companies heeded Milken's message; and returns would comfortably exceed the risk premium. It was a simple, effective message. Increasingly, it worked. Among Milken's early big successes was a group of wealthy, mostly Jewish financiers who had acquired insurance companies. None was a member of the Wall Street establishment. They didn't worry about the stigma associated with low-grade paper, and they liked Milken's new ideas.

Could Drexel do a public high-yield issue, underwritten by Drexel and marketed directly to the public—an original new issue, in other words, rather than the secondary oflFerings that were the mainstays of Drexel's practice? Milken said he'd try. He proceeded to sell the $30 million issue easily, with a whopping underwriting fee of 3%. Milken went on that year to do six more issues for companies that couldn't otherwise get capital. At about the same time, he sold the idea of the first high-yield mutual funds, allowing small investors to invest in a diversified portfolio of junk bonds. Milken's dream of liquidity was close to fruition. The mechanism for a revolution in finance was in place, right under the noses of the Wall Street establishment that had disdained low-grade debt. Winnick, meanwhile, had moved at Kantor's behest to the high-grade bond desk in Drexel's downtown offices. He also traded some of Milken's high-yield products and he quickly became Drexel's top-producing salesman outside the high-yield area.

 

Mathematics for Finance: An Introduction to Financial Engineering by Marek Capinski, Tomasz Zastawniak

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Black-Scholes formula, Brownian motion, capital asset pricing model, cellular automata, delta neutral, discounted cash flows, discrete time, diversified portfolio, interest rate derivative, interest rate swap, locking in a profit, London Interbank Offered Rate, margin call, martingale, quantitative trading / quantitative finance, random walk, short selling, stochastic process, time value of money, transaction costs, value at risk, Wiener process, zero-coupon bond

However, as a small investor, you can invest money at 7% only and borrow at 10%. Does either of the strategies in the proof of Proposition 6.2 give an arbitrage profit if F (0, 1) = 89 and S(0) = 83 dollars, and a $2 dividend is paid in the middle of the year, that is, at time 1/2? Dividend Yield. Dividends are often paid continuously at a specified rate, rather than at discrete time instants. For example, in a case of a highly diversified portfolio of stocks it is natural to assume that dividends are paid continuously rather than to take into account frequent payments scattered throughout the year. Another example is foreign currency, attracting interest at the corresponding rate. We shall first derive a formula for the forward price in the case of foreign currency. Let the price of one British pound in New York be P (t) dollars, and let the risk-free interest rates for investments in British pounds and US dollars be rGBP and rUSD , respectively.

 

pages: 370 words: 112,602

Poor Economics: A Radical Rethinking of the Way to Fight Global Poverty by Abhijit Banerjee, Esther Duflo

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Albert Einstein, Andrei Shleifer, business process, business process outsourcing, call centre, Cass Sunstein, charter city, clean water, collapse of Lehman Brothers, congestion charging, demographic transition, diversified portfolio, experimental subject, hiring and firing, land tenure, low skilled workers, M-Pesa, microcredit, moral hazard, purchasing power parity, randomized controlled trial, Richard Thaler, school vouchers, Silicon Valley, The Fortune at the Bottom of the Pyramid, Thomas Malthus, urban planning

The result is that the same kind of drought has a more negative effect on wages in those villages in India that are more isolated, where it is harder for workers to go outside to look for work. In those places, working more is not necessarily an effective way of coping with getting paid less.9 If coping by working more after the shock hits is not really a good option, the best bet is often to try to limit exposure to risk by building, like a hedge-fund manager, a diversified portfolio, and it is clear that the poor invest a lot of ingenuity in doing so. The only difference is that they diversify activities, not just financial instruments. One striking fact about the poor is the sheer number of occupations that a single family seems to be involved in: In a survey of twenty-seven villages in West Bengal, even households that claimed to farm a piece of land spent only 40 percent of their time farming.10 The median family in this survey had three working members and seven occupations.

 

pages: 299 words: 91,839

What Would Google Do? by Jeff Jarvis

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23andMe, Amazon Mechanical Turk, Amazon Web Services, Anne Wojcicki, barriers to entry, Berlin Wall, business process, call centre, cashless society, citizen journalism, clean water, connected car, credit crunch, crowdsourcing, death of newspapers, disintermediation, diversified portfolio, don't be evil, fear of failure, Firefox, future of journalism, Google Earth, Googley, Howard Rheingold, informal economy, inventory management, Jeff Bezos, jimmy wales, Kevin Kelly, Mark Zuckerberg, moral hazard, Network effects, new economy, Nicholas Carr, PageRank, peer-to-peer lending, post scarcity, prediction markets, pre–internet, Ronald Coase, search inside the book, Silicon Valley, Skype, social graph, social software, social web, spectrum auction, speech recognition, Steve Jobs, the medium is the message, The Nature of the Firm, the payments system, The Wisdom of Crowds, transaction costs, web of trust, Y Combinator, Zipcar

The root of the credit crisis that spread from America around the globe in 2008 was that bad loans were hidden in packages with good loans and sold to financial markets, with no accountability down to the level of each loan and no transparency. That’s not the case in these peer-to-peer loan operations. I don’t mean to pretend that the social banking system could replace banks, but banks could learn a lot from it. Why not set up direct marketplaces that let me establish my own diversified portfolio in small-business loans, home mortgages, and student loans? Why not use the infrastructure the bank has, as Virgin Money and PayPal do, to facilitate our own financial transactions? Why not make banks human again? We may not see such an evolution in big, old banks—they’re just too big and old. That is why we are seeing new and innovative, peer-to-peer banks and financial institutions emerge.

 

pages: 484 words: 104,873

Rise of the Robots: Technology and the Threat of a Jobless Future by Martin Ford

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3D printing, additive manufacturing, Affordable Care Act / Obamacare, AI winter, algorithmic trading, Amazon Mechanical Turk, artificial general intelligence, autonomous vehicles, banking crisis, Baxter: Rethink Robotics, Bernie Madoff, Bill Joy: nanobots, call centre, Capital in the Twenty-First Century by Thomas Piketty, Chris Urmson, Clayton Christensen, clean water, cloud computing, collateralized debt obligation, computer age, debt deflation, deskilling, diversified portfolio, Erik Brynjolfsson, factory automation, financial innovation, Flash crash, Fractional reserve banking, Freestyle chess, full employment, Goldman Sachs: Vampire Squid, High speed trading, income inequality, indoor plumbing, industrial robot, informal economy, iterative process, Jaron Lanier, job automation, John Maynard Keynes: technological unemployment, John von Neumann, Khan Academy, knowledge worker, labor-force participation, labour mobility, liquidity trap, low skilled workers, low-wage service sector, Lyft, manufacturing employment, McJob, moral hazard, Narrative Science, Network effects, new economy, Nicholas Carr, Norbert Wiener, obamacare, optical character recognition, passive income, performance metric, Peter Thiel, Plutocrats, plutocrats, post scarcity, precision agriculture, price mechanism, Ray Kurzweil, rent control, rent-seeking, reshoring, RFID, Richard Feynman, Richard Feynman, Rodney Brooks, secular stagnation, self-driving car, Silicon Valley, Silicon Valley startup, single-payer health, software is eating the world, sovereign wealth fund, speech recognition, Spread Networks laid a new fibre optics cable between New York and Chicago, stealth mode startup, stem cell, Stephen Hawking, Steve Jobs, Steven Levy, Steven Pinker, strong AI, Stuxnet, technological singularity, telepresence, telepresence robot, The Bell Curve by Richard Herrnstein and Charles Murray, The Coming Technological Singularity, Thomas L Friedman, too big to fail, Tyler Cowen: Great Stagnation, union organizing, Vernor Vinge, very high income, Watson beat the top human players on Jeopardy!, women in the workforce

