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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, intangible asset, Long Term Capital Management, money market fund, passive investing, Paul Samuelson, Ponzi scheme, prediction markets, random walk, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, Sharpe ratio, survivorship bias, too big to fail, transaction costs, Vanguard fund, yield curve, zero-sum game

The number of active fund portfolios that beat the index fund portfolio by 0.5 percent or more hardly budged, while the number that underperformed by 0.5 percent or more remained very high. The Real Deal Finally, I conducted an independent real-world test of a randomly selected actively managed fund portfolio versus an all index fund portfolio. I used the actual fund returns from three fund categories going back 15 years. I constructed an index fund portfolio using the funds and weights in Table 6.7. My test compared this index fund portfolio to thousands of randomly selected active funds from the Morningstar list, in the correct weightings. Table 6.7 Model Index Fund Portfolio Used in the Live Study Index Fund Name Percent Allocation Vanguard Total Stock Market Index Fund 45% Vanguard Total International Stock Index Fund* 15% Vanguard Total Bond Market Index Fund 40% * The Vanguard Total International Fund had its first full year under management in 1998.

See Uniform Prudent Management of Institutional Funds Act (UPMIFA) U.S. equity index U.S. equity index funds U.S. Equity mutual funds U.S. News & World Report U.S. Securities and Exchange Commission (SEC) U.S. small cap funds U.S. stocks U.S. Treasury bonds Value investing Value stocks van Dijk, Mathijs A. Vanguard 500 Index Fund: 15-year tax cost ratio for 25-year study on active funds and domestic equity funds of launch of proven record of sales load, lack of Vanguard Bond Market Fund Vanguard First Index Investment Trust Vanguard Group: first index fund, launch of as global investment managers indexing, growth of international indexing analysis web site for Vanguard REIT Index Fund Vanguard S&P 500 index fund Vanguard Small Cap Index Fund Vanguard Total Bond Market Index ETF Vanguard Total Bond Market Index Fund Vanguard Total International Stock Fund Vanguard Total Stock Market Index Fund Vanguard U.S.

When the academics questioned the lagging performance relative to the markets they were quickly reminded by fund company spokesmen that “you can’t buy the market.”4 This was a true statement at the time. Index funds didn’t exist. Now You Can Buy the Market The world changed in 1976 with the introduction of a passively managed S&P 500 index fund by the Vanguard Group. This gave mutual fund investors an option; they could continue to invest in actively managed mutual funds that tended to underperform the market by a considerable amount, or they could buy very close to the market return through the First Index Investment Trust (later renamed the Vanguard 500 Index Fund). The introduction of index funds to the marketplace was an inflection point in mutual fund history. Not only did index funds give investors a choice, they forced active fund companies to redefine their purpose. When asked if Fidelity would follow Vanguard’s lead and offer index funds, Chairman Edward C. Johnson III stated, “I can’t believe that the great mass of investors are [sic] going to be satisfied with just receiving average returns.


pages: 339 words: 109,331

The Clash of the Cultures by John C. Bogle

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asset allocation, collateralized debt obligation, commoditize, 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, money market fund, mortgage debt, new economy, Occupy movement, passive investing, Paul Samuelson, 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, survivorship bias, The Wealth of Nations by Adam Smith, transaction costs, Vanguard fund, William of Occam, zero-sum game

As 2012 begins, Vanguard administers 62 broad market index funds and 12 broad sector index funds, plus another four LifeStrategy Funds and eight Target Retirement Funds, both of which use our existing Vanguard index funds as their underlying investments. These two series of index-oriented asset allocation funds have grown rapidly, with aggregate assets totaling $130 billion as 2012 begins. Part II The Invasion of the ETF Today, Vanguard remains at the pinnacle of the index mutual fund field, as we have for 35 years, accounting for more than 50 percent of the industry’s index fund assets. While our growth in index fund assets from 1986 through the 1990s had come entirely from our traditional index funds (TIFs), most of our growth since then has been driven by “nontraditional” index funds known as “exchange-traded index funds.” ETFs have existed only since 1992, but by 2000 they had become a major force in index investing.

Given the skills and experience of Vanguard’s investment and administrative staff and the firm’s ability to operate at rock-bottom cost, we felt that we had the responsibility to continue to dominate the index fund field. So we quickly pursued a strategy of expanding the original indexing concept to broader uses. The process moved forward quickly and easily. In the years that followed the creation of our stock index fund, we moved first into the bond index area. Thereafter, we would build an index fund “family” that would greatly expand our mandate. Here are the highlights.10 Vanguard Index Fund Family Milestones (1976 to 1996) 1986: The Bond Index Fund. We took this obvious step to build on our reputation as an index manager. Its story is told in greater depth in Box 6.2. Box 6.2: The Bond Index Fund In 1986, the first decade of Vanguard’s stock index fund came to a close. Its assets would soon top the $1 billion milestone.

(Strine) Tower, Edward Trading cost of transactions Trading volumes Traditional index funds (TIFs). See also Index funds assets exchange traded funds versus future of growth in number of as portfolio core profile of trading volumes “Trafficking” in management contracts Transactions: cost of taxes on Trends Turner, Adair Turner, Lynn Turnover: actively managed equity funds exchange traded funds index funds mutual funds Stewardship Quotient and stock market Twardowski, Jan M. 12b-1 fees Value, corporate Vanguard: Admiral shares balanced index fund bond funds, defined-maturity cash flow emerging markets stock fund exchange traded funds “Extended Market” portfolio growth and value index funds history index fund family milestones international funds LifeStrategy Portfolios proxy votes REIT index fund small capitalization stock fund Stewardship Quotient structure and strategy tax-managed index funds Vanguard 500 Index Fund Vanguard Institutional Index Fund Vanguard PRIMECAP Fund Vanguard Total Bond Market Index Fund Vanguard Total Stock Market Index funds Vanguard U.S.

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, money market fund, Myron Scholes, passive investing, prediction markets, random walk, risk tolerance, risk-adjusted returns, risk/return, transaction costs, Vanguard fund, zero-sum game

Low Risk Medium-Low Risk Medium-High Risk High Risk 20/80 40/60 60/40 80120 Average annual return (Geometric) 10.14% 10.89% 11.56% 12.15% Annualized standard deviation 7.51% 8.47% 10.25% 12.51% Worst single calendar year -2.07% -2.02% -7.99% -13.95% Worst two-calendaryear period 7.59% -2.71% -12.51% -21.80% Worst three-calendaryear period 13.32% 0.37% -12.74% -24.69% 180 Appendix B Composition of model portfulillS: 20/ 80 40/60 60/40 2% 10% 8% 80% iShares iShares iShares iShares CON CON CON CON Composite Index Fund (XIC) S&P 500 Index Fund (XSP) MSCI EAFE Index Fund (XIN) Bond Index Fund (XBB) 4% 20% 16% 60% iShares iShares iShares iShares CON CON CON CON Composite Index Fund (X1C) S&P 500 Index Fund (XSP) MSCI EAFE Index Fund (XIN) Bond Index Fund (XBB) 6% iShares iShares iShares iShares CON CON CON CON Composite Index Fund (XIC) S&P 500 Index Fund (XSP) MSCI EAFE Index Fund (XIN) Bond Index Fund (XBB) iShares iShares iShares iShares CON CON CON CON Composite Index Fund (XIC) S&P 500 Index Fund (XSP) MSCI EAFE Index Fund (XIN) Bond Index Fund (XBB) 30% 24% 40% 80/20 8% 40% 32% 20% Raw data used 10 produce performance numbers: iShares CON Composite Index Fund (XIC) =- actual fund retu rns 2002-2005, (TSX 300 Index-o.25% per year) 1977-2001 iShares CON S&P 500 Index Fund (XSP) '" actual fund returns 2002-2005.

See securities industry international stocks benefits of, 130-31, 169 in index funds, 19 Index 189 international Stocks in ETFs. Sa iShares CON MSCI EAFE Index Fund (XIN) investment banks. Set securities induSlry Investment Funds Institute of Canada. 147 investment newsleners and newspapers. Stt financial media investment portfolios benefits of, xii, 12 buying stocks on margin. 77-78 international stocks in. 19. 130-31,169 invcstment professionals. Su securities industry i$hares (ETF funds). website for, 15 &t also ETFs (exchange traded funds) iShares CON Bond Index Fund (XBB), 1\, 130, 180 iShares C DN Composite Index Fund (XIC). 15. 130, 180 iShares CON Income Trust Sector Index Fund, 135 iShares CON MSCI EAFE Index Fund (XlN). 15, 130. 180 iShares C DN S&P 500 Index Fund (XSP) . 15. 130, 180 rebalancing ponfolio$, 120, 132-33 risk and. 122-23 risk return comparison (01",,), 14,74--76 standard deviation to measure risk, 67-68, 85. 126. 138 value and small-cap equities in. 11 4 Set also asset allocation; Four-Step Process for Smart Investors investment portfolios. four model benefits of, 85-86. 144 chan, risk returns, 125 ETFs in, 15, 130-31 examples of, 85, 125--26, 130,180 how to choose, 124 risk and return summary, 179-80 Slandard d~ations in, 67-68,85, 126,138 Jensen, 153 Jog.

Randolph, 162 house funds, 77- 78, 163 Hyperactive Investors about Hyperactive Investors, 19- 20,25,30-33,75 as percentage of all investors, 29 reliance on financial media, 96 See also financial media; psychology of investing Hyperactive Managers about managers, 5 disadvantages of, 9 how to manage, 136-38 myths of, 9 research on, 150 use of fund rating systems, 55-56, 158-59 See also actively managed funds; securities industry Ibbotson, Roger G., 108 Ilkiw, John, 139 income trusts, 134--35, 169 index funds about index funds, 8 benchmark indexes and, 23-24 benefits of, 6, 150 costs and fees, 129, 147 DFA index funds, 112-14, 168 famous investors in, 107-9 four types of, 19 institutional investors in, 89, 105-7, 114, 168 list of Canadian index funds, 112, 167 market returns and, 12, 18 market segment funds, 113-14 regulations on buying U.S. funds, 89 research on, 147, 151, 168 See also ETFs (exchange traded funds) Index Funds, Advisors, 147, 182 Index Funds: The 12-Step Program for Active Investors (Hebner), 148, 150, 151, 182 Index Mutual Funds (Simon), 148 indexes, benchmark, 23-24 See also S&P Composite Index (U.S.); S&P/TSX Composite Index initial public offering (IPOs), prospectus for, 60 insurance companies.


pages: 194 words: 59,336

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

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

In the case of Vanguard, the funds held are all low-cost index funds. As you know by now, that’s a very good thing. The TRFs ranging from 2020 to 2060 each hold only four funds: Total Stock Market Index Fund Total Bond Market Index Fund Total International Stock Market Index Fund Total International Bond Market Index Fund To those four funds the TR 2010, 2015 and 2020 funds add: Short-Term Inflation-Protected Securities Index Fund As the years roll by and the retirement date chosen approaches, the funds will automatically adjust the balance held, becoming steadily more conservative and less volatile over time. You needn’t do a thing. The expense ratios range from .14% to .16%, depending on the fund. Not quite as low as a basic index fund like VTSAX (.05%), but very good considering the extra simplicity these offer.

So without Vanguard in your plan, the question becomes how to select the best option, which by now you know is a low-cost total stock and/or bond index fund. The good news is that—due to the competitive pressure from Vanguard—nearly every other major mutual fund company now offers low-cost index funds. Just like the variations you can find in Vanguard of VTSAX, you can in all probability find a reasonable alternative in your 401(k). Here’s what you are looking for: A low-cost index fund. For tax-advantaged funds you’ll be holding for decades, I slightly prefer a total stock market index fund but an S&P 500 index fund is just fine. You can also look for a total bond market index fund if your needs or preferences call for it. Most plans will also offer these. TRFs (Target Retirement Funds) are frequently offered in 401(k) plans and these can be an excellent choice.

To ignore inflation (too unpredictable), taxes (too variable between individuals) and fees (also variable and if you choose the index funds I recommend, minimal). If you want to see what the numbers look like including any of these variables, I encourage you to visit the calculators and run the numbers with your own specifications. Most often in running these scenarios, the period of time I’ve chosen has been January 1975 - January 2015, for these reasons: It is a nice, solid 40-year period and this book advocates investing for the long term. 1975 is the year Jack Bogle launched the world’s first index fund and this book advocates investing in index funds. 1975 happens to be the year I started investing, not that this matters to you. As it happens, from January 1975 - January 2015, using the parameters I chose above, the market returned an average of 11.9% per year.

All About Asset Allocation, Second Edition by Richard Ferri

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activist fund / activist shareholder / activist investor, asset allocation, asset-backed security, barriers to entry, Bernie Madoff, capital controls, commoditize, 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, intangible asset, Long Term Capital Management, Mason jar, money market fund, mortgage tax deduction, passive income, pattern recognition, random walk, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, selection bias, Sharpe ratio, survivorship bias, too big to fail, transaction costs, Vanguard fund, yield curve

Figure 15-1 compares the fee savings and five-year annualized return advantage of several Vanguard index funds compared to their representative Morningstar category averages. The average fee for the Vanguard index funds was 0.2 percent, and the average fee for the categories ranged between 1.0 and 1.4 percent. In every category, the no-load index funds saved a considerable amount in fees over the category average, and this led to higher returns for index funds in every category. Index funds have no sales commissions. However, many funds in the categories listed do charge a sales commission. In Figure 15-1 commissions have not been deducted, from the five-year average. Index fund returns would have faired even better had the commissions been included in the analysis. CHAPTER 15 304 FIGURE 15-1 Index Fund Fee Savings and Return Advantage Vanguard index fund fee savings over category average fee Vanguard index fund five-year return advantage over category advantage return 1.7% 1.4% 1.3% 1.2% 1.2% Foreign stock REIT funds 1.1% 0.9% 0.9% 0.8% 0.5% Bond funds U.S. total market U.S. small cap Source: Morningstar Principia, January 2010 It is clear to even the most casual observer that low-cost stock and bond index funds have a significant advantage over other funds that charge average fees.

Accordingly, market-matching index funds and ETFs are a logical investment choice for people who want to make the most of asset allocation analysis. Any deviation from index funds adds an element of risk that was not captured in the asset allocation analysis. Fees Matter in Asset Allocation Planning 313 2. Low expense ratios. In general, stock and bond index funds and ETFs have the lowest investment fees in the industry. The lowest-cost index funds and ETFs charge about 0.1 percent per year, which is well below the industry average of 1.4 percent. One word of caution: Not all index funds have low fees. Some investment companies charge over 1.0 percent to invest in exactly the same indexes as very low-cost funds. Let the buyer beware. 3. Low tax liability. Index funds generally have very low turnover of securities compared to actively managed funds.

A list is given in Appendix A. In addition, read All About Index Funds, 2nd edition, by Richard A. Ferri (McGraw-Hill, 2007) and The ETF Book, 2nd edition, by Richard Ferri (John Wiley, 2009). CHAPTER SUMMARY The cornerstone of any equity portfolio is a broadly diversified U.S. stock market index fund. There are several different total U.S. stock market indexes and index fund providers. The most complete U.S. stock market index is the Wilshire 5000 Composite Index. Other broad market indexes include MSCI, Russell, Morningstar, and Standard & Poor’s. Most of these indexes are tracked by a low-cost index fund or ETF. Microcap stocks represent only 3 percent of the total U.S. stock market and can add diversification to a broad market index fund. One problem with microcap stocks is finding a fund that gives you exposure to this niche market.


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, money market fund, passive investing, Paul Samuelson, pez dispenser, price mechanism, profit maximization, profit motive, risk tolerance, risk-adjusted returns, Robert Shiller, Robert Shiller, shareholder value, Silicon Valley, Steve Ballmer, survivorship bias, technology bubble, the market place, transaction costs, Vanguard fund, yield curve, zero-sum game

Trading small-capitalization portfolios involves a significant level of costs. Index funds provide the exception to the mutual-fund rule of ridiculously high portfolio turnover and incredibly burdensome transactions costs. In 2002, index fund portfolio turnover amounted to a modest 7.7 percent, causing commissions to consume a mere 0.007 percent of assets. Ironically, index fund portfolio managers operate in an extremely tough trading environment. The transparency of index fund trades required for full replication and the promptness of execution demanded to match index characteristics combine to increase costs of market impact for index funds. Because market makers see the index portfolio transactions coming, Wall Street stands ready to take more than a fair share of the trade. In spite of the adverse market environment for index fund trading, low turnover causes overall index fund trading costs to remain small.

Morgan Stanley’s indefensible fee structure causes the firm’s S&P 500 Index Funds to fall far short of the index return. Over the five-year period, Class A shares posted an annual deficit of 0.74 percent relative to shortfalls of 1.50 percent for Class B shares and 1.49 percent for Class C shares. In contrast, Vanguard’s cost-efficient, shareholder-friendly management provided investors with a return of only 0.09 percent less than the index result. Comparing Morgan Stanley’s S&P 500 Index Fund results to other index-fund returns only adds to the firm’s shame. Consider the equal-weighted index of thirty leading index funds constructed by mutual-fund data provider Lipper, a Reuters company. By virtue of size, Morgan Stanley Class B shares, the poorest performing of the firm’s three share classes, earn a spot on the roster of Lipper’s index-fund team. With five-year results that fall 1.16 percent per year short of Lipper’s average, Morgan Stanley Class B shares reside decidedly in the fourth quartile.

In sharp contrast, Vanguard set the standard for the Lipper group, beating the average by 0.25 percent per year and generating returns that no other index manager came close to matching.18 Part of Morgan Stanley’s index-fund shortfall stems from the inferior nature of the product. The October 30, 2002, Morgan Stanley S&P 500 Index Fund prospectus noted that “the Fund’s portfolio is managed by the Core Growth Team.”19 In spite of paying ridiculous fees, for the first six years of the fund’s existence, Morgan Stanley clients failed to get a dedicated index-fund management team. In an optimistic development, the September 30, 2003, supplement to the prospectus announced that “the Fund is managed within the Index Team,” mitigating one of the many indignities inflicted on Morgan Stanley Index Fund shareholders.20 Of course, a green index team at Morgan Stanley managing a subscale portfolio poses no competition to the time-tested index-fund managers at Vanguard. Suppose a client wishes to invest in Morgan Stanley’s index funds, in spite of the long list of reasons to avoid the firm’s offerings.


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, money market fund, passive investing, Paul Samuelson, random walk, risk tolerance, risk/return, Sharpe ratio, statistical model, survivorship bias, the rule of 72, transaction costs, Vanguard fund, yield curve, zero-sum game

Here is the crux of the strategy: Instead of hiring an expert, or spending a lot of time trying to decide which stocks or actively managed funds are likely to be top performers, just invest in index funds and forget about it! As we discussed in Chapter 4, an index fund attempts to match the return of the segment of the market it seeks to replicate, minus a very small management fee. For example, Vanguard's Index 500 seeks to replicate the return of the S&P 500; the Total Stock Market Index seeks to replicate the return of a broad U.S. stock market index; and Total International Index seeks to replicate the return of a broad cross-section of international stocks. In addition to stock index funds, there are bond index funds that seek to replicate the performance of various bond indexes. There are also index funds of funds that hold various combinations of stock and bond index funds. WHY INDEXING IS SO EFFECTIVE Index funds outperform approximately 80 percent of all actively managed funds over long periods of time.

Paul Farrell, columnist for CBS Marketwatch and author of The Lazy Person's Guide to Investing: "So much attention is paid to which funds are at the head of the pack today that most people lose sight of the fact that, over longer time periods, index funds beat the vast majority of their actively managed peers." Richard Ferri, author of Protecting Your Wealth in Good Times and Bad: "When you are finished choosing a bond index fund, a total U.S. stock market index fund, and a broad international index fund, you will have a very simple, yet complete portfolio." Walter R. Good and Roy W. Hermansen, authors of Index Your Way to Investment Success: "Index funds save on management and marketing expenses, reduce transaction costs, defer capital gain, and control risk-and in the process, beat the vast majority of actively managed mutual funds!" Arthur Levitt, former chairman of the Securities Exchange Commission and author of Take on the Street: "The fund industry's dirty little secret: Most actively managed funds never do as well as their benchmark."

Jason Zweig, senior writer and columnist at Money magazine and coauthor of the revised edition of Benjamin Graham's classic, The Intelligent Investor: "If you buy-and then hold-a total stock market index fund, it is mathematically certain that you will outperform the vast majority of all other investors in the long run. Graham praised index funds as the best choice for individual investors, as does Warren Buffett." The next time some investment salesperson tells you, "It's a stock picker's market," or they tell you index funds are just going to earn mediocre returns, you may want to show the salesperson this list of quotes from noted authorities on investing. And if the salesperson counters by telling you that those people don't know the real truth about investing, you may find it useful to quote the words of Jack Nicholson in the movie, A Few Good Men: "You want the truth? YOU CAN'T HANDLE THE TRUTH!" HOW TO BUY INDEX FUNDS Not all index funds are created equal. There are a number of fund companies that sell index funds. Not surprisingly, many of them will also charge you a healthy sales commission and a high yearly management fee.

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, commoditize, computer age, correlation coefficient, diversification, diversified portfolio, Eugene Fama: efficient market hypothesis, fixed income, index arbitrage, index fund, intangible asset, Long Term Capital Management, p-value, passive investing, prediction markets, random walk, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, South Sea Bubble, survivorship bias, the rule of 72, the scientific method, time value of money, transaction costs, Vanguard fund, Yogi Berra, zero-coupon bond

Using the above principles, the investor has decided on the following policy allocation: 15% U.S. large market 10% U.S. large value 5% U.S. small market 10% U.S. small value 5% European 5% Pacific 5% Emerging markets 5% REITs 20% Municipal bonds 20% Short-term corporate bonds 154 The Intelligent Asset Allocator Using Table 8-2 for the stock funds, he decides to use the following Vanguard funds and place them in the appropriate taxable or taxsheltered account: Taxable Account 15% Total Stock Market Index Fund 5% Tax-Managed Small-Cap Index Fund 5% European Stock Index Fund 5% Pacific Stock Index Fund 20% Limited-Term Tax-Exempt Fund IRA Account 10% Value Index Fund 10% Small-Cap Value Index Fund 5% Emerging Markets Stock Index Fund 5% REIT Index Fund 20% Short-Term Corporate Fund Notice how the investor has segregated the most tax-efficient assets into the taxable account, and the least tax-efficient assets into the IRA. Executing the Plan From a purely financial point of view, it is usually better to put your money to work right away.

For example, for the three-year period from 1992 to 1994, small stocks outperformed large stocks by 7.59% annually, and the Vanguard 500 Index Fund ranked in only the 46th percentile of its category, while the DFA 9-10 Small Company ranked in the 13th percentile of its category. Dunn’s Law There is in fact a relationship between asset-class performance and index-fund performance, known as Dunn’s law (after Steve Dunn, a friend with an astute eye for asset classes): “When an asset class does relatively well, an index fund in that class does even better.” 100 The Intelligent Asset Allocator The mechanism behind this is relatively straightforward. Let’s again take the performance of the DFA 9–10 Small Company Index Fund and the Vanguard 500 Index Fund as examples. An index fund takes the full brunt of an asset class’s excellent or poor performance relative to other asset classes.

But over many years, it takes a toll, as the SD of 25-year returns is only 1.6% (see Math Details). For large-cap funds, this means that the index-fund advantage, which has about the same 1.6% value, will result in a ⫹1 SD performance. Meaning that the index fund should beat 84% of actively managed funds. A small or foreign index fund with a 3.2% advantage should perform 2 SDs above the norm, meaning that it should beat 97% of active funds over a 25-year period. And an emerging-markets index fund with a several-percentage-point advantage should best all of its actively managed peers. Market Efficiency 97 Unfortunately, the real world is not nearly this neat, and it is worth looking at the actual data. We shall compare index-fund and activefund performance with the Morningstar Principia database. This nifty tool is worth some discussion.


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, money market fund, mortgage debt, mortgage tax deduction, prediction markets, random walk, risk tolerance, Robert Shiller, Robert Shiller, shareholder value, Silicon Valley, survivorship bias, the rule of 72, Vanguard fund

Just as the stock market may fall 10 percent one year and gain 18 percent the next year, index funds will rise and fall with the indexes they track. The big difference is in fees: Index funds have lower fees than mutual funds because there’s no expensive staff to pay. Vanguard’s S&P 500 index fund, for example, has an expense ratio of 0.18 percent. Remember, there are all kinds of index funds. International index funds are relatively volatile since they follow indexes that were just recently established. General U.S.-based index funds, on the other hand, are more reliable. Since they match the U.S. stock market, if the market goes down, index funds will also go down. During the financial crisis, many index funds plummeted as they matched the market, which underwent a global drop. But over the long term, the overall stock market has consistently returned about 8 percent. Let’s look at the performance from two sides: the downside (fees) and the upside (returns).

In short, mutual funds are prevalent because of their convenience, but because actively managed mutual funds are, by definition, expensive, they’re not the best investment any more. Active management can’t compete with passive management, which takes us to index funds, the more attractive cousin of mutual funds. Index Funds: The Attractive Cousin in an Otherwise Unattractive Family In 1975, John Bogle, the founder of Vanguard, introduced the world’s first index fund. These simple funds use computers to buy stocks and match the market (such as the S&P 500 or NASDAQ). Instead of having a mutual fund’s expensive staff of “experts” who try to beat the market, index funds set a lower bar: A computer matches the indexes by automatically matching the makeup of the market. For example, if a stock represents 2 percent of the S&P 500, it will represent 2 percent of the index fund. Index funds are the financial equivalent of “If you can’t beat ’em, join ’em.” And they do so while also being low cost and tax efficient, and requiring hardly any maintenance at all.

Ironically, this results in lots of taxes and trading fees, which, when combined with the expense ratio, makes it virtually impossible for the average fund investor to beat—or even match—the market over time. Bogle opted to discard the old model of mutual funds and introduce index funds. Today, index funds are an easy, efficient way to make a significant amount of money. Note, however, that index funds simply match the market. If you own all equities in your twenties (like me) and the stock market drops (like it has), your investments will drop (like mine, and everyone else’s, did). Index funds reflect the market, which is going through tough times but, as history has shown, will climb back up. As a bonus for using index funds, you’ll anger your friends in finance because you’ll be throwing up your middle finger to their entire industry—and you’ll keep their fees for yourself. Wall Street is terrified of index funds and tries to keep them under wraps with increased marketing of mutual funds and nonsense like “5-Star Funds” and TV shows that highlight action, not results.


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, George Santayana, 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, money market fund, mortgage debt, new economy, pattern recognition, Paul Samuelson, quantitative easing, railway mania, random walk, Richard Thaler, risk tolerance, risk/return, Robert Shiller, Robert Shiller, South Sea Bubble, survivorship bias, The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, the rule of 72, transaction costs, Vanguard fund, yield curve, zero-sum game

But as Vanguard’s reputation, shareholder satisfaction ratings, and, most importantly, assets under management grew, it could no longer be ignored. By 1991, Fidelity threw in the towel and started its own low-cost index funds, as did Charles Schwab. As of this writing, there are now more than 300 index funds to choose from, not counting the newer “exchange-traded” index funds, which we’ll discuss shortly. Of course, not all of the companies offering the new index funds are suffused with Bogle’s sense of mission—fully 20% of index funds carry a sales load of up to 6%, and another 30% carry a 12b-1 annual fee of up to 1% per year for marketing. The most notorious of these is the American Skandia ASAF Bernstein (no relation!) series, which carries both a 6% sales fee and a 1% annual 12b-1 fee. Paying these sorts of expenses to own an index fund boggles the mind and speaks to the moral turpitude of much of the industry. There are other fund companies besides Vanguard well worth dealing with.

The smallest, American Greetings, has a market cap of $700 million, or 0.007% of the index—six hundred times smaller than GE. So an index fund which tracks the S&P 500 would have to own 600 times as much GE as American Greetings. What happens if GE plunges in value and American Greetings zooms? Nothing. Since an index fund simply holds each company in proportion to its market cap, the amount of each owned by an S&P 500 index fund adjusts automatically with its market cap. In other words, an index fund does not have to buy or sell stock with changes in value (unlike Wells Fargo’s ill-fated first index fund, which had to hold equal-dollar amounts of all 1,500 stocks on the New York Stock Exchange). This raises some important semantic points. When most investors say the words “index fund,” they are almost always referring to an S&P 500 fund. But the U.S. market consists of more than 7,000 publicly traded companies.

Steel, 147, 160 USA Today, 219, 220 Value averaging, 283–285 Value Line, 90 Value Line Fund, 90 Value stocks (“bad” companies) asset allocation, 120-122, 172, 248–255, 251–253 Graham on, 158 in portfolio building, 109, 120–122, 172 In Search of Excellence (Peters) on, 64 real returns on, 68, 69, 72 rebalancing, 289–290 returns on, 34-38 tax efficiency of, 263–264 Vanguard 500 Index Fund, 97, 98, 102–104, 215, 216 Vanguard GNMA Fund, 215-216 Vanguard Growth Index Fund, 249 Vanguard Limited Term Tax Exempt Fund, 261 Vanguard mutual funds fee structure, 210, 250, foreign indexed funds, 119 founding by Bogle, 213-214 as no-load company, 205 Vanguard Short-Term Corporate Fund, 261 Vanguard Small-Cap Index Fund, 99 Vanguard Tax-Managed Small-Cap Index Fund, 99 Vanguard Total International Fund, 255, 256 Vanguard Total Stock Market Fund, 104, 246 Vanguard Value Index Fund, 249-250 Variable annuity fund, 204 Variety, 145 Venetian prestiti, 10–13 Vertin, James, 96–97 Victoria, Queen of England, 143 Von Böhm-Bawerk, Eugen, 8 Wal-Mart, 34–35, 185 The Wall Street Journal, 85, 96, 98, 167, 211, 219, 222, 225 Wall Street Week (television program), 224 Walz, Daniel T., 231 Wellington Management Company, 213–214 Wells Fargo, first index fund, 96–97, 215, 245 Westinghouse, 133 Wheeler, Dan, 123 Where are the Customers’ Yachts?


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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3Com Palm IPO, accounting loophole / creative accounting, Albert Einstein, asset allocation, asset-backed security, backtesting, beat the dealer, Bernie Madoff, BRICs, capital asset pricing model, compound rate of return, correlation coefficient, Credit Default Swap, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, Edward Thorp, 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, money market fund, mortgage tax deduction, new economy, Own Your Own Home, passive investing, Paul Samuelson, 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, survivorship bias, The Myth of the Rational Market, the rule of 72, The Wisdom of Crowds, transaction costs, Vanguard fund, zero-coupon bond

Yes, there are exceptions. But you can count on the fingers of your hands the number of mutual funds that have beaten index funds by any significant margin. The Index-Fund Solution: A Summary Let’s now summarize the advantages of using index funds as your primary investment vehicle. Index funds have regularly produced rates of return exceeding those of active managers. There are two fundamental reasons for this excess performance: management fees and trading costs. Public index funds are run at a fee of less than 1/10 of 1 percent. Actively managed public mutual funds charge annual management expenses that average one percentage point per year. Moreover, index funds trade only when necessary, whereas active funds typically have a turnover rate close to 100 percent. Using very modest estimates of trading costs, such turnover is undoubtedly an additional drag on performance.

Those who need a steady income for living expenses could increase their holdings of real estate equities, because they provide somewhat larger current income. A SPECIFIC INDEX-FUND PORTFOLIO FOR AGING BABY BOOMERS Cash (5%)* Fidelity Money Market Fund (FORXX), or Vanguard Prime Money Market Fund (VMMXX) Bonds (27½%)† Vanguard Total Bond Market Index Fund (VBMFX) Real Estate Equities (12½%) Vanguard REIT Index Fund (VGSIX) Stocks (55%) U.S. Stocks (27%) Fidelity Spartan (FSTMX), T. Rowe Price (POMIX), or Vanguard (VTSMX) Total Stock Market Index Fund Developed International Markets (14%) Fidelity Spartan (VSIIX), or Vanguard (VDMIX) International Index Fund Emerging International Markets (14%) Vanguard Emerging Markets Index Fund (VEIEX) Remember also that I am assuming here that you hold most, if not all, of your securities in tax-advantaged retirement plans.

Unfortunately, active managers as a group cannot be like the radio personality Garrison Keillor’s fictional hometown of Lake Wobegon, where “all the children are above average.” Index funds are also tax-friendly. Index funds allow investors to defer the realization of capital gains or avoid them completely if the shares are later bequeathed. To the extent that the long-run uptrend in stock prices continues, switching from security to security involves realizing capital gains that are subject to tax. Taxes are a crucially important financial consideration because the earlier realization of capital gains will substantially reduce net returns. Index funds do not trade from security to security and, thus, tend to avoid capital gains taxes. Index funds are also relatively predictable. When you buy an actively managed fund, you can never be sure how it will do relative to its peers. When you buy an index fund, you can be reasonably certain that it will track its index and that it is likely to beat the average manager handily.


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, intangible asset, invisible hand, Kenneth Rogoff, market bubble, money market fund, passive investing, pattern recognition, prediction markets, risk tolerance, risk/return, Robert Shiller, Robert Shiller, selection bias, sovereign wealth fund, too big to fail, transaction costs, Vanguard fund, yield curve, zero-coupon bond

That said, from my perspective the decision between physical and synthetic ETFs is less important than selecting the right ETF on the basis of tax considerations, liquidity or cost. Index-tracking funds The index funds work like a regular mutual fund or unit trust, even the terminology and exact fund structure vary slightly between jurisdictions (in the UK, for example, they are often called unit trusts or OEICs – open-ended investment companies). In the case of the index funds, the simplest way to think about these is that you give them £1,000 to invest and they then take that £1,000 and buy the underlying securities that make up the index exposure. If you want to redeem or sell your index investment that same index fund will then sell shares in proportion to your index investment and give you back the proceeds from those sales. The index fund sector is more local. Unlike the ETFs that you can buy from any location in the world, like you would a stock, index-tracking funds are typically local financial institutions and the major player in the US is thus not the same as that in Germany, the UK or elsewhere.

As new products come to market there is a risk that the information outlined here grows stale quickly and I would strongly encourage the reader to survey the market for new and better products before making investments. With the large growth of index funds and exchange traded funds (ETF) investing over the past decades, the abundance of different product offerings leave even professional investors confused; it’s no wonder that many investors say ‘forget it’ and revert to doing what they have always done. The two main ways to gain index-type exposure is through ETFs and index funds (this term covers a few different structures). The main difference between the two is that an ETF is traded like any stock while index funds are more akin to mutual funds or unit trusts in their structures. If you can find a product provided by Vanguard, iShares, State Street or one of their major competitors that meets your needs from an exposure and tax perspective, this is probably a very good way to gain your exposure.

Have patience and keep trying – it’s worth your while. Failing that you can always revert to browsing through the ETF or index fund providers listed earlier. While many other product providers try to compete with them there is a reason that those listed are among the market leaders. Some index fund providers charge a small trading fee to get into the fund, just like they do if you redeem from the fund. This charge just reflects the cost to the fund of investing your money in the underlying securities. If there were no charges and you were a long-term holder of the fund (like you hopefully will be) you would instead indirectly be paying the trading fees as other investors come in and out of the fund. While entry/exit fees are explicit in index funds, in ETFs those charges are implicit in the bid/offer spread, or in some cases if the ETFs trade at a premium or discount to the net asset value.


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

Although this 1.75% difference in costs between actively and passively managed mutual funds may not seem like much, there's a growing body of research that says it makes a huge difference in long-term investment results. Other advantages of index funds include diversification (see Mutual Funds) and tax efficiency. And because index funds have a low turnover rate—as described on Mutual Funds—they don't generate as much tax liability. Note Exchange-traded funds (or ETFs) are basically index funds that you can buy and sell like stocks (instead of going through a mutual fund company). To learn more about the subtle differences between index funds and ETFs, head to http://tinyurl.com/YH-etfs. In Unconventional Success: A Fundamental Approach to Personal Investment (Free Press, 2005), David Swensen writes, "Fully 95% of active investors lose to the passive alternative, dropping 3.8% per annum to the Vanguard 500 Index Fund results." In other words, people who own index funds have typically earned almost 4% more each year than those who own actively managed funds.

Stick with the basics you learned in this chapter: Start with an index-fund portfolio. Do your research (you can find a list of recommended reading on this book's Missing CD page at www.missingmanuals.com). As you have the time and education, make adjustments that fit your style and view of the market. Move slowly. Ignore the Wall Street hype machine. Use common sense and don't take unnecessary risks. For 99% of folks reading this book, systematic investments in index funds are the way to go. Though I've pitched index funds as a great place to start, they're also a great place to finish. Many smart investors make index funds the core of their portfolios and never worry about anything else. In other words, they're not a dumbed-down investment that you have to abandon for something more complicated—you can stick with index funds for the rest of your life and still get great returns.

Some succeed and some don't, but as a whole, all actively managed funds earn the market average. Passively managed funds (called index funds), on the other hand, try to match the performance of a specific benchmark, like the Dow Jones Industrial Average or S&P 500 stock-market indexes. As you'll learn in the next section, this makes them a great long-term investment. Index funds Because index funds try to match an index and not beat it, they don't require much intervention from the fund manager, which makes their costs much lower than those of actively managed funds. In The Little Book of Common Sense Investing (Wiley, 2007), John Bogle writes that the average actively managed fund has a total of about 2% in annual costs, whereas a typical passive index fund's costs are only about 0.25%. Although this 1.75% difference in costs between actively and passively managed mutual funds may not seem like much, there's a growing body of research that says it makes a huge difference in long-term investment results.

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

It can be overpowering picking funds with all the technical finance industry jargon, discussions of futures and options, or how foreign markets are performing. Enter the magic of index funds. Index funds buy stocks that represent a whole market or industry, and get rebalanced to keep it representative of the market each year. As the market grows, so does the value of your investments. Instead of having to beat the market, you'll become one with it and benefit from all the hard work of the fund's companies' employees. Index funds also have the benefit of low expenses ratios. An expense ratio is the cut of money that a broker gets for letting you invest money with them, regardless of how well the fund performs. A typical actively managed fund expense ratio is around .71%, which doesn't seem like much, but when you have $600,000 in a fund, this equals $4,440 a year! This is compared to index fund ratios of .25% to as low as .06%. Numerous studies found over a period from 1997 to 2014 index funds outperformed actively managed funds 82-90% of the time!

Numerous studies found over a period from 1997 to 2014 index funds outperformed actively managed funds 82-90% of the time! What's worse is that these managers charge you for their underperformance through a higher expense ratio! It makes little sense to pay someone for doing a worse job that someone that could do it for pennies on the dollar. This might fly in the face of the popular trends in investing or be missing the excitement of having a portfolio manager decide where your money goes. It's definitely exciting to say you have a stock manager giving you advice on money, but what's even more exciting is making plenty of money without the help of someone else. Studies examined how effective different investing techniques are, ranging from day trading to index funds. In most cases, index funds outperformed a majority of actively managed funds, but there are some benefits to actively managed funds.