In a future world where nearly all the income is captured by capital, and human labor is worth very little, why not simply make sure that everyone owns enough capital to be economically secure? Most of these proposals involve strategies like somehow increasing employee stock ownership in businesses or simply giving everyone a substantial balance in a mutual fund. In an article for The Atlantic, economist Noah Smith suggests that the government could give everyone “an endowment of capital” by purchasing a “diversified portfolio of equity” for every citizen when he or she turns eighteen. A rash decision to “cash out, and party” would be “prevented with some fairly light paternalism, like temporary ‘lock-up’ provisions.”18 The problem with this is that “light paternalism” might not be enough. Imagine a future in which your ability to survive economically is determined almost exclusively by what you own; your labor is worth little or nothing.

 

pages: 327 words: 102,322

Losing the Signal: The Spectacular Rise and Fall of BlackBerry by Jacquie McNish, Sean Silcoff

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Albert Einstein, Clayton Christensen, corporate governance, diversified portfolio, indoor plumbing, Iridium satellite, patent troll, QWERTY keyboard, rolodex, Silicon Valley, Silicon Valley startup, skunkworks, Skype, Stephen Hawking, Steve Ballmer, Steve Jobs

Wearing a tan jacket and a blue T-shirt, Balsillie sat down with George Stroumboulopoulos, host of a popular Canadian Broadcasting Corporation TV show. Referencing the popular iPhone, Stroumboulopoulos asked if it was time to add to RIM’s lineup: “Do you ever look at it and go, ‘What are we going to do if this isn’t our primary business, growing RIM beyond … a BlackBerry?’ ” “Um, no,” Balsillie laughed, “we’re a very poorly diversified portfolio.” “You’re just going to focus on one thing!” said Stroumboulopoulos. “It either goes to the moon or it crashes to Earth,” Balsillie replied. In the spring of 2008, no one believed RIM would flame out. Its stock market value was more than $70 billion, quarterly revenues were up 100 percent from the previous year, and the company sold sixty thousand BlackBerrys daily. Still, the company couldn’t afford to be arrogant.

 

pages: 376 words: 109,092

Paper Promises by Philip Coggan

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accounting loophole / creative accounting, balance sheet recession, bank run, banking crisis, barriers to entry, Berlin Wall, Bernie Madoff, Black Swan, Bretton Woods, British Empire, call centre, capital controls, Carmen Reinhart, carried interest, Celtic Tiger, central bank independence, collapse of Lehman Brothers, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, currency peg, debt deflation, delayed gratification, diversified portfolio, eurozone crisis, Fall of the Berlin Wall, falling living standards, fear of failure, financial innovation, financial repression, fixed income, floating exchange rates, full employment, German hyperinflation, global reserve currency, hiring and firing, Hyman Minsky, income inequality, inflation targeting, Isaac Newton, joint-stock company, Kenneth Rogoff, labour market flexibility, Long Term Capital Management, manufacturing employment, market bubble, market clearing, Martin Wolf, money: store of value / unit of account / medium of exchange, moral hazard, mortgage debt, Nick Leeson, Northern Rock, oil shale / tar sands, paradox of thrift, peak oil, pension reform, Plutocrats, plutocrats, Ponzi scheme, price stability, principal–agent problem, purchasing power parity, quantitative easing, QWERTY keyboard, railway mania, regulatory arbitrage, reserve currency, Robert Gordon, Robert Shiller, Robert Shiller, Ronald Reagan, savings glut, short selling, South Sea Bubble, sovereign wealth fund, special drawing rights, The Chicago School, The Great Moderation, The Wealth of Nations by Adam Smith, time value of money, too big to fail, trade route, tulip mania, value at risk, Washington Consensus, women in the workforce

This was particularly true in Great Britain which had an empire stretching round the world, a navy that protected trade routes, a sound currency in sterling, and a willingness to invest its savings overseas. Low yields on British government debt (gilts) caused the prosperous middle classes to buy bonds in Argentine railways in search of higher incomes (an early version of the ‘search for yield’ that would be seen in the current era). The quaintly named Foreign & Colonial Investment Trust, founded in 1868 but still around today, was a fund designed to offer Victorians a diversified portfolio; it acquired investments in Argentina, Brazil, Chile, Russia, Spain and Turkey. The initial yield was 7 per cent at a time when gilts offered just 3 per cent. Trade flowed round the globe. The arrival of steamships in the mid-nineteenth century opened up the possibility of exporting wheat from the US and meat from Argentina to the hungry European markets. The result was an agricultural depression in Britain.

 

pages: 309 words: 95,495

Foolproof: Why Safety Can Be Dangerous and How Danger Makes Us Safe by Greg Ip

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Affordable Care Act / Obamacare, Air France Flight 447, air freight, airport security, Asian financial crisis, asset-backed security, bank run, banking crisis, Bretton Woods, capital controls, central bank independence, cloud computing, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency peg, Daniel Kahneman / Amos Tversky, diversified portfolio, double helix, endowment effect, Exxon Valdez, financial deregulation, financial innovation, Financial Instability Hypothesis, floating exchange rates, full employment, global supply chain, hindsight bias, Hyman Minsky, Joseph Schumpeter, Kenneth Rogoff, London Whale, Long Term Capital Management, market bubble, moral hazard, Network effects, new economy, offshore financial centre, paradox of thrift, pets.com, Ponzi scheme, quantitative easing, Ralph Nader, Richard Thaler, risk tolerance, Ronald Reagan, savings glut, technology bubble, The Great Moderation, too big to fail, transaction costs, union organizing, Unsafe at Any Speed, value at risk

Because American banks tended to be regional, they were acutely vulnerable to localized housing busts. Deep downturns in Massachusetts and Texas had sent many local banks over the edge. MBSs made it possible to pool loans from around the country, diluting the effect of a housing bust in any region on the overall portfolio. Because historically prices never fell on a nationwide basis, investors were much more comfortable holding a diversified portfolio of mortgages. The diversification benefits of MBSs both reduced the cost of borrowing for everybody and expanded the influx of credit into the mortgage market. Investors, believing that nationwide home prices could never go down, acted in a way that guaranteed they would. Certainly, some bankers and investors suspected that home prices were poised to fall and that MBSs sold as safe would turn out not to be.

 

pages: 368 words: 32,950

How the City Really Works: The Definitive Guide to Money and Investing in London's Square Mile by Alexander Davidson

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accounting loophole / creative accounting, algorithmic trading, asset allocation, asset-backed security, bank run, banking crisis, barriers to entry, Big bang: deregulation of the City of London, capital asset pricing model, central bank independence, corporate governance, Credit Default Swap, dematerialisation, discounted cash flows, diversified portfolio, double entry bookkeeping, Edward Lloyd's coffeehouse, Elliott wave, Exxon Valdez, forensic accounting, global reserve currency, high net worth, index fund, inflation targeting, interest rate derivative, interest rate swap, London Interbank Offered Rate, Long Term Capital Management, margin call, market fundamentalism, Nick Leeson, North Sea oil, Northern Rock, pension reform, Piper Alpha, price stability, purchasing power parity, Real Time Gross Settlement, reserve currency, shareholder value, short selling, The Wealth of Nations by Adam Smith, transaction costs, value at risk, yield curve, zero-coupon bond

Since February 2001, the industry standard for settlement of shares held in nominee accounts has been T + 3, meaning that both counterparties to a trade agree to settle a trade three business days after the trade date, although market makers, as opposed to the electronic order book, can offer some flexibility. For paper share certificates, it is T + 10. Some private investors dabble on a one-off basis in the stock market but for those with a more sophisticated approach, the conventional wisdom is to build a diversified portfolio, investing in a number of companies, each in a different sector. This way, the risk is spread. If one share falls in value, the others may outperform, balancing out overall performance. On a broader scale, investments may be diversified across assets and countries. Bonds are less risky assets than equities, and cash deposits are the safest asset class of all. Commodities and property will broaden the spread.

 

The End of Accounting and the Path Forward for Investors and Managers (Wiley Finance) by Feng Gu

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Affordable Care Act / Obamacare, barriers to entry, business process, Claude Shannon: information theory, Clayton Christensen, conceptual framework, corporate governance, Daniel Kahneman / Amos Tversky, discounted cash flows, diversified portfolio, double entry bookkeeping, Exxon Valdez, financial innovation, fixed income, hydraulic fracturing, index fund, inventory management, Joseph Schumpeter, knowledge economy, moral hazard, new economy, obamacare, quantitative easing, quantitative trading / quantitative finance, QWERTY keyboard, race to the bottom, risk/return, Robert Shiller, Robert Shiller, shareholder value, Steve Jobs, The Great Moderation, value at risk

This is the nightmare of every drug and biotech company, and indeed, investors’ reaction was swift and harsh: Prosensa’s stock plunged 70 percent on the announcement of the trial’s failure. It was not a total loss, though, since the stock of Sarepta Therapeutics Inc., a competing biotech firm developing an alternative muscular dystrophy drug increased 18 percent on Prosensa’s failure announcement. One company’s loss is another’s gain. Large drug companies, with diversified portfolios of drugs under development, aren’t hit as hard by clinical test failures, but they are hit nevertheless. The large British pharmaceutical company AstraZeneca lost 2.5 percent of its stock price around August 8, 2012, when it announced an unsuccessful Phase IIb test of its treatment for severe sepsis. Lest you 104 Sins of Omission and Commission 105 wonder: investors react, of course, not only to bad news.

 

pages: 417 words: 109,367

The End of Doom: Environmental Renewal in the Twenty-First Century by Ronald Bailey

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3D printing, additive manufacturing, agricultural Revolution, Albert Einstein, autonomous vehicles, Cass Sunstein, Climatic Research Unit, Commodity Super-Cycle, conceptual framework, corporate governance, credit crunch, David Attenborough, decarbonisation, dematerialisation, demographic transition, diversified portfolio, double helix, energy security, failed state, financial independence, Gary Taubes, hydraulic fracturing, income inequality, invisible hand, knowledge economy, meta analysis, meta-analysis, Naomi Klein, oil shale / tar sands, oil shock, pattern recognition, peak oil, phenotype, planetary scale, price stability, profit motive, purchasing power parity, race to the bottom, RAND corporation, rent-seeking, Stewart Brand, Tesla Model S, trade liberalization, University of East Anglia, uranium enrichment, women in the workforce, yield curve

Meanwhile, the low end of natural gas generation is now $61 per megawatt-hour; for coal generation, it’s $66 per megawatt-hour; and for nuclear, it’s $124 per megawatt-hour. With the current US tax breaks, the low-end solar PV utility-scale costs is $56 per megawatt-hour. Even so, George Bilicic, a vice chairman of Lazard, concluded that utilities “still require conventional technologies to meet the energy needs of a developed economy, but they are using alternative technologies to create diversified portfolios of power generation resources.” Every couple of years the Electric Power Research Institute, a nonprofit think tank sponsored by the electric power generation industry, issues a report on the levelized cost of energy for various power generation technologies. Its Integrated Generation Technology Options 2012 report calculates the low-end levelized cost for solar PV next year at $107 per megawatt-hour.

 

pages: 366 words: 94,209

Throwing Rocks at the Google Bus: How Growth Became the Enemy of Prosperity by Douglas Rushkoff

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3D printing, Airbnb, algorithmic trading, Amazon Mechanical Turk, Andrew Keen, bank run, banking crisis, barriers to entry, bitcoin, blockchain, Burning Man, business process, buy low sell high, California gold rush, Capital in the Twenty-First Century by Thomas Piketty, carbon footprint, centralized clearinghouse, citizen journalism, clean water, cloud computing, collaborative economy, collective bargaining, colonial exploitation, Community Supported Agriculture, corporate personhood, crowdsourcing, cryptocurrency, disintermediation, diversified portfolio, Elon Musk, Erik Brynjolfsson, ethereum blockchain, fiat currency, Firefox, Flash crash, full employment, future of work, gig economy, Gini coefficient, global supply chain, global village, Google bus, Howard Rheingold, IBM and the Holocaust, impulse control, income inequality, index fund, iterative process, Jaron Lanier, Jeff Bezos, jimmy wales, job automation, Joseph Schumpeter, Kickstarter, loss aversion, Lyft, Mark Zuckerberg, market bubble, market fundamentalism, Marshall McLuhan, means of production, medical bankruptcy, minimum viable product, Naomi Klein, Network effects, new economy, Norbert Wiener, Oculus Rift, passive investing, payday loans, peer-to-peer lending, Peter Thiel, post-industrial society, profit motive, quantitative easing, race to the bottom, recommendation engine, reserve currency, RFID, Richard Stallman, ride hailing / ride sharing, Ronald Reagan, Satoshi Nakamoto, Second Machine Age, shareholder value, sharing economy, Silicon Valley, Snapchat, social graph, software patent, Steve Jobs, TaskRabbit, trade route, transportation-network company, Turing test, Uber and Lyft, Uber for X, unpaid internship, Y Combinator, young professional, Zipcar

People, it was believed, should have direct access to personal finance, the game of speculation. And so, with the help of a salivating financial services industry, the now-ubiquitous 401(k) was legislated into existence.8 A hybrid of the IRA and traditional pension plans, the 401(k) is funded by a monthly percentage of the employee’s salary and, sometimes, an optional contribution from the employer. The employee then picks from a range of diversified portfolios, administered by an outside financial firm. Instead of guaranteeing a lifetime of benefits, employers now only have to provide access to a plan and a matching contribution up front, if that. The employee alone is responsible for whether the plan appreciates, keeps up with inflation, or is invested responsibly. Moreover, the costs of asset management, brokerage fees, and financial services are also shifted from the company to the individual employees.9 The finance industry loved this new product, since it meant that instead of advising a few pension-holding companies, it could advise millions of new 401(k)-holding individuals.