In most cases, index funds outperformed a majority of actively managed funds, but there are some benefits to actively managed funds. Ultimately, the best choice for the average investor, who already works a full time job and has other responsibilities, is a passively managed, broadly invested index funds. While looking for the ideal index fund, most people want to go about it with a "set it and forget it" mindset. Total market index funds give us this by buying stocks of 500 to 5000 companies, depending on the fund you choose. By buying so many companies, a fund is essentially mirroring how the economy does and the market has historically grown about 9.6% a year. Keep in mind that this is only what the market has done in the past, not what it will be doing in the future. Keep in mind, these are only investing best practices, not financial recommendations backed up by any professional certification.


pages: 44 words: 13,346

Extreme Early Retirement: An Introduction and Guide to Financial Independence (Retirement Books) by Clayton Geoffreys

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asset allocation, dividend-yielding stocks, financial independence, index fund, passive income, risk tolerance

Be sure to keep an eye out for index funds that are too high in cost because they do not give any meaningful return and should be avoided. Instead, keep your focus on low cost index funds as they make it easier to replicate a market rather than trying to shoot past the charts and fail in the long run. One might argue that you cannot really get high returns by simply investing on an index fund, and while that may be true for the most part, you are still getting a significant amount of return nevertheless. Whatever works will continue to work, and if it is not broken, there is no need to fix it; this can serve as a secondary concept for index funds. Of course there are still risks involved, but these risks are easily calculated and allow you to invest on index funds with minimal effort. Index fund investing is so cost-efficient that it leaves more room for your funds to grow and if you are looking for a strategy for your extreme early retirement endeavors, you are already bringing your foot one step further by investing.

Another thing is to keep your costs at a low level because there is absolutely no reason for you to be investing at a high cost when you can comparatively invest elsewhere at a much lower cost. At this point, one might ask why he or she should try out index fund investing or why is it such a good strategy. Well, there are different reasons as to why you should begin investing, but one of the key designs of an index fund is that it replicates the market trend, and if the market is at an all-time high, what better way to earn returns than with index funds? With index funds, you also know exactly what it is you are investing into, unlike actively-managed funds where the portfolio manager might begin investing into certain stocks and at some point engage in another type of investment, hence, affecting your asset allocation.

Just remember, if you are engaged with actively-managed funds and you decide to invest in other things or sell a few of your investments due to your asset allocation being thrown off course, you will incur taxes and trading fees. On the other hand, index funds provide great consistency and you save more money, allowing room for further investments. Diversification is another reason why you should get started in index investing because the concept is relatively easy to grasp. Think about your stocks, if you own an index fund in that type of investment, then you have already diversified as that index fund replicates the entire stock market. The same thing can be said with your bonds and real estate. Additionally, if you are engaged in these three types of investments (stocks bonds and real estate), you have already created diversity across the markets. Be sure to keep an eye out for index funds that are too high in cost because they do not give any meaningful return and should be avoided.

Investment: A History by Norton Reamer, Jesse Downing

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activist fund / activist shareholder / activist investor, Albert Einstein, algorithmic trading, asset allocation, backtesting, banking crisis, Berlin Wall, Bernie Madoff, break the buck, 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, information asymmetry, 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, money market fund, moral hazard, mortgage debt, Myron Scholes, negative equity, Network effects, new economy, Nick Leeson, Own Your Own Home, Paul Samuelson, 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, survivorship bias, 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

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.

The benefit of the latter approach is lower transaction costs, but it comes at the expense of the possibility of additional tracking error.60 The differences between ETFs and index funds are subtle. First, ETFs can be bought and sold throughout the trading day, whereas index funds are purchased or redeemed once per day. Second, index funds are intended to trade at the net asset value of the portfolio’s underlying holdings, whereas ETFs can actually trade at a discount or premium to net asset value. Many ETFs do have mechanisms to prevent very large deviations in price from net asset value, but there is no structural reason that they have to trade at net asset value (as is the case for index funds). Index funds also reinvest dividends immediately whereas ETFs capture cash for distribution at a regular interval (often quarterly). There tend to be some tax advantages for ETFs over index funds because of how the shares trade and are redeemed, but the need to pay the broker and the bid-ask spread tends to result in higher transaction costs for ETFs.

This fund lasted only 7 years, closing in 1993.57 It was not until the early 1990s that Vanguard started to see any meaningful competition. Vanguard had eleven different index funds by the end of 1992. That same year, thirty-five new index funds were formed by competitors, bringing the total number of index mutual funds in the investment market to just under eighty. The universe of product offerings also expanded. In 1993, Vanguard and some of its competitors offered the first bond index funds. With these, investors could get exposure to a wider array of investments than just equities. The bull market of the 1990s spurred continued growth in the industry, and many of the US equity index funds dramatically outperformed actively managed accounts during this time. 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.


pages: 369 words: 128,349

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

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3Com Palm IPO, Andrei Shleifer, asset allocation, capital asset pricing model, correlation coefficient, cross-subsidies, Daniel Kahneman / Amos Tversky, diversified portfolio, endowment effect, fixed income, index arbitrage, index fund, information asymmetry, liberal capitalism, locking in a profit, Long Term Capital Management, loss aversion, margin call, market friction, market microstructure, mental accounting, merger arbitrage, Myron Scholes, new economy, prediction markets, price stability, profit motive, random walk, Richard Thaler, risk-adjusted returns, risk/return, selection bias, Sharpe ratio, short selling, survivorship bias, transaction costs, Vanguard fund

The primary reason for persistence is the focus on tracking error by index fund managers. Index fund managers are evaluated strictly on the size and volatility of the tracking error (difference between the fund’s return and the S&P 500 return) and not on the direction of the tracking error. A manager of a large index fund (more than $1 billion) is not expected to have a tracking error of more than 0.03 percent in a year. If it is more than 0.10 percent, the manager is 173 174 Beyond the Random Walk likely to be fired. Therefore, it is easy to see that the managers are constrained, and must buy (sell) the firm added to (deleted from) the index on the effective date at the close. Arbitrageurs know this. So they buy the stock added to the index before the effective date knowing that they will be able to unload the stock to the index fund managers at a higher price.

If the change in the index takes place immediately, the arbitrageurs will not be able to time their trades to the detriment of index fund managers. The second reason is the way owners of index funds evaluate the index fund managers. The performance of an index fund manager is measured by the tracking error, which forces the managers to trade exactly at the time that changes to the index are implemented. If the managers were free to trade the stocks deleted from or added to the index within a reasonable period around the effective date, they will not be forced to play into the hands of the arbitrageurs, and the investors will actually gain from this limited freedom given to the managers. Trading Around the Effective Date This section expands on the evidence presented above suggesting that a temporary price effect around the effective date is available for trading.

The consensus is that arbitrageurs have started playing the “S&P game” with the preannouncements, as explained in the section titled “Persistence.” With additions, arbitrageurs or market participants know that the index fund managers must buy the stock at the close of the effective date. Therefore, the arbitrageurs buy the stock be- Changes to the S&P 500 Index fore the effective date in the hope of unloading it to the index fund managers at a higher price on the effective date. For deletions, it is exactly the opposite. A question that arises is why index fund managers don’t buy immediately upon announcement instead of waiting till the effective date. The index fund managers must wait because their objective is not to beat the index but to minimize tracking error. To minimize tracking error, they must buy the added stock at the time and at the price that Standard and Poor’s adds it to the index, neither before nor after.


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, creative destruction, 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, fixed income, Gordon Gekko, implied volatility, index arbitrage, index fund, information retrieval, intangible asset, Internet Archive, John Nash: game theory, Kenneth Arrow, 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, Metcalfe’s law, moral hazard, mutually assured destruction, Myron Scholes, natural language processing, negative equity, 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, Robert Metcalfe, Ronald Reagan, Rubik’s Cube, 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, your tax dollars at work

Even so, there are economies of scale to be had in managing large index funds. This is reflected by the current business situation in which there are a small number of large index fund providers around the world, such as State Street and Barclays Global Investments. Estimates of total assets managed using this sort of passive approach, in a variety of markets, now exceed $4 trillion. 112 Nerds on Wall Str eet Imagine 500 stocks in this box, one for each company in the S&P 500 index. Figure 5.1 Full Replication Index Fund. All the stocks, all the time. Setting aside considerations of trading costs for now, the idea of an index fund is a very simple one. Nevertheless, it is a quantitative concept, and running an index fund requires the use of a computer. The most straightforward way to manage an index fund is simply to hold all of the stocks in the index: every single one of them, each in its index weight.

For the most common S&P 500 there are 500 stocks to deal with. For a total market index like the Russell 3000, there are 3,000. For the Wilshire 5000, there are about 6,700. The measure of how well you are doing in an index fund is clearly not alpha; that should be zero. It is tracking error, a measure of the difference between the calculated index and the actual portfolio. An ideal index fund has a tracking error of zero. Real-world index funds have tracking errors around 0.1 percent. If it gets much larger than that, someone is confused. Index Funds: The Godfather of Quantitative Investing Index funds have an interesting history. Prior to the 1960s, most institutional equity portfolios were managed by bank trust departments, and performance reporting was not the refined art that it has become today. A Gentle Intr oduction to Computerized Investing 111 Bill Fouse, one of the founders of the world’s first indexing group at Wells Fargo in the 1970s, tells stories of when performance reporting by a bank trust department consisted of a table listing all stocks held, the acquisition price of each, the current price, and the size of the position.

The idea, the desire, and the means to achieve it all came together in the early 1970s for index funds. But this is a chapter about alpha strategies, the anti-index funds—so why are we talking about them at all? Because they are a starting point for all active quantitative computerized equity strategies. Indexing 101 Calculating an index is fairly simple. Multiply the prices of the stocks in the index by their weights (usually their share of the total capitalization of the index constituents), add them up, and there’s your index. Charles Dow, a journalist, started doing it with a pencil and paper in 1896. You need to make adjustments for mergers, splits, and the like, and can get fancy, including dividends for total return. Running an index fund is less simple. You have to figure out how many of hundreds or thousands of different stocks to buy (or sell) each time cash moves in or out of the portfolio in the form of investments, withdrawals, and dividends.


pages: 670 words: 194,502

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

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3Com Palm IPO, accounting loophole / creative accounting, air freight, Andrei Shleifer, asset allocation, buy low sell high, capital asset pricing model, corporate governance, corporate raider, Daniel Kahneman / Amos Tversky, diversified portfolio, Eugene Fama: efficient market hypothesis, George Santayana, hiring and firing, index fund, intangible asset, Isaac Newton, Long Term Capital Management, market bubble, merger arbitrage, money market fund, 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, survivorship bias, the market place, the rule of 72, transaction costs, tulip mania, VA Linux, Vanguard fund, Y2K, Yogi Berra

First of all, recognize that an index fund—which owns all the stocks in the market, all the time, without any pretense of being able to select the “best” and avoid the “worst”—will beat most funds over the long run. (If your company doesn’t offer a low-cost index fund in your 401(k), organize your coworkers and petition to have one added.) Its rock-bottom overhead—operating expenses of 0.2% annually, and yearly trading costs of just 0.1%—give the index fund an insurmountable advantage. If stocks generate, say, a 7% annualized return over the next 20 years, a low-cost index fund like Vanguard Total Stock Market will return just under 6.7%. (That would turn a $10,000 investment into more than $36,000.) But the average stock fund, with its 1.5% in operating expenses and roughly 2% in trading costs, will be lucky to gain 3.5% annually. (That would turn $10,000 into just under $20,000—or nearly 50% less than the result from the index fund.) Index funds have only one significant flaw: They are boring.

You’ll never be able to boast that you beat the market, because the job of an index fund is to match the market’s return, not to exceed it. Your index-fund manager is not likely to “roll the dice” and gamble that the next great industry will be teleportation, or scratch-’n’-sniff websites, or telepathic weight-loss clinics; the fund will always own every stock, not just one manager’s best guess at the next new thing. But, as the years pass, the cost advantage of indexing will keep accruing relentlessly. Hold an index fund for 20 years or more, adding new money every month, and you are all but certain to outper-forms the vast majority of professional and individual investors alike. Late in his life, Graham praised index funds as the best choice for individual investors, as does Warren Buffett.6 Tilting the Tables When you add up all their handicaps, the wonder is not that so few funds beat the index, but that any do.

Today’s defensive investor can do even better—by buying a total stock-market index fund that holds essentially every stock worth having. A low-cost index fund is the best tool ever created for low-maintenance stock investing—and any effort to improve on it takes more work (and incurs more risk and higher costs) than a truly defensive investor can justify. Researching and selecting your own stocks is not necessary; for most people, it is not even advisable. However, some defensive investors do enjoy the diversion and intellectual challenge of picking individual stocks—and, if you have survived a bear market and still enjoy stock picking, then nothing that Graham or I could say will dissuade you. In that case, instead of making a total stock market index fund your complete portfolio, make it the foundation of your portfolio.

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, Myron Scholes, new economy, oil shock, passive investing, Paul Samuelson, popular capitalism, 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, survivorship bias, technology bubble, The Great Moderation, The Wisdom of Crowds, transaction costs, tulip mania, Vanguard fund

Indexing became so popular that in the first six months of 1999 nearly 70 percent of the money that was invested went into index funds.13 By 2007, all Vanguard 500 Index funds had attracted over $200 billion in assets, but the largest single equity mutual fund is the American Growth Fund with assets of $185 billion.14 One of the attractions of index funds is their extremely low cost. The total annual cost in the Vanguard 500 Index Fund is only 0.18 percent of market value (and as low as 2 basis points for large institutional investors). Because of proprietary trading techniques and interest income from loaning securities, Vanguard S&P 500 Index funds for individual investors have fallen only 9 basis points behind the index over the last 10 years, and its institutional index funds have actually outperformed the index.15 THE PITFALLS OF CAPITALIZATION-WEIGHTED INDEXING Despite their past success, the popularity of indexing, especially those funds linked to the S&P 500 Index, may cause problems for index 12 Five years before the Vanguard 500 Index Fund, Wells Fargo created an equally weighted index fund called “Samsonite,” but its assets remained relatively small. 13 Heather Bell, “Vanguard 500 Turns 25, Legacy in Passive Investing,” Journal of Index Issues, Fourth Quarter 2001, pp. 8–10. 14 Vanguard’s number includes assets of its 500 Index Fund open to both individuals and institutions. 15 The Vanguard Institutional Index Fund Plus shares, with a minimum investment of $200 million, have outperformed the S&P 500 Index by 7 basis points in the 10 years following the fund’s inception on July 7, 1997. 352 PART 5 Building Wealth through Stocks investors in the future.

Thus, the 1990s witnessed an enormous increase in passive investing, the placement of funds whose sole purpose was to match the performance of an index. The oldest and most popular of the index funds is the Vanguard 500 Index Fund.12 The fund, started by visionary John Bogle, raised only $11.4 million when it debuted in 1976, and few thought the concept would survive. But slowly and surely indexing gathered momentum, and the fund’s assets reached $17 billion at the end of 1995. In the latter stages of the 1990s bull market, the popularity of indexing soared. By March 2000, when the S&P 500 Index reached its alltime high, the fund claimed the title of the world’s largest equity fund with assets over $100 billion. Indexing became so popular that in the first six months of 1999 nearly 70 percent of the money that was invested went into index funds.13 By 2007, all Vanguard 500 Index funds had attracted over $200 billion in assets, but the largest single equity mutual fund is the American Growth Fund with assets of $185 billion.14 One of the attractions of index funds is their extremely low cost.

Steel Group, 49 Utilities sector: in GICS, 53 global shares in, 175i, 177 Utility, 322 Valuation, 144–145 value versus growth stocks and, 144–145 Value Line Index, 47n, 256 Value stocks, 362–363 growth stocks versus, 144–145 nature of, 157 Value-weighted indexes, 42–45 (See also Center for Research in Security Prices [CRSP] index; Nasdaq Index; Standard & Poor’s [S&P] index) Valuing Wall Street (Smithers and Wright), 117 Vanguard 500 Index Fund, 263n Vanguard Institutional Index Fund Plus, 351n Vanguard S&P 500 Index funds, 351 Van Strum, Kenneth S., 80n Verizon, 177 Vesting, 106 Viceira, Luis M., 35n Vietnam War, 233 bear market and, 85 Virginia Carolina Chemicals, 60i, 63 Vishny, R., 326n VIX Index, 281–282, 282i, 334 Vodafone, 177 Volatility (see Market volatility) 380 Volcker, Paul, 9, 195 Vuolteenaho, Tuomo, 158n Wachovia Bank, 21n Wages, Nixon’s freezing of, 194 Wall Street Journal, 38, 290 Wal-Mart, 155, 176i, 177 Wang, Jiang, 304n War: market movements and, 225, 231–235 (See also specific wars) War on terrorism, 234 Weber, Steven, 218n Wein, Byron, 86 Index Welch, Ivo, 325n Wells Fargo, 351n Werner, Walter, 12n, 21n Western Co., 63 White, Weld & Co., 97 Williams, Frank J., 319q Williams, John Burr, 101 Wilshire 5000 index, 342 Wisdom Tree Investments, 356 Withers, Hartley, 81 Wm.


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, money market fund, moral hazard, Myron Scholes, 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

In 1999, you had just over one million dollars in the index fund. It’s almost 10 years later and you’ve only gained about $200,000, or 13.72 percent. Looking at your statements, you earned 15.61 percent last year! Your head starts to hurt. Has the market gone nowhere since the beginning of the decade? Little did you know that next year, in 2008, the S&P 500 would plunge 36.58 percent. Out of frustration, you sell all of your shares at the end of the year for just more than $750,000. Looking at your statements from 1997 and 1998, you realize that you had about the same amount of money back then. Where did it all go? Aren’t index funds supposed to be a good investment? index fund A mutual fund that seeks to track the performance of a market index (e.g., S&P 500). Developed in 1973, index funds provide investors a way to trade broad indexes.

Developed in 1973, index funds provide investors a way to trade broad indexes. Professional investors use index funds to capture the performance of a broad market without the cost of buying hundreds of stocks. Charlatans have been known to create mutual funds that try to beat the index, but are in fact simply “closet index funds.” The most popular index funds are Exchange Traded Funds. See Chapter 8. My Dinner with Burton It was November of 2008 and I was invited to a due diligence conference in Boston. For those outside the Wall Street system, this is an event where a company flies you someplace nice and warm to hear them pitch a story under the cover of education. It was winter in Boston—you had to want to go to this one. My main reason for leaving the relatively decent weather in New Mexico was to hear Dr. Burton Malkiel speak. You may not know the name, but this guy is a legend in the business.

If you would have bought the index and held it for the same time period, reinvesting all of the dividends, you only would have earned 1,211.57 percent. Not bad for 13.12 times your original $100 investment. But you only would have ended up with $1,311.57! Table 1.2 Performance 1970–2010 Stock portfolio S&P 500a Average monthly total return 1.13% 0.54% Total return 1970-2010 21,628.91% 1,211.57% Value in 1970 $100.00 $100.00 Value in 2010 $21,728.91 $1,311.57 a S&P 500 is treated as an imaginary no-load index fund priced at the index value. But Wait There’s More! It’s 1990 and your kids are older and grown up. They’re all broke except for your son Cornelius, who wants to start investing like you did back in the day. Disneyland is certainly still around. Coca-Cola is still the preferred drink of the Magic Kingdom. Digital photography has not yet overtaken film. IBM miraculously has survived the death of mainframes and the birth of PCs.


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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activist fund / activist shareholder / activist investor, Albert Einstein, Andrei Shleifer, asset allocation, asset-backed security, bank run, beat the dealer, Benoit Mandelbrot, Black-Scholes formula, Bretton Woods, Brownian motion, capital asset pricing model, card file, Cass Sunstein, collateralized debt obligation, complexity theory, corporate governance, corporate raider, 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, Edward Thorp, endowment effect, Eugene Fama: efficient market hypothesis, experimental economics, financial innovation, Financial Instability Hypothesis, fixed income, floating exchange rates, George Akerlof, Henri Poincaré, Hyman Minsky, implied volatility, impulse control, index arbitrage, index card, index fund, information asymmetry, invisible hand, Isaac Newton, John Meriwether, John Nash: game theory, John von Neumann, joint-stock company, Joseph Schumpeter, Kenneth Arrow, libertarian paternalism, linear programming, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, market bubble, market design, Myron Scholes, New Journalism, Nikolai Kondratiev, Paul Lévy, Paul Samuelson, 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 Bork, 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, Vilfredo Pareto, volatility smile, Yogi Berra

More directly on topic (and on Bogle’s reading list at the time) was a 1974 essay by Paul Samuelson in the Journal of Portfolio Management, a wonky new publication for quantitatively inclined money managers, pension executives, and such.36 Samuelson declared that “most portfolio decision makers should go out of business” and pleaded for someone, anyone, to launch an index fund for small investors.37 A year later came a Financial Analysts Journal article by pension consultant Charley Ellis, titled “The Losers’ Game,” which reiterated a point that Ben Graham had made a decade before—professional investors now were the market, which meant that their performance must on average, after fees, trail the market.38 Bogle got SEC approval for the fund in 1976 but struggled to find a Wall Street firm willing to underwrite its launch. Then the magazine that had gotten him into the mutual fund business, Fortune, came through for him with a lengthy article by a recent graduate of the University of Rochester’s Business School, headlined “Index Funds—An Idea Whose Time Is Coming.”39 After that, the money flowed.40 Now it’s possible that the index fund would have been created even in the absence of these writings and of the efficient market hypothesis that helped inspire them.

The work of ivory tower scholars had launched a new school of investing, one that would survive and flourish in the decades to come. It was one of the great practical triumphs in the history of the social sciences. AFTER THE LAUNCH OF THE Vanguard index fund, Paul Samuelson announced in his Newsweek column that he had celebrated the birth of his first grandson by buying the boy a few shares.41 Ben Graham, just before he died in 1976, offered his own endorsement. In a Q&A with Charley Ellis in the Financial Analysts Journal, Graham defended index funds against their detractors on Wall Street and said that, in some matters, he now considered himself “on the side of the ‘efficient market’ school of thought now generally accepted by the professors.” This utterance has since been portrayed as an admission of defeat on the part of a tired old man, but it wasn’t that at all.42 Graham had been saying similar things for years.

He used mathematical tools that presaged Albert Einstein’s work to describe this randomness. Fischer Black Computer scientist who was introduced to finance working alongside Jack Treynor at the consulting firm Arthur D. Little in the 1960s. Coauthor with Myron Scholes of the Black-Scholes option pricing model, later a partner at Goldman Sachs and an early supporter of behavioral finance research. John Bogle After arguing against unmanaged index funds in 1960, the veteran mutual fund executive launched the first retail index fund at Vanguard in 1976. Warren Buffett Student of value-investing legend Benjamin Graham at Columbia Business School who went on to great success as an investor. Outspoken critic of the efficient market hypothesis and the academic approach to finance. Alfred Cowles III Chicago Tribune heir who, while convalescing from tuberculosis in Colorado in the 1920s, decided to research the effectiveness of various stock market forecasters.


Adaptive Markets: Financial Evolution at the Speed of Thought by Andrew W. Lo

Albert Einstein, Alfred Russel Wallace, algorithmic trading, Andrei Shleifer, Arthur Eddington, Asian financial crisis, asset allocation, asset-backed security, backtesting, bank run, barriers to entry, Berlin Wall, Bernie Madoff, bitcoin, Bonfire of the Vanities, bonus culture, break the buck, Brownian motion, business process, butterfly effect, capital asset pricing model, Captain Sullenberger Hudson, Carmen Reinhart, Chance favours the prepared mind, collapse of Lehman Brothers, collateralized debt obligation, commoditize, computerized trading, corporate governance, creative destruction, Credit Default Swap, credit default swaps / collateralized debt obligations, cryptocurrency, Daniel Kahneman / Amos Tversky, delayed gratification, Diane Coyle, diversification, diversified portfolio, double helix, easy for humans, difficult for computers, Ernest Rutherford, Eugene Fama: efficient market hypothesis, experimental economics, experimental subject, Fall of the Berlin Wall, financial deregulation, financial innovation, financial intermediation, fixed income, Flash crash, Fractional reserve banking, framing effect, Gordon Gekko, greed is good, Hans Rosling, Henri Poincaré, high net worth, housing crisis, incomplete markets, index fund, interest rate derivative, invention of the telegraph, Isaac Newton, James Watt: steam engine, job satisfaction, John Maynard Keynes: Economic Possibilities for our Grandchildren, John Meriwether, Joseph Schumpeter, Kenneth Rogoff, London Interbank Offered Rate, Long Term Capital Management, loss aversion, Louis Pasteur, mandelbrot fractal, margin call, Mark Zuckerberg, market fundamentalism, martingale, merger arbitrage, meta analysis, meta-analysis, Milgram experiment, money market fund, moral hazard, Myron Scholes, Nick Leeson, old-boy network, out of africa, p-value, paper trading, passive investing, Paul Lévy, Paul Samuelson, Ponzi scheme, predatory finance, prediction markets, price discovery process, profit maximization, profit motive, quantitative hedge fund, quantitative trading / quantitative finance, RAND corporation, random walk, randomized controlled trial, Renaissance Technologies, Richard Feynman, Richard Feynman, Richard Feynman: Challenger O-ring, risk tolerance, Robert Shiller, Robert Shiller, short selling, sovereign wealth fund, statistical arbitrage, Steven Pinker, stochastic process, survivorship bias, The Great Moderation, the scientific method, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, theory of mind, Thomas Malthus, Thorstein Veblen, Tobin tax, too big to fail, transaction costs, Triangle Shirtwaist Factory, ultimatum game, Upton Sinclair, US Airways Flight 1549, Walter Mischel, Watson beat the top human players on Jeopardy!, WikiLeaks, Yogi Berra, zero-sum game

But the transition from equal weighting to market-cap weighting occurred through trial and error, not because the market for new financial products was particularly efficient. The emergence of the multitrillion-dollar index fund industry was an evolutionary process driven by competition, innovation, and natural selection. This is the Adaptive Markets Hypothesis at work. NEW SPECIES OF INDEX FUNDS The success of the index mutual fund, beginning with the Vanguard Index Trust, led to an evolutionary explosion of financial innovation. Three different stock market index futures debuted in 1982, based on the New York Stock Exchange (NYSE) Composite, the S&P 500, and the Value Line index, respectively. Indexes for each asset class emerged, and additional index funds to track them: the first bond index fund for retail investors in 1986, the first international share index funds in 1990, and the first exchange-traded fund in 1993. Exchange traded funds were similar to index mutual funds in that they closely tracked an index, but could be bought and sold throughout the day on exchanges. 266 • Chapter 8 If the previous financial generation saw “markets in everything,” we currently see “indexes in everything,” as well as funds and derivatives based on those indexes.

Instead, he advised readers to put their money in broadly 6 • Introduction diversified, passive mutual funds that charged minimal fees—and millions of his readers did. In a curious twist of fate, a former Princeton undergraduate launched a mutual fund company for this exact purpose a year after Malkiel’s book debuted. You may have heard of this individual, the index fund pioneer John C. Bogle. His little startup, the Vanguard Group, manages over $3 trillion and employs more than fourteen thousand people as of December 31, 2014.5 Vanguard’s main message, and the advice most often dispensed to millions of consumers, is “don’t try this at home.” Don’t try to beat the market. Instead, stick to passive buy-and-hold investments in broadly diversified stock index funds, and hold these investments until you retire. Still, there’s no shortage of examples of investors who did and do beat the market. A few well-known portfolio managers have routed it decisively, like Warren Buffett, Peter Lynch, and George Soros.

On the other side were the behavioral Introduction • 7 economists, who believe that we are all irrational animals, driven by fear and greed like so many other species of mammals. Some debates are merely academic. This one isn’t. If you believe that people are rational and markets are efficient, this will largely determine your views on gun control (unnecessary), consumer protection laws (caveat emptor), welfare programs (too many unintended consequences), derivatives regulation (let a thousand flowers bloom), whether you should invest in passive index funds or hyperactive hedge funds (index funds only), the causes of financial crises (too much government intervention in housing and mortgage markets), and how the government should or shouldn’t respond to them (the primary financial role for government should be producing and verifying information so that it can be incorporated into market prices). The financial crisis became a battleground in a greater ideological war.


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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, computerized markets, 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, intangible asset, interest rate swap, inventory management, London Interbank Offered Rate, margin call, market fundamentalism, money market fund, mortgage debt, Myron Scholes, 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

Technically, one cannot buy an index, but one can purchase index mutual funds and exchange-traded funds that allow investors to invest in securities representing broad market indexes. Related Terms: • Benchmark • Dow Jones Industrial Average—DJIA • Index Fund • Index Futures • Standard & Poor’s 500 Index—S&P 500 Index Fund What Does Index Fund Mean? A type of mutual fund with a portfolio constructed to match or track the components of a market index such as the Standard & Poor’s 500 Index (S&P 500). An index mutual fund is said to provide broad market exposure, low operating expenses, and low portfolio turnover. Investopedia explains Index Fund Indexing is a passive form of fund management that some argue outperforms most actively managed mutual funds. The most popular index funds track the S&P 500, but a number of other indexes, including the Russell 2000 (small companies), the DJ Wilshire 5000 (total stock market), the MSCI EAFE (foreign stocks in Europe, Australasia, and the Far East), and the Lehman Aggregate Bond Index (total bond market), are followed widely by investors.

Related Terms: • Debt • Interest Rate • Money Market • London Interbank Offer Rate—LIBOR • Singapore Interbank Offered Rate—SIBOR Exchange-Traded Fund (ETF) What Does Exchange-Traded Fund (ETF) Mean? A type of closed-end mutual fund that trades like a stock on an exchange; ETFs usually are constructed to track an index, a commodity, or a basket of assets like an index fund. ETFs fluctuate in price during the trading day as they are bought and sold on an exchange just like a stock. Investopedia explains Exchange-Traded Fund (ETF) Because it trades like a stock, an ETF does not have its net asset value (NAV) calculated every day the way an open-end mutual fund does. By owning an ETF, an investor gets the diversification of an index fund as well as the ability to sell short, buy on margin, and purchase as little as one share (like a stock). Another advantage is that the expense ratios for most ETFs are lower than those of the average mutual fund.

Investopedia explains Lehman Aggregate Bond Index The index, which is constructed by Lehman Brothers, is considered by investors to be the best total market bond tracking index. Along with the aggregate index, Lehman has bond indexes tailored to European and Asian investors. This index cannot be purchased, but it is tracked by bond index funds; there are also exchange-traded funds (ETFs) that track the index. The Lehman Aggregate Bond Index trades on an exchange just like a stock. Related Terms: • Bond • Corporate Bond • Index • Index Fund • Mortgage-Backed Securities—MBS Letter of Credit What Does Letter of Credit Mean? A letter from a bank guaranteeing that a buyer’s payment to a seller will be received on time and for the correct amount. If the buyer is unable to make a payment on the purchase, the bank will be required to cover the full or remaining amount of the purchase.


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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activist fund / activist shareholder / activist investor, Admiral Zheng, banking crisis, Basel III, Bernie Madoff, Black Swan, centralized clearinghouse, clean water, computerized trading, 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, fixed income, Flash crash, income inequality, index fund, information asymmetry, invisible hand, Kenneth Arrow, light touch regulation, London Whale, Long Term Capital Management, moral hazard, Myron Scholes, 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

These funds attempt to track the returns and risks of an asset class (as represented by a benchmark such as the S&P 500 or FTSE 100) and make no effort to outperform it. The great advantage of index funds is that they generally charge very low fees.57 Nearly a quarter of all mutual fund assets in the United States are now in index funds, as are about 17 percent in Europe.58 Even in the United Kingdom, a redoubt of active management, the market share of “trackers” recently reached a market record 8.7 percent in 2012, up from 7.4 percent in 2011.59 Many professionals create a “core and satellite” structure, using index funds as the core allocation to any asset class (say, bonds and stocks) and active managers for specialty allocations. USING COLLECTIVE ACTION The popularity of index funds has its own consequences. When large numbers of investors are locked into a list of stocks, portfolio companies receive less robust signals of confidence or discontent through the marketplace.

The amount of each stock within that index will vary with its market capitalization. As of this writing, for example, the largest company, Apple Computer, comprises about 3 percent of the S&P 500 index, while the tenth largest, AT&T, comprises about 1.5 percent. The companies that rank 499th and 500th in the index account for only a few hundredths of a percent. To track accurately, an index fund comprises its portfolio by owning stocks in the same percentages as the index. Index funds are constituted that way because modern portfolio theory says that the market overall is the result of thousands or millions of Warren Buffetts making active, considered decisions. The result, according to the theory, is a market that efficiently prices risk and reward. The market weights of the various stocks are therefore rational and can form the basis of a relatively efficient index.

See International Finance Corporation (IFC) IMF (International Monetary Fund), 163–64 Impartiality, fiduciary duty and, 139 Incentives: executive compensation and, 72–73, 175–76, 245n29 for dishonesty, 144–45 for fiduciaries, 137 for finance industry, 30–31, 33–35, 60, 61, 188 fund management company, 77–78 institutional investors and performance, 112–13 interaction with social and institutional factors, 179–80 regulation and, 133 Income Data Services, 71 Indentures, 18 Index fund managers, stock selection and, 46 Index funds (tracker funds), 57 determination of, 45–46 Individual savings, collective pensions vs., 263n1 Indulgences, 23, 237n8 Information, access to relevant and unbiased, 141, 149–50 Institute for New Economic Thinking, 180, 189 Institutional design, regulation and, 146 Institutional investors: civil society organizations and behavior of, 119–20 corporate governance and, 98 fiduciary duty and, 11, 111–12 financial crisis and, 8 governance and oversight of, 228 improving accountability and, 109–14 ownership and, 3–4, 249n3 reducing number of agents, 58–59 Institutions, 262n51 economic, 183–86 market, 170 political, 183–84 systemic regulation, 141–42.


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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, corporate raider, 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, Kenneth Arrow, law of one price, linear programming, Louis Bachelier, mandelbrot fractal, martingale, means of production, money market fund, Myron Scholes, new economy, New Journalism, Paul Samuelson, 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, zero-sum game

To perform as well as the index was to perform well above average, and at lower levels of risk. The index funds have had the last laugh. There is nothing like solid quantitative proof to make people sit up and take notice. Once started, the indexing business grew steadily, from $6 million in 1971 to $10 billion in 1980. It is now a huge and varied business, with about 30 percent of total institutional equity assets currently indexed. According to one authoritative count, as of mid-1990 a total of $270 billion of financial assets was in index funds, one-third of it at Wells Fargo. Not all of it was in stock funds, and not all of what was in stock funds was in the S&P 500. According to another survey, as of late 1990 112 out of the top 200 pension funds were invested in equity index funds and 56 in bond index funds. Indexes that reflect the non-S&P part of the domestic stock market have become increasingly popular.

They also helped with his experiments on the use of beta, industry breakdowns, company size, and other sophisticated variations on the security selection problem. Treynor was so impressed that he predicted that Mellon would be the first institution to go into the business of putting the new ideas into practice. Fouse now felt the wind in his sails. In 1969, he recommended that Mellon launch an index fund that would replicate one of the popular market indexes, like the Standard & Poor’s 500-Stock Composite. An index fund requires no one to select stocks, no security analysts, and no portfolio manager. It is a passively managed rather than an actively managed portfolio. Fouse felt that the index fund would give him an opportunity to put Sharpe’s idea about the super-efficient portfolio on a real-time basis. For his efforts, Fouse recalls, he was “figuratively thrown out of the policy meeting.”b But Fouse was irrepressible. His had encountered John Burr Williams’s Dividend Discount Model in business school, and he set out to apply that model to security analysis.

The first two contributions to the fund were Wells Fargo’s own pension fund, with $5 million, and the pension fund of Illinois Bell, with a like amount. Those contributions fell short of the $25 million required to buy 1,000 shares of each of the 500 components of the index. So a sampling strategy had to be followed—with unfortunate errors in tracking the index—until the total reached $25 million. From that point forward, the S&P 500 index fund has held the 500 stocks in proportion to their relative market values. In 1976, Samsonite folded its equal-weighted New York Stock Exchange fund into the S&P 500 index fund. That fund has been the model for index funds ever since, even though, as McQuown describes it, “It’s a weird damn thing.” The Composite includes most of the large companies in the United States, so it accounts for a major share of the market. But its composition, as determined by the Standard & Poor’s Corporation that publishes it, is forever changing.


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, fixed income, fudge factor, full employment, Gordon Gekko, high net worth, index card, index fund, job satisfaction, Menlo Park, money market fund, 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

Mutual fund managers are constrained by regulations imposed by the Security and Exchange Commission (SEC), a federal agency. Index Funds Index Funds are mutual funds designed to mimic the performance of stock market indices such as the Dow Industrials, the NASDAQ Composite and the S&P 500. As an FI investor you have learned when enough is enough, particularly in terms of your money. In using index funds to invest your capital you are not attempting to beat the market. Instead you are looking for enough of a return to meet your short-term as well as long-term goals while taking as little risk as possible. That is why index funds, with their low fees and ability for diversification, can work well for the FI investment program. At its core, index fund investing means you are using an approach and strategy that seeks to track the investment returns of a specified stock or bond market benchmark or index.

At its core, index fund investing means you are using an approach and strategy that seeks to track the investment returns of a specified stock or bond market benchmark or index. One of the most popular index funds today is the S&P 500 Index Fund, which attempts to replicate the investment results of this specific target index. There is no attempt to use traditional “active” money management or to make “bets” on individual stocks. Indexing is a passive investment approach emphasizing broad diversification and low portfolio trading activity. Low cost is a key advantage of index funds, leaving a larger share of the pie for investors, which is why this choice aligns well for your FI investment plan. Low Fees Are Key Fees, by far, are one of the most overlooked areas in terms of investment decisions. Index funds boast some of the lowest portfolio-management fees in the industry, which is why they are the vehicle of choice for investors looking for value as well as performance.

Post-FI3 you can carefully rearrange your investments, avoiding as much as possible fees for early withdrawal. When you have a choice about where to invest your money, though, choose firms that offer no-load funds, carry no sales fees (loads) and don’t charge 12b-1 fees to cover marketing expenses. Actively Managed Funds or Index Funds? If you can’t figure out which to choose—an actively managed mutual fund or an index fund—no worries. The sharpest minds in the industry seem to favor index funds for people like us. A few examples: Legendary investor Warren Buffett: “Most investors are better off putting their money in low-cost index funds. A very low-cost index is going to beat a majority of the professionally managed money.” Best-selling author Larry Swedroe from his book, What Wall Street Doesn’t Want You to Know: “Regardless of the asset class [see below], use only index or passive asset class funds.


pages: 120 words: 39,637

The Little Book That Still Beats the Market by Joel Greenblatt

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backtesting, index fund, intangible asset, random walk, survivorship bias, transaction costs

There just aren’t that many great managers, and your chances of finding one are quite slim. So that’s why many people just choose to invest in an index fund.27 An index fund is a mutual fund that just tries to equal the overall market’s return, less a very small fee. These funds pick a market index (perhaps the S&P 500 index of 500 large stocks or the Russell 2000 index, an index that consists of 2,000 somewhat smaller stocks) and buy all of the stocks in that particular index. Although this strategy won’t help you beat the market, it will help you achieve returns that are at least close to the market averages.28 Since, after taking into account fees and other costs, most other investment choices leave you with much lower returns than index funds, many people who have carefully studied the issue have concluded that settling for average returns is actually a pretty good alternative.

Let me tell you this much: In the beginning, there were mutual funds, and that was good. But their sales fees and expenses were way too high. Then came no-load funds, which were better. They eliminated the sales fee, but were still burdened with management fees and with the tax and transactional burden that comes from active management. Then came “index funds,” which cut fees, taxes, and transaction costs to the bone. Very, very good. What Joel would have you consider, in effect, is an index-fund-plus, where the “plus” comes from including in your basket of stocks only good businesses selling at low valuations. And he has an easy way for you to find them. Not everyone can beat the averages, of course—by definition. But my guess is that patient people who follow Joel’s advice will beat them over time. And that if millions of people should adopt this strategy (Vanguard: please hurry up and offer a low-priced fund like this), two things will happen.

Market can do anything in the short term, money that you require over the next few years for necessities is best left in the bank. Otherwise, you may be forced to sell to Mr. Market at just the wrong time (for instance, when you need money to cover expenses and a depressed Mr. Market is offering low prices for your shares). 27 Or an exchange-traded fund (ETF), an index fund that trades similar to the way a stock trades. 28 Also, if you are not investing using a tax-free retirement account and taxes are a concern for you, this strategy will minimize the amount of taxes you must pay because index funds typically do not sell their stock holdings unless a particular security is dropped from the index. This is usually less than 10 percent of the securities in the index in any one year. 29 Either a traditional investment retirement account or a Roth IRA. 30 Thereafter making no further contributions of any kind. 31 From investing the maximum allowable $4,000 per year in an IRA over two years and then the increased maximum of $5,000 per year for the following four years equaling $28,000 over the six years. 32 It’s fascinating to note that if you had decided to contribute $5,000 per year for the remaining 24 years of this 30-year period, rather than stopping contributions after just six years as we did in this example, your IRA account would have grown to approximately $16.5 million after 30 years versus the $13.4 million from just those six contributions.

Stock Market Wizards: Interviews With America's Top Stock Traders by Jack D. Schwager

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Asian financial crisis, banking crisis, barriers to entry, beat the dealer, Black-Scholes formula, commodity trading advisor, computer vision, East Village, Edward Thorp, financial independence, fixed income, implied volatility, index fund, Jeff Bezos, John Meriwether, John von Neumann, locking in a profit, Long Term Capital Management, margin call, money market fund, Myron Scholes, paper trading, passive investing, pattern recognition, random walk, risk tolerance, risk-adjusted returns, short selling, Silicon Valley, statistical arbitrage, the scientific method, transaction costs, Y2K

It can even be WIZARD LESSONS argued that the mere knowledge of the existence of large portfolio insurance sell orders below the market was one of the reasons for the enormous magnitude of the October 19, 1987, decline. Index funds may well provide a current example of this principle. As Lauer explained, index funds originally made a lot of sense for the investor, providing the opportunity to own a representative piece of the market, with presumably lower risk due to the index's diversification, and a low cost structure and favorable tax treatment (due to low turnover). As index funds outperformed the majority of actively managed funds, however, they attracted steadily expanding investment flows. This investment shift, in turn, created more buying for the stocks in the index at the expense of the rest of the market, which helped the index funds outperform the vast majority of individual stocks, attracting still more assets, and so on.

It allows the investor to own a representative piece of the market, with presumably lower risk due to the index's diversification. In addition, because of their low turnover of stock holdings, index funds also offer the benefits of lower management fees and more favorable tax treatment. Frankly, there is nothing wrong with this argument. Indexation, as it was intended, is a reasonable investment strategy. As index funds outperformed the majority of other funds at lower costs, however, they attracted a steadily expanding portion of investment flows. This shift, in turn, created more buying for the stocks in the index at the expense of much of the rest of the market, which helped the index funds outperform the vast majority of individual stocks, and so on. As a result, what started out as a strategy for investors to link their fortunes to the market via an index has been turned on its head, with the index responding to the ever-increasing share of index-linked investment capital.

Thus, we now have a phenomenon of the top fifty stocks in the S&P 500 trading at an average of over fifty times estimated earnings, compared with an average of only about twenty for the remaining 450 stocks in the index, and the high teens for a broaderbased index, such as the Russell 2000. The bottom line is that in the present perverse incentive structure of benchmark-guided portfolios, there is more risk for fund managers in not owning certain grossly overvalued mega-capitalization stocks than in abstaining from them. Including enhanced index funds, such as Fidelity Magellan, the S&P 500 index funds now account for over two-thirds of new equity investments. What happens when the enhanced index funds want to MICHAEL LAUER lighten or liquidate their current positions, which are overwhelmingly concentrated in severely overpriced stocks? Who are they going to sell to? This is an amazingly small community. Only about 25 mutual fund institutions control almost one-third of total equity assets in this country, and every one of those guys knows what the others are doing.


pages: 515 words: 132,295

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

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

15 Another fund management firm papered Wall Street with posters showing an angry Uncle Sam putting a rubber stamp across index funds. “Index funds are un-American!” the ad screamed. “Help stamp out index funds.” Even the prudent Bostonians got into the game. My husband’s father, Robert Minturn Sedgwick, happened to be one of those stewards who worked in the Boston asset management industry before and after World War II. During his time as an associate with Scudder, Stevens & Clark, he came to believe (like Bogle and a growing number of others of that generation) that the whole actively managed fund business was basically a scam. The average investor was far better off putting his or her money into what Sedgwick called the “20 largest,” a group of big-cap US stocks that he came up with, which essentially mimicked a modern index fund. He published an article about his idea in the Harvard Business Review and began raising it within his firm.

(Morningstar, the respected purveyor of mutual fund analysis services, basically conceded this point in 2010.)13 A particularly telling recent piece of research done by law academics at Yale and the University of Virginia found that after considering costs, not only did index funds outperform actively managed portfolios by a significant amount, but 16 percent of the time the impact of high fees would actually offset the entire tax benefit of investing in a 401(k) plan for young workers over the course of their careers.14 Investors then and now were better off simply linking their investments to the market via an index fund, an industry that Bogle and others had begun to develop. But active fund management was much more profitable, and the industry worked hard to convince average Joe investors that they needed to pay for professional guidance through this wild world of investing. “You wouldn’t settle for an ‘average’ brain surgeon,” said one index fund critic. “So why would you settle for an ‘average’ mutual fund?”

It’s likely that CSC will use behavioral nudges to get as many eligible people as possible to participate, for instance by making enrollment automatic unless a worker opts out, rather than requiring a sign-up to opt in.45 Participants in CSC would sock away at least 3 percent of their income, most likely in a conservative index fund like an S&P 500 fund, where the pooled money is invested in all 500 stocks in that index. Index funds are considered a simple way to ensure that investors see the same return as the overall stock market—and they’re cheaper, too, since index funds don’t employ stock-picking wizards and charge the related fees. Advocates say that the government role will be to help recruit more people to save, and that costs of such plans will be kept low through efficiencies of scale derived from all those participants, much as happens at some big public employee plans.


pages: 505 words: 142,118

A Man for All Markets by Edward O. Thorp

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3Com Palm IPO, Albert Einstein, asset allocation, beat the dealer, Bernie Madoff, Black Swan, Black-Scholes formula, Brownian motion, buy low sell high, carried interest, Chuck Templeton: OpenTable, Claude Shannon: information theory, cognitive dissonance, collateralized debt obligation, compound rate of return, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, Edward Thorp, Erdős number, Eugene Fama: efficient market hypothesis, financial innovation, George Santayana, German hyperinflation, Henri Poincaré, high net worth, High speed trading, index arbitrage, index fund, interest rate swap, invisible hand, Jarndyce and Jarndyce, Jeff Bezos, John Meriwether, John Nash: game theory, Kenneth Arrow, Livingstone, I presume, Long Term Capital Management, Louis Bachelier, margin call, Mason jar, merger arbitrage, Murray Gell-Mann, Myron Scholes, NetJets, Norbert Wiener, passive investing, Paul Erdős, Paul Samuelson, Pluto: dwarf planet, Ponzi scheme, price anchoring, publish or perish, quantitative trading / quantitative finance, race to the bottom, random walk, Renaissance Technologies, RFID, Richard Feynman, Richard Feynman, risk-adjusted returns, Robert Shiller, Robert Shiller, rolodex, Sharpe ratio, short selling, Silicon Valley, statistical arbitrage, stem cell, survivorship bias, The Myth of the Rational Market, The Predators' Ball, the rule of 72, The Wisdom of Crowds, too big to fail, Upton Sinclair, value at risk, Vanguard fund, Vilfredo Pareto, Works Progress Administration

This means if the oil giant Exxon has a market value, computed as share price times number of shares outstanding, of $400 billion and the total market value of all stocks is $10 trillion, then the index fund puts 4 percent of its net worth in Exxon, and so on for all the other stocks. A mutual fund like this that replicates the composition and investment results of a specified pool of securities is called an index fund, and investors who buy such funds are known as indexers. Call any investment that mimics the whole market of listed US securities “passive” and notice that since each of these passive investments acts just like the market, so does a pool of all of them. If these passive investors together own, say, 15 percent of every stock, then “everybody else” owns 85 percent and, taken as a group, their investments also are like one giant index fund. But “everybody else” means all the active investors, each of whom has his own recipe for how much to own of each stock and none of whom has indexed.

To see what might be done, imagine you’re an eighteen-year-old blue-collar worker with no savings and no prospects. What if, somehow, you could save $6 a day and buy shares in the Vanguard S&P 500 Index Fund at the end of each month? If that investment grows in a tax-deferred retirement plan at the long-term average for large stocks of about 10 percent, then after forty-seven years you can retire at age sixty-five with $2.4 million. But where do you find an extra $6 a day? The pack-and-a-half-a-day smoker who kicks his drug habit saves $6 each day. If the construction worker who drinks two $5 six-packs of beer or Coke each day switches to tap water he can save $10 a day, $6 of which he puts in an index fund and $4 of which he spends on healthy food to replace the junk calories from the beer or Coke. Most of us, with greater opportunities to redirect our expenditures, can expect to do better than our poor, young, blue-collar worker.

A calculation shows that in 1.2 million years we would be a solid sphere of flesh with a radius almost as large as that of our galaxy, expanding at the speed of light! How fast do ordinary investments grow? The best simple long-term choice has been a broad common-stock index fund. At the average past growth rate of about 10 percent a year, such an investment has doubled in about 7.3 years. Historically, inflation offset about 3 percent of this, stretching to a little over a decade the average time required to double real buying power. Taxable investors in an index fund, which generates dividends and some realized capital gains, pay government another percent or so annually, delaying the doubling time to about twelve years. To get quick approximate answers to compound interest problems like these, accountants have a handy trick called “the rule of 72.”


pages: 244 words: 79,044

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

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activist fund / activist shareholder / activist investor, Bernie Madoff, capital asset pricing model, corporate raider, diversification, diversified portfolio, family office, fixed income, forensic accounting, Gordon Gekko, hiring and firing, implied volatility, index fund, intangible asset, 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

Instead of enriching the many layers of financial advisers and principals, Mr Straw should simply have put his money in Treasury bonds, and slept easily at night (particularly as his retirement date was fast approaching) or a stock-market index fund if he wanted market exposure. But wouldn’t Mr Straw be quite upset with the company canteen folks if they forced him to pay this kind of price premium for a slightly more exotic-sounding and tasting fruit as part of his standard company lunch? The example described needs one further explanation. Namely, how did the hedge fund generate its 10 per cent return? If the hedge fund was just long the Standard & Poor’s 500 index and that index was up 10 per cent for the year, Mr Straw would have paid large fees for very little additional value. He could just have bought a Vanguard index fund and paid 0.2 per cent in total fees, not 7 per cent (although he might not be able to avoid some pension-fund costs to gain tax advantages).

As far as I have been able to find out, there are few money-management firms that do the kind of investing described above. When I asked a former professor of mine at HBS, he said that for whatever reason the world does not seem to value this kind of investing very highly. Increasing amounts of money are invested in index funds like Vanguard, but taking that a step further and picking broad arrays of indices has, for whatever reason, not been something a lot of people do or are willing to pay a lot for. 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.

Although the portfolio would not be static, there would be fairly little trading and the costs and fees could be kept very low as a result – besides, it is fairly cheap to buy whole markets through ETFs, index funds or futures. The arguments in this section are based on the premise of what an investor that does not have edge in the markets should do. This does not mean that edge does not exist – I’m on the board of a few hedge funds that I certainly believe have edge in the market, and they are well worth their fees as a result. After making my own scepticism about the high levels of fees floating around the financial system clear to anyone who cares to listen (and many that don’t), I often get asked how I think people should be investing their money. The above may sound like financial mumbo-jumbo, but it is eminently practicable in the real world – sort of a real and practical adapted version of a capital asset pricing model (CAPM). You buy a portfolio of world stock-index funds, corporate and government debts, and do so in the cheapest way, while trying to tax-optimise and adjust your gearing level.


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, John Meriwether, law of one price, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, market bubble, merger arbitrage, money market fund, new economy, passive investing, Paul Samuelson, price mechanism, purchasing power parity, risk tolerance, risk-adjusted returns, risk/return, Ronald Reagan, selection bias, shareholder value, Sharpe ratio, short selling, statistical arbitrage, survivorship bias, the market place, transaction costs, Y2K, yield curve, zero-sum game

I’m not talking about a traditional tactical asset allocation (TAA). Rather, I am talking about a somewhat intermediate step between SAA and TAA. Call it cyclical asset allocation (CAA). Such a strategy emphasizes different asset classes as well as activeversus-passive management, as cycles dictate. When markets do not provide much in terms of selection opportunities for securities, the index fund is a cost-efficient tool with which to access broad market moves. But, market efficiency has cycles, too. Correspondingly, reallocating index funds is another source of value that can be added through the asset-allocation process. There is a time for everything. There is a time for active management and a time for passive management; a time for value stocks and a time for growth stocks; a time for large-caps and a time for small-caps. Constructing major stock indices provides an excellent illustration of this.

Given our portfolio’s 40 percent allocation to fixed income, it follows we allocate 4 percent to short-term instruments and 36 percent to longer-maturity instruments. (We could further disaggregate the longer-term fixed-income instruments into a global allocation, but for this exercise, we stay domestic.) Figure 6.3 illustrates the SAA produced by my interpretation of the various asset classes’ market weights. Either exchange-traded funds (ETFs), or passively managed low-cost index funds, could fill most buckets in question. ETFs and the low cost-managed index funds are diversified baskets of securities designed to track the performance of well-known indices, proprietary indices or basket of securities. The major differences between the two is that the ETF are traded as individual stocks on major exchanges while the passive funds are subject to the traditional mutual funds-pricing mechanism (that is, at the close of market).

If taxes and governmental regulations rise, what does that mean for bonds? A forward-looking view one can tie together such important variables is critical to the asset-allocation process. But, the process needs to differentiate itself in two additional ways: The first way has to do with the versatility of the framework. The second way has to do with actively using passive vehicles (also known as index funds). xix When I talk about the framework’s versatility, I mean the assetallocation model can be changed to find opportunity. For example, I do not view the nontraditional sector as the hedge fund’s exclusive domain. To me, it is a place for any investment decision that does not correlate with traditional capital-market indices but does have value. This sector can include hedge funds, but it can also include investments in discounted closed-end funds and industry-sector funds, or specific securities representing good long-term value.


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, intangible asset, invisible hand, Isaac Newton, John Nash: game theory, Long Term Capital Management, loss aversion, Louis Bachelier, mandelbrot fractal, margin call, mental accounting, Myron Scholes, Nash equilibrium, Network effects, passive investing, Paul Erdős, Paul Samuelson, Ponzi scheme, price anchoring, Ralph Nelson Elliott, random walk, Richard Thaler, Robert Shiller, Robert Shiller, short selling, six sigma, Stephen Hawking, survivorship bias, transaction costs, ultimatum game, Vanguard fund, Yogi Berra

Chapter 8 - Connectedness and Chaotic Price Movements Insider Trading and Subterranean Information Processing Trading Strategies, Whim, and Ant Behavior Chaos and Unpredictability Extreme Price Movements, Power Laws, and the Web Economic Disparities and Media Disproportions Chapter 9 - From Paradox to Complexity The Paradoxical Efficient Market Hypothesis The Prisoner’s Dilemma and the Market Pushing the Complexity Horizon Game Theory and Supernatural Investor/Psychologists Absurd Emails and the WorldCom Denouement Bibliography Index Copyright Page Also by John Allen Paulos Mathematics and Humor (1980) I Think Therefore I Laugh (1985) Innumeracy: Mathematical Illiteracy and its Consequences (1988) Beyond Numeracy: Ruminations of a Numbers Man (1991) A Mathematician Reads the Newspaper (1995) Once Upon a Number: The Hidden Mathematical Logic of Stories (1998) To my father, who never played the market and knew little about probability, yet understood one of the prime lessons of both. “Uncertainty,” he would say, “is the only certainty there is, and knowing how to live with insecurity is the only security.” 1 Anticipating Others’ Anticipations It was early 2000, the market was booming, and my investments in various index funds were doing well but not generating much excitement. Why investments should generate excitement is another issue, but it seemed that many people were genuinely enjoying the active management of their portfolios. So when I received a small and totally unexpected chunk of money, I placed it into what Richard Thaler, a behavioral economist I’ll return to later, calls a separate mental account. I considered it, in effect, “mad money.”

Studying the market wasn’t nearly as engaging as doing mathematics or philosophy or watching the Comedy Network. Thus, taking Keynes literally and not having much confidence in my judgment of popular taste, I refrained from investing in individual stocks. In addition, I believed that stock movements were entirely random and that trying to outsmart dice was a fool’s errand. The bulk of my money therefore went into broad-gauge stock index funds. AWC, however, I deviated from this generally wise course. Fathoming the market, to the extent possible, and predicting it, if at all possible, suddenly became live issues. Instead of snidely dismissing the business talk shows’ vapid talk, sports-caster-ish attitudes, and empty prognostication, I began to search for what of substance might underlie all the commentary about the market and slowly changed my mind about some matters.

Is the “double-dip” recession discussed in early 2002 simply a double bottom? Predictability and Trends I often hear people swear that they make money using the rules of technical analysis. Do they really? The answer, of course, is that they do. People make money using all sorts of strategies, including some involving tea leaves and sun-spots. The real question is: Do they make more money than they would investing in a blind index fund that mimics the performance of the market as a whole? Do they achieve excess returns? Most financial theorists doubt this, but there is some tantalizing evidence for the effectiveness of momentum strategies or short-term trend-following. Economists Narasimhan Jegadeesh and Sheridan Titman, for example, have written several papers arguing that momentum strategies result in moderate excess returns and that, having done so over the years, their success is not the result of data mining.


pages: 483 words: 141,836

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

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activist fund / activist shareholder / activist investor, Albert Einstein, algorithmic trading, Asian financial crisis, Atul Gawande, backtesting, Basel III, Bayesian statistics, beat the dealer, Benoit Mandelbrot, Bernie Madoff, Black Swan, capital asset pricing model, central bank independence, Checklist Manifesto, corporate governance, creative destruction, credit crunch, Credit Default Swap, disintermediation, distributed generation, diversification, diversified portfolio, Edward Thorp, 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 market fund, money: store of value / unit of account / medium of exchange, moral hazard, Myron Scholes, natural language processing, open economy, Pierre-Simon Laplace, 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, Thomas Bayes, too big to fail, transaction costs, value at risk, yield curve

Or at least they felt safer than they would have navigating among tens of thousands of small investment managers with complicated strategies. However, I think the biggest perceived problem in the IGT world would have been a lack of basic fairness. There are problems in index funds, but people like that any individual can get the average return of the market, without much expense or effort. All the slick people trying to do better, do worse as a group. If some make money, others lose it, and neither the winners nor the losers hurt the index fund investor (but both pay more fees, expenses, and taxes than the index fund investor). This fairness helps generate the social support for the financial system. In the IGT world, people would have hated Wall Street for the reasons they used to—that it was a bunch of sharpies playing with other people’s money and doing no social good—rather than the current reasons—that it wrecked the economy and used huge bailout funds to pay obscene bonuses.

Belief in MPT CAPM helped make the markets more efficient cross-sectionally; that is, returns on different asset classes over the same time periods aligned pretty well with their respective risk levels. But, at least arguably, MPT CAPM contributed toward prices diverging from fundamental value. Index fund investors don’t ask what something is worth; they want to hold it in proportion to its price. Among other things, it guarantees that they are overinvested in anything overpriced, and underinvested in anything underpriced. It may be impossible to tell overpriced assets from underpriced ones, but that doesn’t matter; it’s a mathematical certainty the index fund investor has the worst of both worlds. (Of course, as Ken French and John Bogle independently pointed out to me, half the nonindex investors must be even more overweighted in the overpriced assets, and all the nonindex investors pay higher costs.)

What if IGT had been the dominant theory instead, and had encouraged the growth of hedge funds while discouraging index funds and other highly diversified investments? We can imagine the Securities and Exchange Commission insisting that investment managers know a lot about the securities they buy, not just buy everything available at the asking price. Other regulators might insist that professional managers provide rigorous oversight and demonstrate that their strategies didn’t exacerbate bubbles and crashes. In fact, things like these have happened over the years, but not due to IGT or any other comprehensive theory. They were reactions to market events caused in part by MPT-based investment techniques. We had bubbles and crashes long before we had MPT or index funds, so they cannot be the main cause. It is undoubtedly active investors who trigger these events.


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

In the discussion a few paragraphs above, where we contrasted a buy-and-hold strategy with an oil indicator strategy and saw our return double, the results were based on buying and selling “the market.” And this was not in any way a mere theoretical exercise: it is entirely possible to buy and sell “the market” by investing in index funds that include all the stocks in particular market indices. In our comparisons, we assumed you were buying and selling the Vanguard 500 Index Fund, which is a no-load fund that can be purchased through the Vanguard Group. But while index funds are a convenient way to showcase our oil indicator’s performance, they won’t be good investments in the years ahead, and when oil flashes a positive signal, we don’t suggest that you buy “the market.” That’s because, as we explain later, we believe that oil prices have embarked upon a long-term uptrend.

As energy prices rise, the industry’s woes will multiply. A few airlines will survive, and there may be some new entrants and some consolidations, but we think the industry is doomed to struggle fiercely to very little avail. One final category of things to avoid should be obvious given our projections of rough sledding ahead for the general run of stocks. In the 1990s some of the most popular investments were the index funds, such as the enormously successful Vanguard 500 Index Fund. It was the perfect choice for scads of investors, who no doubt felt they had discovered the Holy Grail—a one-shot investment in a highly diversified group of safe big-cap stocks that seemed capable of returning annual gains of 20 percent or more year after year. But the fund began to turn sour in 2000 and will continue to produce unsatisfactory returns for a while to come.

As noted above, though, it quickly became clear that Saddam lacked the ability to cripple oil production. And as oil prices collapsed back to the high teens, the recession ended. Stocks once again embarked upon a bull run—and this one was to be a bull run for the ages. Between 1991 and 2000, with oil prices remaining well under control, stocks staged one of the greatest rallies any financial market has ever seen. If you had invested in the S&P 500, say, by buying the Vanguard 500 Index Fund, in January 1991, you would have gained on average 20 percent a year for the next nine years. To put it differently, a $10,000 investment would have turned into more than $50,000. And because those nine years were ones of low inflation, your gains were mostly real gains in terms of their actual purchasing power. Moreover, as everyone knows, while the market as a whole was thriving, the tech sector, especially as the decade drew to a close, was on a real tear.


pages: 297 words: 91,141

Market Sense and Nonsense by Jack D. Schwager

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3Com Palm IPO, asset allocation, Bernie Madoff, Brownian motion, collateralized debt obligation, commodity trading advisor, computerized trading, 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, negative equity, 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, selection bias, Sharpe ratio, short selling, statistical arbitrage, statistical model, survivorship bias, transaction costs, two-sided market, value at risk, yield curve

Long-Only Funds (Mutual Funds) If a fund is highly correlated to the market (or a sector)—as is true for virtually all long-only funds—its performance will be far more a reflective of the market than the fund’s investment process and skill. For example, a so-called closet index fund—a fund that is managed so that its performance does not deviate much from the selected index—would by design be highly correlated to the market. For a closet index fund, high returns would simply mean that the market had witnessed similar high returns and would provide no additional information about the fund’s relative merits. Although closet index funds may represent an extreme case, most long-only mutual funds are still highly correlated to whichever index most closely resembles the types of stocks in their portfolios (an index representing similar capitalization companies, sector, and country or region) and could be described as quasi-closet index funds. In contrast, a market neutral fund—a fund in which long and short positions are equally balanced—would likely have a low correlation to the market.

Although this limited sample does not rise to the level of a persuasive proof, the results are entirely consistent with the available academic research on the subject. The general conclusion appears to be that the advice of the financial experts may sometimes trigger an immediate price move as the public responds to their recommendations (a price move that is impossible to capture), but no longer-term net benefit. My advice to equity investors is either buy an index fund (but not after a period of extreme gains—see Chapter 3) or, if you have sufficient interest and motivation, devote the time and energy to develop your own investment or trading methodology. Neither of these approaches involves listening to the recommendations of the experts. Michael Marcus, a phenomenally successful trader, offered some sage advice on the matter: “You have to follow your own light. . . .

Investment Insights Most of key assumptions related to the efficient market hypothesis, which underlies much of investment theory, are simply inconsistent with the way markets actually behave. Although markets are often efficiently priced (or approximately so), there are many exceptions, and it is the exceptions that provide skilled market participants the opportunity for outperformance. Markets are indeed difficult to beat, and recognition of this fact means that for many investors, the best choice might well be traditional academic advice: Invest in index funds so that you can at least match the market. But there is a big difference between hard to beat and impossible to beat. Investors with an interest in markets who are willing to put in the hard work to develop an investment or trading methodology and who have the discipline to follow a plan should not be dissuaded from that endeavor by the efficient market hypothesis. The model of market prices being determined strictly by fundamentals is overly simplistic.


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, fixed income, 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, money market fund, pension reform, presumed consent, profit maximization, rent-seeking, Richard Thaler, Right to Buy, risk tolerance, Robert Shiller, Robert Shiller, Saturday Night Live, school choice, school vouchers, transaction costs, Vanguard fund, Zipcar

The asset allocation is 65 percent foreign (that is, non-Swedish) stocks, 17 percent Swedish stocks, 10 percent fixed-income securities (bonds), 4 percent hedge funds, and 4 percent private equity. Across all asset classes, 60 percent of the funds are managed passively, meaning that the portfolio managers are simply buying an index of stocks and not trying to beat the market. One good thing about index funds is that they are cheap. The fees they charge investors are much lower than those charged by funds that try to beat the market. These low fees for the index funds helped keep *In fact, the percentage of active choosers has declined steadily, from 17.6 percent in 2001, the first year after the launch. 149 150 MONEY Table 9.1 Comparison of the default fund and the mean actively chosen portfolio Asset allocation Default (%) Mean actively chosen portfolio (%) Equities Sweden Americas Europe Asia Fixed-income securities (bonds) Hedge funds Private equity 82 17 35 20 10 10 4 4 96.2 48.2 23.1 18.2 6.7 3.8 0 0 Indexed 60 4.1 Fee Returns for the first three years Returns through July 2007 0.17 29.9 21.5 0.77 39.6 5.1 Note: The table compares the default fund and the mean actively chosen portfolio.

Louis, 18n Germany, organ donations in, 178–79 Gilovich, Tom, 27–30, 61 Give More Tomorrow, 229–30 Goldstein, Dan, 178 Goolsbee, Austan, 230–31 Gore, Al, 159 Gould, Stephen Jay, 27 government: distrust of, 10, 248; libertarian paternalism of, 13; neutrality in, 246–48; paternalism of, 47; and RECAP, 93–94; and retirement plans, 115–17; and slippery slope, 236–38; starting points provided by, 10–11; transparency in, 240, 244–46 government bonds, 118 greenhouse gas emissions, 186, 188, 196 Greenhouse Gas Inventory (GGI), proposed, 191 Green Lights, EPA program, 195–96 Gross, David, 51 group norms, 57–58 gut feelings, 21–22 Hackman, Gene, 50 Halloween night experiment, 123–24 H&R Block, and FAFSA software, 141 Harvard School of Public Health, 67 Hazard Communication Standard (HCS), 189 health care, 207–14; birth control pills, 89; choosing, 76; costs of, 207, 210; defensive medicine, 210; Destiny Health Plan, 233; deterrent effect of tort liability in, 210–11; drug compliance, 89; framing in, 157; freedom of contract in, 174, 210, 214; incentive conflicts in, 98; ineffective lawsuits in, 210, 211–12; libertarian paternalists on, 157–58; medical malpractice liability, 209–14; negligence defined in, 213; “no-fault” system in some countries, 213; organ donations, 157–58, 175–82; prescription drug plan, 157, 159–74; right to sue for negligence, 207–14; social influences in, 157; treatment options, 92 “heuristics and biases” approach, 23 Hoffman, Dustin, 50, 51 home-building industry, 192–93 home equity loans, 103 Home Ownership and Equity Protection Act, 136 homo economicus (economic man), 6–8 “hot-cold empathy gap,” 42 hot-hand theory, 30, 31 hot states, 41, 42 Houston Natural Gas, 125 Howell, William, 201 Hoxby, Carolyn, 200 Humans: Automatic Systems used by, 22; conformity of, 55–60; difficult choices for, 77, 83; influenced by a nudge, 8; loss aversion of, 120–21; and money, 101; social pressures on, 53; use of term, 7 Hurricane Katrina, 13 287 288 INDEX Illinois First Person Consent registry, 181– 82, 181 imitation, 238n incentives, 8, 97–100; conflicts of, 98, 203–5; in free markets, 97; in investments, 131; and salience, 98–99 income tax: Automatic Tax Return, 230– 31; compliance in, 66; refunds from, 48–49n index funds, 149–50, 154 inertia: and default option, 35, 83; and loss aversion, 34; and organ donations, 176; power of, 7–8, 238n; and status quo bias, 12–13, 34–35; “yeah, whatever,” 35, 83 information, spread of, 54, 71 Informed Decisions, 172 inheritance, 217 INSEAD School of Business, France, 99 insurance: costs of, 93; fraught choices in, 77; health, 233 Internal Revenue Service (IRS), 230–31 intuitive thinking, test of, 21–22 investment goods, 73 investments, 118–31; asset allocation in, 34–35, 118–28; in company stock, 125– 28, 247; default options, 129–30; and ERISA, 127–28, 131; error expected in, 130; feedback in, 131; incentives in, 131; index funds, 149–50; “lifestyle” funds, 124–25, 129; mappings in, 131; and market timing, 121–22; mental accounting in, 51; mutual funds, 119, 120, 122, 127; past performance of, 126–27; portfolio management, 131; portfolio theory, 123; rates of return, 123; risk in, 118, 120–21, 124–25, 129; rules of thumb for, 122– 25; stocks and bonds, 118, 119–20; structuring complex choices, 130; “target maturity funds,” 129–30 iPhone and iPod, 11 IRAs, 103 Johnson, Eric, 178 Johnson, Samuel, 32 Jones, Rev.

Treasury bills (short-term, completely safe, bonds issued by the government), you would have turned your dollar into $18, a 3.7 percent rate of return per year. That does not seem bad until you realize 119 120 MONEY that just to keep up with inflation you had to earn 3.0 percent per year. If you had invested your money in longer-term bonds, your dollar would have become $71, a 5.5 percent rate of return, which is quite a bit better. But if you had invested in mutual funds that held shares in the largest American companies (such as an S&P 500 index fund), your dollar would have grown into $2,658, a 10.4 percent rate of return, and if you had invested in a broad portfolio of the stocks of smaller companies, you could have earned even more. In economics jargon, in which stocks are referred to as equities, the difference in the returns between Treasury bills and equities is called the “equity premium.” This premium is considered to be compensation for the greater risk associated with investing in stocks.


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, money market fund, 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

Demand for journalists who could write about personal finance began to outpace supply in the 1990s as newspapers upped their coverage of this formerly ignored subject. “I was ignorant,” wrote an anonymous Fortune writer about his or her time recommending investments for an Internet publication in a 1999 piece titled “Confessions of a Former Mutual Funds Reporter.” “My only personal experience had been bumbling into a load fund until a colleague steered me to an S&P 500 index fund. I worried I’d misdirect readers, but I was assured that in personal finance journalism it doesn’t matter if the advice turns out to be right, as long as it’s logical.” There are any number of things you can take from my story and others like it. The first is about money and what it means to us. When you write about people and money, you write about much more than dollars and cents. You write about their lives.

Over the years Quinn made numerous enemies, ranging from brokers to heads of mutual fund companies, for relentlessly putting the financial interests of the consumer ahead of the financial interests of the financial services industry. Quinn sees herself as both a part of the consumer movement and the personal finance and investment communities. She names as her contemporaries such financial pioneers as Bruce Bent, the creator of the now ubiquitous money market fund, and John Bogle, the force behind Vanguard’s low-cost index funds. Yet a look at Quinn’s work demonstrates both the promise and the perils of the financial advice arena. A quick run through the many, many profiles of her penned over the years shows howlers mixed in with the prescient comments, sometimes in the same piece, proving how hard it is to get this forecasting thing right. In a USA Today interview in 1991, for example, she opines “You can no longer count on your real estate to make you rich,” a statement that was objectively untrue, at least at that time.

That will, of course, come on top of the fees you are already paying on the account. Fee-only financial planners and registered investment advisers (RIAs) are willing to help out too—provided, that is, they can count your savings toward their assets under management and collect the fees. Surveying the situation, no one less than John Bogle, the founder of the Vanguard Group and the man who pioneered the low-cost index fund, has come forward to say the mutual fund and retirement industries collect so much money in fees that the entire system is a “train wreck.” But a train wreck for your future retirement is a gravy train for those collecting the fees. As a result, the political influence of the industry can’t be oversold. According to OpenSecrets.org, a Washington-based non-profit that monitors and tracks the flow of money in American politics, companies ranging from Vanguard to Legg Mason have doubled the amount of money they dole out for lobbying expenses in recent years, while others such as Fidelity have political action committees that have donated hundreds of thousands of dollars to candidates for political office.


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, intangible asset, interest rate derivative, interest rate swap, John Meriwether, 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, Right to Buy, shareholder value, short selling, The Wealth of Nations by Adam Smith, transaction costs, value at risk, yield curve, zero-coupon bond

Most commodities investors put their money in index funds, of which the largest is the Goldman Sachs Commodity Index (GSCI), which Standard & Poor’s acquired in February 2007. The GSCI, which is heavily weighted towards energy, rose in value from US $4–5 billion in 2001 to US $60 billion in early 2007. Index funds can only take a long position, which means they cannot profit from a declining market by taking short positions, and they are not geared. Backwardation and contango Index funds will roll contracts at periods that the market can often predict. If the market is in backwardation, the forward price (agreement to buy or sell at an agreed future point) is lower than spot (agreement to buy and sell immediately and settle for cash). Index funds will gain because they sell high and buy low.

Index funds will gain because they sell high and buy low. If the market is in contango, the forward price is higher than spot, and index funds will lose money because they sell low and buy high. In early 2007, some commodities had switched into contango, which made it arguably a bad time to start investing in commodities. Some index funds are looking at rolling futures contracts differently to reduce the contango effect. Retail investment in commodities is negligible. But private investors can invest in managed funds that invest in underlying companies such as energy or mining companies, or directly in the companies themselves. This does not always achieve the same result as investing in pure commodities because a lot of corporate factors unrelated to commodities must be taken into account. Spread betting (see Chapter 9) is a way to trade commodity derivatives.

The industry showed an initial mixed reaction to the proposals that, as the second edition of this book went to press, were under consultation. There were concerns about the distinction between the two types of adviser and whether the ‘independent’ label would truly mean there was no bias. Some felt that the idea of primary products had been tried before and did not work, and could lead to mis-selling because some products like index funds were simple to explain but not low risk. Meanwhile, a review is underway to research and prepare a national approach to ‘generic’ financial advice, led by Otto Thoreson, chief executive at insurer Aegon UK. A generic adviser should take a holistic view of the consumer’s finances and recommend that the customer move to the stage of buying products only when it suited his or her circumstances. The generic adviser would not be regulated to sell products but might refer the client to a financial adviser.


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, beat the dealer, 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, Edward Thorp, en.wikipedia.org, Eugene Fama: efficient market hypothesis, high net worth, index fund, interest rate swap, Isaac Newton, Johann Wolfgang von Goethe, John Meriwether, John von Neumann, Kenneth Arrow, Long Term Capital Management, Louis Bachelier, margin call, market bubble, market fundamentalism, Marshall McLuhan, Myron Scholes, New Journalism, Norbert Wiener, offshore financial centre, Paul Samuelson, publish or perish, quantitative trading / quantitative finance, random walk, risk tolerance, risk-adjusted returns, Robert Shiller, Robert Shiller, Ronald Reagan, Rubik’s Cube, 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, zero-sum game

A passive investor is defined as anyone sensible enough to realize you can’t beat the market. The passive investor puts all his money into a market portfolio of every stock in existence (roughly, an “index fund”). An active investor is anyone who suffers from the delusion that he can beat the market. The active investor puts his money into anything except a market portfolio. By Sharpe’s terminology, an active investor need not trade “actively.” A retired teacher who has two shares of AT&T in the bottom of her dresser drawer counts as an active investor. She is operating on the assumption that AT&T is a better stock to own than a total market index fund. Active investors include anyone who tries to pick “good” stocks and shun “bad” ones, or who hires someone else to do that by putting money in an actively managed mutual fund or investment partnership.

At the Kefauver hearings, Willie Moretti supplied a telling definition of the word mob: “People are mobs that make six percent more on the dollar than anyone else does.” It is not just criminals who cherish the belief that there is an easier way of getting rich. The small investor has long been inundated by mutual fund and brokerage ads implying that you’d be a sap to settle for “average” returns. It is an American credo that you can pick a “good” mutual fund from Morningstar ratings. “Good” presumably means that it will earn more cents on the dollar than an index fund. It is a more astonishing credo that the small investor can pick market-beating stocks him- or herself just by doing a little research on the Internet and watching pundits on CNBC. This raises an important point, the connection between market information and return. “In an efficient market,” Eugene Fama wrote, “competition among the many intelligent participants leads to a situation where, at any point in time, actual prices of individual securities already reflect the effect of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future.”