 

pages: 389 words: 109,207

Fortune's Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street by William Poundstone

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Albert Einstein, anti-communist, asset allocation, Benoit Mandelbrot, Black-Scholes formula, Brownian motion, buy low sell high, capital asset pricing model, Claude Shannon: information theory, computer age, correlation coefficient, diversified portfolio, en.wikipedia.org, Eugene Fama: efficient market hypothesis, high net worth, index fund, interest rate swap, Isaac Newton, Johann Wolfgang von Goethe, John von Neumann, Long Term Capital Management, Louis Bachelier, margin call, market bubble, market fundamentalism, Marshall McLuhan, New Journalism, Norbert Wiener, offshore financial centre, publish or perish, quantitative trading / quantitative finance, random walk, risk tolerance, risk-adjusted returns, Robert Shiller, Robert Shiller, Ronald Reagan, short selling, speech recognition, statistical arbitrage, The Predators' Ball, The Wealth of Nations by Adam Smith, transaction costs, traveling salesman, value at risk, zero-coupon bond

The important thing was that the broker be someone of unquestioned honesty and discretion. Regan found someone who seemed just about perfect. His name was Michael Milken. Michael Milken IN HIS OWN WAY, Milken founded his career on the less-than-perfect efficiency of the market. As a Berkeley business student, Milken came across a study by W. Braddock Hickman on the bonds of companies with poor credit ratings. Hickman determined that a diversified portfolio of these neglected bonds was in fact a relatively safe and high-yielding investment. His study examined the period from 1900 to 1943. No one paid much attention to Hickman’s study except for Milken and a certain T. R. Atkinson, who extended it to cover the period 1944–65 and came to much the same conclusion. What Milken did with this finding was entirely different from what Thorp was doing with market inefficiencies.

 

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

Look at the asses on people in this country. Just let them try to cut back on wheat, and sugar, and corn! At least that’s what Goldman Sachs told its institutional investors back in 2005, in a pamphlet entitled Investing and Trading in the Goldman Sachs Commodities Index, given out mainly to pension funds and the like. Commodities like oil and gas, Goldman argued, would provide investors with “equity-like returns” while diversifying portfolios and therefore reducing risk. These investors were encouraged to make a “broadly-diversified, long-only, passive investment” in commodity indices. But there were several major problems with this kind of thinking—i.e., the notion that the prices of oil and gas and wheat and soybeans were something worth investing in for the long term, the same way one might invest in stock. For one thing, the whole concept of taking money from pension funds and dumping it long-term into the commodities market went completely against the spirit of the delicate physical hedger/speculator balance as envisioned by the 1936 law.

 

pages: 111 words: 1

Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets by Nassim Nicholas Taleb

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Antoine Gombaud: Chevalier de Méré, availability heuristic, backtesting, Benoit Mandelbrot, Black Swan, complexity theory, corporate governance, currency peg, Daniel Kahneman / Amos Tversky, discounted cash flows, diversified portfolio, endowment effect, equity premium, global village, hindsight bias, Long Term Capital Management, loss aversion, mandelbrot fractal, mental accounting, meta analysis, meta-analysis, quantitative trading / quantitative finance, QWERTY keyboard, random walk, Richard Feynman, Richard Feynman, road to serfdom, Robert Shiller, Robert Shiller, shareholder value, Sharpe ratio, Steven Pinker, stochastic process, too big to fail, Turing test, Yogi Berra

When the market started dipping in June, his friendly sources informed him that the sell-off was merely the result of a “liquidation” by a New Jersey hedge fund run by a former Wharton professor. That fund specialized in mortgage securities and had just received instructions to wind down the overall inventory. The inventory included some Russian bonds, mostly because yield hogs, as these funds are known, engage in the activity of building a “diversified” portfolio of high-yielding securities. Averaging Down When the market started falling, he accumulated more Russian bonds, at an average of around $52. That was Carlos’ trait, average down. The problems, he deemed, had nothing to do with Russia, and it was not some New Jersey fund run by some mad scientist that was going to decide the fate of Russia. “Read my lips: It’s a li-qui-dation!” he yelled at those who questioned his buying.

 

pages: 265 words: 93,231

The Big Short: Inside the Doomsday Machine by Michael Lewis

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Asperger Syndrome, asset-backed security, collateralized debt obligation, Credit Default Swap, credit default swaps / collateralized debt obligations, diversified portfolio, facts on the ground, financial innovation, fixed income, forensic accounting, Gordon Gekko, high net worth, housing crisis, illegal immigration, income inequality, index fund, interest rate swap, London Interbank Offered Rate, Long Term Capital Management, medical residency, moral hazard, mortgage debt, pets.com, Ponzi scheme, Potemkin village, quantitative trading / quantitative finance, short selling, Silicon Valley, too big to fail, value at risk, Vanguard fund

This is what Goldman Sachs had cleverly done. Their--soon to be everyone's--nifty solution to the problem of selling the lower floors appears, in retrospect, almost magical. Having gathered 100 ground floors from 100 different subprime mortgage buildings (100 different triple-B-rated bonds), they persuaded the rating agencies that these weren't, as they might appear, all exactly the same things. They were another diversified portfolio of assets! This was absurd. The 100 buildings occupied the same floodplain; in the event of flood, the ground floors of all of them were equally exposed. But never mind: The rating agencies, who were paid fat fees by Goldman Sachs and other Wall Street firms for each deal they rated, pronounced 80 percent of the new tower of debt triple-A. The CDO was, in effect, a credit laundering service for the residents of Lower Middle Class America.

 

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

Instead, they have grown increasingly assertive over the last 15 or 20 years, disguising themselves GOVERNANCE behind a rhetoric of democracy, independence, and accountability. Shareholders love to present themselves as the ultimate risk-bearers. But their liabilities are limited by definition to what they paid for the shares, they can always sell their shares in a troubled firm, and if they have diversified portfolios, they can handle an occasional wipeout with hardly a stumble. Employees, and often customers and suppliers, are rarely so well-insulated. Add to this Keynes's argument that the notion of liquidity cannot apply to a community^ as a whole, and you have a very damaging critique of shareholder-centered governance: what's divine for rentiers is bad news for everyone else. Apologists for the rentier agenda also argue that "them are us": the portfolio managers demonized as greedy Wall Streeters are really managing all of society's savings for the long-term interest of all.^^ The figures on concentration of stock ownership presented in Chapter 2 make that argument hard to sustain, but apologists also point to the pension benefits that we'll all collect someday if we're lucky enough to make it to 65 or 67.