His point was that a horse race is like a particularly fast-paced and vicious stock market. It would be alarming to visit a great stock exchange and find the floor littered with worthless stock certificates. Try visiting a racetrack. Most wager tickets become worthless within minutes. It is folly to bet everything on a favorite (horse or stock). The only way to survive is through diversification. Someone who bets on every horse—or buys an index fund—will at least enjoy average returns, minus transaction costs. “Average” isn’t so hot at the racetrack, given those steep track takes. “Average” is pretty decent for stocks, something like 6 percent above the inflation rate. For a buy-and-hold investor, commissions and taxes are small. Shannon was more interested in above average returns. The only way to beat the market (of stocks or horse wagers) is by knowing something that other people don’t.


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, creative destruction, 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, fixed income, 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, John Markoff, Joseph Schumpeter, Kenneth Rogoff, libertarian paternalism, low skilled workers, lump of labour, Malacca Straits, market bubble, microcredit, money market fund, 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 rule of 72, 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, zero-sum game

(Burton Malkiel has pointed out that since diversification is important, the monkey should actually throw a wet towel at the stock pages.) Indeed, investors now have access to their own monkey with a towel: index funds. Index funds are mutual funds that do not purport to pick winners. Instead, they buy and hold a predetermined basket of stocks, such as the S&P 500, the index that comprises America’s largest five hundred companies. Since the S&P 500 is a broad market average, we would expect half of America’s actively managed mutual funds to perform better, and half to perform worse. But that is before expenses. Fund managers charge fees for all the tire-kicking they do; they also incur costs as they trade aggressively. Index funds, like towel-throwing monkeys, are far cheaper to manage. But that’s all theory. What do the data show? It turns out that the monkey with a towel can be an investor’s best friend.

But look what happens as the time frame gets longer: Only 45 percent of actively managed funds beat the S&P over a twenty-year stretch, which is the most relevant time frame for people saving for retirement or college. In other words, 55 percent of the mutual funds that claim to have some special stock-picking ability did worse over two decades than a simple index fund, our modern equivalent of a monkey throwing a towel at the stock pages. If you had invested $10,000 in the average actively managed equity fund in 1973, when Malkiel’s heretical book A Random Walk Down Wall Street first came out, it would be worth $355,091 today (many editions later). If you had invested the same amount of money in an S&P 500 index fund, it would now be worth $364,066. Data notwithstanding, the efficient markets theory is obviously not the most popular idea on Wall Street. There is an old joke about two economists walking down the street. One of them sees a $100 bill lying in the street and points it out to his friend.

Craig MacKinlay of the Wharton School are the authors of a book entitled A Non-Random Walk Down Wall Street in which they assert that financial experts with extraordinary resources, such as supercomputers, can beat the market by finding and exploiting pricing anomalies. A BusinessWeek review of the book noted, “Surprisingly, perhaps, Lo and MacKinlay actually agree with Malkiel’s advice to the average investor. If you don’t have any special expertise or the time and money to find expert help, they say, go ahead and purchase index funds.”8 Warren Buffett, arguably the best stock picker of all time, says the same thing.9 Even Richard Thaler, the guy beating the market with his behavioral growth fund, told the Wall Street Journal that he puts most of his retirement savings in index funds.10 Indexing is to investing what regular exercise and a low-fat diet are to losing weight: a very good starting point. The burden of proof should fall on anyone who claims to have a better way. As I’ve already noted, this chapter is not an investment guide. I’ll leave it to others to explain the pros and cons of college savings plans, municipal bonds, variable annuities, and all the other modern investment options.


pages: 284 words: 79,265

The Half-Life of Facts: Why Everything We Know Has an Expiration Date by Samuel Arbesman

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Albert Einstein, Alfred Russel Wallace, Amazon Mechanical Turk, Andrew Wiles, bioinformatics, British Empire, Cesare Marchetti: Marchetti’s constant, Chelsea Manning, Clayton Christensen, cognitive bias, cognitive dissonance, conceptual framework, David Brooks, demographic transition, double entry bookkeeping, double helix, Galaxy Zoo, guest worker program, Gödel, Escher, Bach, Ignaz Semmelweis: hand washing, index fund, invention of movable type, Isaac Newton, John Harrison: Longitude, Kevin Kelly, life extension, Marc Andreessen, meta analysis, meta-analysis, Milgram experiment, Nicholas Carr, p-value, Paul Erdős, Pluto: dwarf planet, publication bias, randomized controlled trial, Richard Feynman, Richard Feynman, Rodney Brooks, social graph, social web, text mining, the scientific method, Thomas Kuhn: the structure of scientific revolutions, Thomas Malthus, Tyler Cowen: Great Stagnation

It’s hard enough to have the newest knowledge in one’s own field, but dealing with knowledge that’s outside of one’s area of expertise is even harder. Unless we want to make it our jobs to figure out how to invest, just use index funds and don’t bother focusing too carefully on individual stocks. Perhaps the same advice can be used for knowledge. Unless it’s one’s job to keep abreast of a certain field of knowledge, simply use the informational equivalent of index funds. But what are informational index funds? They are publications and Web sites that aggregate changing knowledge all in a single place. These include magazines, blogs, and the “What’s News” column in the Wall Street Journal, among other sources. While informational index funds can help, reading omnivorously is still important, and we have already been given some help with this. The Atlantic has begun running a series called Media Diet, which asks influential thinkers what they read and how they get their facts and news.

., 174 Godwin’s law, 105 Goldbach’s Conjecture, 112–13 Goodman, Steven, 107–8 Gould, Stephen Jay, 82 grammar: descriptive, 188–89 prescriptive, 188–89, 194 Granovetter, Mark, 76–78 Graves’ disease, 111 Great Vowel Shift, 191–93 Green, George, 105–6 growth: exponential, 10–14, 44–45, 46–47, 54–55, 57, 59, 130, 204 hyperbolic, 59 linear, 10, 11 Gumbel, Bryant, 41 Gutenberg, Johannes, 71–73, 78, 95 Hamblin, Terry, 83 Harrison, John, 102 Hawthorne effect, 55–56 helium, 104 Helmann, John, 162 Henrich, Joseph, 58 hepatitis, 28–30 hidden knowledge, 96–120 h-index, 17 Hirsch, Jorge, 17 History of the Modern Fact, A (Poovey), 200 Holmes, Sherlock, 206 homeoteleuton, 89 Hooke, Robert, 21, 94 Hull, David, 187–88 human anatomy, 23 human computation, 20 hydrogen, 151 hyperbolic growth rate, 59 idiolect, 190 impact factors, 16–17 inattentional blindness (change blindness), 177–79 India, 140–41 informational index funds, 197 information transformation, 43–44, 46 InnoCentive, 96–98, 101, 102 innovation, 204 population size and, 135–37, 202 prizes for, 102–3 simultaneous, 104–5 integrated circuits, 42, 43, 55, 203 Intel Corporation, 42 interdisciplinary research, 68–69 International Bureau of Weights and Measures, 47 Internet, 2, 40–41, 53, 198, 208, 211 Ioannidis, John, 156–61, 162 iPhone, 123 iron: magnetic properties of, 49–50 in spinach, 83–84 Ising, Ernst, 124, 125–26, 138 isotopes, 151 Jackson, John Hughlings, 30 Johnson, Steven, 119 Journal of Physical and Chemical Reference Data, 33–35 journals, 9, 12, 16–17, 32 Kahneman, Daniel, 177 Kay, Alan, 173 Kelly, Kevin, 38, 46 Kelly, Stuart, 115 Kelvin, Lord, 142–43 Kennaway, Kristian, 86 Keynes, John Maynard, 172 kidney stones, 52 kilogram, 147–48 Kiribati, 203 Kissinger, Henry, 190 Kleinberg, Jon, 92–93 knowledge and facts, 5, 54 cumulative, 56–57 erroneous, 78–95, 211–14 half-lives of, 1–8, 202 hidden, 96–120 phase transitions in, 121–39, 185 spread of, 66–95 Koh, Heebyung, 43, 45–46, 56 Kremer, Michael, 58–61 Kuhn, Thomas, 163, 186 Lambton, William, 140 land bridges, 57, 59–60 language, 188–94 French Canadians and, 193–94 grammar and, 188–89, 194 Great Vowel Shift and, 191–93 idiolect and, 190 situation-based dialect and, 190 verbs in, 189 voice onset time and, 190 Large Hadron Collider, 159 Laughlin, Gregory, 129–31 “Laws Underlying the Physics of Everyday Life Really Are Completely Understood, The” (Carroll), 36–37 Lazarus taxa, 27–28 Le Fanu, James, 23 LEGO, 184–85, 194 Lehman, Harvey, 13–14, 15 Leibniz, Gottfried, 67 Lenat, Doug, 112 Levan, Albert, 1–2 Liben-Nowell, David, 92–93 libraries, 31–32 life span, 53–54 Lincoln, Abraham, 70 linear growth, 10, 11 Linnaeus, Carl, 22, 204 Lippincott, Sara, 86 Lipson, Hod, 113 Little Science, Big Science (Price), 13 logistic curves, 44–46, 50, 116, 130, 203–4 longitude, 102 Long Now Foundation, 195 long tails: of discovery, 38 of expertise, 96, 102 of life, 38 of popularity, 103 Lou Gehrig’s disease (ALS), 98, 100–101 machine intelligence, 207 Magee, Chris, 43, 45–46, 56, 207–8 magicians, 178–79 magnetic properties of iron, 49–50 Maldives, 203 Malthus, Thomas, 59 mammal species, 22, 23, 128 extinct, 28 manuscripts, 87–91, 114–16 Marchetti, Cesare, 64 Marsh, Othniel, 80–81, 169 mathematics, 19, 51, 112–14, 124–25, 132–35 Matthew effect, 103 Mauboussin, Michael, 84 Mayor, Michel, 122 McGovern, George, 66 McIntosh, J.


pages: 364 words: 101,286

The Misbehavior of Markets by Benoit Mandelbrot

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

As in many scientific fields, so in the dismal science a consensus emerges about what is right and what is wrong, what research is worthy a doctoral thesis and what is not. I have run counter-trend most of my professional career. In the 1960s, most theoretical economists were lionizing Bachelier and his heirs. The next decade, Wall Street embraced their theories. They were the intellectual foundation for stock-index funds, options exchanges, executive stock options, corporate capital-budgeting, bank risk-analysis, and much of the world financial industry as we know it today. Throughout this time, I was being heard, but as a near-lone voice denouncing the flaws in the logic. By the late 1980s and 1990s, however, I was no longer alone in seeing those flaws. The financial dislocations convinced many professional financiers that something was wrong.

And if you have special insights into a stock, you could profit from being the first in the market to act on it. But you cannot be sure you are right or first; after all, the market is full of people at least as smart as you. So, in sum, it may not be worth your while to spend all that time and money getting the information in the first place. Cheaper and safer to ride with the market. Buy a stock index fund. Relax. Be passive. Or as Samuelson at MIT put it: “They also serve who only sit and hold.” His advice, then:A respect for evidence compels me to incline toward the hypothesis that most portfolio decision makers should go out of business—take up plumbing, teach Greek, or help produce the annual GNP by serving as corporate executives. Even if this advice to drop dead is good advice, it obviously is not counsel that will be eagerly followed.

If fluctuations in stock prices suggested a second, better investment palette, then everybody would start moving their money into that new portfolio and abandoning the first. Soon, there would again be just one portfolio, the “market portfolio.” So the market, itself, was doing the Markowitz calculations. It was the most powerful computer of all, producing tick-by-tick the optimum investment fund. Thus was born the notion of a stock-index fund: a big pool of money, from thousands of investors, holding shares in exactly the same proportion as the real market overall. Of course, the details are not so simple. First decide what you mean by “the market”: just the thirty industrial stocks in the Dow, or the hundred shares in the British FTSE index? Should you include bonds? What about other risky assets, like home equity? And, whatever the market, you will still need to keep re-tuning the fund to track it.


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, commoditize, 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, information asymmetry, 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, Myron Scholes, negative equity, New Journalism, oil shock, p-value, passive investing, Paul Samuelson, 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, selection bias, Sharpe ratio, short selling, sovereign wealth fund, statistical arbitrage, statistical model, stochastic volatility, survivorship bias, 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, zero-sum game

(This could have been accepted, had they not as a group consistently underperformed index funds.) Lumping alpha and beta together in a tie-in sale made sense for sellers who could add some long-run value by providing access to the equity premium (and camouflaging any underperformance), but not for buyers, who could access the equity premium much more cheaply through index funds. Add a notion that HF managers can provide positive alpha even after their costs and fees—unlike traditional managers—and, voilà, alpha–beta separation is the way to go. A barbell of very cheap index funds (beta providers) and more expensive hedge funds (alpha providers) can be more cost-effective than investment in a traditional long-only fund. This argument became a great defense against institutional investors’ qualms about high HF fees: the blended fee in a portfolio of index funds and hedge funds is arguably competitive with traditional active long-only managers if we consider their alpha–beta mix (both contain equity beta but HFs much less than traditional long-only) and insist that beta exposure should earn only an index fund fee.

A key example is the S&P 500 inclusion effect—the finding that new entries to the S&P 500 index experience a sudden and persistent price jump, presumably due to new buying pressure from index funds. Shleifer (1986) argued that if stocks have horizontal demand curves, no price impact is expected, but if demand curves are downward sloping, the rightward shift in the demand curve implies a sudden price increase, consistent with the evidence. Later research shows that the degree of substitutability varies (some stocks to be included have close counterparts, while others have much lower correlations—and thus have greater arbitrage risk). Stocks lacking close substitutes experience higher price jumps upon inclusion into the S&P 500. Still, index funds are expected by their investors to hold every stock in the S&P 500 index and some price pressure effect should be observed for any stock added to that index, no matter how many close substitutes the stock has.

This argument became a great defense against institutional investors’ qualms about high HF fees: the blended fee in a portfolio of index funds and hedge funds is arguably competitive with traditional active long-only managers if we consider their alpha–beta mix (both contain equity beta but HFs much less than traditional long-only) and insist that beta exposure should earn only an index fund fee. Not surprisingly, most institutional inflows after the millennium have gone into the alpha–beta barbell—not to traditional managers. A variation on this strategy is alpha transport (portable alpha). A beta position is established using index derivatives, which do not tie up very much capital. Then, a portfolio of HFs is assembled to add alpha. (HFs do require that the investor put up capital.) This blend substitutes for the more traditional strategy of selecting active managers with the beta position as their benchmark. For years, the HF industry had a wonderful marketing story, especially as long as investors believed that all returns produced by the mythical “good” HF manager are pure alpha.


pages: 379 words: 114,807

The Land Grabbers: The New Fight Over Who Owns the Earth by Fred Pearce

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Asian financial crisis, banking crisis, big-box store, blood diamonds, British Empire, Buy land – they’re not making it any more, Cape to Cairo, carbon footprint, clean water, corporate raider, credit crunch, Deng Xiaoping, Elliott wave, en.wikipedia.org, energy security, farmers can use mobile phones to check market prices, index fund, Jeff Bezos, land reform, land tenure, Mahatma Gandhi, market fundamentalism, megacity, Mohammed Bouazizi, Nikolai Kondratiev, offshore financial centre, out of africa, quantitative easing, race to the bottom, Ronald Reagan, smart cities, structural adjustment programs, too big to fail, urban planning, urban sprawl, WikiLeaks

New kinds of financial derivatives were created, somewhat analogous to those behind the subprime mortgage business, whose collapse triggered the 2008 banking crisis. Traditional futures are themselves a form of derivative, of course. But the new forms began in 1991, when Goldman Sachs packaged up commodities futures of all sorts (from coffee and corn to oil and copper) into the Goldman Sachs Commodity Index. It then sold stakes in index funds. By buying them, investors were betting on the future price of a basket of commodities. The first index funds bumped along for years without attracting too much attention. Then in 2005, three things happened that suddenly made them extremely attractive to investors. First, real food prices started to push up after a long period of decline. Second, it started to look like investing in some of the other derivatives markets beloved by speculators, like subprime mortgages, might not be so clever.

Between 2005 and 2008, speculators piled into commodities index funds. The funds swiftly came to dominate key U.S. markets in corn, wheat, and soy. A report from Morgan Stanley estimated that the number of contracts in corn futures increased fivefold between 2003 and 2008. The distinguished Indian economist Jayati Ghosh said later: “From about late 2006, a lot of financial firms realized that there was really no more profit to be made in the US housing market.” They switched to commodities and began pushing up prices “so that what was a trickle in late 2006 becomes a flood from early 2007.” As the prices of shares, real estate, and other former wealth generators fell during the credit crunch of 2008, the prices of commodities index funds continued to rise, as investors poured in. This accelerated as governments in the United States and Europe tried to save the world banking system by pumping in new money—quantitative easing.

Rain and tornadoes put wheat crops in jeopardy in the U.S. and Canadian prairies, and La Niña messed with the harvests in Argentina and Brazil. But a bad situation was again made worse by rampant speculation. After federal reserve chairman Ben Bernanke pumped another $600 billion of “quantitative easing” into the U.S. economy in November 2010, Barclays Capital said speculators were pushing record amounts into index funds, in the hope of tapping more profits as prices rose. Investment in commodity index funds in the United States alone was reported at above $400 billion. The bubble inflated. Back in the real world, by mid-2011, wheat was up 98 percent from the previous May, beef 32 percent, sugar 48 percent, cocoa 80 percent, cooking oils 53 percent, and rice 33 percent. Food prices overall had tripled since 2004. It is becoming clear things have gone badly wrong.


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, commoditize, 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, George Santayana, 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, Myron Scholes, 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, selection bias, Sharpe ratio, short selling, sovereign wealth fund, special drawing rights, statistical arbitrage, stochastic volatility, survivorship bias, The Great Moderation, Thomas Bayes, time value of money, too big to fail, transaction costs, unbiased observer, value at risk, Vanguard fund, yield curve, zero-sum game

If Protégé wins, the money is to be given to Absolute Return for Kids (ARK), an international philanthropy based in London. If Buffett wins, the intended recipient is Girls Inc. of Omaha. To see more information about the bet, go to www.longbets.org. During the course of 2008, the Vanguard S&P 500 fund was down 37 percent and on average (net of all fees, costs, and expenses) the five funds-of-funds selected by Protégé were down 23.9 percent. At year-end 2009, the Vanguard 500 Index Fund’s (VFINX) return was 26.5 percent while the HFRI Fund of Funds Composite Index (a proxy for the five funds-of-hedge-funds) was up 11.2 percent for the year. After two years of performance, the approximate BAV (Bet Asset Value) is: Protégé 84.6; Buffett 79.7. You cannot have it both ways. Either you take an absolute return approach regardless of the market environment, or you just go for efficient beta and be happy with the outcome.

Speaking at a conference in the spring of 2008, I said there is a good chance the market goes to hell because the system needs to be cleaned and we have to pay for an orgy of credit. People thought I was crazy. A year ago I was a cash manager. Then I became a corporate bond buyer—I did not care about stocks. Six months ago I became a value stock buyer, buying all the deep value I could find. Now I am a long-only index fund, trying not to get whipsawed by the market’s gyrations and trying not to get distracted by people talking about the end of the rally. I am working from the principle that the big fear is behind us. Because people are only as good as their last six months in our industry, those who were negative and have not participated in the recent rally are looking for an excuse. In markets, you cannot be one thing or another; rather, you have to evolve according to different market environments.

But this year I probably made 10 times more money in bank stocks than a traditional mutual fund financial specialist made over the last few years because financials were completely wiped out. Identifying a new subject and having the flexibility and the skill to go trade it is what is required. So you read the papers and watch the tape all day, every day, in markets around the world? At times like the present, I do nothing—again, I am an index fund right now. I do not want to watch the tape—I do not care about the tape. Sometimes it is very important to look at the tape, but not right now. Sometimes, as a fund manager, it is very important to escape from the markets in order to avoid getting disturbed by the noise. I try to stay out of the office now. Every time the market has a wobble my traders get nervous and say it looks very bad—they want to sell everything, yet I tell them to buy.


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, fixed income, 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

Tan Wei, “China’s CIC likely to Diversify away from Further U.S. Banking Sector Investments, Source Says,” Financial Times, 30 December 2007. 120. An index fund is a passively managed mutual fund that tries to mirror the performance of a specific index, such as the S&P 500. An index fund aims to replicate the movements of an index of a specific financial market, or a set of rules of ownership that are held constant, regardless of market conditions. Tracking can be achieved by trying to hold all of the securities in the index, in the same proportions as the index. Other methods include statistically sampling the market and holding “representative” securities. Many index funds rely on a computer model with 218 Notes little or no human input in the decision as to which securities to purchase and is therefore a form of passive management. 121.

In an effort to earn a greater return, the managers of Norway’s Government Pension Fund adopted a macro-level investment formula that calls for placing 60% of Oslo’s portfolio in indexed equities and the remaining 40% in fixed income instruments.30 The head of the Kuwait Investment Authority contends he seeks to follow a model employed at the Harvard and Yale endowment funds—a mix of stocks, private equity funds, and real estate.31 The manager of Russia’s stabilization fund reports he is required to pursue an even broader mix of investments ranging from foreign currencies to shares in investment funds.32 Unfortunately, this turn to private equity does not mean simply shifting the monies from Washington to New York. As investors at Harvard and Yale have discovered, a long-term commitment to indexed funds listed on Wall Street is not as profitable as many Americans would like to believe. Increasingly, diversification in the sovereign wealth fund world means placing the money in assets Sovereign Wealth Funds: The Peril and Potential for America 9 outside the United States. All of this suggests that the big losers here are not just the U.S. Treasury; corporate America is also poised to begin paying more for the privilege of borrowing money.

According to the Norges Bank Investment Management team, their performance could best be attributed to two events: (1) the fund’s move to place more than 40% of its investments in the equity market since 1998, and (2) the “worst decline in global equities markets since the 1930s,” which began in 2000.37 Needless to say, this performance has garnered significant criticism at home, with at least one critic claiming the fund’s investment managers only “make Norway more poor.”38 (The Norges Bank team actually did not do as poorly as one might first suspect. A review of stock performance using a buy-and-hold model for the same time period (1998–2006) reveals that the following rates of return could have been expected by purchasing only “name brand” shares: Dow Jones Industrials 6.11%, Standard & Poor’s 500 Index 4.94%, Vanguard 500 Index Fund 7.37%, and NASDAQ Composite Index 5.88%.) China’s new sovereign wealth fund managers have also suffered setbacks in their efforts to wisely invest the approximately $200 billion39 Beijing has placed in their hands.40 The China Investment Corporation (CIC) purchased a 9.3% share of the Blackstone Group private equity firm for $3 billion prior to the firm’s initial public offering (IPO) in June 2007.


pages: 263 words: 89,368

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

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

Fees vary widely from fund to fund. Funds that seek to beat market returns are often called actively managed funds; these funds tend to charge more. Funds that seek to match the return of a market index are called index funds. They can match market returns more easily because they simply buy a basket of stocks (or bonds) that represent the index well. The composition of most indexes changes infrequently so little management of index funds is required so their costs are much lower. Since most funds don’t beat the market consistently and those that try have higher fees, buying index funds with low expense ratios seems a good bet. Other Fees and Expenses: Mutual funds may charge you a variety of fees and expenses, but all must be disclosed before you make your purchase. It is impossible to predict accurately the returns you’ll earn on a mutual fund investment.

Consider the costs: mutual fund managers collect their money by charging the investors small fees to enter the fund and for managing the money each year. The “load” refers to the fee to enter the investment and the “expense ratio” refers to the annual cost. If you invest in a fund with a 6% load and a 2% expense ratio, your fund will need to generate an 8% annual return (tough to do) just for you to break even in the first year. Look for “no load” funds and funds with low expense ratios. Many of the lowest cost funds are “index” funds that don’t try to beat a market index, they just try to match it. Given that very few funds consistently beat the market, focusing on fees is a great way to keep your money growing. Evaluate the risk: consider your personal appetite for risk and screen mutual funds to find those that appeal to your sense of adventure or your fear of falling, as the case may be. Remember that risk is generally compared among funds of the same class.

Any bond fund has the potential to lose value, but generally they tend to be more stable in value than stock funds. Bond funds are suitable investments for both retirement savings and college savings accounts. For college funds, emphasize short and intermediate term funds. Sector Funds: There are number of funds that focus all of their investments on stocks in a particular sector. These funds tend to be much riskier. The broad index funds provide real diversification because they invest in a variety of companies from across the economic landscape. Sector funds concentrate their bets on a single industry. All of the companies in an industry face the same economic challenges—and benefits together. Hence, these funds behave much more like individual stocks with much greater swings in value. As a general rule, these are not suitable investments.


pages: 206 words: 70,924

The Rise of the Quants: Marschak, Sharpe, Black, Scholes and Merton by Colin Read

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Albert Einstein, Bayesian statistics, Black-Scholes formula, Bretton Woods, Brownian motion, capital asset pricing model, collateralized debt obligation, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, David Ricardo: comparative advantage, discovery of penicillin, discrete time, Emanuel Derman, en.wikipedia.org, Eugene Fama: efficient market hypothesis, financial innovation, fixed income, floating exchange rates, full employment, Henri Poincaré, implied volatility, index fund, Isaac Newton, John Meriwether, John von Neumann, Joseph Schumpeter, Kenneth Arrow, Long Term Capital Management, Louis Bachelier, margin call, market clearing, martingale, means of production, moral hazard, Myron Scholes, naked short selling, Paul Samuelson, price stability, principal–agent problem, quantitative trading / quantitative finance, RAND corporation, random walk, risk tolerance, risk/return, Ronald Reagan, shareholder value, Sharpe ratio, short selling, stochastic process, The Chicago School, the scientific method, too big to fail, transaction costs, tulip mania, Works Progress Administration, yield curve

For instance, he produced a discrete-time binomial option pricing procedure that offered a readily applicable procedure for BlackScholes securities pricing, which will be covered in the next part of this book. He also developed the Sharpe ratio, a measure of the risk of a mutual or index fund versus its reward. Sharpe continued to work to make financial concepts more democratic and more accessible. He helped develop Financial Engines, an Internetbased application to deliver investment advice online. 78 The Rise of the Quants Ever concerned about the practitioner’s side of finance, Sharpe began to consult with investment houses, first Merrill Lynch and then Wells Fargo. At Merrill Lynch, he helped set up their CAPM analysis capacity. At Wells Fargo, he helped develop methodologies for the creation of index funds and the assessment of portfolio risk. In 1986 Sharpe collaborated with the Frank Russell Company to establish the Sharpe-Russell Research firm.

By this we mean that there are no transactions costs or taxes, that no trader has the power to influence prices and all are equally and costlessly informed, that assets can be traded in infinitely divisible amounts, and that expectations are homogenous while investors are rational maximizers in the domain of security means and variances. In addition, the market portfolio must contain all securities in proportion to their relative capitalization, and each security is efficiently priced according to its risk. If we accept these premises, there is an important consequence. An individual investor is freed from analyzing the entire market and can simply hold a market portfolio, or an efficient index fund. The investor can price additions to the portfolio by simply considering the security’s beta. Then the market acts as a pool of the risk aversion of all participants, weighted by their holdings, and each individual security is simply priced relative to its covariance relative to the market variance. All securities price risk efficiently and hence the combination of any two securities could replicate the market portfolio.

Lorie (1922–2005) and the CBOE’s champion and first Vice Chairman, Edmund O’Connor. Lorie was renowned at the time for his creation of the Center for Research in Stock Prices (CRSP) database, still the most commonly employed finance database for financial academics today. He had also Applications 119 come across Black when Black and Associates was advocating for Wells Fargo to create various index funds. At the same time, O’Connor had risen to leadership at the CBOT and had convinced skeptics on the Board that the time was ripe for the world’s first options exchange. O’Connor was convincing and helped bring the CBOE to fruition in 1973, within months of Black and Scholes’ publication. William Brodsky, Chairman of the CBOE, reported that: “Although the idea came from Ed and a couple of others at the Board of Trade, they were constantly fighting at the Board of Trade about whether it should even happen and whether it should continue to be funded.


pages: 545 words: 137,789

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

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

Most immediately, it raised the popularity of “index funds”—mutual funds that bought large baskets of stocks, seeking to replicate the performance of the overall market. If fundamental analysis doesn’t work and most fund managers routinely fail to outperform the market, there can be no justification for the hefty fees that actively managed mutual funds charge investors. Investing in index funds, which keep their fees at minimal levels, is much more sensible. By 2000, tens of millions of Americans had taken Malkiel’s advice and placed much of their retirement money in these types of savings vehicles. (For many years, Malkiel served as a director of the Vanguard Group, which pioneered index funds. Fama joined another firm that manages index funds, Dimensional Fund Advisors.) The rise of efficient market theory also signaled the beginning of quantitative finance.

Wall Street had three answers: diversification, subordination, and the building up of reserves. The argument for diversification was the same one that applies to salting away your retirement savings in mutual funds rather than investing in individual stocks. If you put all of your money in one company and it goes bankrupt, you lose everything; if you invest in five hundred companies, through an index fund, say, and one of them goes out of business, it shouldn’t have much impact on the value of the fund. A bit more formally, the Nobel-winning financial theorist Harry Markowitz demonstrated back in the 1950s that diversification allows investors to minimize the impact of particular damaging events, or what is often referred to as “idiosyncratic risk.” If the oil price plummets, the oil stocks in your retirement fund will probably go down, but cheaper gas frees up cash that gets spent on other things, and the stock in the sectors that benefit, such as retailers and restaurants, should go up.

.”: Quoted in John Cassidy, Dot.con: The Greatest Story Ever Sold (New York: HarperPerennial, 2002), 122–23. 179 “[I]f they want to beat their . . .”: Quoted in “Valuing Those Internet Stocks,” BusinessWeek, February 8, 1999. 179 “I simply can’t analyze . . .”: Quoted in Fidelity Magellan Annual Report, March 31, 1999, available at www.secinfo.com/d1RUq.6c.htm. 179 “Time has come . . .”: “Fidelity Magellan Fund-FMAGX-Rated ‘Aggressive Buy’ and Vanguard 500 Index Fund-VFINX-Rated ‘Buy’ by FidelityAdviser.com,” Business Wire, April 1, 1999. 180 “Is the stock market in a speculative bubble?”: Lauren R. Rublin, “Party On! America’s Portfolio Managers Grow More Bullish on Stocks and Interest Rates,” Barron’s, May 3, 1999, 31–38. 181 Pension fund investment in the Internet bubble: Eli Ofek and Matthew Richardson, “DotCom Mania: The Rise and Fall of Internet Stock Prices,” Journal of Finance 57, no. 3 (June 2003): 1122. 181 “From an efficient markets perspective . . .”: Markus K.


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The Little Book of Hedge Funds by Anthony Scaramucci

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Andrei Shleifer, asset allocation, Bernie Madoff, business process, carried interest, corporate raider, 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, John Meriwether, Long Term Capital Management, mail merge, margin call, mass immigration, merger arbitrage, money market fund, Myron Scholes, 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, the new new thing, too big to fail, transaction costs, Vanguard fund, Y2K, Yogi Berra, zero-sum game

Scott Frush, Understanding Hedge Funds (New York: McGraw-Hill, 2006). 4. Mark J. P. Anson, The Handbook of Alternative Assets (Hoboken, NJ: John Wiley & Sons, 2006), 123. Chapter One What Is a Hedge Fund? The Traditional Long-Only Portfolio versus the Alternative Hedge Fund Portfolio Hedge funds are generally perceived to be the investment of choice of the rich and the informed, and they are more interesting and fun to discuss than your Vanguard index fund. —Cliff Asness, AQR Capital Management The year was 1989. I had just started working at Goldman Sachs in the world of investment banking—the industry adored by many Ivy League students and business school graduates. A few floors up, legendary research director Lee Cooperman was asked by Goldman Sachs to create a mutual fund and lead the Asset Management Division. This long-only equity mutual fund was called GS Capital Growth.

—John Brooks, The Go-Go Years Think about it: If it didn’t exist somebody would have invented it. A system of money management that allows the manager and the capital to have an efficient, symbiotic, and symmetrical relationship. Here’s the deal. There are boring ways to run money, the blunt instruments of asset management—long-only mutual funds and their arch nemeses, the exchange-traded fund (ETF) and the index fund. These products have their followers, and, of course, the true believers will assert the sanctity of their respective product lines with religious ferocity and certainty. Then there are the curmudgeons of finance, the Old Salts who have been there and done that. Can’t fool them—ever—and while there is a sucker born every minute there are 10 sages born in a century, and each of them knows it all.

Chapter Nine The Men Behind the Curtains Fund of Hedge Funds A fund of funds due to the fees involved will, over time, underperform the ETF on the S&P 500. I’ll betcha. —Warren Buffett (well, not really) Okay. Warren buffett never uttered the words above, but he may as well have. In 2008, the Oracle of Omaha bet Protégé Partners LLC—a money management firm that runs a fund of hedge funds—that the returns from a low-cost S&P 500 Index fund sold by Vanguard will outperform the average returns delivered by 5 fund of hedge funds (net of fees, costs, and expenses) over 10 years. Having put up roughly $320,000 on each side, this winner-takes-all wager is serious business. Although the 2007 to 2009 economic crisis put Buffett behind, he is now closing the gap. 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.


pages: 200 words: 54,897

Flash Boys: Not So Fast: An Insider's Perspective on High-Frequency Trading by Peter Kovac

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bank run, barriers to entry, bash_history, Bernie Madoff, computerized markets, computerized trading, Flash crash, housing crisis, index fund, locking in a profit, London Whale, market microstructure, merger arbitrage, prediction markets, price discovery process, Sergey Aleynikov, Spread Networks laid a new fibre optics cable between New York and Chicago, transaction costs, zero day

As any experienced trader will tell you, sometimes odd lots are necessary when you need to precisely offset or hedge your risk in something else. For example, P&G is a large component of the Dow Jones Industrials stock index. If you sold 3,000 shares of the Dow index fund, you might hedge that sale by purchasing the number of shares of P&G that trade represents – about 190 shares. Or if you sold 2,000 shares of the Dow index fund, you might hedge that sale by purchasing the number of shares of P&G that trade represents – about 130 shares. (The ratios change over time, and vary slightly based on the precise model used.) So imagine this: some trader sells 3,000 shares of DIA, an exchange-traded index fund that represents the Dow Jones index. He wants to immediately hedge his risk in P&G and looks to buy the equivalent number of shares. He could buy those shares at the displayed offer in the public markets of $80.52.


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 market fund, money: store of value / unit of account / medium of exchange, moral hazard, Myron Scholes, 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

Long-term, investors were better off investing in the index fund than with active managers. Like Gary Kasparov being beaten by Deep Blue, a low-cost, mechanical rule of holding US equities in proportion to their company size turns out to eventually perform better than most managers. Even though by chance some active managers may beat the market in the long term, it is hard to figure out in advance who will outperform. Why does the indexation policy grind its competitors into dust? Simple: low fees and low trading costs. Active managers are expensive. They do a lot of research; they gather and digest information. They maintain staffs of analysts covering the prospects for various industries. They monitor economic developments that might affect the value of their securities. In contrast, index funds simply hold everything.

Following Lowenfeld’s maxim to diversify internationally, as a group, London’s investors in the golden age of globalization appear to have held assets in near-optimal proportion, as given by a Markowitz model.2 The CAPM is not only an elegant—though abstract—theory, but it is actually widely used for many things in finance. The prediction it makes about equilibrium rates of expected return for high-beta stocks and low-beta stocks is used in corporate decision-making and risk analysis. The prediction about the universal demand for holding a capital-weighted portfolio of assets led to the development of a new type of investment product, an index fund. INDEXATION The development of passive index-based investing came about from the convergence of two streams of academic research in the 1970s. The first is the CAPM result about the market portfolio. Sharpe’s model was a marketer’s dream, because it predicts immediate, widespread demand for a very simple product. The second was a re-consideration of the case for equity investment. In the 1970s, with Edgar Lawrence Smith mostly forgotten, two young Chicago professors, Roger Ibbotson and Rex Sinquefield, decided to return to the basic question of whether stocks were a good long-term investment.

See Great Depression derivatives, financial, 276; on Law’s Mississippi Company shares, 357; pricing models for, 284; Regnault’s valuation of, 281 Detroit, bankruptcy of, 517 development: China’s Self-Strengthening Movement and, 430; imperialism associated with, 418–19; World Bank and, 459. See also economic growth De Witt, Johan, 255–57, 262, 266, 270 Dilmun, in Mesopotamian copper trade, 53–55, 58, 59, 64 Dimson, Elroy, 464 discovery. See exploration Disraeli, Benjamin, 420 diversification of investments: in ancient Near East, 58, 61, 64; in Athenian maritime trade, 79; with first British investment funds, 417; globalization of equity and, 403; by index funds, 508, 509–11; by investment trusts, 473–74; limited liability and, 119–20; Lowenfeld’s science of, 414–16, 453, 470; modern science of, 404; portfolio optimization models for, 504–8; Roman publican societies and, 123. See also mutual funds dividend futures, of Casa di San Giorgio, 292 dividends: of Casa di San Giorgio, 291–92; of China Merchants Steamship Navigation Company, 431, 432; of Dutch East India Company, 317, 318; of Honor del Bazacle, 297, 298, 299; in Marxist analysis, 408; from Smith’s investment funds, 473; of South Sea Company, 339, 340 divination, Chinese, 146–47, 271 Dodd, David, 473, 489–90, 507 double-entry bookkeeping, 246–47 Dow, Charles Henry, 486 Dow Theory, 486–88 Drehem tablet, 37–40, 44, 70, 71 Drew, Daniel, 470 Dunhuang, 177 Dutch canal and dike system, 249–52 Dutch East India Company (VOC), 305, 316–19, 331; Rotterdam and, 363; stock prices in 1720, 369; tradable shares of, 316, 317–18 Dutch finance.


pages: 346 words: 102,625

Early Retirement Extreme by Jacob Lund Fisker

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

Since the risk-reward profiles of most, but not all fund advisors are skewed--that is, fail conventionally and you're okay; fail unconventionally and you're fired; win conventionally and you're okay; win unconventionally and you're a genius--mutual fund advisors that wish to keep their jobs tend to flock together and behave like a herd. This has resulted in the growing popularity of "buy and hold" index funds, which simply mimic what everybody else is doing, on average, at less cost. Of course, the emerging behavior of such a strategy is eventual chaos, as nobody leads and everybody follows each other. Buy and hold is an investment strategy with no exit strategy. What this typically means is that stocks are usually liquidated when money is needed, rather than taking into account when a given stock is overvalued.

It would be a big mistake to think that a choice made now will also be valid only 10 years from now, just as any particular investment vehicle I could suggest now will probably sound silly a decade from now. Thirty years ago everybody hated stocks but loved gold. Twenty years ago mutual funds were the hottest thing. Then after a decade of trending stock markets, which moved up no matter what people owned, it was decided that the managers weren't needed and index funds came into fashion--why do you need a manager if markets go up all on their own? At that point nobody wanted to own gold. In the past 10 years the market has been in a trading range and now gold is more expensive than ever, so who knows what the future will bring? My suggestion is not to presume that one can pick an asset class and then stick with it forever. Despite this, there are a few established principles in the art of investing.

As a result, I always feel slightly worried when I hear the phrase, "They'll think of something..." This changed my attitude towards problems and solutions and I began to use the same approach that I used for my research job in the rest of my life, always trying to understand why something was the way it was, whether it could be different, and if so, how? Instead of adopting the standard moneymanagement plan of saving 15% in an index fund in my retirement plan while getting in debt up to my eyeballs thanks to a "starter home," I started looking into the principles behind the system I was living in. I realized that the standard option of becoming an indebted consumer was just one of many, but that if anyone wanted different options, they'd have to take a different and more active approach rather than just asking "what?" and "when?"


pages: 121 words: 31,813

The Art of Execution by Lee Freeman-Shor

Black Swan, cognitive bias, collapse of Lehman Brothers, credit crunch, Daniel Kahneman / Amos Tversky, diversified portfolio, family office, I think there is a world market for maybe five computers, index fund, Isaac Newton, Jeff Bezos, Long Term Capital Management, loss aversion, price anchoring, Richard Thaler, Robert Shiller, Robert Shiller, rolodex, Skype, South Sea Bubble, Steve Jobs, technology bubble, The Wisdom of Crowds, too big to fail, tulip mania, zero-sum game

Relativity Finally, many fund managers think in relative terms. A fund manager’s performance is assessed relative to an index or his peers. His or her reviewers (employer and clients) are trying to decide whether the manager has been doing a good job. A comparison with an index is suitable because anyone invested in the fund is paying an active fund manager more than it costs to invest in a passive fund (an index fund or exchange-traded fund) that simply replicates the benchmark. For that extra fee, the client is expecting the fund manager to materially outperform. A comparison with peers is also fair because the client who has decided that he or she wants to pay for active management could have invested with a number of other active managers. Many studies over the years have shown that clients have a bias to investing in the best performing funds.

This was a period that captured both the massive technology bubble of the late 1990s and the subsequent popping of that bubble and stock market crash from 2000 to 2002. Given the fact that it is a requirement for most funds to file their holdings with the SEC, their study captured the majority of funds in existence that people could invest in during that period. The only caveat was that the fund had to have net assets of at least $5m and contain at least 20 stocks. Index funds were excluded for the obvious reason that they try to replicate the performance of an index, and the largest holdings cannot be said to represent an active manager’s best ideas. Their findings were startling. They discovered: •The single highest-conviction stock of every manager taken together outperformed the market, as well as the other stocks in those managers’ portfolios, by approximately 1–14%.


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, financial thriller, 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, information asymmetry, intangible asset, interest rate derivative, interest rate swap, invention of the wheel, Irish property bubble, Isaac Newton, John Meriwether, light touch regulation, London Whale, Long Term Capital Management, loose coupling, low cost carrier, M-Pesa, market design, millennium bug, mittelstand, money market fund, moral hazard, mortgage debt, Myron Scholes, new economy, Nick Leeson, Northern Rock, obamacare, Occupy movement, offshore financial centre, oil shock, passive investing, Paul Samuelson, 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

Vanguard – the largest asset management firm after Black-Rock and Allianz – was established in 1975 by Jack Bogle, an evangelical promoter of passive investment.7 Bogle’s thesis was that, since the chances of out-performing a stock market index on a sustained basis were slight, replicating that index was a simple and inexpensive investment strategy. Passive investment has steadily grown in scale, and much of the activity of BlackRock, Vanguard and State Street is in the management of indexed funds, an activity that can now be entrusted to a computer. There are significant economies of scale in passive investment, and these large incumbents derive competitive advantage from their size. The total costs of intermediation include management fees, administrative, custodial and regulatory costs, the costs of remunerating intermediaries, paying trading commissions and spreads between bid and offer price. If you invest directly in an indexed fund, you might be able to reduce these annual costs to 25–50 basis points (the finance sector describes one-hundredth of 1 per cent as a ‘basis point’). This figure is the minimum cost of using the investment channel.

The persuasive rationale of passive management was that most active management was not worth what it cost; the motivation of savers in seeking passive funds is to secure better value for money, not to minimise tracking error, and tracking error is a measure of risk for fund managers, not investors. A passive fund that buys and holds a well-considered selection of stocks achieves the same goal as an index fund, probably more effectively – and avoids the problem, evident on the London Stock Exchange, in which companies of doubtful reputation seek listings in order to force holders of passive funds to buy their stock. There should be more managed intermediation. Transparency and liquidity seem at first sight a good thing, and so of course is the prevention of fraud, and certainly the regulatory provisions have been made with good intentions.

There are many studies of this. See, for example, Malkiel, B. G., 2012, A Random Walk down Wall Street, 10th edn, New York and London, W.W. Norton. pp. 177–83. Porter, G.E., and Trifts, J.W., 2014, ‘The Career Paths of Mutual Fund Managers: The Role of Merit’, Financial Analysts Journal, 70 (4), July/August, pp. 55–71. Philips, C.B., Kinniry Jr, F.M., Schlanger, T., and Hirt, J.M., 2014, ‘The Case for Index-Fund Investing’, Vanguard Research, April, https://advisors.vanguard.com/VGApp/iip/site/advisor/researchcommentary/article/IWE_InvComCase4Index. 20. Kahneman himself is not guilty of this: Kahneman, D., 2011, Thinking Fast and Slow, New York, Farrar, Straus and Giroux. 21. Rubin, R., 2004, In an Uncertain World, New York, Random House. 22. The unknown unknown was famously described by Donald Rumsfeld; see Taleb, N.N., 2007, The Black Swan: The Impact of the Highly Improbable, London, Penguin. 23.

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

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

In the mid-1960s, he had led an effort to rethink equity management at Wells Fargo bank. He had brought in Fischer Black and Myron Scholes, among many other finance notables, to work on the problem, and the ultimate outcome had been the creation of index funds. In that era he had met Oldrich, newly arrived from Czechoslovakia, and convinced him he should come work on finance problems at Wells (rather than analyzing dolphin communications, another offer Oldrich was contemplating at the time). Mac had departed Wells in the early 1970s for the life of an entrepreneur. At the time I met him, he had been involved with starting a small stock index fund, Dimensional Fund Advisors, in Los Angeles, as well as a premium California wine producer, Chalone Group. Mac had a reputation as a bit of a wild man, but I was struck by his interest in people and the world.

I found it very rewarding to build teams and see them succeed in a highly competitive activity. As the Japanese products started to generate great investment returns, I switched to heading BGI’s active equity business in the United States. In early 2001, our biggest challenge was not investment performance, as our equity products had impressive track records. Instead, it was convincing prospects that we were more than just a big index fund provider. In part, this was just BGI’s problem. But in part it also spoke to the very limited legitimacy of quantitative active management. Over a two-year period, my colleague Scott Clifford and I devoted considerable amounts of our time toward changing these perceptions. As investors began to JWPR007-Lindsey 46 May 7, 2007 16:30 h ow i b e cam e a quant notice how BGI and other quantitative managers had managed to deliver on return promises while controlling risk over long periods of time, perceptions changed.

Along with math and physics, I had studied international economics in college. In business school, I also studied taxation and accounting. When I graduated from business school in 1983, I was offered a job in the treasurer’s department at Exxon. It was a dream come true. At the time, Exxon’s treasurer’s department was considered one of the spots in finance. Exxon managed much of its pension fund internally, including a large S&P500 index fund. It had also begun to issue its own debt, bypassing Wall Street bankers and fees. Exxon had global operations and had applied the latest thinking in project analysis using discounted cash flow methods and was analyzing and hedging the impact of currency changes on its operations. It should have been exciting. All in all, there couldn’t have been a more stifling place to work. JWPR007-Lindsey 180 April 30, 2007 18:1 h ow i b e cam e a quant Exxon had layers and layers of management.


pages: 270 words: 75,803

Wall Street Meat by Andy Kessler

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accounting loophole / creative accounting, Andy Kessler, automated trading system, banking crisis, Bob Noyce, George Gilder, index fund, Jeff Bezos, market bubble, Menlo Park, pets.com, Robert Metcalfe, rolodex, Sand Hill Road, Silicon Valley, Small Order Execution System, Steve Jobs, technology bubble, Y2K

Books were being written about chimpanzees and dart throwers doing better than professional money managers. John Bogle at Vanguard in Pennsylvania had a solution, i.e., if you can’t beat the market, just become the market. Index the whole thing. The bulk of the market was represented by the Standards and Poor (S&P) 500 index, the top 500 valuable public companies in the U.S. Bogle offered an index fund that did neither better, nor worse than the market, and it caught on as a savior of investors. Money came out of banks and into mutual funds, much of which were index funds. By 1996, over $1 trillion was in mutual funds. Quacking Ducks But indexing is dull. Those looking for better returns tried other ways to beat the market. General Electric, worth $240 billion makes up 4% of the $8 trillion S&P 500 index. If it halves in value one day, but two $60 billion valued companies double in value that same day, the index doesn’t budge.

Despite lowering their standards, the damn thing worked. It was worth $1 billion on its first day of trading. I thought it was a bargain at half the price. Shows you what I know, it kept going up. The problem was that there just weren’t that many Internet companies to go around. Every momo had to own a piece of Yahoo, and bid it up. As the performance of momo funds improved, more money came out of index funds and into momo funds. What was needed was more public Internet companies. Not a problem, for there were plenty of companies that 173 Wall Street Meat could quickly adopt the Internet, put dotcom at the end of their name, and get fed to the ducks. Wall Street was happy to oblige, for a modest 7% fee. · · · One of the first high profile deals Frank won was Amazon.com, an online bookseller in Seattle.


pages: 224 words: 13,238

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

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

Investment managers and traders executing on behalf of disciplines focused on value and growth with long-term horizons may lack the skill-set to be savvy enough to execute at the best available execution price. 96 Electronic and Algorithmic Trading Technology Management Style Trade Motivation Liquidity Demands Execution Costs Opportunity Costs Value Value Low Low Low Growth Value Low Low Low Information High High High Passive Variable Variable High Passive High High High Earnings Surprise Index-Fund Large-Cap Index-Fund Small-Cap Exhibit 9.3 Expectations—cost and management style. Source: David J. Leinweber, Trading and Portfolio Management: Ten Years Later, California Institute of Technology, May 2002. These traders may lack close relationships with the street to get the best prices through comparison shopping. Traders executing on behalf of investment strategies that depend on quick execution based on market reaction may have better relationships with broker-dealers who may offer price discounts to give incentive for quick execution traders to come back and Net Transaction Costs (Basis Points) Observations- Cost vs.

Costs and Management Style Can transaction costs be predicted through investment management style? Patient disciplines such as value and growth investing with longer time horizons may be expected to have lower transaction costs. Investment strategies that depend on quicker execution to capture the market’s reaction to differences between expected and actual earnings may have higher transactions. Index funds tracking small capitalization stocks would theoretically be expected to have larger transaction costs because of the characteristics of smaller stock made up in those indexes. The theoretical expectations are shown in Exhibit 9.3. However, the actual observations are listed in Exhibit 9.4. Why is there such a wide deviation between the expectations summarized versus the actual observations? Several explanations can be made regarding the results.


pages: 293 words: 81,183

Doing Good Better: How Effective Altruism Can Help You Make a Difference by William MacAskill

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barriers to entry, basic income, Black Swan, Branko Milanovic, Cal Newport, Capital in the Twenty-First Century by Thomas Piketty, carbon footprint, clean water, corporate social responsibility, correlation does not imply causation, Daniel Kahneman / Amos Tversky, David Brooks, effective altruism, en.wikipedia.org, end world poverty, experimental subject, follow your passion, food miles, immigration reform, income inequality, index fund, Intergovernmental Panel on Climate Change (IPCC), Isaac Newton, job automation, job satisfaction, labour mobility, Lean Startup, M-Pesa, mass immigration, meta analysis, meta-analysis, microcredit, Nate Silver, Peter Singer: altruism, purchasing power parity, quantitative trading / quantitative finance, randomized controlled trial, self-driving car, Skype, Stanislav Petrov, Steve Jobs, Steve Wozniak, Steven Pinker, The Future of Employment, The Wealth of Nations by Adam Smith, universal basic income, women in the workforce

Finally, the independent development think tank Innovations for Poverty Action has run a randomized controlled trial on GiveDirectly, so we can be confident not just about the efficacy of cash transfers in general but also about cash transfers as implemented by GiveDirectly. Because cash transfers is such a simple program, and because the evidence in favor of them is so robust, we could think about them as like the “index fund” of giving. Money invested in an index fund grows (or shrinks) at the same rate as the stock market; investing in an index fund is the lowest-fee way to invest in stocks. Actively managed mutual funds, in contrast, take higher management fees, and it’s only worth investing in one if that fund manages to beat the market by a big enough margin that the additional returns on investment are greater than the additional management costs. In the same way, one might think, it’s only worth it to donate to charitable programs rather than simply transfer cash directly to the poor if the other programs provide a benefit great enough to outweigh the additional costs incurred in implementing them.


pages: 829 words: 186,976

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

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

That seems nonrandom and it is: a standard statistical test38 would have claimed that there was only about a 1-in-7 quintillion possibility (1 chance in 7,000,000,000,000,000) that this resulted from chance alone. But statistical significance does not always equate to practical significance. An investor could not have profited from this trend. Suppose that an investor had observed this pattern for ten years—gains tended to be followed by gains and losses by losses. On the morning of January 2, 1976, he decided to invest $10,000 in an index fund39 which tracked the Dow Jones Industrial Average. But he wasn’t going to be a passive investor. Instead he’d pursue what he called a Manic Momentum strategy to exploit the pattern. Every time the stock market declined over the day, he would pull all his money out, avoiding what he anticipated would be another decline the next day. He’d hold his money out of the market until he observed a day that the market rose, and then he would put it all back in.

.* And while most individual, retail-level investors make common mistakes like trading too often and do worse than the market average, a select handful probably do beat the street.91 Buy High, Sell Low You should not rush out and become an options trader. As the legendary investor Benjamin Graham advises, a little bit of knowledge can be a dangerous thing in the stock market.92 After all, any investor can do as well as the average investor with almost no effort. All he needs to do is buy an index fund that tracks the average of the S&P 500.93 In so doing he will come extremely close to replicating the average portfolio of every other trader, from Harvard MBAs to noise traders to George Soros’s hedge fund manager. You have to be really good—or foolhardy—to turn that proposition down. In the stock market, the competition is fierce. The average trader, particularly in today’s market, in which trading is dominated by institutional investors, is someone who will have ample credentials, a high IQ, and a fair amount of experience.

Few investors beat the stock market over the long run relative to their level of risk and accounting for their transaction costs, unless they have inside information. It is hard to tell how many investors beat the stock market over the long run, because the data is very noisy, but we know that most cannot relative to their level of risk, since trading produces no net excess return but entails transaction costs, so unless you have inside information, you are probably better off investing in an index fund. The first approximation—the unqualified statement that no investor can beat the stock market—seems to be extremely powerful. By the time we get to the last one, which is full of expressions of uncertainty, we have nothing that would fit on a bumper sticker. But it is also a more complete description of the objective world. There is nothing wrong with an approximation here and there.


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, commoditize, 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, John Meriwether, Long Term Capital Management, margin call, market bubble, Maui Hawaii, Mexican peso crisis / tequila crisis, moral hazard, Myron Scholes, new economy, Nick Leeson, oil shale / tar sands, oil shock, out of africa, paper trading, Paul Samuelson, 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, zero-sum game

If you were advising an institution—let’s say a conservative university endowment—where would you recommend they invest their funds? Commodities and non–U.S. dollar assets. Fifty-fifty or how would you split it up? If I had told the board of trustees of Princeton University to put all its money into an S&P index fund in 1982, they would have run me out of town. But that is what they should have done. THE PIONEER 221 Now, in 2005, a large amount of their assets should go into commodities either via a commodity index fund, which is probably the best way, or via a manager, which traditionally has not been the best way.They should have a large part of their assets in raw materials.At what percentage, I leave that to you, but the rest of the assets, if there are any left over, should go into non–U.S. dollar investments.

There seem to be a lot of artificial opportunities in the investment world because money management companies have rules such as “You can’t buy a stock below ten dollars.” Absolutely. Another favorite of mine, obviously, is commodities. It was the end of 1998 when I started this commodities index fund because I was convinced that the 20-year bear market in commodities was coming to an end.You cannot believe the ridicule I used to get on CNBC.They were all giggling and drooling and talking about dot-com this and dot-com that, while I was sitting there saying, “I am starting a commodities index fund and China is a great place to invest.”Well, you know the rest of that story. That has been a nice one.There are many mistakes I could tell you about, but you asked about my favorites. I’d love to hear about some of your mistakes and what you learned from them.


pages: 317 words: 84,400

Automate This: How Algorithms Came to Rule Our World by Christopher Steiner

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23andMe, Ada Lovelace, airport security, Al Roth, algorithmic trading, backtesting, big-box store, Black-Scholes formula, call centre, cloud computing, collateralized debt obligation, commoditize, Credit Default Swap, credit default swaps / collateralized debt obligations, delta neutral, Donald Trump, Douglas Hofstadter, dumpster diving, Flash crash, Gödel, Escher, Bach, High speed trading, Howard Rheingold, index fund, Isaac Newton, John Markoff, John Maynard Keynes: technological unemployment, knowledge economy, late fees, Marc Andreessen, Mark Zuckerberg, market bubble, medical residency, money market fund, Myron Scholes, Narrative Science, PageRank, pattern recognition, Paul Graham, Pierre-Simon Laplace, prediction markets, quantitative hedge fund, Renaissance Technologies, ride hailing / ride sharing, risk tolerance, Sergey Aleynikov, side project, Silicon Valley, Skype, speech recognition, Spread Networks laid a new fibre optics cable between New York and Chicago, transaction costs, upwardly mobile, Watson beat the top human players on Jeopardy!, Y Combinator

O’Connor & Associates, also in Chicago, was employing very similar tactics to Peterffy’s, outfitting its traders with cheat sheets for valuing options and supplementing that information with computers that constantly crunched data upstairs while piping new numbers down to the pits. O’Connor was so secretive about its methods that when it bought two hundred Symbolics computers in the mid-1980s, executives shredded the packaging so Dumpster-diving competitors couldn’t determine what technology the firm used.6 THE ALGORITHMS SPREAD COAST TO COAST By 1987, index funds, which tracked groups of stocks such as the S&P 500, had grown popular not only with the public but also with professional traders. But certain indexes, the S&P 500 included, could only be licensed for trade in one market. In the case of the S&P 500, the license belonged to the Chicago Mercantile Exchange. So other exchanges employed indexes that were not exactly the same, but close. The Chicago Board Options Exchange traded the OEX, which was the same as the S&P 100; the New York Stock Exchange traded the NYSE composite, which tracked the entire NYSE; the AMEX traded the Major Market Index, which tracked the thirty biggest stocks; and the Pacific Exchange had what it called the PSE, which was based on technology companies, a growing share of the market.

., 170 NASA mission control in, 166, 175 Howes, Ash, 78–79 Hull, Blair, 40, 46 Hull Trading, 40, 46 human intuition, algorithms and, 127, 129 human irrationality, 132–33 humanities, education in, 139–40, 219 human personalities, 61, 163–83 compatibility among types of, 174–76 Kahler’s types of, 172–74 and NASA predictive science, 61, 164, 165–72, 174–77, 180 Hungary, 18, 20 Huygens, Christiaan, 67 hybrid vigor, 161 hyperparathyroidism, 162 IBM, 33, 144, 214 Brown and Mercer at, 178–79 Deep Blue chess-playing computer developed by, 126–27, 129, 133, 141 options on stock of, 21–22 Watson computer by, 127, 161–62 IBM PCs, Peterffy’s trading via, 12–16 identity theft, 193 “I Kissed a Girl,” 89 ILLIAC computer, 92 Illiac Suite, 92 Illinois, University of, 91–92, 188 at Urbana-Champaign, 95, 116, 219 Illinois Institute of Technology, 115 indexes of refraction, 115 index funds, 40–46 index futures, 113 India, 154, 218 Indiana University, 97 infants, preterm delivery of, 158 Infinite Ascent (Berlinski), 60 Infinium Capital Management, 51–52, 116 influencers, social, 212–14 “In My Life,” 110–11 inputs, in algorithms, 54 insider trading, 30 insurance, 66–67 health, 162, 181 intelligence: backgrounds of personnel in, 139–40 game theory and algorithms in, 135–40 information gathering by, 138 subjective calls in, 137 Interactive Brokers, 47–48 interest: compound, 68 payment systems, 57 rates, 22, 130 Intermountain Medical Center, algorithms used by, 157–58 international nuclear weapons nonproliferation treaty, 139 Internet, 116, 205 algorithms and, 112 dial-up, 117 hubs and authorities on, 214 influencers on, 213 Internet dating sites, algorithms for, 144–45, 214 “Into the Great Wide Open,” 84 Investigation of the Laws of Thought (Boole), 72 investment banks, 189, 192, 201, 206, 208, 210 algorithms used by, 46 iPads, 37, 159 iPhones, 159 IPO, for Interactive Brokers, 47–48 Iran, 137, 138–39 IRAs, 50 Ireland, 72, 193 Isaacson, Leonard, 92 Israel, 138 Istanbul Museum, 55 Italy, 56, 80 “I’ve Got a Feeling,” 78 Iverson, Allen, 143 Ivy League, 140, 143, 207 “I Want to Hold Your Hand,” 103 Jackson, Miss., 116 James, Brent, 157–58 Jarecki, Henry, 20, 21–24, 26–27, 34 Java, 189 Jennings, Ken, 127 Jeopardy!

., 140, 165 Nobel Prize, 23, 106 North Carolina, 48, 204 Northwestern University, 145, 186 Kellogg School of Management at, 10 Novak, Ben, 77–79, 83, 85, 86 NSA, 137 NuclearPhynance, 124 nuclear power, 139 nuclear weapons, in Iran, 137, 138–39 number theory, 65 numerals: Arabic-Indian, 56 Roman, 56 NYSE composite index, 40, 41 Oakland Athletics, 141 Obama, Barack, 46, 218–19 Occupy Wall Street, 210 O’Connor & Associates, 40, 46 OEX, see S&P 100 index Ohio, 91 oil prices, 54 OkCupid, 144–45 Olivetti home computers, 27 opera, 92, 93, 95 Operation Match, 144 opinions-driven people, 173, 174, 175 OptionMonster, 119 option prices, probability and statistics in, 27 options: Black-Scholes formula and, 23 call, 21–22 commodities, 22 definition of, 21 pricing of, 22 put, 22 options contracts, 30 options trading, 36 algorithms in, 22–23, 24, 114–15 Oregon, University of, 96–97 organ donor networks: algorithms in, 149–51, 152, 214 game theory in, 147–49 oscilloscopes, 32 Outkast, 102 outliers, 63 musical, 102 outputs, algorithmic, 54 Pacific Exchange, 40 Page, Larry, 213 PageRank, 213–14 pairs matching, 148–51 pairs trading, 31 Pakistan, 191 Pandora, 6–7, 83 Papanikolaou, Georgios, 153 Pap tests, 152, 153–54 Parham, Peter, 161 Paris, 56, 59, 121 Paris Stock Exchange, 122 Parse.ly, 201 partial differential equations, 23 Pascal, Blaise, 59, 66–67 pathologists, 153 patient data, real-time, 158–59 patterns, in music, 89, 93, 96 Patterson, Nick, 160–61 PayPal, 188 PCs, Quotron data for, 33, 37, 39 pecking orders, social, 212–14 Pennsylvania, 115, 116 Pennsylvania, University of, 49 pension funds, 202 Pentagon, 168 Perfectmatch.com, 144 Perry, Katy, 89 Persia, 54 Peru, 91 Peterffy, Thomas: ambitions of, 27 on AMEX, 28–38 automated trading by, 41–42, 47–48, 113, 116 background and early career of, 18–20 Correlator algorithm of, 42–45 early handheld computers developed by, 36–39, 41, 44–45 earnings of, 17, 37, 46, 48, 51 fear that algorithms have gone too far by, 51 hackers hired by, 24–27 independence retained by, 46–47 on index funds, 41–46 at Interactive Brokers, 47–48 as market maker, 31, 35–36, 38, 51 at Mocatta, 20–28, 31 Nasdaq and, 11–18, 32, 42, 47–48, 185 new technology innovated by, 15–16 options trading algorithm of, 22–23, 24 as outsider, 31–32 profit guidelines of, 29 as programmer, 12, 15–16, 17, 20–21, 26–27, 38, 48, 62 Quotron hack of, 32–35 stock options algorithm as goal of, 27 Timber Hill trading operation of, see Timber Hill traders eliminated by, 12–18 trading floor methods of, 28–34 trading instincts of, 18, 26 World Trade Center offices of, 11, 39, 42, 43, 44 Petty, Tom, 84 pharmaceutical companies, 146, 155, 186 pharmacists, automation and, 154–56 Philips, 159 philosophy, Leibniz on, 57 phone lines: cross-country, 41 dedicated, 39, 42 phones, cell, 124–25 phosphate levels, 162 Physicians’ Desk Reference (PDR), 146 physicists, 62, 157 algorithms and, 6 on Wall Street, 14, 37, 119, 185, 190, 207 pianos, 108–9 Pincus, Mark, 206 Pisa, 56 pitch, 82, 93, 106 Pittsburgh International Airport, security algorithm at, 136 Pittsburgh Pirates, 141 Pius II, Pope, 69 Plimpton, George, 141–42 pneumonia, 158 poetry, composed by algorithm, 100–101 poker, 127–28 algorithms for, 129–35, 147, 150 Poland, 69, 91 Polyphonic HMI, 77–79, 82–83, 85 predictive algorithms, 54, 61, 62–65 prescriptions, mistakes with, 151, 155–56 present value, of future money streams, 57 pressure, thriving under, 169–70 prime numbers, general distribution pattern of, 65 probability theory, 66–68 in option prices, 27 problem solving, cooperative, 145 Procter & Gamble, 3 programmers: Cope as, 92–93 at eLoyalty, 182–83 Peterffy as, 12, 15–16, 17, 20–21, 26–27, 38, 48, 62 on Wall Street, 13, 14, 24, 46, 47, 53, 188, 191, 203, 207 programming, 188 education for, 218–20 learning, 9–10 simple algorithms in, 54 Progress Energy, 48 Project TACT (Technical Automated Compatibility Testing), 144 proprietary code, 190 proprietary trading, algorithmic, 184 Prussia, 69, 121 PSE, 40 pseudocholinesterase deficiency, 160 psychiatry, 163, 171 psychology, 178 Pu, Yihao, 190 Pulitzer Prize, 97 Purdue University, 170, 172 put options, 22, 43–45 Pythagorean algorithm, 64 quadratic equations, 63, 65 quants (quantitative analysts), 6, 46, 124, 133, 198, 200, 202–3, 204, 205 Leibniz as, 60 Wall Street’s monopoly on, 183, 190, 191, 192 Queen’s College, 72 quizzes, and OkCupid’s algorithms, 145 Quotron machine, 32–35, 37 Rachmaninoff, Sergei, 91, 96 Radiohead, 86 radiologists, 154 radio transmitters, in trading, 39, 41 railroad rights-of-way, 115–17 reactions-based people, 173–74, 195 ReadyForZero, 207 real estate, 192 on Redfin, 207 recruitment, of math and engineering students, 24 Redfin, 192, 206–7, 210 reflections-driven people, 173, 174, 182 refraction, indexes of, 15 regression analysis, 62 Relativity Technologies, 189 Renaissance Technologies, 160, 179–80, 207–8 Medallion Fund of, 207–8 retirement, 50, 214 Reuter, Paul Julius, 122 Rhode Island hold ‘em poker, 131 rhythms, 82, 86, 87, 89 Richmond, Va., 95 Richmond Times-Dispatch, 95 rickets, 162 ride sharing, algorithm for, 130 riffs, 86 Riker, William H., 136 Ritchie, Joe, 40, 46 Rochester, N.Y., 154 Rolling Stones, 86 Rondo, Rajon, 143 Ross, Robert, 143–44 Roth, Al, 147–49 Rothschild, Nathan, 121–22 Royal Society, London, 59 RSB40, 143 runners, 39, 122 Russia, 69, 193 intelligence of, 136 Russian debt default of 1998, 64 Rutgers University, 144 Ryan, Lee, 79 Saint Petersburg Academy of Sciences, 69 Sam Goody, 83 Sandberg, Martin (Max Martin), 88–89 Sandholm, Tuomas: organ donor matching algorithm of, 147–51 poker algorithm of, 128–33, 147, 150 S&P 100 index, 40–41 S&P 500 index, 40–41, 51, 114–15, 218 Santa Cruz, Calif., 90, 95, 99 satellites, 60 Savage Beast, 83 Saverin, Eduardo, 199 Scholes, Myron, 23, 62, 105–6 schools, matching algorithm for, 147–48 Schubert, Franz, 98 Schwartz, Pepper, 144 science, education in, 139–40, 218–20 scientists, on Wall Street, 46, 186 Scott, Riley, 9 scripts, algorithms for writing, 76 Seattle, Wash., 192, 207 securities, 113, 114–15 mortgage-backed, 203 options on, 21 Securities and Exchange Commission (SEC), 185 semiconductors, 60, 186 sentence structure, 62 Sequoia Capital, 158 Seven Bridges of Königsberg, 69, 111 Shannon, Claude, 73–74 Shuruppak, 55 Silicon Valley, 53, 81, 90, 116, 188, 189, 215 hackers in, 8 resurgence of, 198–211, 216 Y Combinator program in, 9, 207 silver, 27 Simons, James, 179–80, 208, 219 Simpson, O.


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The Drunkard's Walk: How Randomness Rules Our Lives by Leonard Mlodinow

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Albert Einstein, Alfred Russel Wallace, Antoine Gombaud: Chevalier de Méré, Atul Gawande, Brownian motion, butterfly effect, correlation coefficient, Daniel Kahneman / Amos Tversky, Donald Trump, feminist movement, forensic accounting, Gerolamo Cardano, Henri Poincaré, index fund, Isaac Newton, law of one price, pattern recognition, Paul Erdős, probability theory / Blaise Pascal / Pierre de Fermat, RAND corporation, random walk, Richard Feynman, Richard Feynman, Ronald Reagan, Stephen Hawking, Steve Jobs, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, Thomas Bayes, V2 rocket, Watson beat the top human players on Jeopardy!

Nordin, “Perceptual Learning in Olfaction: Professional Wine Tasters Versus Controls,” Physiology and Behavior 62, no. 5 (November 1997): 1065–70. 22. Gregg E. A. Solomon, “Psychology of Novice and Expert Wine Talk,” American Journal of Psychology 103, no. 4 (Winter 1990): 495–517. 23. Rivlin, “In Vino Veritas.” 24. Ibid. 25. Hal Stern, “On the Probability of Winning a Football Game,” American Statistician 45, no. 3 (August 1991): 179–82. 26. The graph is from Index Funds Advisors, “Index Funds.com: Take the Risk Capacity Survey,” http://www.indexfunds3.com/step3page2.php, where it is credited to Walter Good and Roy Hermansen, Index Your Way to Investment Success (New York: New York Institute of Finance, 1997). The performance of 300 mutual fund managers was tabulated for ten years (1987–1996), based on the Morningstar Principia database. 27. Polling Report, “President Bush—Overall Job Rating,” http://pollingreport.com/BushJob.htm. 28.

And though many studies show that these past market successes are not good indicators of future success—that is, that the successes were largely just luck—most people feel that the recommendations of their stockbrokers or the expertise of those running mutual funds are worth paying for. Many people, even intelligent investors, therefore buy funds that charge exorbitant management fees. In fact, when a group of savvy students from the Wharton business school were given a hypothetical $10,000 and prospectuses describing four index funds, each composed in order to mirror the S&P 500, the students overwhelmingly failed to choose the funds with the lowest fees.19 Since paying even an extra 1 percent per year in fees could, over the years, diminish your retirement fund by as much as one-third or even one-half, the savvy students didn’t exhibit very savvy behavior. Of course, as Spencer-Brown’s example illustrates, if you look long enough, you’re bound to find someone who, through sheer luck, really has made startlingly successful predictions.


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, George Santayana, index fund, intangible asset, 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

In dismissing Buffett, modern finance enthusiasts still insist that an investor's best strategy is to diversify based on betas or dart throwing, and constantly reconfigure one's portfolio of investments. Buffett responds with a quip and some advice: the quip is that devotees of his investment philosophy should probably endow chairs to ensure the perpetual teaching of efficient market dogma; the advice is to ignore modern finance theory and other quasi-sophisticated views of the market and stick to investment knitting. That can best be done for many people through long-term investment in an index fund. Or it can be done by conducting hardheaded analyses of businesses within an investor's competence to evaluate. In that kind of thinking, the risk that matters is not beta or volatility, but the possibility of loss or injury from an investment. Assessing that kind of investment risk requires thinking about a company's management, products, competitors, and debt levels. The inquiry is whether after-tax returns on an investment are at least equal to the purchasing power of the initial investment plus a fair rate of return.

Should you choose to pursue this course, you should adopt the outlook of the casino that owns a roulette wheel, which will want to see lots of action because it is favored by probabilities; but will refuse to accept a single, huge bet. Another situation requiring wide diversification occurs when an investor who does not understand the economics of specific businesses nevertheless believes it in his interest to be a long-term owner of American industry. That investor should both own a large number of equities and space out his purchases. By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when "dumb" money acknowledges its limitations, it ceases to be dumb. On the other hand, if you are a know-something investor, able to understand business economics and to find five to ten sensiblypriced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you.

All too often, we've seen value stagnate in the presence of hubris or of boredom that caused the attention of managers to wander. That's not going to happen again at Coke and Gillette, however-not given their current and prospective managements. * * * * * Let me add a few thoughts about your own investments. Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals. Should you choose, however, to construct your own portfolio, there are a few thoughts worth remembering. Intelligent investing is not complex, though that is far from saying that it is easy. What an investor needs is the ability to correctly evaluate selected businesses.


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, Myron Scholes, passive investing, Richard Feynman, Richard Feynman, Richard Feynman: Challenger O-ring, risk tolerance, risk-adjusted returns, risk/return, selection bias, Sharpe ratio, short selling, statistical model, survivorship bias, systematic trading, technology bubble, the market place, Thomas Kuhn: the structure of scientific revolutions, transaction costs, value at risk, yield curve, zero-sum game

., minimum asset floor) investment models are used, which permit an investor to feel assured that the minimum investment level is protected while automatically increasing investment and potential return through alternative investments as the minimum investment level is systematically increased and investor wealth or investment levels increase. (Of course, if 118 THE NEW SCIENCE OF ASSET ALLOCATION EXHIBIT 6.5 Comparison Correlations for Benchmark, Core, and Satellite Groupings Benchmark Core Correlations to Benchmark Satellite 1 Investments Correlations to Benchmark Satellite 1 Investments Correlations to Core ■ Russell 1000 Russell 2000 iShares Russell 1000 Index Fund iShares Russell 2000 Index Fund 1.00 1.00 Lipper Lg-Cap Core Lipper Sm-Cap Core 1.00 0.98 Lipper Lg-Cap Core 1.00 MSCI EAFE MSCI EM BarCap US Gov BarCap US Agg iShares MSCI EAFE iShares MSCI EM iShares Barclays Government/ Credit Bond Fund iShares Barclays Aggregate Bond Fund 0.98 Lipper Non US Stock 0.97 Lipper Emerg Mkt Fd 0.86 0.95 Lipper A Rated Bnd Fd Lipper Gen US Govt Fd 0.99 Lipper Emerg Mkt Fd 0.97 0.94 Lipper Sm-Cap Core 0.93 Lipper Non US Stock Lipper A Rated Bnd Fd Lipper Gen US Govt Fd 0.98 0.95 0.97 0.89 0.87 wealth or investment levels decrease, systematic reductions would also be conducted.)

., invest in unfamiliar asset classes). 119 Core and Satellite Investment: Market/Manager Based Alternatives BarCap US Corporate High-Yield Private Equity Index SPDR Barclays Capital High Yield Bond ETF S&P GSCI FTSE NAREIT ALL REITS CISDM EW HF Index CISDM CTA EW Index PowerShares Listed Private Equity Portfolio iShares S&P GSCI Commodity Indexed Trust iShares FTSE NAREIT Real Estate 50 Index Fund HF Replication CTA Replication 0.95 0.94 0.99 0.99 0.94 Lipper HI Cur Yld Bd Private Equity MF Lipper Nat Res Fd IX Lipper Real Estate Fd HF Investable (Mgr. Based) 0.73 CTA Investable (Mgr. Based) 0.98 0.68 0.63 0.99 0.90 Lipper HI Cur Yld Bd Private Equity MF Lipper Nat Res Fd IX Lipper Real Estate Fd HF Investable (Mgr. Based) 0.41 CTA Investable (Mgr. Based) 0.90 0.83 0.85 0.98 0.91 0.73 ■ Personal Character: Optimism, entrepreneurship, and the discipline of staying with a predefined strategy.


pages: 398 words: 108,889

The Paypal Wars: Battles With Ebay, the Media, the Mafia, and the Rest of Planet Earth by Eric M. Jackson

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bank run, business process, call centre, creative destruction, disintermediation, Elon Musk, index fund, Internet Archive, iterative process, Joseph Schumpeter, market design, Menlo Park, Metcalfe’s law, money market fund, moral hazard, Network effects, new economy, offshore financial centre, Peter Thiel, Robert Metcalfe, Sand Hill Road, shareholder value, Silicon Valley, Silicon Valley startup, telemarketer, The Chicago School, the new new thing, Turing test

X.com made a media splash when Elon lured Bill Harris, the former CEO of software maker Intuit, to head the venture. Harris bragged to The Wall Street Journal that he had received CEO offers from more than one hundred startups but chose X.com because he saw it as “a blank canvas upon which to write new rules on the delivery of financial services.”2 X.com also generated some additional buzz toward the end of 1999 with a no-fee, no-minimum balance S&P 500 index fund, the only one of its kind.3 This loss leader product had been rationalized as a way to attract new users who could be up-sold to X.com’s other financial products, including its bond and money market funds, interest-bearing checking accounts, and low APR credit lines. X.com certainly seemed eager to become a financial services supermarket, but Confinity had not seen any sign that it held an interest in following PayPal into person-to-person payments.