 

pages: 598 words: 140,612

Triumph of the City: How Our Greatest Invention Makes Us Richer, Smarter, Greener, Healthier, and Happier by Edward L. Glaeser

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affirmative action, Andrei Shleifer, Berlin Wall, British Empire, Broken windows theory, carbon footprint, Celebration, Florida, clean water, congestion charging, declining real wages, desegregation, diversified portfolio, Edward Glaeser, endowment effect, European colonialism, financial innovation, Frank Gehry, global village, Guggenheim Bilbao, haute cuisine, Home mortgage interest deduction, James Watt: steam engine, Jane Jacobs, job-hopping, John Snow's cholera map, Mahatma Gandhi, McMansion, megacity, mortgage debt, mortgage tax deduction, New Urbanism, place-making, Ponzi scheme, Potemkin village, Ralph Waldo Emerson, rent control, RFID, Richard Florida, Rosa Parks, school vouchers, Seaside, Florida, Silicon Valley, Skype, smart cities, Steven Pinker, strikebreaker, the built environment, The Death and Life of Great American Cities, The Wealth of Nations by Adam Smith, trade route, transatlantic slave trade, upwardly mobile, urban planning, urban renewal, urban sprawl, William Shockley: the traitorous eight, Works Progress Administration, young professional

What forces draw the poor to urban areas? Above all, they come for jobs. Urban density makes trade possible; it enables markets. The world’s most important market is the labor market, in which one person rents his human capital to people with financial capital. But cities do more than merely allow laborer and capitalist to interact. They provide a wide range of jobs, often thousands of them; a big city is a diversified portfolio of employers. If one employer in a city goes belly-up, there’s another one (or two or ten) to take its place. This mixture of employers may not provide insurance against the global collapse of a great depression, but it sure smooths out the ordinary ups and downs of the marketplace. A one-company town like Hershey, Pennsylvania, depends on a single employer, and workers’ lives depend on whether that employer rises or falls.

 

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

Others have no interest in building portfolios (even of just three or four funds) or can't afford the minimum investments. If you don't want to mess with allocating assets, consider plunking down some cash for just one investment. Two good options are lifecycle funds and all-in-one funds. These might not suit your needs perfectly, but they're a fine place to start. Lifecycle funds Many mutual-fund companies now offer lifecycle funds (also called target-date funds), which try to create a diversified portfolio that's appropriate for a specific age group. For example, say you were born around 1970. In that case, you might consider a fund like Fidelity Freedom 2035, which includes a mix of investments that make sense for people who plan to retire in 2035 (when they'll be around 65). Lifecycle funds have a lot of things going for them. For example, you get: Automatic asset allocation, since lifecycle funds include various asset classes.

 

pages: 460 words: 122,556

The End of Wall Street by Roger Lowenstein

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Asian financial crisis, asset-backed security, bank run, banking crisis, Berlin Wall, Bernie Madoff, Black Swan, Brownian motion, Carmen Reinhart, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, diversified portfolio, eurozone crisis, Fall of the Berlin Wall, fear of failure, financial deregulation, fixed income, high net worth, Hyman Minsky, interest rate derivative, invisible hand, Kenneth Rogoff, London Interbank Offered Rate, Long Term Capital Management, margin call, market bubble, Martin Wolf, moral hazard, mortgage debt, Northern Rock, Ponzi scheme, profit motive, race to the bottom, risk tolerance, Ronald Reagan, savings glut, short selling, sovereign wealth fund, statistical model, the payments system, too big to fail, tulip mania, Y2K

Wall Street adopted quantitative strategies because they afforded more precision than old-fashioned judgment—they seemed to convert financial gambles into hard science. Investment banks stocked risk departments with PhDs. The problem was that homeowners weren’t molecules, and finance wasn’t physics. Merrill hired John Breit, a particle theorist, as a risk manager, and Breit tried to explain to his peers that the laws of Brownian motion didn’t truly describe finance—this wasn’t science, it was pseudoscience. The models said a diversified portfolio of municipal bonds would lose money once every 10,000 years, but as Breit pointed out, such a portfolio had been devastated merely 150 years ago, during the Civil War. With regard to Merrill’s portfolio of CDOs, the firm judged its potential loss to be “$71.3 million.”6 This was absurd—not because the number was high or low, but because of the arrogance and self-delusion embedded in such fine, decimal-point precision.

 

pages: 431 words: 132,416

No One Would Listen: A True Financial Thriller by Harry Markopolos

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backtesting, barriers to entry, Bernie Madoff, call centre, centralized clearinghouse, correlation coefficient, diversified portfolio, Emanuel Derman, Eugene Fama: efficient market hypothesis, family office, fixed income, forensic accounting, high net worth, index card, Long Term Capital Management, Louis Bachelier, offshore financial centre, Ponzi scheme, price mechanism, quantitative trading / quantitative finance, regulatory arbitrage, Renaissance Technologies, risk-adjusted returns, risk/return, rolodex, Sharpe ratio, statistical arbitrage, too big to fail, transaction costs

If you don’t believe me, ask what their budget for due diligence is this year in both dollar terms and as a percent of revenue. If they can’t give you an immediate answer, then they aren’t even taking the time to measure what is supposed to be their most important function—preserving your capital! My observation is that most fund of funds spend a lot more effort on their marketing than on their due diligence which, of course, doesn’t help their investors very much. A well run HFOF can provide a diversified portfolio and generate attractive returns for their investors. While too many HFOFs got caught up in the Madoff Ponzi scheme, I applaud those organizations that did their homework and helped their investors avoid this disaster. In the United States, almost 11 percent of the HFOFs had Madoff—so 89 percent avoided him. But in Europe, particularly Switzerland, the HFOFs got hit hard. Switzerland had Madoff exposure in almost 29 percent of its HFOFs.

 

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

An LBO firm could buy control with the other family members, who remained as managers. But as the firms had greater and greater amounts of capital at their disposal, they increasingly took on bigger businesses, including public companies like Houdaille and sizable subsidiaries of conglomerates. In their heyday in the 1960s, conglomerates had been the darlings of the stock market, assembling ever more sprawling, diversified portfolios of dissimilar businesses. They lived for growth and growth alone. One of the golden companies of the era, Ling-Temco-Vought, the brainchild of a Texas electrical contractor named Jimmy Ling, eventually amassed an empire that included the Jones & Laughlin steel mills, a fighter jet maker, Braniff International Airlines, and Wilson and Company, which made golf equipment. Ling’s counterpart at ITT Corporation, Harold Geneen, made what had been the International Telephone & Telegraph Company into a vehicle for acquisitions, snatching up everything from the Sheraton hotel chain to the bakery that made Wonder Bread; the Hartford insurance companies; Avis Rent-a-Car; and sprinkler, cigar, and racetrack businesses.

 

A Voyage Long and Strange: On the Trail of Vikings, Conquistadors, Lost Colonists, and Other Adventurers in Early America by Tony Horwitz

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airport security, Atahualpa, back-to-the-land, Bartolomé de las Casas, Colonization of Mars, Columbian Exchange, dematerialisation, diversified portfolio, Francisco Pizarro, Hernando de Soto, illegal immigration, joint-stock company, out of africa, Ralph Waldo Emerson, trade route, urban renewal

Born in Extremadura, the rugged Spanish province that also spawned Cortés and Pizarro, De Soto sailed to America at the age of fourteen and arrived with only a sword and buckler. He went straight to work, fighting Indians in Panama, and quickly won renown as a ruthless warrior: the go-to guy for brutal raids against natives. Contemporaries described him as dark, handsome, hotheaded (apasionado), “hard and dry of word,” and “very busy in hunting Indians.” He was also a shrewd businessman, amassing a diversified portfolio of plundered gold, grants of Indian labor, and stakes in mining and shipping. De Soto sealed his fortune by joining in the conquest of Peru, where Pizarro dispatched him as an emissary to Atahualpa. With characteristic bravura, De Soto rode straight into the Incan camp and reared his foaming steed before the emperor. When the Spanish later garroted Atahualpa and looted Peru’s gold and silver, De Soto’s cut came to more than $10 million in today’s dollars.