“I guess I see why you’d be concerned. Look, this isn’t a bad deal for us. For one thing, they actually have almost two hundred thousand users, about as many as we do!” Luke confided. “They were careful not to make it public, but as part of the due diligence we found this out. I guess that $20 bonus they were giving out to people to sign up really worked! “Also, with all of the financial services like money markets, index funds, and debit cards that they offer, each of their accounts is probably worth a lot more than ours,” he continued. “And since we were beginning to burn through cash pretty quickly and will have to do some more financing soon, merging with our top competitor will help us raise a lot more funds. “Plus, Peter felt that there was probably only a market for one player in this space to go public, and whoever had an IPO first would have enough resources to crush the competition.

See Oracle/Windows schism at X.com (PayPal) Wining Bidder Notification (WBN) feature, 191–192 wireless PayPal product, 135 Woolway, Mark, 91, 303 “World Domination Index,” 19 deactivation of, 102 “world domination” speech, 25–26, 269 World Trade Center attacks, 218–222 “X,” associations with the letter, 129, 139 X.com business model, 40 challenge to Confinity, 39–41 competition with PayPal on eBay, 54 customer base, 167–168 dogging of PayPal, 66 domain name cost, 131 focus groups research, 131–132 PayPal merger announcement, 69 vs. Confinity corporate culture, 118 . See also Musk, Elon; X.com (PayPal) X.com financial services after merger with PayPal, 103 difficulty of integrating PayPal with, 120–121, 123 no-minimum-balance index fund, 40, 76 X.com (PayPal) achievements, 88–89 benefits of merger, 79 branding issues, 110–111, 128–132 business development deals, 104–105 business model, 76–77 cash flow problems, 121 corporate structure, 75, 78–79 customer reactions to merger, 81–82 customer service overload, 98–101 databases, 76 effect of eBay/Wells Fargo partnership, 81 e-mail system incompatibilities, 103 fallout from ouster of CEO, 165 fraud loss amounts, 147, 148 internal communications, 112 marketing strategy, 97 merger woes and remedy, 118 press release, 81 problems resolved in early 2000, 138 product development halt announcement, 143–144 promise not to charge sellers, 127, 153 reaction to dotBank buyout, 83–84 reaction to Half.com buyout, 133–134 reason for merger, 72–73 response to customer service crisis, 100–101, 107–108 response to eBay logo policy, 86 shift of business model, 122 spending limit fiasco, 125–128 venture capital financing, 89–91 web server crisis, 101–103 .


pages: 130 words: 11,880

Optimization Methods in Finance by Gerard Cornuejols, Reha Tutuncu

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

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

(5.8) In this equation, wit quantities represent the sensitivities of Rt to each one of the n fach iT tors, and t represents the non-factor return. We use the notation wt = w1t , . . . , wnt h i and Ft = F1t , . . . , Fnt . The linear factor model (5.8) has the following convenient interpretation when the factor returns Fit correspond to the returns of passive investments, such as those in an index fund for an asset class: One can form a benchmark portfolio of the passive investments (with weights wit ) and the difference between the fund return Rt and the return of the benchmark portfolio Ft wt is the non-factor return contributed by the fund manager using stock selection, market timing, etc. In other words, t represents the additional return resulting from active management of the fund. Of course, this additional return can be negative.


pages: 234 words: 53,078

The Conservative Nanny State: How the Wealthy Use the Government to Stay Rich and Get Richer by Dean Baker

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accounting loophole / creative accounting, affirmative action, Asian financial crisis, Bretton Woods, corporate governance, declining real wages, full employment, index fund, Jeff Bezos, medical malpractice, medical residency, money market fund, offshore financial centre, price discrimination, risk tolerance, spread of share-ownership

They recognized the high administrative costs associated with the existing system of defined contribution pensions in the United States, as well as the costs of privatized Social Security systems in other countries. In order to reduce the costs of a privatized system, they proposed having a single centralized system which would pool workers’ savings from all over the country. Their proposal called for having a limited number of investments options (e.g. a stock index fund, a bond index fund, a money market fund, and possibly one or two other options) and limited opportunities to switch between funds. According to the Bush commission’s estimates, the administrative costs of this bare-bones system would be approximately 5 percent of the money paid into the system. While this is still very expensive compared to the 0.5 percent in administrative fees charged by Social Security, it is far less than the 15-20 percent in fees charged by financial firms for operating private sector defined contribution pensions in the United States, or that financial firms charge to operate privatized Social Security accounts in other countries.


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 - Herbert Stein's Law, index fund, Lao Tzu, margin call, market bubble, McMansion, money market fund, 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

DBC, with an expense ratio of 0.75 percent, pioneered making commodities investing available in ETFs and has grown to a recent market capitalization of more than $2.3 billion. The prospectus, which you should read before investing, is available at dbfunds.db.com. When Jim Rogers saw that we were entering a long-term secular bull market for commodities, he decided to start a commodities index fund. Just as the stock market has index funds that follow the S&P 500, the Dow Jones Industrial Average, or some other index, Rogers looked for a commodities index as the basis of his fund, one that was well thought out and representative of the dynamics of global economic change. What he found was disappointing. One index weighted oil and orange juice equally. “I don’t know about you,” said Rogers, “but in my life oil plays a much larger role than orange juice.”


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, break the buck, Bretton Woods, call centre, Carmen Reinhart, cloud computing, collapse of Lehman Brothers, collateralized debt obligation, computerized trading, 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, endogenous growth, 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, information asymmetry, 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, money market fund, mortgage debt, mortgage tax deduction, Myron Scholes, negative equity, 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

When the fire was burned out, the price at that moment became the official opening price for the next day. Because trading often kept going beyond this point, “watermen” would dash whole buckets of water over the crowd in order to disperse them. The price that prevailed then—the okenedan, or “bucket price”—was the settlement price for the day. There were rules for everything.5 The need to standardize can be discerned in market after market. Indexes are one example. An index fund spreads risks across a lot of different securities in a fixed and transparent manner by mimicking the constituents of the index in question. The oldest US stock-market index is the Dow Jones Transportation Average, started in 1894; the still-celebrated Dow Jones Industrial Average began two years later; the S&P 500 index, widely considered the best representation of the health of the American stock market, kicked off in 1957.

See Credit-default swap Cecchetti, Stephen, 79 Church-tower principle, 207 Cigarettes, as means of payment, 5 Clark, Geoffrey Wilson, 144 Clearinghouse, 39 ClearStreet, 210 Clinical drug trials, indemnification of, xii–xiii Coates, John, 116 Code, simplification of, 63 Cohen, Ronald, 91–95, 97, 106, 108, 112 Coins, history of, 4 Collateral, xiv, 7, 38, 65, 76, 150, 177, 185, 204–206, 215 Collateralized-debt obligations (CDOs), 43, 234–235 Collective Health, 104 College graduates, earning power of, 170–171 Commenda, 7–8, 19 Commercial paper, 185 Commodity Futures Trading Commission, 54 CommonBond, 182, 184, 197 Confusion de Confusiónes (de la Vega), 24 Congressional Budget Office, 99, 169 Consumer Financial Protection Bureau overdraft fees and prepaid cards, concern about, 203–204 report on reverse mortgages, 141 survey on payday borrowing, 200 CoRI, 132 Corporate debt, in United States, 120 Corporate finance, 237–238 Correlation risk, 165 Cortisol and testosterone, effect of on risk appetite and aversion, 116 Counterparty risk, 22 Credit, industrialization of, 206 Credit Card Accountability, Responsibility, and Disclosure (Credit CARD) Act of 2009, 203 Credit cards, 203 Credit-default swap (CDS), 37, 64–65, 75, 124, 169, 238 Credit ratings, 24, 120–121, 233–236 Credit-reporting firms, 24 Credit risk, 200, 201, 237, 238 Credit scores, 47–49, 201, 216–217 Creditworthiness, xiv, 10, 12, 47, 121, 197, 202, 204, 216 Crowdcube, 152–155, 158–159, 162 Damelin, Errol, 208 Dark Ages, banking in, 11 Dark pools, 60 DCs (defined-contribution schemes), 129, 131 DE Shaw, 163 Debit cards, 204 Debt, 6, 7, 70, 149, 164 Decumulation, 138–139 Defined-benefit schemes, 129, 131 Defined-contribution (DC) schemes, 129, 131 Dependent variable, 201 Deposit insurance, 13, 43–44 Derivatives, 3, 9–10, 29–32, 38, 40 Desai, Samir, 189 Development-impact bonds, 103 Diabetes, cost of in United States, 102 Dimensional Fund Advisors, 129 Direct lending, 184 Discounting, 19 Disposition effect, 25 Diversification, 8, 12, 20, 117–119, 196, 236 Doorways to Dreams (D2D), 213–214 Dot-com boom, 148 Dow Jones Industrial Average, 40 Dow Jones Transportation Average, 40 Drug development, investment in, vii-viii, 114–115 Drug-development megafund adaptive market hypothesis and, 115–117 Alzheimer’s disease, 122 credit rating, importance of, 120–121 diversification and, 117, 119–120, 122 drug research, improvement of economics of, 114–115 financial engineering, need for, 119 guarantors for, 121 orphan diseases and, 118–119, 122 reactions to, 118 securitization and, 117–119, 122 Dumb money, comparison of to smart money, 155–158 Dun and Bradstreet, 24 Durbin Amendment (2010), 204 Dutch East India Company (VOC), 14–15, 38 E-Mini contracts, 54–55 Eaglewood Capital, 183–184 Ebola outbreak (2014), mortality rate of, 230 Ebrahimi, Rod, 210–211 Ecology, finance and, 113 Economist 2013 conference, xv on railways, 25 on worth of residential property, 70 Educational equity adverse selection in, 174, 175, 182 CareerConcept, 166 differences in funding rates, 176 enforceability, 177 in Germany, 166 Gu, Paul, 172, 175–176 income-share legislation, US Senate and, 172 information asymmetry, 174 Lumni, 165, 168, 175 Oregon, interest in income-share agreements, 172, 176 Pave, 166–168, 173, 175, 182 peer-to-peer insurance, 182 problems with, 167–168, 173–174 providers and recipients, contact between, 160, 175 risk-based pricing model, 176 student loans, 169–171 Upstart, 166–168, 173, 175, 182 Yale University and, 165 Efficient-market hypothesis, 115 Endogeneity, 239 Epidemiology, finance and, 113 Eqecat, 222 Equity, 7–8, 149–150, 186–187 Equity-crowdfunding in Britain, 154 Crowdcube, 152–155, 158–159, 162 Friendsurance, 182–183 Equity-crowdfunding in Britain (continued) herding, 159–160 social insurance, 182–183 Equity-derivatives contracts, 29 Equity-sharing, 7–8 Equity-to-assets ratio, 186 Eren, Selcuk, 73 Eroom’s law, 114 Essex County Council, 95 Eurobond market, 32 European Bank for Reconstruction and Development, 169 Exceedance-probability curve, 231–232, 232 figure 3 Exxon, 169 Facebook, 174 Fair, Bill, 47 False substitutes, 44 Fama, Eugene, 115 Fannie Mae, 48, 78, 85, 168 Farmer, Doyne, 60, 63 Farynor, Thomas, 16 FCIC (Financial Crisis Inquiry Commission), 50 Federal Deposit Insurance Corporation (FDIC), 186, 200 Federal Reserve Bank of New York, 170, 204, 205 Feynman, Richard, 115 Fibonacci (Leonardo of Pisa), 19 FICO score, 47–49 Films to rent, study of hyperbolic discounting, 133–134 Finance bailouts, 35–36 banks, purpose of, 11–14 collective-action problem in, 62 computerization of, 31–32 democratization of, 26–28 economic growth and, 33–34 fresh ideas, need for, xviii, 38–39, 80, 85–86 globalization and, 30, 225 heuristics, use of in, 45–50 illiteracy, financial, 134–135 importance of, 10 information, importance of, 10–11 inherent failings in, 241 misconceptions about, xiii–xvi panic, consequences of, 44 regulatory activity, results of, 33 risk assessment, 24, 45, 77–78 risk management, 55, 117–118, 123 as solution to real-world problems, 114 standardization, 39–41, 45, 47, 51 unconfirmed trades, backlog of, 64–65 use of catastrophe risk modeling in, 233–239 See also High-frequency trading (HFT); Internet Finance, history of bank, derivation of word, 12 Book of Calculation (Fibonacci), 19 call options, 10 Code of Hammurabi, 8 coins, 4 commodity forms of exchange, 4–5 credit and debt, 5–7 in Dark Ages, 11 democratization, 26–28 deposits, 6 derivatives, 29–32, 38 Dutch East India Company (VOC), 14–15, 38 early financial contracts, 5 early forms of finance, 3 equity contracts, 7–8 fire insurance, 16–17 first futures market, 29, 39–40 forward contracts, 38 in Greece, 11 industrialization and, 3, 27–28 inflation-protected bonds, 26 insurance, 8–10, 16–17, 20–22 interest, origin of, 5 in Italy, 9, 14 life annuities, 20–22 maritime trade and, 7–8, 14, 17, 23 payment, forms of, 4–5 put options, 9–10 railways, effect of on, 23–25 in Roman Empire, 7, 8, 11, 36 securities markets, 14 stock exchanges, 14, 24–25 Finance, innovation in absence of, xvi–xvii credit and debt, 5–7 derivatives, 9–10, 29–32 diffusion, pattern of, 45 drivers of, 22–26 equity, 7–8 importance of, 66, 242–243 insurance, 8–9, 16–17, 20–22 lessons from, 32–34 mathematical insights, 18–20 payment, forms of, 4–5 risks of, 145 stock exchanges, 14–16 Finance and the Good Society (Shiller), 242 Financial Crisis Inquiry Commission (FCIC), 50 Financial crisis of 2007–2008 causes of, xv, 34, 69 effects of, xx–xi future of finance, effect on, 243 mortgage debt, role of in, 69–70 new regulations since, 185, 187 Financial Times, quote from Chuck Prince in, 62 Fire insurance, early, 16–17 Fitch Ratings, 24 Flash Boys (Lewis), 57 Flash crash, 54–56, 63 Florida, hurricane damage in, 223, 225 Florida, new residents per day in, 225 Foenus nauticum, 8 Forward contracts, 38 Forward transactions, 15 France collapse of Mississippi scheme in, 36 eighteenth century life annuities in, 20–21 government spending in, 99 Freddie Mac, 48, 85 Fresno, California, social-impact bond pilot program in, 103–104 Friedman, Milton, 165 Friendsurance, 182–183 Fundamental sellers, 54–55 Funding Circle, 181–182, 189, 197 Futures, 29, 39–40 Galton Board, 17, 18 figure 1 Gaussian copula, 235 Geithner, Timothy, 64–65 Genentech, xii General Motors, bailout of, xi Geneva, Switzerland, annuity pools in, 21–22 Gennaioli, Nicola, 42, 44 Ginnie Mae, 168 Girouard, Dave, 166 Glaeser, Edward, 74 Globalization, finance and, 30, 225 Goldman Sachs, 61, 98, 156, 235 Google Trends, 218 Gorlin, Marc, 218 Government spending, rise in, 99–100 Governments, support for new financial products by, 168–169 Grameen Bank, 203 Greece, forerunners of banks in, 11 Greenspan, Alan, 236 Greenspan consensus, 236 Grillo, Baliano, 9 Gu, Paul, 162–164, 166, 172, 175–176 Guardian Maritime, 151 Haldane, Andy, 188 Halley, Edmund, 19–20 Hamilton, Alexander, 35–36 Hammurabi, Code of, 5, 8 Health conditions, SIB early detection programs for, 102–104 Health-impact bonds, 103–104 Hedge funds, 123, 158, 183 Hedging, 30–31, 54, 124, 129, 131, 156, 206, 227 Heiland, Frank, 73 Herding, 24, 159–160 Herengracht Canal properties, Amsterdam, real price level for, 74 Heuristics, 45–50 HFRX, 157–158 High-frequency trading (HFT) benefits of, 58 code, simplification of, 63 flash crash, 54–56 latency, attempts to lower, 53 pre-HFT era, 59–61 problems with, 56–58, 62–63 Hinrikus, Taavet, 190–191 HIV infection rates, SIB program for reduction of, 103 Holland, tulipmania in, 33, 36 Home equity, 139–140 Home-ownership rates, in United States, 85, 170 Homeless people, SIB program for, 96–97 Housing boom of mid-2000s, 148–149 Human capital contracts, 165, 167, 173–174, 176, 177 defined, 6 as illiquid asset, 177 Hurricane Andrew, effect of on insurers, 223–224, 225 Hurricane Hugo, 223 Hyperbolic discounting, 133–134, 211 IBM, 169 If You Don’t Let Us Dream, We Won’t Let You Sleep (drama), 111 IMF (International Monetary Fund), 125–126 Impact investing, 92 Implied volatility, 116 Impure altruism, 109–110 Income-share agreements, 167, 172–178 Independent variables, 201 Index funds, 40 India, CDS deals in, 37 India, social-impact bonds (SIBs) in, 103 Industrialization, effect of on finance, 3, 27–28 Inflation-protected Treasury bills, 131 Information asymmetry, 174 Innovator’s dilemma, 189 Instiglio, 103 Insurance, 8–10, 16–17, 142, 223–225 Insurance-linked securities, 222 Interbank markets, x Interest, origin of, 5 Interest-rate swaps, 29 International Maritime Bureau Piracy Reporting Centre, 151 International Monetary Fund (IMF), 125–126 International Swaps and Derivatives Association (ISDA), 40 Internet, role of in finance creditworthiness, determination of, 172–173, 202, 218 direct connection of suppliers and consumers, xviii, 32 equity crowdfunding, 152–155 income-share agreements, 172–173 ROSCAs, 210 small business loans, 216 speed and ease of borrowing, 189 student loans, 166–167 Intertemporal exchange, 6 Intuit, 218 Investment grade securities, 121 Ireland, banking crisis in, xiv–xv, 69 Isaac, Earl, 47 ISDA (International Swaps and Derivatives Association), 40 ISDA master agreement, 40 Israel, SIBs in, 97 Italy discrimination against female borrowers in, 208 financial liberalization and, 34 first securities markets in, 14 maritime trade partnerships in, 7–8 J.


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, survivorship bias, transaction costs, Vanguard fund

To illustrate how an investor might analyze a portfolio ex ante, let’s examine three simple portfolios as described on Paul c08 P2: c/d QC: e/f JWBT412-Marston T1: g December 8, 2010 17:51 Printer: Courier Westford 160 PORTFOLIO DESIGN 10.00% 9.00% Return per Annum P1: a/b 8.00% 7.00% Portfolios with three assets: Barclays Aggregate Bond, Russell 3000, and MSCI EAFE Stock Indexes 6.00% 5.00% 5% 7% 9% 11% 13% 15% Standard Deviation FIGURE 8.7 Model Portfolios Based on Table 8.3 Returns R . Data Sources: Barclays Capital, MSCI, and Russell B. Farrell’s MarketWatch.com web site. Farrell labels them Lazy Portfolios because they can be implemented easily using index funds.14 The three portfolios chosen are the three simplest of his eight portfolios. They are labeled A through C in Table 8.4, but on his web site they have the colorful names Margaritaville, Dr. Bernstein’s No Brainer, and Second Grader’s Starter.15 The portfolios range from conservative to aggressive with investment in bonds ranging from 33 percent, 25 percent, to 10 percent, respectively. The portfolio returns are estimated by using the premium estimates reported in Tables 8.2 and 8.3.

The Tremont hedge fund data set, for example, begins in 1994, while the HFRI data set begins in 1990. 13. Since geometric averages are involved, the premium is measured using the compound formula, (1.102)/(1.099) – 1 = 0.3%. And the estimate of the EAFE return based on the S&P 500’s 9.4 percent return is calculated as (1.094)∗(1.003) – 1 = 9.7%. 14. These portfolios are all invested in Vanguard Index Funds. The analysis below substitutes the bond and stock indexes which most closely correspond to the Vanguard funds involved. 15. Margaritaville was developed by Scott Burns, a Dallas Morning News financial columnist. Dr. Bernstein is a financial advisor to high net worth individuals, and Second Grader is presumably a young investor with a long enough horizon to invest 90 percent in equity! After we introduce alternative investments, we will consider another MarketWatch portfolio, the Unconventional Success portfolio recommended by David Svensen of the Yale Endowment.

Hedge funds are low in correlation TABLE 9.3 Correlations Between Hedge Funds and Other Assets, 1990–2009 HFRI Fund-Weighted Hedge Fund Index HFRI Fund-Weighted Hedge Fund Index Barclays Aggregate Bond Index Russell 3000 Stock Index MSCI EAFE Stock Index Barclays Aggregate Bond Index Russell 3000 Stock Index 1.00 0.11 1.00 0.77 0.17 1.00 0.65 0.14 0.73 R Data Sources: HFRI, Barclays Capital, Russell , and MSCI. P1: a/b c09 P2: c/d QC: e/f JWBT412-Marston T1: g December 20, 2010 17:1 Printer: Courier Westford 175 Hedge Funds TABLE 9.4 Betas and Alphas of HFRI Hedge Fund Indexes, 1990–2009 HFRI Hedge Fund Index Fund-Weighted (Aggregate) Event Driven Relative Value Equity Macro Emerging Market Correlation with R 3000 Standard Deviation Beta Alpha 0.77 0.73 0.51 0.75 0.36 0.64 7.1% 7.0% 4.5% 9.2% 7.8% 14.7% 0.36 0.33 0.15 0.46 0.18 0.62 6.1% 6.5% 5.7% 7.5% 8.6% 7.2% Note: Betas are calculated using the Russell 3000 index as the market benchmark. R . Data Sources: HFRI and Russell with U.S. bonds, but have sizable correlations with domestic and foreign stocks.


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, fixed income, 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

For example, for the management of some types of portfolio, regulations dictate that each security should only be present to a fixed maximum extent, which is incompatible with passive management if a security represents a particularly high level of stock-exchange capitalisation on the market. Another problem is that the presence of some securities that not only have high rates but are indivisible, and this may lead to the construction of portfolios with a value so high that they become unusable in practice. These problems have led to the creation of ‘index funds’, collective investment organisations that ‘imitate’ the market. After choosing an index that represents the market in which one wishes to invest, one puts together a portfolio consisting of the same securities as those in the index (or sometimes simply the highest ones), in the same proportions. Of course, as and when the rates of the constituent equities change, the composition of the portfolio will have to be adapted, and this presents a number of difficulties.

., Economic Forces of the Stock Market, Journal of Business, No. 59, 1986, pp. 383–403. 286 Asset and Risk Management Absolute global risk European equities portfolio Systematic APT profile – systematic risk 0.10 100 % 0.08 90 % 0.06 80 % 0.04 70 % 0.02 60 % 0.00 –0.02 50 % –0.04 40 % –0.06 30 % 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Real European equities Target 20 % 10 % European equities portfolio 19.64 0.00 10.00 17.61 8.69 20/80 FT EURO 16.82 0.00 723.00 16.75 1.53 1/99 Global risk Target - portfolio stock overlap Number of securities Systematic Specific Specific/systematic ratio 0% Portolio/Cash FT Euro/Cash Specific Figure 11.1 Stock picking fund Absolute global risk European equities portfolio APT profile – systematic risk Systematic 0.10 100 % 0.08 0.06 90 % 0.04 80 % 0.02 70 % 0.00 60 % –0.02 50 % –0.04 –0.06 40 % 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Real European equities Global risk Target - portfolio stock overlap Number of securities Systematic Specific Specific/systematic ratio FT EURO 16.82 0.00 723.00 16.75 1.53 1/99 30 % 20 % Target European equities portfolio 17.27 3.14 72.00 17.04 2.83 3/97 10 % 0% Portfolio/Cash FT Euro/Cash Specific Figure 11.2 Index fund indicator of the a priori risk, and can be used as an indicator of overperformance or underperformance. When the portfolio reaches the upper range, 96 % (Figure 11.3), the probability of rising above the range will have dropped to 2 %. Conversely, the probability of arbitrage of the strategy by the market, in accordance with the theory of APT, is close to certainty (98 %). The opposite to this is underperformance, which pulls the relative performance of the portfolio down towards the lower range.

INTERNET SITES http://www.aptltd.com http://www.bis.org/index.htm http://www.cga-canada.org/fr/magazine/nov-dec02/Cyberguide f.htm http://www.fasb.org http://www.iasc.org.uk/cmt/0001.asp http://www.ifac.org http://www.prim.lu Index absolute global risk 285 absolute risk aversion coefficient 88 accounting standards 9–10 accrued interest 118–19 actuarial output rate on issue 116–17 actuarial return rate at given moment 117 adjustment tests 361 Aitken extrapolation 376 Akaike’s information criterion (AIC) 319 allocation independent allocation 288 joint allocation 289 of performance level 289–90 of systematic risk 288–9 American option 149 American pull 158–9 arbitrage 31 arbitrage models 138–9 with state variable 139–42 arbitrage pricing theory (APT) 97–8, 99 absolute global risk 285 analysis of style 291–2 beta 290, 291 factor-sensitivity profile 285 model 256, 285–94 relative global risk/tracking error 285–7 ARCH 320 ARCH-GARCH models 373 arithmetical mean 36–7 ARMA models 318–20 asset allocation 104, 274 asset liability management replicating portfolios 311–21 repricing schedules 301–11 simulations 300–1 structural risk analysis in 295–9 VaR in 301 autocorrelation test 46 autoregressive integrated moving average 320 autoregressive moving average (ARMA) 318 average deviation 41 bank offered rate (BOR) 305 basis point 127 Basle Committee for Banking Controls 4 Basle Committee on Banking Supervision 3–9 Basle II 5–9 Bayesian information criterion (BIC) 319 bear money spread 177 benchmark abacus 287–8 Bernouilli scheme 350 Best Linear Unbiased Estimators (BLUE) 363 beta APT 290, 291 portfolio 92 bijection 335 binomial distribution 350–1 binomial formula (Newton’s) 111, 351 binomial law of probability 165 binomial trees 110, 174 binomial trellis for underlying equity 162 bisection method 380 Black and Scholes model 33, 155, 174, 226, 228, 239 for call option 169 dividends and 173 for options on equities 168–73 sensitivity parameters 172–3 BLUE (Best Linear Unbiased Estimators) 363 bond portfolio management strategies 135–8 active strategy 137–8 duration and convexity of portfolio 135–6 immunizing a portfolio 136–7 positive strategy: immunisation 135–7 bonds average instant return on 140 390 Index bonds (continued ) definition 115–16 financial risk and 120–9 price 115 price approximation 126 return on 116–19 sources of risk 119–21 valuing 119 bootstrap method 233 Brennan and Schwarz model 139 building approach 316 bull money spread 177 business continuity plan (BCP) 14 insurance and 15–16 operational risk and 16 origin, definition and objective 14 butterfly money spread 177 calendar spread 177 call-associated bonds 120 call option 149, 151, 152 intrinsic value 153 premium breakdown 154 call–put parity relation 166 for European options 157–8 canonical analysis 369 canonical correlation analysis 307–9, 369–70 capital asset pricing model (CAPM or MEDAF) 93–8 equation 95–7, 100, 107, 181 cash 18 catastrophe scenarios 20, 32, 184, 227 Cauchy’s law 367 central limit theorem (CLT) 41, 183, 223, 348–9 Charisma 224 Chase Manhattan 224, 228 Choleski decomposition method 239 Choleski factorisation 220, 222, 336–7 chooser option 176 chord method 377–8 classic chord method 378 clean price 118 collateral management 18–19 compliance 24 compliance tests 361 compound Poisson process 355 conditional normality 203 confidence coefficient 360 confidence interval 360–1 continuous models 30, 108–9, 111–13, 131–2, 134 continuous random variables 341–2 contract-by-contract 314–16 convergence 375–6 convertible bonds 116 convexity 33, 149, 181 of a bond 127–9 corner portfolio 64 correlation 41–2, 346–7 counterparty 23 coupon (nominal) rate 116 coupons 115 covariance 41–2, 346–7 cover law of probability 164 Cox, Ingersoll and Ross model 139, 145–7, 174 Cox, Ross and Rubinstein binomial model 162–8 dividends and 168 one period 163–4 T periods 165–6 two periods 164–5 credit risk 12, 259 critical line algorithm 68–9 debentures 18 decision channels 104, 105 default risk 120 deficit constraint 90 degenerate random variable 341 delta 156, 181, 183 delta hedging 157, 172 derivatives 325–7 calculations 325–6 definition 325 extrema 326–7 geometric interpretations 325 determinist models 108–9 generalisation 109 stochastic model and 134–5 deterministic structure of interest rates 129–35 development models 30 diagonal model 70 direct costs 26 dirty price 118 discrete models 30, 108, 109–11. 130, 132–4 discrete random variables 340–1 dispersion index 26 distortion models 138 dividend discount model 104, 107–8 duration 33, 122–7, 149 and characteristics of a bond 124 definition 121 extension of concept of 148 interpretations 121–3 of equity funds 299 of specific bonds 123–4 Index dynamic interest-rate structure 132–4 dynamic models 30 dynamic spread 303–4 efficiency, concept of 45 efficient frontier 27, 54, 59, 60 for model with risk-free security 78–9 for reformulated problem 62 for restricted Markowitz model 68 for Sharpe’s simple index model 73 unrestricted and restricted 68 efficient portfolio 53, 54 EGARCH models 320, 373 elasticity, concept of 123 Elton, Gruber and Padberg method 79–85, 265, 269–74 adapting to VaR 270–1 cf VaR 271–4 maximising risk premium 269–70 equities definition 35 market efficiency 44–8 market return 39–40 portfolio risk 42–3 return on 35–8 return on a portfolio 38–9 security risk within a portfolio 43–4 equity capital adequacy ratio 4 equity dynamic models 108–13 equity portfolio diversification 51–93 model with risk-free security 75–9 portfolio size and 55–6 principles 515 equity portfolio management strategies 103–8 equity portfolio theory 183 equity valuation models 48–51 equivalence, principle of 117 ergodic estimator 40, 42 estimated variance–covariance matrix method (VC) 201, 202–16, 275, 276, 278 breakdown of financial assets 203–5 calculating VaR 209–16 hypotheses and limitations 235–7 installation and use 239–41 mapping cashflows with standard maturity dates 205–9 valuation models 237–9 estimator for mean of the population 360 European call 158–9 European option 149 event-based risks 32, 184 ex ante rate 117 ex ante tracking error 285, 287 ex post return rate 121 exchange options 174–5 exchange positions 204 391 exchange risk 12 exercise price of option 149 expected return 40 expected return risk 41, 43 expected value 26 exponential smoothing 318 extrema 326–7, 329–31 extreme value theory 230–4, 365–7 asymptotic results 365–7 attraction domains 366–7 calculation of VaR 233–4 exact result 365 extreme value theorem 230–1 generalisation 367 parameter estimation by regression 231–2 parameter estimation using the semi-parametric method 233, 234 factor-8 mimicking portfolio 290 factor-mimicking portfolios 290 factorial analysis 98 fair value 10 fat tail distribution 231 festoon effect 118, 119 final prediction error (FPE) 319 Financial Accounting Standards Board (FASB) 9 financial asset evaluation line 107 first derivative 325 Fisher’s skewness coefficient 345–6 fixed-income securities 204 fixed-rate bonds 115 fixed rates 301 floating-rate contracts 301 floating-rate integration method 311 FRAs 276 Fréchet’s law 366, 367 frequency 253 fundamental analysis 45 gamma 156, 173, 181, 183 gap 296–7, 298 GARCH models 203, 320 Garman–Kohlhagen formula 175 Gauss-Seidel method, nonlinear 381 generalised error distribution 353 generalised Pareto distribution 231 geometric Brownian motion 112, 174, 218, 237, 356 geometric mean 36 geometric series 123, 210, 328–9 global portfolio optimisation via VaR 274–83 generalisation of asset model 275–7 construction of optimal global portfolio 277–8 method 278–83 392 Index good practices 6 Gordon – Shapiro formula 48–50, 107, 149 government bonds 18 Greeks 155–7, 172, 181 gross performance level and risk withdrawal 290–1 Gumbel’s law 366, 367 models for bonds 149 static structure of 130–2 internal audit vs. risk management 22–3 internal notation (IN) 4 intrinsic value of option 153 Itô formula (Ito lemma) 140, 169, 357 Itô process 112, 356 Heath, Jarrow and Morton model 138, 302 hedging formula 172 Hessian matrix 330 high leverage effect 257 Hill’s estimator 233 historical simulation 201, 224–34, 265 basic methodology 224–30 calculations 239 data 238–9 extreme value theory 230–4 hypotheses and limitations 235–7 installation and use 239–41 isolated asset case 224–5 portfolio case 225–6 risk factor case 224 synthesis 226–30 valuation models 237–8 historical volatility 155 histories 199 Ho and Lee model 138 homogeneity tests 361 Hull and White model 302, 303 hypothesis test 361–2 Jensen index 102–3 Johnson distributions 215 joint allocation 289 joint distribution function 342 IAS standards 10 IASB (International Accounting Standards Board) 9 IFAC (International Federation of Accountants) 9 immunisation of bonds 124–5 implied volatility 155 in the money 153, 154 independence tests 361 independent allocation 288 independent random variables 342–3 index funds 103 indifference curves 89 indifference, relation of 86 indirect costs 26 inequalities on calls and puts 159–60 inferential statistics 359–62 estimation 360–1 sampling 359–60 sampling distribution 359–60 instant term interest rate 131 integrated risk management 22, 24–5 interest rate curves 129 kappa see vega kurtosis coefficient 182, 189, 345–6 Lagrangian function 56, 57, 61, 63, 267, 331 for risk-free security model 76 for Sharpe’s simple index model 71 Lagrangian multipliers 57, 331 law of large numbers 223, 224, 344 law of probability 339 least square method 363 legal risk 11, 21, 23–4 Lego approach 316 leptokurtic distribution 41, 182, 183, 189, 218, 345 linear equation system 335–6 linear model 32, 33, 184 linearity condition 202, 203 Lipschitz’s condition 375–6 liquidity bed 316 liquidity crisis 17 liquidity preference 316 liquidity risk 12, 16, 18, 296–7 logarithmic return 37 logistic regression 309–10, 371 log-normal distribution 349–50 log-normal law with parameter 349 long (short) straddle 176 loss distribution approach 13 lottery bonds 116 MacLaurin development 275, 276 mapping cashflows 205–9 according to RiskMetricsT M 206–7 alternative 207–8 elementary 205–6 marginal utility 87 market efficiency 44–8 market model 91–3 market price of the risk 141 market risk 12 market straight line 94 Index market timing 104–7 Markowitz’s portfolio theory 30, 41, 43, 56–69, 93, 94, 182 first formulation 56–60 reformulating the problem 60–9 mathematic valuation models 199 matrix algebra 239 calculus 332–7 diagonal 333 n-order 332 operations 333–4 symmetrical 332–3, 334–5 maturity price of bond 115 maximum outflow 17–18 mean 343–4 mean variance 27, 265 for equities 149 measurement theory 344 media risk 12 Merton model 139, 141–2 minimum equity capital requirements 4 modern portfolio theory (MPT) 265 modified duration 121 money spread 177 monoperiodic models 30 Monte Carlo simulation 201, 216–23, 265, 303 calculations 239 data 238–9 estimation method 218–23 hypotheses and limitations 235–7 installation and use 239–41 probability theory and 216–18 synthesis 221–3 valuation models 237–8 multi-index models 221, 266 multi-normal distribution 349 multivariate random variables 342–3 mutual support 147–9 Nelson and Schaefer model 139 net present value (NPV) 298–9, 302–3 neutral risk 164, 174 New Agreement 4, 5 Newson–Raphson nonlinear iterative method 309, 379–80, 381 Newton’s binomial formula 111, 351 nominal rate of a bond 115, 116 nominal value of a bond 115 non-correlation 347 nonlinear equation systems 380–1 first-order methods 377–9 iterative methods 375–7 n-dimensional iteration 381 principal methods 381 393 solving 375–81 nonlinear Gauss-Seidel method 381 nonlinear models independent of time 33 nonlinear regression 234 non-quantifiable risks 12–13 normal distribution 41, 183, 188–90, 237, 254, 347–8 normal law 188 normal probability law 183 normality 202, 203, 252–4 observed distribution 254 operational risk 12–14 business continuity plan (BCP) and 16 definition 6 management 12–13 philosophy of 5–9 triptych 14 options complex 175–7 definition 149 on bonds 174 sensitivity parameters 155–7 simple 175 strategies on 175–7 uses 150–2 value of 153–60 order of convergence 376 Ornstein – Uhlenbeck process 142–5, 356 OTC derivatives market 18 out of the money 153, 154 outliers 241 Pareto distribution 189, 367 Parsen CAT 319 partial derivatives 329–31 payment and settlement systems 18 Pearson distribution system 183 perfect market 31, 44 performance evaluation 99–108 perpetual bond 123–4 Picard’s iteration 268, 271, 274, 280, 375, 376, 381 pip 247 pockets of inefficiency 47 Poisson distribution 350 Poisson process 354–5 Poisson’s law 351 portfolio beta 92 portfolio risk management investment strategy 258 method 257–64 risk framework 258–64 power of the test 362 precautionary surveillance 3, 4–5 preference, relation of 86 394 Index premium 149 price at issue 115 price-earning ratio 50–1 price of a bond 127 price variation risk 12 probability theory 216–18 process risk 24 product risk 23 pseudo-random numbers 217 put option 149, 152 quadratic form 334–7 qualitative approach 13 quantifiable risks 12, 13 quantile 188, 339–40 quantitative approach 13 Ramaswamy and Sundaresan model 139 random aspect of financial assets 30 random numbers 217 random variables 339–47 random walk 45, 111, 203, 355 statistical tests for 46 range forwards 177 rate fluctuation risk 120 rate mismatches 297–8 rate risk 12, 303–11 redemption price of bond 115 regression line 363 regressions 318, 362–4 multiple 363–4 nonlinear 364 simple 362–3 regular falsi method 378–9 relative fund risk 287–8 relative global risk 285–7 relative risks 43 replicating portfolios 302, 303, 311–21 with optimal value method 316–21 repos market 18 repricing schedules 301–11 residual risk 285 restricted Markowitz model 63–5 rho 157, 173, 183 Richard model 139 risk, attitude towards 87–9 risk aversion 87, 88 risk factors 31, 184 risk-free security 75–9 risk, generalising concept 184 risk indicators 8 risk management cost of 25–6 environment 7 function, purpose of 11 methodology 19–21 vs back office 22 risk mapping 8 risk measurement 8, 41 risk-neutral probability 162, 164 risk neutrality 87 risk of one equity 41 risk of realisation 120 risk of reinvestment 120 risk of reputation 21 risk per share 181–4 risk premium 88 risk return 26–7 risk transfer 14 risk typology 12–19 Risk$TM 224, 228 RiskMetricsTM 202, 203, 206–7, 235, 236, 238, 239–40 scenarios and stress testing 20 Schaefer and Schwartz model 139 Schwarz criterion 319 scope of competence 21 scorecards method 7, 13 security 63–5 security market line 107 self-assessment 7 semi-form of efficiency hypothesis 46 semi-parametric method 233 semi-variance 41 sensitivity coefficient 121 separation theorem 94–5, 106 series 328 Sharpe’s multi-index model 74–5 Sharpe’s simple index method 69–75, 100–1, 132, 191, 213, 265–9 adapting critical line algorithm to VaR 267–8 cf VaR 269 for equities 221 problem of minimisation 266–7 VaR in 266–9 short sale 59 short-term interest rate 130 sign test 46 simulation tests for technical analysis methods 46 simulations 300–1 skewed distribution 182 skewness coefficient 182, 345–6 specific risk 91, 285 speculation bubbles 47 spot 247 Index spot price 150 spot rate 129, 130 spreads 176–7 square root process 145 St Petersburg paradox 85 standard Brownian motion 33, 355 standard deviation 41, 344–5 standard maturity dates 205–9 standard normal law 348 static models 30 static spread 303–4 stationarity condition 202, 203, 236 stationary point 327, 330 stationary random model 33 stochastic bond dynamic models 138–48 stochastic differential 356–7 stochastic duration 121, 147–8 random evolution of rates 147 stochastic integral 356–7 stochastic models 109–13 stochastic process 33, 353–7 particular 354–6 path of 354 stock exchange indexes 39 stock picking 104, 275 stop criteria 376–7 stop loss 258–9 straddles 175, 176 strangles 175, 176 strategic risk 21 stress testing 20, 21, 223 strike 149 strike price 150 strong form of efficiency hypothesis 46–7 Student distribution 189, 235, 351–2 Student’s law 367 Supervisors, role of 8 survival period 17–18 systematic inefficiency 47 systematic risk 44, 91, 285 allocation of 288–9 tail parameter 231 taste for risk 87 Taylor development 33, 125, 214, 216, 275–6 Taylor formula 37, 126, 132, 327–8, 331 technical analysis 45 temporal aspect of financial assets 30 term interest rate 129, 130 theorem of expected utility 86 theoretical reasoning 218 theta 156, 173, 183 three-equity portfolio 54 395 time value of option 153, 154 total risk 43 tracking errors 103, 285–7 transaction risk 23–4 transition bonds 116 trend extrapolations 318 Treynor index 102 two-equity portfolio 51–4 unbiased estimator 360 underlying equity 149 uniform distribution 352 uniform random variable 217 utility function 85–7 utility of return 85 utility theory 85–90, 183 valuation models 30, 31–3, 160–75, 184 value at risk (VaR) 13, 20–1 based on density function 186 based on distribution function 185 bond portfolio case 250–2 breaking down 193–5 calculating 209–16 calculations 244–52 component 195 components of 195 definition 195–6 estimation 199–200 for a portfolio 190–7 for a portfolio of linear values 211–13 for a portfolio of nonlinear values 214–16 for an isolated asset 185–90 for equities 213–14 heading investment 196–7 incremental 195–7 individual 194 link to Sharp index 197 marginal 194–5 maximum, for portfolio 263–4 normal distribution 188–90 Treasury portfolio case 244–9 typology 200–2 value of basis point (VBP) 19–20, 21, 127, 245–7, 260–3 variable contracts 301 variable interest rates 300–1 variable rate bonds 115 variance 41, 344–5 variance of expected returns approach 183 variance – covariance matrix 336 Vasicek model 139, 142–4, 174 396 Index vega (kappa) 156, 173 volatility of option 154–5 yield curve 129 yield to maturity (YTM) 250 weak form of the efficiency hypothesis 46 Weibull’s law 366, 367 Wiener process 355 zero-coupon bond 115, 123, 129 zero-coupon rates, analysis of correlations on 305–7 Index compiled by Annette Musker


pages: 358 words: 106,729

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

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

The lay investor’s version of such benchmarking is to compare the manager’s return with a return on a benchmark portfolio consisting of similar securities: for example, the returns generated by a fund manager investing in large U.S. firms will be compared with the return on the S&P 500 index of large U.S. stocks. Such benchmarking is logical, because the investor can easily achieve the returns on the S&P 500 index by buying a low-cost index fund, and a manager should not earn anything for merely matching this return. Instead, investors will reward a manager handsomely only if the manager consistently generates excess returns, that is, returns exceeding those of the risk-appropriate benchmark. In the jargon, such excess returns are known as “alpha.” Why should a manager care about generating alpha? If she wants to attract substantial new inflows of money, which is the key to being paid large amounts, she has to give the appearance of superior performance.