 

pages: 590 words: 153,208

Wealth and Poverty: A New Edition for the Twenty-First Century by George Gilder

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affirmative action, Albert Einstein, Bernie Madoff, British Empire, capital controls, cleantech, cloud computing, collateralized debt obligation, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, deindustrialization, diversified portfolio, Donald Trump, equal pay for equal work, floating exchange rates, full employment, George Gilder, Home mortgage interest deduction, Howard Zinn, income inequality, invisible hand, Jane Jacobs, Jeff Bezos, job automation, job-hopping, Joseph Schumpeter, knowledge economy, labor-force participation, margin call, Mark Zuckerberg, means of production, medical malpractice, minimum wage unemployment, money: store of value / unit of account / medium of exchange, Mont Pelerin Society, moral hazard, mortgage debt, non-fiction novel, North Sea oil, paradox of thrift, Plutocrats, plutocrats, Ponzi scheme, post-industrial society, price stability, Ralph Nader, rent control, Robert Gordon, Ronald Reagan, Silicon Valley, Simon Kuznets, skunkworks, Steve Jobs, The Wealth of Nations by Adam Smith, Thomas L Friedman, upwardly mobile, urban renewal, volatility arbitrage, War on Poverty, women in the workforce, working poor, working-age population, yield curve

In three decades the U.S. debt was reduced to less than one-quarter of GNP and Britain’s to less than half. Even including private debt, there is virtually no evidence that the burden was greater at that point than it was ten or twenty years before. The statistics of growing private debt chiefly reflect not an increase in final claims on income and wealth, but an expansion in the number of intermediary institutions lending to one another, diversifying portfolios, and probably making the system more stable. The problem in the United States and Britain is not debt but waste, not deficit spending but a redistributionist war against wealth that makes everyone poorer—and ironically even promotes inequality. The crucial question on the inflation tax is what is it used for. As Nobel-winning economist W. Arthur Lewis wrote,Some naive investigators have professed to show that inflation does not increase capital formation, by showing that in a number of places where inflation has occurred (notably in Latin America), capital formation has not increased.

 

pages: 442 words: 39,064

Why Stock Markets Crash: Critical Events in Complex Financial Systems by Didier Sornette

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Asian financial crisis, asset allocation, Berlin Wall, Bretton Woods, Brownian motion, capital asset pricing model, capital controls, continuous double auction, currency peg, Deng Xiaoping, discrete time, diversified portfolio, Elliott wave, Erdős number, experimental economics, financial innovation, floating exchange rates, frictionless, frictionless market, full employment, global village, implied volatility, index fund, invisible hand, John von Neumann, joint-stock company, law of one price, Louis Bachelier, mandelbrot fractal, margin call, market bubble, market clearing, market design, market fundamentalism, mental accounting, moral hazard, Network effects, new economy, oil shock, open economy, pattern recognition, Paul Erdős, quantitative trading / quantitative finance, random walk, risk/return, Ronald Reagan, Schrödinger's Cat, short selling, Silicon Valley, South Sea Bubble, statistical model, stochastic process, Tacoma Narrows Bridge, technological singularity, The Coming Technological Singularity, The Wealth of Nations by Adam Smith, Tobin tax, total factor productivity, transaction costs, tulip mania, VA Linux, Y2K, yield curve

Third, the resurgence of capital flows also reflected the clear recognition by investors that the economic fundamentals in most emerging markets in the 1990s had vastly improved over those that prevailed in the late 1970s. Since 1987, both the direct barriers, such as capital controls, and the indirect barriers, such as difficulties in evaluating corporate information, that prevented the free flow of capital had gradually been reduced. As capital controls were gradually lifted, global investors with more diversified portfolios began to influence stock prices, particularly in emerging markets [422]. This trend of opening up financial markets meant that firms from emerging markets were able to raise capital, both domestically and internationally, at a lower cost. In fact, firms from emerging markets were able to raise long-term equity and debt capital in global markets at unprecedented rates [422]. The capital infusion from foreign investors made it possible for emerging market firms to capitalize on their growth opportunities in a way that would have been impossible had they been restricted to raising funds in domestic markets.

 

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

See also bonds; mortgages debt overhang, 153, 156 democratization: of finance, 43–44, 47, 144, 150, 209–11, 214, 235, 239; of financial capitalism, xiii–xiv, xvii, 5–6, 8–9; of insurance, 65–67, 68 Deng Xiaoping, 3 derivatives: definition of, 75; expanding markets, 62–63, 80; forward markets, 75; history, 76–77; on housing prices, 62; investment managers’ use of, 35; justifications, 77–80; pricing, 132; public perceptions, 75, 80. See also futures markets; mortgage securities; options developing countries: insurance, 66–67; microfinance, 44; philanthropy in, 126 De Waal, Frans, 227 Diagnostic and Statistical Manual of Mental Disorders (DSM- IV), 179 directors. See boards of directors disquiet, and inequality, 141–42 diversified portfolios, 28, 29 Dixit, Avinash K., 76 Djilas, Milovan, 25 Dodd-Frank Wall Street Reform and Consumer Protection Act, 23, 43, 51, 114, 154, 184, 217 Domenici, Pete, 192 Donaldson, Lufkin & Jenrette, 176 donor-advised funds, 207 dopamine system, 59–60, 139–40, 245n4 (Chapter 6) Douglas, William O., 209–10 DreamWorks Studios, 189 DSM-IV. See Diagnostic and Statistical Manual of Mental Disorders Duflo, Esther, 5 Dutch East India Company, 46 earthquakes, 66, 67 East India Company, 46 economic forecasting, 111–12, 113–14 economic stabilization policies, 111, 112, 113, 117–18 education system, 6, 103–6, 242n8.

 

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

Individuals file tax returns once a year; similarly, while pensions and endowments make reports to their boards on a regular basis, the annual report is probably the most salient. The implication of our analysis is that the equity premium—or the required rate of return on stocks—is so high because investors look at their portfolios too often. Whenever anyone asks me for investment advice, I tell them to buy a diversified portfolio heavily tilted toward stocks, especially if they are young, and then scrupulously avoid reading anything in the newspaper aside from the sports section. Crossword puzzles are acceptable, but watching cable financial news networks is strictly forbidden.# During our year at Russell Sage, Colin and I would frequently take taxis together. Sometimes it was difficult to find an empty cab, especially on cold days or when a big convention was in town.

 

pages: 572 words: 134,335

The Making of an Atlantic Ruling Class by Kees Van der Pijl

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anti-communist, banking crisis, Berlin Wall, Boycotts of Israel, Bretton Woods, British Empire, capital controls, collective bargaining, colonial rule, cuban missile crisis, deindustrialization, deskilling, diversified portfolio, European colonialism, floating exchange rates, full employment, imperial preference, Joseph Schumpeter, means of production, North Sea oil, Plutocrats, plutocrats, profit maximization, RAND corporation, strikebreaker, trade liberalization, trade route, union organizing, uranium enrichment, urban renewal, War on Poverty

Moreover, capital gains are much larger than dividends. In the income brackets between $500,000 and $1 million in the United States, more than half of such income was accounted for by capital gains in 1964; according to Babeau and Strauss-Kahn, ¾ to 4/5 of all property formation in the United States derives from capital gains.4 The issue of dividend payments versus consolidation of profits may pit the smaller rentiers owning a diversified portfolio against the corporate owner-managers more closely interested in the long-term prospects and overall financial position of their company. The owners of big blocks, profiting from tax rates on capital gains varying from 25% in the United States to zero in the Netherlands, are not dependent upon dividends, so conflict with the smaller rentiers has become a familiar phenomenon of annual shareholders’ meetings.

 

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

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. The beauty of lifestyle funds is that with the purchase of one mutual fund you end up owning five funds spread across a variety of asset classes. For example, a lifestyle fund might divide its holdings among the U.S stock market, the U.S. bond market, the international stock index and a variety of other options. This approach takes the guesswork out of where and how to invest your capital, which is often the reason many people avoid the stock market in the first place.

 

pages: 515 words: 142,354

The Euro: How a Common Currency Threatens the Future of Europe by Joseph E. Stiglitz, Alex Hyde-White

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bank run, banking crisis, barriers to entry, battle of ideas, Berlin Wall, Bretton Woods, capital controls, Carmen Reinhart, cashless society, central bank independence, centre right, cognitive dissonance, collapse of Lehman Brothers, collective bargaining, corporate governance, correlation does not imply causation, credit crunch, Credit Default Swap, currency peg, dark matter, David Ricardo: comparative advantage, disintermediation, diversified portfolio, eurozone crisis, Fall of the Berlin Wall, fiat currency, financial innovation, full employment, George Akerlof, Gini coefficient, global supply chain, Growth in a Time of Debt, housing crisis, income inequality, incomplete markets, inflation targeting, investor state dispute settlement, invisible hand, Kenneth Rogoff, knowledge economy, labour market flexibility, labour mobility, manufacturing employment, market bubble, market friction, market fundamentalism, Martin Wolf, Mexican peso crisis / tequila crisis, moral hazard, mortgage debt, neoliberal agenda, new economy, open economy, paradox of thrift, pension reform, pensions crisis, price stability, profit maximization, purchasing power parity, quantitative easing, race to the bottom, risk-adjusted returns, Robert Gordon, Robert Shiller, Robert Shiller, Ronald Reagan, savings glut, secular stagnation, Silicon Valley, sovereign wealth fund, the payments system, The Wealth of Nations by Adam Smith, too big to fail, transaction costs, transfer pricing, trickle-down economics, Washington Consensus, working-age population

In another case of massive market manipulation, Citigroup, JPMorgan, Barclays, Royal Bank of Scotland, and UBS agreed to plead guilty to a felony of market manipulation. 16 George A. Akerlof and Robert A. Shiller, Phishing for Phools: The Economics of Manipulation and Deception (Princeton, NJ: Princeton University Press, 2015). 17 In the United States almost unbounded campaign contributions are made to the individual and the party that comes the closest to leaving the sector unregulated, with significant amounts given to the opposition for good measure. This diversified portfolio approach to campaign giving has worked well for the banks, generating large bailouts under both Democratic and Republic administrations. These investments in America’s political process paid off far better than the financial investments that were supposed to be their expertise, but episodically turned out to be disastrous. 18 See later discussion of Chile’s experience with stripping away virtually all regulations. 19 In December 2014, the US Congress put a provision undoing one of the key parts of the Dodd-Frank Wall Street Reform and Consumer Protection Act regulating banks—a provision intended to ensure that government-insured institutions do not engage in risky trading in derivatives—in a budget bill that the president had to sign to keep the government open. 20 As one example: it would have the right to ban insurance products where the buyer of the insurance has no insurable risk—that is, I cannot buy a life insurance product on someone whose death would have no consequence for me.

 

Red Rabbit by Tom Clancy, Scott Brick

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anti-communist, battle of ideas, diversified portfolio, Ignaz Semmelweis: hand washing, information retrieval, union organizing, urban renewal

CHAPTER 1 RUMBLINGS AND DREAMS "WHEN DO YOU START, JACK?" Cathy asked in the quiet of their bed. And her husband was glad it was their bed. Comfortable as the New York hotel had been, it is never the same, and besides, he'd had quite enough of his father-in-law, with his Park Avenue duplex and immense sense of self-importance. Okay, Joe Muller had a good ninety million in the bank and his diversified portfolio, and it was growing nicely with the new presidency, but enough was enough. "Day after tomorrow," her husband answered. "I suppose I might go in after lunch, just to look around." "You ought to be asleep by now," she said. There were drawbacks to marrying a physician, Jack occasionally told himself. You couldn't hide much from them. A gentle, loving touch could convey your body temperature, heart rate, and Christ knew what else, and docs hid their feelings about what they found with the skill of a professional poker player.

 

pages: 726 words: 172,988

The Bankers' New Clothes: What's Wrong With Banking and What to Do About It by Anat Admati, Martin Hellwig

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Andrei Shleifer, asset-backed security, bank run, banking crisis, Basel III, Bernie Madoff, Big bang: deregulation of the City of London, Black Swan, bonus culture, Carmen Reinhart, central bank independence, centralized clearinghouse, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, diversified portfolio, en.wikipedia.org, Exxon Valdez, financial deregulation, financial innovation, financial intermediation, George Akerlof, Growth in a Time of Debt, income inequality, invisible hand, Jean Tirole, joint-stock company, joint-stock limited liability company, Kenneth Rogoff, London Interbank Offered Rate, Long Term Capital Management, margin call, Martin Wolf, moral hazard, mortgage debt, mortgage tax deduction, Nick Leeson, Northern Rock, open economy, peer-to-peer lending, regulatory arbitrage, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, shareholder value, sovereign wealth fund, technology bubble, The Market for Lemons, the payments system, too big to fail, Upton Sinclair, Yogi Berra

In the case of equity, in particular, the investors who invest in bank stocks and become shareholders of the bank think about the risk of their investment in bank stocks in the same way they think of the risk of any other stocks or investments they might make. Bank equity investors are often the very same investors as those that invest in other stocks. They are mutual funds investing on behalf of individuals in broad diversified portfolios, or they are other investors that think of the risks and returns of all the various investments they can make. Many of us have some bank stocks as part of our pension fund investments if we diversify our holdings among many investments. The notion that the required ROE is fixed and independent of the funding mix is as fallacious for banks as it is for nonfinancial corporations. It is an article of the bankers’ new clothes that must be seen as the fiction that it is.22 There is in fact substantial empirical evidence that the average returns on the shares of banks that rely on more borrowing are higher than the average returns on shares of banks that rely on less borrowing and have more equity.23 The debt-equity mix that corporations use does have an impact on their overall funding costs.