A competitive system is also likely to produce the financial innovation necessary to broaden access and spread risk. Financial innovation nowadays seems to be synonymous with credit-default swaps and collateralized debt obligations, derivative securities that few outside Wall Street now think should have been invented. But innovation also gave us the money-market account, the credit card, interest-rate swaps, indexed funds, and exchange-traded funds, all of which have proved very useful. So, as with many things, financial innovations span the range from the good to the positively dangerous. Some have proposed a total ban on offering a financial product unless it has been vetted, much as the Food and Drug Administration vets new drugs. This proposal probably goes too far, as many products are minor tweaks on previous ones, are not life threatening, and cannot really be understood until tried out.


pages: 397 words: 112,034

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

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

According to LCM Research, adding exchange-traded options and futures contracts to the latter figure represents no less than seven billion barrels of oil. The deleveraging that took place in the second half of 2008 reduced this amount to about 1.7 billion barrels. Over-the-counter crude oil contracts exacerbated this speculative spike, adding a full 120 percent to the peak figure as opposed to a fraction (on the order of 80 percent) before and after the spring 2008 episode. Similarly, passive investment into index funds also rose and fell spectacularly, from about $75 billion in 2006 to $280 billion by mid-summer 2008, and back to the 2006 level six months later.40 The Goldman Sachs–fed allure of $200-per-barrel oil has faded, and it is unlikely that the next couple of years will see an episode of exuberant investing comparable to the year 2008 that is still remembered for oil at $147 per barrel. Nevertheless, the fourth quarter of 2009 saw sustained investment in oil futures, and there may be other reasons why paper markets may not remain neutral for long.

EMISSIONS STANDARDS: Rules and requirements that limit the amount of pollutants that can be released into the environment by various entities. EN BLOC: As a whole. EUROZONE: A group of European countries that uses the euro as a common currency. EXCESS RESERVES: The amount of reserves that are held by a bank or financial institution above the reserve requirement. EXCHANGE-TRADED FUND: A financial security that tracks an index, a commodity, or a basket of assets much like an index fund does; however, it trades on an exchange and experiences price changes throughout the trading day. EXCISE TAX: Taxes paid on purchases of goods or activities. They are often incorporated into the price of the product or activity. EXPATRIATE: A person who withdraws oneself from one’s country, either temporarily or permanently, in allegiance and/or residence. FED FUNDS RATE: The short-term interest rate at which US depository institutions lend to each other overnight within the Federal Reserve System.


pages: 317 words: 100,414

Superforecasting: The Art and Science of Prediction by Philip Tetlock, Dan Gardner

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Affordable Care Act / Obamacare, Any sufficiently advanced technology is indistinguishable from magic, availability heuristic, Black Swan, butterfly effect, cloud computing, cuban missile crisis, Daniel Kahneman / Amos Tversky, desegregation, drone strike, Edward Lorenz: Chaos theory, forward guidance, Freestyle chess, fundamental attribution error, germ theory of disease, hindsight bias, index fund, Jane Jacobs, Jeff Bezos, Kenneth Arrow, Mikhail Gorbachev, Mohammed Bouazizi, Nash equilibrium, Nate Silver, obamacare, pattern recognition, performance metric, Pierre-Simon Laplace, place-making, placebo effect, prediction markets, quantitative easing, random walk, randomized controlled trial, Richard Feynman, Richard Feynman, Richard Thaler, Robert Shiller, Robert Shiller, Ronald Reagan, Saturday Night Live, Silicon Valley, Skype, statistical model, stem cell, Steve Ballmer, Steve Jobs, Steven Pinker, the scientific method, The Signal and the Noise by Nate Silver, The Wisdom of Crowds, Thomas Bayes, Watson beat the top human players on Jeopardy!

In 1994 Jim Collins and Jerry Porras published Built to Last: Successful Habits of Visionary Companies, which examined eighteen exemplary companies and from these created “a master blueprint for building organizations that will prosper long into the future.” It was a great read that won many accolades. But as the business professor Phil Rosenzweig noted, if Collins and Porras were right, we should, at a minimum, expect that the eighteen exemplary companies would continue to do well. Collins and Porras ended their study in 1990, so Rosenzweig checked how the companies did over the next ten years: “You would have been better off investing in an index fund than putting your money on Collins’ and Porras’ visionary companies.” See Philip Rosenzweig, The Halo Effect … and the Eight Other Business Delusions That Deceive Managers (New York: Free Press, 2014), p. 98. The dart-throwing chimp strikes again. 14. The size of the father-son correlation determines how much you should move your prediction of the son’s height toward the population average of five feet eight inches.

It’s far from an ideal measure, but if I held out for Platonic perfection I would have stayed in the lab. The result? The correlation with intelligence did decline. So this gauge is telling us that practice really does make forecasters better. 10. Reading this footnote could save you exponentially more money than the cost of this book. Overconfidence can be expensive. Imagine two people deciding whether to invest $100,000 in retirement savings in either a stock market index fund that yields the base-rate return (the S&P 500 average) or Firm Alpha, an expert-guided actively managed fund that claims to beat market averages. Starting from the stylized facts that there is no consistency in which active funds beat passive funds each year, and that Firm Alpha charges 1% per year to manage funds and the passive fund charges 0.1%, we can compute the cumulative cost, over thirty years, of overestimating one’s skill at picking winners.


pages: 347 words: 97,721

Only Humans Need Apply: Winners and Losers in the Age of Smart Machines by Thomas H. Davenport, Julia Kirby

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AI winter, Andy Kessler, artificial general intelligence, asset allocation, Automated Insights, autonomous vehicles, basic income, Baxter: Rethink Robotics, business intelligence, business process, call centre, carbon-based life, Clayton Christensen, clockwork universe, commoditize, conceptual framework, dark matter, David Brooks, deliberate practice, deskilling, digital map, Douglas Engelbart, Edward Lloyd's coffeehouse, Elon Musk, Erik Brynjolfsson, estate planning, fixed income, follow your passion, Frank Levy and Richard Murnane: The New Division of Labor, Freestyle chess, game design, general-purpose programming language, Google Glasses, Hans Lippershey, haute cuisine, income inequality, index fund, industrial robot, information retrieval, intermodal, Internet of things, inventory management, Isaac Newton, job automation, John Markoff, John Maynard Keynes: Economic Possibilities for our Grandchildren, John Maynard Keynes: technological unemployment, Khan Academy, knowledge worker, labor-force participation, lifelogging, loss aversion, Mark Zuckerberg, Narrative Science, natural language processing, Norbert Wiener, nuclear winter, pattern recognition, performance metric, Peter Thiel, precariat, quantitative trading / quantitative finance, Ray Kurzweil, Richard Feynman, Richard Feynman, risk tolerance, Robert Shiller, Robert Shiller, Rodney Brooks, Second Machine Age, self-driving car, Silicon Valley, six sigma, Skype, speech recognition, spinning jenny, statistical model, Stephen Hawking, Steve Jobs, Steve Wozniak, strong AI, superintelligent machines, supply-chain management, transaction costs, Tyler Cowen: Great Stagnation, Watson beat the top human players on Jeopardy!, Works Progress Administration, Zipcar

Those who have stepped up in the financial investments industry perhaps noticed, for example, that members of the millennial generation are, as investors, very comfortable with technology and rather uncomfortable with coming into an office and discussing their financial situations. At the same time, someone taking a broad view of the investment landscape might have noticed the shift away from stock and bond picking by experts, to index funds that invest in major segments of markets. From such observations, the idea might occur quite readily to create a “robo-advisor” capable of proposing portfolios of these types of investments. For that matter, the rise of cognitive technologies is a big-picture idea in itself. It’s not surprising that these types of systems would take off, given macro trends relating to the power of computers, the intensity of global competition, and the shift from goods to services by mature economies.

We’ll illustrate the process of planning and developing an augmented solution with a variety of examples, but for each step in the process we describe for you, we’ll also point you to one particularly instructive example—Vanguard Group’s initiative to support its financial advisors with an intelligent system capable of formulating fast, accurate responses to clients’ asset management questions. Vanguard is known for looking out for investors with low costs and index funds, but here it also did a good job of combining smart people and smart machines. Step 1: Know Your Highest-Impact Decisions and Knowledge Bottlenecks Unfortunately, it is possible to spend a lot of time implementing intelligent technologies that aren’t actually a fit for your business or don’t solve a very important problem. So it’s a good idea to start with a very simple question: If you could wave a magic wand and give some select professionals in your organization superpowers, in what way would you expand their capacity?


pages: 831 words: 98,409

SUPERHUBS: How the Financial Elite and Their Networks Rule Our World by Sandra Navidi

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activist fund / activist shareholder / activist investor, assortative mating, bank run, barriers to entry, Bernie Sanders, Black Swan, Bretton Woods, butterfly effect, Capital in the Twenty-First Century by Thomas Piketty, Carmen Reinhart, central bank independence, cognitive bias, collapse of Lehman Brothers, collateralized debt obligation, commoditize, conceptual framework, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, diversification, East Village, Elon Musk, eurozone crisis, family office, financial repression, Gini coefficient, glass ceiling, Goldman Sachs: Vampire Squid, Google bus, Gordon Gekko, haute cuisine, high net worth, hindsight bias, income inequality, index fund, intangible asset, Jaron Lanier, John Meriwether, Kenneth Arrow, Kenneth Rogoff, knowledge economy, London Whale, Long Term Capital Management, Mark Zuckerberg, mass immigration, McMansion, mittelstand, money market fund, Myron Scholes, NetJets, Network effects, offshore financial centre, old-boy network, Parag Khanna, Paul Samuelson, peer-to-peer, performance metric, Peter Thiel, Plutocrats, plutocrats, Ponzi scheme, quantitative easing, Renaissance Technologies, rent-seeking, reserve currency, risk tolerance, Robert Gordon, Robert Shiller, Robert Shiller, rolodex, Satyajit Das, shareholder value, Silicon Valley, sovereign wealth fund, Stephen Hawking, Steve Jobs, The Future of Employment, The Predators' Ball, too big to fail, women in the workforce, young professional

Bernstein, CFO of Citigroup, CEO of Citi Wealth Management, and lastly as head of global wealth and investment management at Bank of America. The financial crisis cost Krawcheck her last two jobs, and after being let go from Bank of America she purchased the women’s network 85 Broads, which had been founded by a female Goldman Sachs partner as a platform for female senior executives. In 2014, Krawcheck gave it the clever moniker Ellevate and launched the Pax Ellevate Global Women’s Index Fund, which invests in companies highly rated in terms of advancing female leadership. The verdict on the Ellevate network’s effectiveness is still out, but it is a promising start. THE NETWORKING GAP: SCHMOOZE OR LOSE The comparative weakness of female networks also results from women’s dispositions. Studies show that women are more reluctant than men to use their peer-to-peer networks because they feel uncomfortable using connections opportunistically.

See Davos need for, 112 Network power communication used to form, 41 description of, xxv of Klaus Schwab, 95 network strength and, 97 Network science description of, xxvi financial system viewed through, 6–7 human relationships viewed through, 7 patterns in, 7 Networkers, 100–101 Networking at charity events, 128–129 at Davos, 5, 9 family office platform for, 123–124 at fitness clubs, 125–126 mind-set of, 100–101 power lunches for, 124–125 at Private parties, 126–128 purpose of, 100, 104, 108 resistance to, 104 by Superhubs, 100 by women, 151 Networking gap, 151, 161–162 New York charity events in, 128 Four Seasons restaurant in, 124 real estate in, 90–91 New York Fed, 45–46, 183, 208–209, 215 New York Times, 17, 56, 71, 125, 148, 158, 189 New York University, 36, 47, 64 New Zealand, 13 Newsweek, 80 Niccolini, Julian, 124 Niederauer, Duncan, 85 Nodes definition of, xxvi description of, 18–19 failure of, 216 in financial system, 19–20 hierarchy of, 19 with limited connections, 20 links to, 19 preferential attachment of, xxvi senior, 77 superhub connections to, 19–20 Nonverbal communication, 99–100, 149 Nooyi, Indra, 157 Norms, 222 Northwestern University, 220 Norway, 114 Novogratz, Michael, 109 Noyer, Christian, 160 O Oaktree Capital Management, 90 Obama, Barack, 58, 165, 168, 173–174, 188–189, 196 Observer, 87 Obsessiveness, 69 Och, Dan, 170 Och-Ziff, 170 “Office housework,” 152 Office of the Chief Economist, 164 Old boys’ network, 82–85, 150 Old Lane Partners, 139 On the Brink, 172 On Tour with the IMF, 160 O’Neal, Stanley, 56 O’Neill, Michael, 140 Open-mindedness, 62 Opportunities, 52–53 Opportunity gap, 13 Orszag, Peter, 168 Osborne, George, 121, 137 Osório, Horta, 137 Oxfam, 213 P Pain, 71 Paine Webber, 209 Palantir Technologies, 72 Panama Papers, 211 Pandit, Vikram, 23, 53, 57, 139–140, 203 Pao, Ellen, 196–203 Papandreou, George, 27 Paranoia, 71 Paris, 131–132 Parties private, 126–128 at World Economic Forum, 114–116 Patton, Arch, 87 Paulson & Co., 42, 88 Paulson, Hank AIG and, 183 Alan Greenspan and, 36 as U.S. treasury secretary, 36, 167 background on, 172 at Bilderberg conference, 121 networking by, 172–173, 182 personal relationships, 11 in public and private sectors, 165 revolving door phenomenon and, 165 Robert Rubin and, 167 Paulson, John, xxvii, 7, 82, 88, 129 Pax Ellevate Global Women’s Index Fund, 151 Peer-to-peer networking at Davos, 5, 9 by women, 151 P=EFT formula, 63–64, 192 Pelosi, Nancy, 27, 173 Peltz, Nelson, 154 People’s Bank of China, 209 Pepsi, 157 Perfectionism, 137 Performance-based assessments, 152 Performance-based compensation, 86 “Perma-bears,” 48 Perry, Richard, 170 Perry Capital, 170 Personal connections access and, 52 benefits of, 45–46 description of, 7–8, 10–12 in financial crisis of 2007–2008 resolution, 172–173 influence of, 41–42 information from, 41–42 leveraging of, 175 need for, 98 networking to create, 100–101 technology’s role in, 99–100 value of, 175 Peterson, Pete, 27, 30, 53, 61, 79, 124 Peterson Institute, 107 Petraeus, General David, 121 Petro Saudi, 170 “Philanthrocapitalism,” 128 Philanthropy, 17, 70, 75–76, 128, 129, 169, 171, 192, 199 Philippe, King of Belgium, 114 Picasso, Pablo, 124–125 Piketty, Thomas, 49 PIMCO, 42, 44, 53, 66–67, 69 Pinchuk, Victor, 195 Place Vendôme, 132 Plato, 79 Plaza Hotel, 158 Point72 Asset Management, 88 Policy makers, 85 Political capital, 169 Political protection, 175–176 Politics, finance and, 163 Ponzi schemes, 196, 201–202 Pool Room, 124 Pope, 220 Portugal, 177 “Positive linking,” 100 Potential versus performance, 152–153 Poverty, 213 Power network.


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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activist fund / activist shareholder / activist investor, air freight, barriers to entry, Basel III, BRICs, business climate, business process, capital asset pricing model, capital controls, Chuck Templeton: OpenTable, cloud computing, commoditize, compound rate of return, conceptual framework, corporate governance, corporate social responsibility, creative destruction, credit crunch, Credit Default Swap, discounted cash flows, distributed generation, diversified portfolio, energy security, equity premium, fixed income, index fund, intangible asset, iterative process, Long Term Capital Management, market bubble, market friction, meta analysis, meta-analysis, Myron Scholes, negative equity, 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, survivorship bias, technology bubble, time value of money, too big to fail, transaction costs, transfer pricing, value at risk, yield curve, zero-coupon bond

If the 3 Nonfundamental investors could be called “irrational” because they don’t make decisions based on an economic analysis of a company. We call them nonfundamental, because their strategies might be rational and sophisticated even though not based on fundamentals. 4 Our two investor groups are quite similar to feedback traders and smart-money investors, as in W. N. Goetzmann and M. Massa, “Daily Momentum and Contrarian Behavior of Index Fund Investors,” Journal of Financial and Quantitative Analysis 37, no. 3 (September 2002): 375–389. MARKETS AND FUNDAMENTALS: A MODEL 67 EXHIBIT 5.1 Model of Share Price Trading Boundaries Time = T 100 90 Upper trading boundary 80 Upper intrinsic value Share price Price 70 60 Lower intrinsic value Lower trading boundary 50 40 30 20 Time noise traders act not only on price movements but also on random, insignificant events, there will also be price oscillations within the band.

Singal, “The Price Response to S&P 500 Index Additions and Deletions: Evidence of Asymmetry and a New Explanation,” Journal of Finance 59, no. 4 (August 2004): 1901–1929. 31 See also, for example, L. Harris and E. Gurel, “Price and Volume Effects Associated with Changes in the S&P 500: New Evidence for the Existence of Price Pressures,” Journal of Finance 41 (1986): 815–830; and R. A. Brealey, “Stock Prices, Stock Indexes, and Index Funds,” Bank of England Quarterly Bulletin (2000): 61–68. 32 For further details, see M. Goedhart and R. Huc, “What Is Stock Membership Worth?” McKinsey on Finance, no. 10 (Winter 2004): 14–16. MARKET MECHANICS DON’T MATTER 87 EXHIBIT 5.14 Delisting from U.S./UK Exchanges: No Value Impact on Companies from Developed Markets 5 4 Average return Cumulative returns,¹ % 3 2 Average abnormal return 1 0 –25 2 –20 –15 –10 –5 0 5 10 15 20 25 –1 –2 –3 –4 –5 Day relative to date of announcement 1 Sample of 229 delistings from New York Stock Exchange, NASDAQ, or London International Main Market.

Koller, “Inside a Hedge Fund: An Interview with the Managing Partner of Maverick Capital,” McKinsey on Finance, no. 19 (Spring 2006): 6–11. WHICH INVESTORS MATTER? 687 matter greatly in the short term. However, they don’t take a view on companies’ long-term strategies and business performance. Mechanical investors control about 35 to 40 percent of institutional equity in the United States. They make decisions based on strict criteria or rules. Index funds are the prototypical mechanical investor, merely building their portfolios by matching the composition of an index such as the S&P 500. Another group of mechanical investors are the so-called quantitative investors, who use mathematical models to build their portfolios and make no qualitative judgments on a company’s intrinsic value. Finally, closet indexers, although they are promoted as active managers, have portfolios that look like an index.


pages: 598 words: 172,137

Who Stole the American Dream? by Hedrick Smith

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Affordable Care Act / Obamacare, Airbus A320, airline deregulation, anti-communist, asset allocation, banking crisis, Bonfire of the Vanities, British Empire, business process, clean water, cloud computing, collateralized debt obligation, collective bargaining, commoditize, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, David Brooks, Deng Xiaoping, desegregation, Double Irish / Dutch Sandwich, family office, full employment, global supply chain, Gordon Gekko, guest worker program, hiring and firing, housing crisis, Howard Zinn, income inequality, index fund, industrial cluster, informal economy, invisible hand, Joseph Schumpeter, Kenneth Rogoff, Kitchen Debate, knowledge economy, knowledge worker, laissez-faire capitalism, late fees, Long Term Capital Management, low cost carrier, manufacturing employment, market fundamentalism, Maui Hawaii, mega-rich, mortgage debt, negative equity, new economy, Occupy movement, Own Your Own Home, Paul Samuelson, Peter Thiel, Plutonomy: Buying Luxury, Explaining Global Imbalances, Ponzi scheme, Powell Memorandum, Ralph Nader, RAND corporation, Renaissance Technologies, reshoring, rising living standards, Robert Bork, Robert Shiller, Robert Shiller, rolodex, Ronald Reagan, shareholder value, Shenzhen was a fishing village, Silicon Valley, Silicon Valley startup, Steve Jobs, The Chicago School, The Spirit Level, too big to fail, transaction costs, transcontinental railway, union organizing, Unsafe at Any Speed, Vanguard fund, We are the 99%, women in the workforce, working poor, Y2K

So you the investor put up 100 percent of the capital. You take 100 percent of the risk. And you capture about 46 percent of the return. Wall Street puts up none of the capital, takes none of the risk, and takes out 54 percent of the return.” That is why Bogle is a staunch advocate of stock index funds, a basket of diverse stocks combined in an index to represent the whole market. Index funds cost the customer much less, Bogle pointed out, because the index has a fixed portfolio and does not require a fund manager to trade in and out of stocks. “You can buy an index fund for one-tenth of 1 percent,” he said. “No turnover expense. No sales load or commission. You get 4.9 percent investment gain out of the 5 percent growth. You get $6.78 out of that $7.04 instead of seeing most of it go to the financial industry.” How Much to Save?


pages: 374 words: 114,600

The Quants by Scott Patterson

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Albert Einstein, asset allocation, automated trading system, beat the dealer, Benoit Mandelbrot, Bernie Madoff, Bernie Sanders, Black Swan, Black-Scholes formula, Bonfire of the Vanities, Brownian motion, buttonwood tree, buy low sell high, capital asset pricing model, centralized clearinghouse, Claude Shannon: information theory, cloud computing, collapse of Lehman Brothers, collateralized debt obligation, commoditize, computerized trading, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, Donald Trump, Doomsday Clock, Edward Thorp, Emanuel Derman, Eugene Fama: efficient market hypothesis, fixed income, Gordon Gekko, greed is good, Haight Ashbury, I will remember that I didn’t make the world, and it doesn’t satisfy my equations, index fund, invention of the telegraph, invisible hand, Isaac Newton, job automation, John Meriwether, John Nash: game theory, law of one price, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, margin call, merger arbitrage, money market fund, Myron Scholes, NetJets, new economy, offshore financial centre, old-boy network, Paul Lévy, Paul Samuelson, Ponzi scheme, quantitative hedge fund, quantitative trading / quantitative finance, race to the bottom, random walk, Renaissance Technologies, risk-adjusted returns, Rod Stewart played at Stephen Schwarzman birthday party, Ronald Reagan, Sergey Aleynikov, short selling, South Sea Bubble, speech recognition, statistical arbitrage, The Chicago School, The Great Moderation, The Predators' Ball, too big to fail, transaction costs, value at risk, volatility smile, yield curve, éminence grise

At bottom, EMH was based on the idea, as Bachelier had argued, that the market moves in a random fashion and that current prices reflect all known information about the market. That being the case, it’s impossible to know whether the market, or an individual stock, currency, bond, or commodity, will rise or fall in the future—the future is random, a coin flip. It’s a fancy way of saying there’s no free lunch. This idea eventually spawned the megabillion-dollar index fund industry, based on the notion that if active managers can’t consistently put up better returns than the rest of the market, why not simply invest in the entire market itself, such as the S&P 500, for a much lower fee? While Thorp fully understood the notion of random walks, which he’d used to price warrants, he thought EMH was academic hot air, the stuff of cloistered professors spinning airy fantasies of high-order math and fuzzy logic.

The travails of AQR, once one of the hottest hedge funds on Wall Street, and the intense pressures placed on Asness captured the plight of an industry struggling to cope with the most tumultuous market in decades. The market’s chaos had made a hash of the models deployed by the quants. AQR’s losses were especially severe in late 2008 after Lehman Brothers collapsed, sending markets around the globe into turmoil. Its Absolute Return Fund fell about 46 percent in 2008, compared with a 48 percent drop by the Standard & Poor’s 500-stock index. In other words, investors in plain-vanilla index funds had done just about as well (or poorly) as investors who’d placed their money in the hands of one of the most sophisticated asset managers in the business. It was the toughest year on record for hedge funds, which lost 19 percent in 2008, according to Hedge Fund Research, a Chicago research group, only the second year since 1990 that the industry lost money as a whole. (In 2002, hedge funds slid 1.5 percent.)


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, beat the dealer, Bernie Madoff, Black Swan, buy low sell high, capital asset pricing model, Clayton Christensen, commodity trading advisor, computerized trading, correlation coefficient, Daniel Kahneman / Amos Tversky, delayed gratification, deliberate practice, diversification, diversified portfolio, Edward Thorp, Elliott wave, Emanuel Derman, Eugene Fama: efficient market hypothesis, Everything should be made as simple as possible, fiat currency, fixed income, game design, hindsight bias, housing crisis, index fund, Isaac Newton, John Meriwether, John Nash: game theory, linear programming, Long Term Capital Management, mandelbrot fractal, margin call, market bubble, market fundamentalism, market microstructure, mental accounting, money market fund, Myron Scholes, 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, survivorship bias, 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, zero-sum game

Mark Abraham Quantitative Capital Management, L.P. 10 Trend Following (Updated Edition): Learn to Make Millions in Up or Down Markets “I often hear people swear they make money with technical analysis. Do they really? The answer, of course, is that they do. People make money using all sorts of strategies, including some involving tea leaves and sunspots. The real question is: Do they make more money than they would investing in a blind index fund that mimics the performance of the market as a whole? Most academic financial experts believe in some form of the random-walk theory and consider technical analysis almost indistinguishable from a pseudoscience whose predictions are either worthless or, at best, so barely discernibly better than chance as to be unexploitable because of transaction costs.”12 Markets aren’t chaotic, just as the seasons follow a series of predictable trends, so does price action.

Large positive returns are penalized, and thus the removal of the highest returns from the distribution can increase the Sharpe ratio: a case of reductio ad absurdum for Sharpe ratio as a universal measure of quality!” Other readers on my blog responded to Bhardwaj: “Of course Geetesh Bhardwaj’s affiliation is significant. Vanguard is famous for taking the position that actively managed funds are a waste of time. That is why the vast majority of their assets under management are in indexed funds. So is it surprising that their marketing department hired an economics major to write reports that show active management in a bad light? Don’t hold it against Geetesh. His previous job being a vice president of a disaster like AIG can’t look good on a resume. He’s probably lucky to be working at all.” Another reader responded: “The Sharpe ratio of CTAs [trend following traders] does not need to be ‘explained.’


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, beat the dealer, 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, commoditize, complexity theory, computerized trading, corporate governance, corporate raider, Credit Default Swap, credit default swaps / collateralized debt obligations, cuban missile crisis, currency peg, disintermediation, diversification, diversified portfolio, Edward Thorp, Eugene Fama: efficient market hypothesis, Everything should be made as simple as possible, 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, John Meriwether, locking in a profit, Long Term Capital Management, mandelbrot fractal, margin call, market bubble, Marshall McLuhan, mass affluent, mega-rich, merger arbitrage, Mexican peso crisis / tequila crisis, money market fund, moral hazard, mutually assured destruction, Myron Scholes, 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, Right to Buy, risk-adjusted returns, risk/return, Satyajit Das, shareholder value, short selling, South Sea Bubble, statistical model, technology bubble, the medium is the message, the new new thing, time value of money, too big to fail, transaction costs, value at risk, Vanguard fund, volatility smile, yield curve, Yogi Berra, zero-coupon bond

There is the unknown unknown – pure uncertainty, things that never happened before. 4 Risk/reward – William Sharpe, John Lintner and Jack Treynor showed, using the CAPM (capital asset price model), that risk and return were related. If you took more risk then you needed higher returns. Old time investors wept with joy. They had been doing CAPM without knowing it. Fund managers had their own papal fashions, known as investment styles: see Table 3.1. Table 3.1 N Investment styles Style What is it? What does it mean? Index funds The fund manager invests to match some index like the S & P 500. The fund manager tries to pick stocks that will do better than the market. The fund manager chases whatever is going up. The fund manager has given up trying to beat the market. Active management Momentum investing Value investing L The fund manager invests in undervalued gems that he has uncovered through research. The triumph of hope over experience.

The funds names inevitably include the term ‘capital’ – remember Long Term Capital Management. Hedge funds have been around for about 50 years and rose to prominence in the 1990s. Originally, the funds got their money from the rich, as the minimum investment was $1 million. Now, most of the money comes from traditional investors – insurance companies, fund managers and private banks. Investors gave up trying to beat the market. Weary of underperformance they switched to index funds, just buying the entire market. These days some fund managers invest about 90% in indexes to match the market (their beta). They give the remaining 10% to hedge funds to try to beat the market (the elusive alpha). Disgruntled fund managers and traders from dealers, especially derivative specialists, set up hedge funds. Fund managers were tired of the politics and inflexibility of large organizations and increasing compliance burdens.


pages: 415 words: 125,089

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

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Albert Einstein, Alvin Roth, Andrew Wiles, Antoine Gombaud: Chevalier de Méré, Bayesian statistics, Big bang: deregulation of the City of London, Bretton Woods, buttonwood tree, capital asset pricing model, cognitive dissonance, computerized trading, 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, Kenneth Arrow, linear programming, loss aversion, Louis Bachelier, mental accounting, moral hazard, Myron Scholes, Nash equilibrium, Paul Samuelson, Philip Mirowski, 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, Thomas Bayes, trade route, transaction costs, tulip mania, Vanguard fund, zero-sum game

No one knows when their next takeoff will come, if ever. The fine performance record of unmanaged index funds is vulnerable to the same kinds of criticism, because the guidance provided by past performance is no more reliable here than it is for active managements. Indeed, more dramatically than any other portfolio, the indexes reflect all the fads and nonrational behavior that is going on in the market. Yet a portfolio designed to track one of the major indexes, like the S&P 500, still has clear advantages over actively managed portfolios. Since turnover occurs only when a change is made in the index, transaction costs and capital-gains taxes can be held to a minimum. Furthermore, the fees charged by managers of index funds run about 0.10% of assets; active managers charge many times that, often exceeding 1% of assets.


pages: 504 words: 139,137

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

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activist fund / activist shareholder / activist investor, 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, money market fund, mortgage debt, Myron Scholes, 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, selection bias, shareholder value, Sharpe ratio, short selling, sovereign wealth fund, statistical arbitrage, statistical model, survivorship bias, systematic trading, technology bubble, time value of money, total factor productivity, transaction costs, value at risk, Vanguard fund, yield curve, zero-coupon bond

The idiosyncratic risk can be positive or negative, is zero on average, and is independent of market moves. Knowing a strategy’s beta is useful for many reasons. For instance, if you mix a hedge fund with other investments, the beta risk is not diversified away, while idiosyncratic risk largely is. Furthermore, market exposure (“beta risk”) is easy to obtain at very low fees, for example, by buying index funds, exchange traded funds (ETFs), or futures contracts. Hence, you should not be paying high fees for market exposure. Many hedge funds are (or claim to be) market neutral. This important concept means that the hedge fund’s performance does not depend on whether the stock market is moving up or down. That is, the hedge fund has equally good potential to make money in bull and bear markets because its strategy is not simply to bet on the market going up.

See also backtests of strategies; investment styles; specific strategies hedge ratio (delta, Δ): in binomial option pricing model, 237; in convertible bond arbitrage, 275, 275f, 283; to make a strategy market neutral, 28; in slope trade, 251 hedging: as benefit of short-selling, 123; of convertible bonds versus straight bonds, 270; defined, 19; dynamic, 234, 235, 237–38, 240; in fixed-income arbitrage, 241; Scholes on broker-dealers and, 267; tail hedging, 59, 228 Heisenberg uncertainty principle of finance, 135 herding, 209, 210, 211–12 high-conviction trades: going for the jugular with, 12, 321; portfolio construction and, 55, 57 high-frequency trading (HFT), 10, 134, 134t, 135, 153–57; flash crash of 2010 and, 156–57; as market making, 44–45, 153–55 high-minus-low (HML) factor, 29, 137, 137n high-moneyness convertible bonds, 282, 282f, 284, 284f high water mark (HWM), 21–22, 35, 36f holding periods, 105–6; at Maverick Capital, 111–12 hurdle rate, 21 Huygens, Christiaan, 81 hybrid convertible bonds, 282, 282f idiosyncratic risk, 27–28; in information ratio, 30; washed out in quant investing, 144 illiquid assets, in asset allocation, 168, 170 illiquidity premium, 43 illiquid securities, defined, 63 IMA (investment management agreement), 25 immunization, 246, 251 implementation costs, 63–64. See also funding costs; transaction costs implementation shortfall (IS), 70–72, 73f implied cost of capital, 93 implied expected returns, 93 implied volatility, 239, 262 index arbitrage, 153 index funds, 28 index options: demand pressure for, 46; implied volatilities of, 239 index weightings, Maverick’s indifference to, 111 industry-neutral portfolio construction, 144; quant event of 2007 and, 146 industry rotation, 98 inefficient markets: Asness on successful strategies and, 164; defined, vii. See also efficiently inefficient markets inflation: aggregate demand and, 193f, 194; aggregate supply and, 193, 193f; bond returns and, 180; central bank policies and, 189–90; currency returns and, 182–83; economic environment and, 191–92, 191t; employment and, 193; equity returns and, 178–79; Federal Reserve policy and, 189–90; interest rates and, 189–90, 194, 250; supply or demand shocks and, 195t inflation risk premium, 196 information: efficient market hypothesis and, 201, 227; short sellers as providers of, 132; as source of profits, 39, 40–42, 40f information ratio (IR), 30, 31; adjusted for stale prices, 37 in-sample backtests, 50, 53 insider selling, 125, 128 insider trading, 9, 40–41, 294, 318 Integrated Resources, 129 interest rate futures, 190 interest-rate risk: in convertible bond arbitrage, 283; in event-driven investment, 292 interest rates: aggregate demand and, 194; in efficiently inefficient markets, 7t; inflation and, 189–90, 194, 250; in neoclassical finance, 7t; option instruments related to, 262; overnight, central banks and, 248–49.


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

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

These days, after a decade of frantic growth in mortgage-backed securities and other complex instruments traded off exchanges, that clarity is gone. Large parts of American financial markets have become a hall of mirrors. 12 Ordinary investors are starting to pay a price for what is fast becoming a tattered pretense. Information is deficient, not efficient; the theory behind the EMH has spurred a dubious shift toward passive index funds and the “buy and hold” approach and away from market timing and active management. The EMH assumption that the stock market provides the best guide to the value of corporate assets is undercut by the lack of attention to private debt in U.S. and British data collection. In addition, the investment theory taught in U.S. business schools may be useless with respect to East Asia, where complex social networks differ from those of the West.

“Hindenburg Omen” Hindu Hoening, Thomas Holmes, Oliver Wendell home-equity loan (HEL) Hong Kong Hoover, Herbert Hotson, John Houdaille Industries House of Representatives, U.S. bailouts of 2008 and “Houses That Saved the World, The” (Economist) housing in CPI debt and GDP and mortgage crisis and opacity and recession and risk and securitization and subprime crisis and HSBC Huckabee, Mike Hu Jintao Hunt, Lacy Hussein, Saddam Husseini, Sadad al- “If We Are Rome, Wall Street’s Our Coliseum” (Farrell) Indebted Society (Medoff and Harless) index funds India “India, China, and the Asian Axis of Oil” (Varadarajan) Indonesia Industrial and Commercial Bank of China Industrial Revolution inflation Federal Reserve and see also price revolutions Inhofe, James Institute of International Bankers Internal Revenue Service International Energy Agency (IEA) International Monetary Fund (IMF) Investment Outlook InvestTech Research Iolanthe (Gilbert and Sullivan) Iran hostage crisis Iraq Anglo-American oil interests in U.S. invasion of Ireland Islam Islamic banking Islamic finance market Islamic Financial Services Board Israel Israel, Jonathan Italy Jackson, Andrew Japan as economical rival Jefferson, Thomas Johnson, Lyndon B.


pages: 479 words: 113,510

Fed Up: An Insider's Take on Why the Federal Reserve Is Bad for America by Danielle Dimartino Booth

Affordable Care Act / Obamacare, asset-backed security, bank run, barriers to entry, Basel III, Bernie Sanders, break the buck, Bretton Woods, central bank independence, collateralized debt obligation, corporate raider, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, Donald Trump, financial deregulation, financial innovation, fixed income, Flash crash, forward guidance, full employment, George Akerlof, greed is good, high net worth, housing crisis, income inequality, index fund, inflation targeting, interest rate swap, invisible hand, John Meriwether, Joseph Schumpeter, liquidity trap, London Whale, Long Term Capital Management, margin call, market bubble, Mexican peso crisis / tequila crisis, money market fund, moral hazard, Myron Scholes, natural language processing, negative equity, new economy, Northern Rock, obamacare, price stability, pushing on a string, quantitative easing, regulatory arbitrage, Robert Shiller, Robert Shiller, Ronald Reagan, selection bias, short selling, side project, Silicon Valley, The Great Moderation, The Wealth of Nations by Adam Smith, too big to fail, trickle-down economics, yield curve

Fed-blown bubbles have decimated their savings not once, but twice. Though they might not be able to name the Fed as the party rigging the game, their instincts remind them about the old adage: Fool me once, shame on you. Fool me twice, shame on me. As for those mom-and-pop investors who remain in the market, they have little chance of escaping Fed policy because their assets are tied up in expensive and rigid 401(k) plans that emphasize index funds. The Fed’s artificially low interest-rate level has distorted the relationship between stocks and bonds. Rather than one providing cover when the other is in distress, asset classes have increasingly moved in concert. And though portfolio advisers make it sound safe, index investing will prove disastrous when markets finally correct. The one true growth industry? That would be all that high cotton harvested in high finance.

But the move to government service saved him as much as $50 million thanks to a clause in tax law passed in 1989, a substantial perk of public office. Section 1043 of the Internal Revenue Code provides that individuals in the Executive Branch forced to sell stock to comply with federal conflict-of-interest rules can defer paying capital gains tax, provided that the proceeds are then reinvested in government securities, diversified index funds, or similar investments. The rule is intended to “minimize the burden of public service.” Thus Paulson would avoid a huge tax bill on the capital gains of his Goldman stock, which had more than doubled in value since the firm went public in May 1999. A pretty big incentive to spend a few years in Washington. Paulson went so far as to specify that he would have no interaction with Goldman executives for his entire term as treasury secretary, saying, “I believe that these steps will ensure that I avoid even the appearance of a conflict of interest in the performance of my duties as Secretary of the Treasury.”

Quantitative Trading: How to Build Your Own Algorithmic Trading Business by Ernie Chan

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algorithmic trading, asset allocation, automated trading system, backtesting, Black Swan, Brownian motion, business continuity plan, compound rate of return, Edward Thorp, Elliott wave, endowment effect, fixed income, general-purpose programming language, index fund, John Markoff, Long Term Capital Management, loss aversion, p-value, paper trading, price discovery process, quantitative hedge fund, quantitative trading / quantitative finance, random walk, Ray Kurzweil, Renaissance Technologies, risk-adjusted returns, Sharpe ratio, short selling, statistical arbitrage, statistical model, survivorship bias, systematic trading, transaction costs

Before proceeding to devote your time to P1: JYS c02 JWBK321-Chan September 24, 2008 13:47 Printer: Yet to come 18 QUANTITATIVE TRADING performing a comprehensive backtest on this strategy (not to mention devoting your capital to actually trading this strategy), there are a number of quick checks you can do to make sure you won’t be wasting your time or money. How Does It Compare with a Benchmark and How Consistent Are Its Returns? This point seems obvious when the strategy in question is a stocktrading strategy that buys (but not shorts) stocks. Everybody seems to know that if a long-only strategy returns 10 percent a year, it is not too fantastic because investing in an index fund will generate as much, if not better, return on average. However, if the strategy is a long-short dollar-neutral strategy (i.e., the portfolio holds long and short positions with equal capital), then 10 percent is quite a good return, because then the benchmark of comparison is not the market index, but a riskless asset such as the yield of the three-month U.S. Treasury bill (which at the time of this writing is about 4 percent).


pages: 207 words: 63,071

My Start-Up Life: What A by Ben Casnocha, Marc Benioff

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affirmative action, Albert Einstein, barriers to entry, Bonfire of the Vanities, business process, call centre, creative destruction, David Brooks, don't be evil, fear of failure, hiring and firing, index fund, informal economy, Jeff Bezos, Lao Tzu, Menlo Park, Paul Graham, place-making, Ralph Waldo Emerson, Sand Hill Road, side project, Silicon Valley, Steve Jobs, Steven Pinker, technology bubble, traffic fines

Read The Kite Runner along with Jack Welch’s Straight from the Gut. See which you find more interesting. Online: Find other nonbusiness books that will rock your world. Day 12. Research charities, give money, and then talk to your friends about why you did it. Tune your antenna to causes that excite you. Online: Find out about charities that are changing the world. Day 13. Build a smart “personal finance infrastructure.” Start saving money. Invest in index funds. Keep and track a budget. Get wealthy. Online: Personal finance 101. Day 14. Write a blog. Put yourself out there. Share your ideas. Disclose yourself. Become transparent. Online: How to start a blog and which blogs to read. Day 15. Pour your heart into it. Say what you mean and mean what you say. Total enthusiasm—straight from the heart—in all efforts. APPENDIX B 177 Day 16. Form an advisory board.

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, negative equity, new economy, Northern Rock, pattern recognition, Ponzi scheme, prediction markets, Right to Buy, risk tolerance, risk-adjusted returns, risk/return, short selling, side project, sovereign wealth fund, statistical arbitrage, systematic trading, transaction costs, yield curve

Real estate investment trusts (REITs) There are also one or two REITs with forestry exposure, the best known including Potlatch and Plum Creek Timber in the United States, which has about 70 per cent timber exposure according to market commentator George Nichols in June 2008.4 Exchange-traded funds (ETFs) Designed to track the performance of a benchmark like the FTSE 100 or S&P 500, ETFs combine the diversification of a fund with the flexibility of a share (live pricing, ease of access and continuous dealing). Examples are Claymore/Clear Global Timber Index ETF (‘CUTS’) and iShares S & P Global Timber & Forestry Index Fund (managed by Barclays Global Investment) (‘WOOD’). George Nichols has pointed out that, despite their labels, some of these may in fact have a limited exposure to organic growth.5 He mentions that one of the major holdings of the CUTS ETF is International Paper, which derived only about 2 per cent of its annual income from forestry/timber revenues in 2007. Forestry conglomerates (equity) It is also possible to invest in companies active in the forestry sector, such as Stor Enso and UPM whose shares are traded in Germany.


pages: 193 words: 11,060

Ethics in Investment Banking by John N. Reynolds, Edmund Newell

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accounting loophole / creative accounting, activist fund / activist shareholder / activist investor, banking crisis, capital controls, collapse of Lehman Brothers, corporate governance, corporate social responsibility, credit crunch, Credit Default Swap, discounted cash flows, financial independence, index fund, invisible hand, light touch regulation, margin call, moral hazard, Nick Leeson, Northern Rock, quantitative easing, shareholder value, short selling, South Sea Bubble, stem cell, the market place, The Wealth of Nations by Adam Smith, too big to fail, zero-sum game

In some ways, in stock markets, most equity investment is a form of speculation, in that it involves taking risks (in Islamic finance, risk-taking is considered to be ethically necessary in an investment). There is a major difference between short-term trading and “gambling”, as in the latter case an unearned return is sought based on chance, rather than work or effort. Hedge funds or investment banks trading distressed securities are likely to carry out at least as much research as long-only investment managers, and significantly more than index funds, given the high levels of risk they take; it is therefore difficult to equate this type of activity to gambling. This raises interesting questions about whether, for example, a professional poker player who bases their playing on an understanding of mathematical odds is therefore strictly a “gambler” (based on a narrow Recent Ethical Issues in Investment Banking 93 definition). Gambling is considered unethical for its general impact, in terms of damage to people who become addicted to it, and the collateral impact on their families.


pages: 183 words: 17,571

Broken Markets: A User's Guide to the Post-Finance Economy by Kevin Mellyn

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banking crisis, banks create money, Basel III, Bernie Madoff, Big bang: deregulation of the City of London, Bonfire of the Vanities, bonus culture, Bretton Woods, BRICs, British Empire, call centre, Carmen Reinhart, central bank independence, centre right, cloud computing, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, corporate raider, creative destruction, credit crunch, crony capitalism, currency manipulation / currency intervention, disintermediation, eurozone crisis, fiat currency, financial innovation, financial repression, floating exchange rates, Fractional reserve banking, global reserve currency, global supply chain, Home mortgage interest deduction, index fund, information asymmetry, joint-stock company, Joseph Schumpeter, labor-force participation, labour market flexibility, light touch regulation, liquidity trap, London Interbank Offered Rate, lump of labour, market bubble, market clearing, Martin Wolf, means of production, mobile money, money market fund, moral hazard, mortgage debt, mortgage tax deduction, negative equity, Ponzi scheme, profit motive, quantitative easing, Real Time Gross Settlement, regulatory arbitrage, reserve currency, rising living standards, Ronald Coase, seigniorage, shareholder value, Silicon Valley, statistical model, Steve Jobs, The Great Moderation, the payments system, Tobin tax, too big to fail, transaction costs, underbanked, Works Progress Administration, yield curve, Yogi Berra, zero-sum game

eBook <www.wowebook.com> What is certain is that equities are a claim on future earnings, which are always subject to events and shifts in sentiment. Given that, companies that make money in transparent ways and can actually pay a dividend to shareholders are often safer bets. The virtues of diversification have been oversold because in a panic, assets tend to fall across the board, but investing in index funds that mirror whole markets or broadly diversified mutual funds is probably well advised for the average investor. One point to bear in mind is that the emerging markets are likely to grow much faster over the next several years and decades than the mature economies of the West. Direct investing in such markets can be risky and costly, but you can participate in their growth by investing in US companies with strong and growing footprints in those countries.


pages: 278 words: 70,416

Smartcuts: How Hackers, Innovators, and Icons Accelerate Success by Shane Snow

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3D printing, Airbnb, Albert Einstein, attribution theory, augmented reality, barriers to entry, conceptual framework, correlation does not imply causation, David Heinemeier Hansson, deliberate practice, Elon Musk, Fellow of the Royal Society, Filter Bubble, Google X / Alphabet X, hive mind, index card, index fund, Isaac Newton, job satisfaction, Khan Academy, Law of Accelerating Returns, Lean Startup, Mahatma Gandhi, meta analysis, meta-analysis, pattern recognition, Peter Thiel, popular electronics, Ray Kurzweil, Richard Florida, Ronald Reagan, Ruby on Rails, Saturday Night Live, self-driving car, side project, Silicon Valley, Steve Jobs

Executive Jim Stengel, formerly global marketing head of Procter & Gamble, teamed up with research firm Millward Brown in the 2000s to collect a decade’s worth of data on the market performance of major brands that orient themselves around a noble purpose or ideal. What he found was more dramatic than he expected. Brands with lofty purposes beyond making profits wildly outperformed the S&P 500. From 2001 to 2011, an investment in the 50 most idealistic brands—the ones opting for the high-hanging purpose and not just low-hanging profits—would have been 400 percent more profitable than shares of an S&P index fund. Why is this? The simple explanation is that human nature makes us surprisingly willing to support big ideals and big swings. That means more customers, more investors, and more word-of-mouth for the dreamers. So there’s evidence both in business and academia to support 10x Thinking. But not every big dream gains followers or comes true. Just because you’re righteous doesn’t mean people will support you.


pages: 247 words: 81,135

The Great Fragmentation: And Why the Future of All Business Is Small by Steve Sammartino

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3D printing, additive manufacturing, Airbnb, augmented reality, barriers to entry, Bill Gates: Altair 8800, bitcoin, BRICs, Buckminster Fuller, citizen journalism, collaborative consumption, cryptocurrency, David Heinemeier Hansson, Elon Musk, fiat currency, Frederick Winslow Taylor, game design, Google X / Alphabet X, haute couture, helicopter parent, illegal immigration, index fund, Jeff Bezos, jimmy wales, Kickstarter, knowledge economy, Law of Accelerating Returns, lifelogging, market design, Metcalfe's law, Metcalfe’s law, Minecraft, minimum viable product, Network effects, new economy, peer-to-peer, post scarcity, prediction markets, pre–internet, profit motive, race to the bottom, random walk, Ray Kurzweil, recommendation engine, remote working, RFID, Rubik’s Cube, self-driving car, sharing economy, side project, Silicon Valley, Silicon Valley startup, skunkworks, Skype, social graph, social web, software is eating the world, Steve Jobs, survivorship bias, too big to fail, US Airways Flight 1549, web application, zero-sum game

There was no gatekeeper and I could do most of it for free using the gift of democratised knowledge and connection tools. Now it makes me antifragile. ‘Antifragility’ is a term coined by author Nassim Taleb to describe something that improves when it breaks or is disrupted by shocks so it can reconfigure and grow stronger. I have multiple sources of revenue and the relative diversification of a personal index fund of tech revolution-proof skills. It’s what both employees and employers need to do: focus less on functional departments and more on connecting seemingly disparate skills and overlaps. Industrial education All of this comes back to the education system. It’s not surprising, given our current government-funded education systems are a child of the industrial age. The industrial template was used to design a schooling system that could produce great workers for the industrial era and promote orderly political behaviour.


pages: 289 words: 77,532

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

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

Shortly after the commodity position limits proposal’s late-January debut in the Federal Register, the CFTC faced an onslaught of complaints. Critics from Morgan Stanley and Goldman Sachs to Cargill and the International Swaps and Derivatives Association blasted the intended curbs, complaining they were ineffective, undermining, and unnecessary. The Futures Industry Association echoed Dunn’s language, calling the limits “a ‘solution’ to a nonexistent problem.” Large commodity index fund managers were equally annoyed. The proposal would “hamper” the ability to “prudently” manage investments, argued U.S. Commodity Funds. Over time, more than fifteen thousand comment letters were dispatched. For the rulemakers, the attacks were wearying, and Chilton, whose mere appearance could often cause chatter, had become a polarizing character. He and his wife spent most of their time in Hot Springs Village, Arkansas, where their daughter and grandson lived, making him hard to pin down.


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, Chuck Templeton: OpenTable, Credit Default Swap, cross-subsidies, crowdsourcing, disintermediation, diversified portfolio, experimental economics, George Akerlof, Goldman Sachs: Vampire Squid, income inequality, index fund, information asymmetry, Jean Tirole, Kenneth Arrow, Lean Startup, Lyft, Marc Andreessen, Mark Zuckerberg, market microstructure, Martin Wolf, McMansion, Menlo Park, Metcalfe’s law, moral hazard, multi-sided market, Network effects, patent troll, Paul Graham, Peter Thiel, pez dispenser, ride hailing / ride sharing, Robert Metcalfe, 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

That’s how many of us regard Goldman Sachs, the Wall Street giant that the journalist Matt Taibbi famously, and to great applause, called “a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money.”29 Indeed, a study of brand perceptions showed that people’s ratings of Goldman Sachs put the company squarely in the cold-incompetent quadrant.30 It’s not just Goldman Sachs that can evoke contempt, of course. Consider today’s typical money managers: whether they are personal financial advisors or pros managing multibillion-dollar mutual funds, most fail to beat the market—and when you take management fees into account, most actually underperform cheaper alternatives, such as index funds.31 What’s more, although there may be value to having an expert tailor a portfolio of investments right for your age and risk preferences, recent evidence suggests that financial advisors tend to create one-size-fits-all portfolios for their clients, providing off-the-rack services for bespoke-level fees.32 So when people say, as PBS economics correspondent Paul Solman has, that “most money management firms are parasites who live handsomely off innocent investors,” their strong feelings have a basis in reality.33 Consider, too, the primary middlemen in car sales in the United States: although many new-car dealers are probably skilled, honest, and customer-oriented, their trade groups are another story: the National Automobile Dealers Association and its state and local counterparts seem most concerned with lobbying for protectionist laws that benefit neither car buyers nor manufacturers.34 Middlemen who are seen as both cold (interested only in their own gain) and incompetent (creating more cost than value) will evoke contempt,35 and for them, the Parasite label is harsh but more or less apt.


pages: 251 words: 76,868

How to Run the World: Charting a Course to the Next Renaissance by Parag Khanna

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Albert Einstein, Asian financial crisis, back-to-the-land, bank run, blood diamonds, Bob Geldof, borderless world, BRICs, British Empire, call centre, carbon footprint, charter city, clean water, cleantech, cloud computing, commoditize, continuation of politics by other means, corporate governance, corporate social responsibility, Deng Xiaoping, Doha Development Round, don't be evil, double entry bookkeeping, energy security, European colonialism, facts on the ground, failed state, friendly fire, global village, Google Earth, high net worth, index fund, informal economy, Intergovernmental Panel on Climate Change (IPCC), invisible hand, labour mobility, laissez-faire capitalism, Live Aid, Masdar, mass immigration, megacity, microcredit, mutually assured destruction, Naomi Klein, New Urbanism, off grid, offshore financial centre, oil shock, open economy, out of africa, Parag Khanna, private military company, Productivity paradox, race to the bottom, RAND corporation, reserve currency, Silicon Valley, smart grid, South China Sea, sovereign wealth fund, special economic zone, sustainable-tourism, The Fortune at the Bottom of the Pyramid, The Wisdom of Crowds, too big to fail, trade liberalization, trickle-down economics, UNCLOS, uranium enrichment, Washington Consensus, X Prize

To set up stock exchanges and find brokers to handle the billions of dollars in investment capital that an ever-growing number of American pension and mutual funds want to invest outside America. The firm of Auerbach Grayson makes their markets liquid, and the rest can take care of itself. It has built formal ties with stock exchanges in 128 countries, many of which have delivered impressive returns on index funds in recent years. Even when the worst news is coming out of countries—the Israel-Hezbollah war of 2006, the Kenyan riots of 2008, Israel’s incursion into Palestinian Gaza in 2008, and the Sri Lankan military campaign against the Tamil Tigers in 2009—Auerbach sees arrows pointing upward. “Even when they’re bombing in Gaza, they’re trading in Ramallah,” he says. As conflicts in Iraq and Sri Lanka wind down, investors quickly move in.


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, John Meriwether, Kitchen Debate, laissez-faire capitalism, locking in a profit, Long Term Capital Management, market bubble, minimum wage unemployment, money market fund, Mont Pelerin Society, moral hazard, mortgage debt, Myron Scholes, new economy, North Sea oil, Northern Rock, oil shock, Paul Samuelson, Philip Mirowski, price stability, quantitative easing, Ralph Nader, rent control, road to serfdom, Robert Bork, 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

Established before World War II, new mutual fund companies such as Dreyfus and Oppenheimer now had many different kinds of funds under one roof. The creation by the federal government in 1974 of tax-advantaged Individual Retirement Accounts (IRAs) made mutual funds a still more popular investment as individuals sought places to invest for their retirement. Among the most important innovations were index funds, which provided a way to buy a piece of a stock market average, like the S&P 500. This was a way around the perennially bullish and often wrong recommendations by Wall Street professionals to buy individual stocks. Most of the new index funds, usually computer-driven, charged low management fees and eliminated the high upfront sales charges. An especially effective innovation was the money market mutual fund, which provided savers with much higher interest rates than were available at banks, ultimately circumventing Regulation Q.


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

Because they’re not looking at relative performance. Emerging markets have gone up a lot over time. So if, for example, emerging markets are up an average of 10 percent per year, and he is up 6 percent per year, they are just looking at the fact that their investment is up. Besides marketing, what other reasons are there for investors choosing long-only emerging market funds over emerging market indexes? The other reason is that even index funds in emerging markets underperform the index because of high fees. Why would you buy a guaranteed loser? Marketing guys hold out the hope that maybe you will pick one of the funds that outperform the index. Why did you recently decide to give back about three-quarters of your investor assets? The type of trading around our core investment positions that I do to control risk in the portfolio is very time-consuming and burns a lot of heart muscle.

You might think you could do better by trying to find managers among the 30 percent that outperform the market. The problem, however, is that there is no correlation between those who did well in the past 3, 5, or 10 years and those who continue to do well in the future. Since investors can’t predict which 30 percent of the managers will do better than the market, the obvious conclusion is to simply go with an index fund, which has lower cost and is tax efficient. And that makes some sense. But it turns out that most popular indexes, such as the S&P 500 and Russell indexes, are very inefficient because they are market capitalization weighted. In a market capitalization weighted index, the higher the price of a stock, the larger the percentage of the index it will represent. Therefore, by definition, a market capitalization weighted index will automatically own too much of the overpriced stocks and too few of the bargain-priced ones.


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, break the buck, British Empire, centralized clearinghouse, collapse of Lehman Brothers, computerized trading, corporate raider, diversified portfolio, Donald Trump, dumpster diving, Edward Thorp, financial deregulation, financial thriller, fixed income, forensic accounting, Gordon Gekko, index fund, locking in a profit, mail merge, merger arbitrage, money market fund, Plutocrats, plutocrats, Ponzi scheme, Potemkin village, random walk, Renaissance Technologies, riskless arbitrage, Ronald Reagan, short selling, Small Order Execution System, source of truth, sovereign wealth fund, too big to fail, transaction costs, traveling salesman

Some were warned by Madoff not to talk about being his investors. For most of his career, he was not registered with the SEC as an investment adviser, surely something a small pension plan trustee or IRA investor would have noticed. True, he paid relatively modest returns—roughly equal to an S&P 500 index mutual fund—but his results were far less volatile and, hence, much safer than an index fund. How was that possible? If he was a lot safer than an index fund, shouldn’t his returns have been a lot lower? As Madoff’s victims sought redress, the question of who should have known would split the world cleanly into two groups. One group looked at Madoff’s stature in the industry, his long track record with his investors, his obvious wealth, and his phoney but immensely convincing paper trail—voluminous account statements, simulated DTCC screens, bogus trading terminals for conducting fake trades—and asked, “How could his victims have ever figured it out?”


pages: 554 words: 168,114

Oil: Money, Politics, and Power in the 21st Century by Tom Bower

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Ayatollah Khomeini, banking crisis, bonus culture, corporate governance, credit crunch, energy security, Exxon Valdez, falling living standards, fear of failure, forensic accounting, index fund, interest rate swap, kremlinology, LNG terminal, Long Term Capital Management, margin call, Mikhail Gorbachev, millennium bug, new economy, North Sea oil, offshore financial centre, oil shale / tar sands, oil shock, passive investing, peak oil, Piper Alpha, price mechanism, price stability, Ronald Reagan, shareholder value, short selling, Silicon Valley, sovereign wealth fund, transaction costs, transfer pricing, zero-sum game, éminence grise

The revolution affected every oil and natural gas field in the world, but was ignored in the frenzied reports that Qatar could not fulfill plans to double exports by 2011 to 77 million tons (20 percent of the world’s LNG) or meet the increasing demand for natural gas, which was destined by 2030 to overtake oil. The hysteria drowned out those who maintained during the early summer of 2008 that there were ample supplies. Bowing to the mantra of irreversible shortages, speculators appeared to have grabbed control of oil from traditional traders. The number of contracts held by Nymex traders rose from 850,000 in 2003 to 2,700,000 in 2008. Like a herd, pension funds, index funds, hedge funds and investment bankers introduced an estimated additional $80 billion into oil trading. Even that statistic fueled further speculation. Everyone knew that the growth of the swaps was huge, but beyond that part of the OTC market regulated by Nymex, no one knew its size. The mystery in New York and London was the identity of the participants. The Washington Post would report that the CFTC had noted that Vitol, which boasted an annual $147 billion turnover, had traded contracts for 57.7 million barrels by June 2008, three times the USA’s daily needs, and at one point in July held a huge 11 percent of the futures market.

The speculators, financier George Soros told a Senate commerce committee, were inflating a bubble into a “super bubble” superimposed on a naturally rising market. Data produced by Barclays bank in June suggested that sentiment rather than facts was influencing prices: only 2 percent of the “long” positions, reported Nymex, was owned by speculators without seeking ownership, so no physical oil was being held back from the market. Speculative bets, agreed the CFTC, had fallen by 48.5 percent. The regulators did not realize that index fund managers were compelled by internal rules to sell their future contracts as prices rose. Contrary to the politicians’ jargon, some speculators were actually dumping oil. Beyond the politicians’ understanding, more critical events were unfolding. Eager to lead the public outcry, British Prime Minister Gordon Brown joined Bush in accusing Saudi Arabia of manipulating prices by cutting production between March 2006 and April 2007 by about a million barrels a day.


pages: 342 words: 99,390

The greatest trade ever: the behind-the-scenes story of how John Paulson defied Wall Street and made financial history by Gregory Zuckerman

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1960s counterculture, banking crisis, collapse of Lehman Brothers, collateralized debt obligation, Credit Default Swap, credit default swaps / collateralized debt obligations, financial innovation, fixed income, index fund, Isaac Newton, Long Term Capital Management, margin call, Mark Zuckerberg, Menlo Park, merger arbitrage, mortgage debt, mortgage tax deduction, Ponzi scheme, Renaissance Technologies, rent control, Robert Shiller, Robert Shiller, rolodex, short selling, Silicon Valley, statistical arbitrage, Steve Ballmer, Steve Wozniak, technology bubble, zero-sum game

Some mutual funds bought into the prevailing mantra that technology shares were worth the rich valuations or were unable to bet against stocks or head to the sidelines as hedge funds did. Most mutual funds considered it a good year if they simply beat the market, even if it meant losing a third of their investors’' money, rather than half. Reams of academic data demonstrated that few mutual funds could best the market over the long haul. And while index funds were a cheaper and better-performing alternative, these investment vehicles only did well if the market rose. Once, Peter Lynch, Jeffrey Vinik, Mario Gabelli, and other savvy investors were content to manage mutual funds. But the hefty pay and flexible guidelines of the hedge-fund business allowed it to drain much of the talent from the mutual-fund pool by the early years of the new millennium—--another reason for investors with the financial wherewithal to turn to hedge funds.


pages: 350 words: 103,270

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

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

In other words, owning two stocks is always better than owning one, and three is better still, but once your portfolio gets large enough the benefits diminish, while the risk of a market downturn impacting the entire portfolio stays the same. It was easy to identify the systematic risk with an index of stock prices (which is just an average), an insight that spurred the development of products such as equity index funds in the 1970s. Vasicek seized upon all these ideas and applied them to credit. Exploiting Merton’s “window” to work in the Gaussian world of the stock market, he identified a parameter, called correlation, that measured how closely individual stocks tracked the index.4 Transformed back into the credit world, his model transmitted a downward swing in the index (perhaps the stock market, although he didn’t spell this out) into a wave of corporate defaults sweeping across a portfolio.


pages: 391 words: 97,018

Better, Stronger, Faster: The Myth of American Decline . . . And the Rise of a New Economy by Daniel Gross

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2013 Report for America's Infrastructure - American Society of Civil Engineers - 19 March 2013, Affordable Care Act / Obamacare, Airbnb, American Society of Civil Engineers: Report Card, asset-backed security, Bakken shale, banking crisis, BRICs, British Empire, business process, business process outsourcing, call centre, Carmen Reinhart, clean water, collapse of Lehman Brothers, collateralized debt obligation, commoditize, creative destruction, credit crunch, currency manipulation / currency intervention, demand response, Donald Trump, Frederick Winslow Taylor, high net worth, housing crisis, hydraulic fracturing, If something cannot go on forever, it will stop - Herbert Stein's Law, illegal immigration, index fund, intangible asset, intermodal, inventory management, Kenneth Rogoff, labor-force participation, LNG terminal, low skilled workers, Mark Zuckerberg, Martin Wolf, Maui Hawaii, McMansion, money market fund, mortgage debt, Network effects, new economy, obamacare, oil shale / tar sands, oil shock, peak oil, Plutocrats, plutocrats, price stability, quantitative easing, race to the bottom, reserve currency, reshoring, Richard Florida, rising living standards, risk tolerance, risk/return, Silicon Valley, Silicon Valley startup, six sigma, Skype, sovereign wealth fund, Steve Jobs, superstar cities, the High Line, transit-oriented development, Wall-E, Yogi Berra, zero-sum game, Zipcar

Companies don’t just export a commodity or a finished product; rather, they export the brand or consumer experience and then integrate it into burgeoning local consuming cultures. Such developments may not directly boost exports or lead to significant direct employment, but they can be hugely beneficial to American companies, and to the economy at large. First and foremost, inports are good for shareholders, whose numbers include the tens of millions of Americans with pension funds or index funds. Standard & Poor’s measures the percentage of revenues that companies in the S&P 500 index say they derive from overseas. In 2010, for the firms that broke out such results separately, 46.3 percent of revenues came from outside the United States, up from 43.5 percent in 2006. The biggest growth in overseas sales has come from sectors that have tapped into the global growth boom. Companies that make consumer discretionary goods, like clothing and toys, saw their shares of overseas sales rise from 35 percent in 2004 to 43 percent in 2010, while consumer staples firms reported a rise from 38.9 percent in 2004 to 45.6 percent in 2010.

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

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active measures, Affordable Care Act / Obamacare, barriers to entry, business process, Claude Shannon: information theory, Clayton Christensen, commoditize, conceptual framework, corporate governance, creative destruction, Daniel Kahneman / Amos Tversky, discounted cash flows, diversified portfolio, double entry bookkeeping, Exxon Valdez, financial innovation, fixed income, hydraulic fracturing, index fund, information asymmetry, intangible asset, inventory management, Joseph Schumpeter, Kenneth Arrow, 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

Because you need a modern-day Fibonacci to free you from the shackles of “ancient,” clunky accounting-based investment analysis you learned in business school, like we did, decades ago—an analysis that focuses on the “bottom line,” comparing quarterly reported earnings with analysts’ consensus estimates, and attempting to predict future earnings and stock prices, primarily based on accounting reports and complex spreadsheets. The depressing performance of such investment analysis drove hordes of investors to give up entirely on analyzing individual companies and invest in index funds. Bye-bye accounting. A new investment analysis is obviously called for. As we have shown in Chapter 11, what determines a company’s ability to grow and sustain competitive advantage—the long-term enterprise goal—is the existence and effective deployment of strategic assets, those resources that are rare, are difficult to imitate, and generate benefits. Consider a successful clinical test of a drug under development, the prospects of an oil field under exploration, trends in the capacity utilization of airplanes, the book-to-bill ratio of tech companies, patterns of policy renewals of insurance companies, or the customer churn rate of Internet and telecom companies.


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, activist fund / activist shareholder / activist investor, 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, corporate raider, creative destruction, 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, Marc Andreessen, 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, The Future of Employment, trade route, transportation-network company, Turing test, Uber and Lyft, Uber for X, unpaid internship, Y Combinator, young professional, zero-sum game, Zipcar

By 2000, the New York Times reported, 7.4 million households were engaged in online trading.24 According to Brad Barber of the University of California at Berkeley, from 1995 through mid-2000, investors opened 12.5 million online brokerage accounts.25 The busiest year on record was 2013 for both Ameritrade and E*Trade, whose average trades per day were up 24 and 25 percent, respectively, from 2012.26 But this increased access to the stock markets does not mean people have gained access to the game as the professionals have been playing it. Studies of this new population of do-it-yourself traders invariably show that increased access to trading tools and market data creates the illusion of market competency and encourages poor decision-making. Even before net access, do-it-yourself investors tended to make poorer investment decisions than those who used financial advisors or, best of all, invested in entirely unmanaged “index” funds. The main reason for DIY investors’ poor results? Amateurs trade too much. Meanwhile, online trading brokerages—whose profit comes almost solely from commissions on trading—have a stake in getting their users to make as many trades as possible. As the data shows, the same brokerage houses profit from the same trading activity in the same way they always have, while retail investors’ actual percent of profits and trading accuracy goes down.


pages: 330 words: 91,805

Peers Inc: How People and Platforms Are Inventing the Collaborative Economy and Reinventing Capitalism by Robin Chase

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3D printing, Airbnb, Amazon Web Services, Andy Kessler, banking crisis, barriers to entry, basic income, Benevolent Dictator For Life (BDFL), bitcoin, blockchain, Burning Man, business climate, call centre, car-free, cloud computing, collaborative consumption, collaborative economy, collective bargaining, commoditize, congestion charging, creative destruction, crowdsourcing, cryptocurrency, decarbonisation, don't be evil, Elon Musk, en.wikipedia.org, ethereum blockchain, Ferguson, Missouri, Firefox, frictionless, Gini coefficient, hive mind, income inequality, index fund, informal economy, Intergovernmental Panel on Climate Change (IPCC), Internet of things, Jane Jacobs, Jeff Bezos, jimmy wales, job satisfaction, Kickstarter, Lean Startup, Lyft, means of production, megacity, Minecraft, minimum viable product, Network effects, new economy, Oculus Rift, openstreetmap, optical character recognition, pattern recognition, peer-to-peer, peer-to-peer lending, peer-to-peer model, Richard Stallman, ride hailing / ride sharing, Ronald Coase, Ronald Reagan, Satoshi Nakamoto, Search for Extraterrestrial Intelligence, self-driving car, shareholder value, sharing economy, Silicon Valley, six sigma, Skype, smart cities, smart grid, Snapchat, sovereign wealth fund, Steve Crocker, Steve Jobs, Steven Levy, TaskRabbit, The Death and Life of Great American Cities, The Future of Employment, The Nature of the Firm, transaction costs, Turing test, turn-by-turn navigation, Uber and Lyft, Zipcar

In December 2012, 350.org launched its divestiture campaign, encouraging universities and other institutions to excise fossil fuel companies from their investment portfolios; this has brought about even more debate and soul-searching, as well as divestment, among wealthy individuals, universities, foundations, companies, counties, cities, religious institutions, and the press.15 In response to the new demand, financial institutions are creating new index funds and new metrics are being discussed. The whole idea of “stranded assets”—fossil-fuel assets that are counted on company balance sheets but which may prove to be worthless—stems from 350.org’s divestment push. Remember, 350.org raises the issue, provides the fact sheets, and tracks progress, but it is the participating peers at universities and in boardrooms across the country and around the world who are carrying out the discussions.


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, John Meriwether, London Interbank Offered Rate, Long Term Capital Management, medical residency, money market fund, moral hazard, mortgage debt, pets.com, Ponzi scheme, Potemkin village, quantitative trading / quantitative finance, Robert Bork, short selling, Silicon Valley, the new new thing, too big to fail, value at risk, Vanguard fund, zero-sum game

And we're not the only ones watching it." Mike Burry couldn't see exactly who was following his financial moves, but he could tell which domains they came from. In the beginning his readers came from EarthLink and AOL. Just random individuals. Pretty soon, however, they weren't. People were coming to his site from mutual funds like Fidelity and big Wall Street investment banks like Morgan Stanley. One day he lit into Vanguard's index funds and almost instantly received a cease and desist order from Vanguard's attorneys. Burry suspected that serious investors might even be acting on his blog posts, but he had no clear idea who they might be. "The market found him," says the Philadelphia mutual fund manager. "He was recognizing patterns no one else was seeing." By the time Burry moved to Stanford Hospital in 1998 to take up his residency in neurology, the work he had done between midnight and three in the morning had made him a minor but meaningful hub in the land of value investing.


pages: 586 words: 159,901

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

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accounting loophole / creative accounting, activist fund / activist shareholder / activist investor, 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, computerized trading, corporate governance, corporate raider, 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, information asymmetry, interest rate swap, Internet Archive, invisible hand, Irwin Jacobs, Isaac Newton, joint-stock company, Joseph Schumpeter, kremlinology, labor-force participation, late capitalism, law of one price, liberal capitalism, liquidationism / Banker’s doctrine / the Treasury view, London Interbank Offered Rate, Louis Bachelier, market bubble, Mexican peso crisis / tequila crisis, microcredit, minimum wage unemployment, money market fund, moral hazard, mortgage debt, mortgage tax deduction, Myron Scholes, oil shock, Paul Samuelson, payday loans, pension reform, Plutocrats, plutocrats, price mechanism, price stability, prisoner's dilemma, profit maximization, publication bias, Ralph Nader, random walk, reserve currency, Richard Thaler, risk tolerance, Robert Gordon, Robert Shiller, Robert Shiller, selection bias, shareholder value, short selling, Slavoj Žižek, South Sea Bubble, The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, 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

screens As might be expected, the field is populated by a full range of people, from cynics looking for a market niche to some fine people looking to transform the world. The mainstream of the SI industry is characterized by some form of social screening. The flavor of that screening can be sampled in an ad in the May-June 1995 issue of the Utne Reader for Working Assets, the SI mutual fund giant. Working Assets touted its No-Load Citizens Index Fund thus: "Unlike the S&P 500, however, we have a low concentration in dirty, dying industries like heavy equipment, oil and chemicals, weapons, utilities, alcohol and tobacco. Instead, we've concentrated on WALL STREET clean industries of the future, such as communications, consumer products and services, business equipment, high-tech, finance, healthcare and food production." While every individual company is socially screened, the economic analysis underlying this portfolio selection remains happily unexamined.


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, information asymmetry, intangible asset, 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, Paul Samuelson, quantitative trading / quantitative finance, random walk, risk/return, Ronald Reagan, Schrödinger's Cat, selection bias, 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

THE NASDAQ CRASH OF APRIL 2000 In the last few years of the second millenium, there was a growing divergence in the stock market between New Economy and Old Economy stocks, between technology and almost everything else. Over 1998 and 1999, stocks in the Standard & Poor’s technology sector rose nearly fourfold, while the S&P 500 index gained just 50%. And without technology, the benchmark would be flat. In January 2000 alone, 30% of net inflows into mutual funds went to science and technology funds, versus just 8.7% into S&P 500 index funds. As a consequence, the average price-over-earnings ratio (P/E) for Nasdaq companies was above 200 (corresponding to a ridiculous earnings yield of 05%), a stellar value above anything that serious economic valuation theory would consider reasonable. It is worth recalling that the very same concept and wording of a so-called New Economy was hot in the minds and mouths of i