 

pages: 559 words: 169,094

The Unwinding: An Inner History of the New America by George Packer

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Affordable Care Act / Obamacare, Apple's 1984 Super Bowl advert, bank run, big-box store, citizen journalism, cleantech, collateralized debt obligation, collective bargaining, Credit Default Swap, credit default swaps / collateralized debt obligations, deindustrialization, diversified portfolio, East Village, El Camino Real, Elon Musk, family office, financial independence, financial innovation, Flash crash, Henry Ford's grandson gave labor union leader Walter Reuther a tour of the company’s new, automated factory…, housing crisis, income inequality, informal economy, Jane Jacobs, life extension, Long Term Capital Management, low skilled workers, margin call, Mark Zuckerberg, market bubble, market fundamentalism, Maui Hawaii, Menlo Park, new economy, New Journalism, obamacare, Occupy movement, oil shock, peak oil, Peter Thiel, Ponzi scheme, Richard Florida, Ronald Reagan, Ronald Reagan: Tear down this wall, shareholder value, side project, Silicon Valley, Silicon Valley startup, single-payer health, smart grid, Steve Jobs, strikebreaker, The Death and Life of Great American Cities, the scientific method, too big to fail, union organizing, urban planning, We are the 99%, We wanted flying cars, instead we got 140 characters, white flight

When he returned to Washington, Connaughton picked up a new book titled The Trillion Dollar Meltdown, by a former banker named Charles R. Morris. It argued that overleveraged banks and debt-strapped consumers with unaffordable mortgage payments were creating a credit bubble that would soon pop and create a global financial calamity. Connaughton read the book and tossed it aside. That March, Bear Stearns failed. Connaughton kept an eye on his stocks, where he had most of his wealth in a globally diversified portfolio. The markets were falling, but not precipitously. He expected at most a 10 percent correction. It was never easy to time getting out and back in just right. He stayed put as the Dow dropped toward 10,000. In September, Lehman Brothers went bankrupt, the rest of Wall Street poised to perish with it. Charles R. Morris’s meltdown—now two trillion dollars—happened faster than anyone could have imagined.

 

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

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. I’m not going to worry about losing my job because my one boss is going to fire me, because I have thousands of bosses at newspapers everywhere. One of the ways to not worry about stress is to eliminate it. I don’t worry about my stock picks because I have a diversified portfolio. Diversification works in almost every area of your life to reduce your stress.” Dilbert Hardware—What Scott Draws On Wacom Cintiq tablet The Logic of the Double or Triple Threat On “career advice,” Scott has written the following, which is slightly trimmed for space here. This is effectively my mantra, and you’ll see why I bring it up: If you want an average, successful life, it doesn’t take much planning.

 

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

Now, looking forward to financial futures in Chapter 7, we will shift the focus away from agricultural commodities like wheat to financial ‘commodities’ like stock indexes and stock index futures contracts as their hedging vehicles. FIGURE 6.1 Long vs. 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.

 

pages: 558 words: 168,179

Dark Money: The Hidden History of the Billionaires Behind the Rise of the Radical Right by Jane Mayer

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affirmative action, Affordable Care Act / Obamacare, anti-communist, Bakken shale, bank run, battle of ideas, Berlin Wall, Capital in the Twenty-First Century by Thomas Piketty, carried interest, centre right, clean water, Climategate, Climatic Research Unit, collective bargaining, crony capitalism, David Brooks, desegregation, diversified portfolio, Donald Trump, energy security, estate planning, Fall of the Berlin Wall, George Gilder, housing crisis, hydraulic fracturing, income inequality, invisible hand, job automation, low skilled workers, market fundamentalism, Mont Pelerin Society, More Guns, Less Crime, Nate Silver, New Journalism, obamacare, Occupy movement, offshore financial centre, oil shale / tar sands, oil shock, Plutocrats, plutocrats, Ralph Nader, Renaissance Technologies, road to serfdom, Ronald Reagan, school choice, school vouchers, The Bell Curve by Richard Herrnstein and Charles Murray, The Chicago School, the scientific method, University of East Anglia, Unsafe at Any Speed, War on Poverty, working poor

Lewis’s Investigative Reporting Workshop spent a year in 2013 culling through the Kochs’ financial records and concluded that their operation was “unprecedented in size, scope, and funding” and also in the way that it was “mutually reinforcing to the direct financial and political interests” of Koch Industries. In 1992, David Koch likened the brothers’ multipronged political strategy to that of venture capitalists with diversified portfolios. “My overall concept is to minimize the role of government and to maximize the role of the private economy and to maximize personal freedoms,” he told the National Journal. “By supporting all of these different [nonprofit] organizations I am trying to support different approaches to achieve those objectives. It’s almost like an investor investing in a whole variety of companies. He achieves diversity and balance.

 

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

Some employees were more interested in the firm’s performance; asymmetric compensation policies meant that others were more interested in individual portfolio performance. There was no system that gradually transferred company ownership from old employees to new ones, and that reinforced traders’ tendency to put their portfolios above the overall company’s health. LTCM’s risk management framework was a strength and a weakness. Traders were more likely to take on marginal trades because they believed that the diversified portfolio protected them. When we came into 1998, I didn’t like a lot of our trades. They were very marginal. I didn’t do anything about it. I thought with our diversification, it would come out in the wash. There was a general notion that if these trades were standalone trades, we would not have put them on. Diversification fooled us. —Hans Hufschmid interview, September 30, 2010 Diversification may have also encouraged less experienced, more theoretical traders to make experimental trades.

 

pages: 1,073 words: 302,361

Money and Power: How Goldman Sachs Came to Rule the World by William D. Cohan

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asset-backed security, Bernie Madoff, buttonwood tree, collateralized debt obligation, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, diversified portfolio, fear of failure, financial innovation, fixed income, Ford paid five dollars a day, Goldman Sachs: Vampire Squid, Gordon Gekko, high net worth, hiring and firing, hive mind, Hyman Minsky, interest rate swap, London Interbank Offered Rate, Long Term Capital Management, margin call, market bubble, merger arbitrage, moral hazard, mortgage debt, paper trading, passive investing, Ponzi scheme, price stability, profit maximization, risk tolerance, Ronald Reagan, Saturday Night Live, South Sea Bubble, time value of money, too big to fail, traveling salesman, value at risk, yield curve, Yogi Berra

“These mortgage loans may be considered to be of a riskier nature than mortgage loans made by traditional sources of financing, so that the holders of the securities may be deemed to be at greater risk of loss than if the mortgage loans were made to other types of borrowers.” In typical Wall Street fashion, Goldman had not made any of these home loans itself. It had no idea who the borrowers were or whether they could repay the mortgages. Goldman knew something about their credit scores but that was about it. It was counting on both the perceived power of the ongoing housing bubble to keep housing values inflated and a diversified portfolio to spread the risk across the pool of geographically diverse mortgages in order to minimize the risk of any one individual borrower or group of borrowers. Of course, Goldman had no intention of keeping the mortgages itself but rather bought them for the sole purpose of packaging them together and selling them off to investors for a fee determined by the difference between the price it paid for them and the price it sold them for.

 

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

The Drexel-designed securities that were exchanged lacked even this saving grace. They were probably very good examples of what Graham and Dodd most disapproved of in the financial markets. In the ensuing collapse, most of them had no recovery at all. Graham and Dodd had the insight that the difference between the risk-free rate of return and the yields offered by securities of varying risk created investment opportunities, especially if a diversified portfolio could lock in high returns while reducing the overall risk. In almost any kind of investing, returns have at least some (if not a mathematically exact) connection to the risk-free rate of return, with investors demanding higher returns for greater risk. The premium that investors demand for high yield bonds over the safety of Fed Funds offers a good snapshot for the market’s appetite for risk, as seen in this two-decade survey: ARE YOU GETTING PAID TO TAKE RISK?