diversification

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The Permanent Portfolio by Craig Rowland, J. M. Lawson

Andrei Shleifer, asset allocation, automated trading system, backtesting, bank run, banking crisis, Bernie Madoff, buy and hold, capital controls, correlation does not imply causation, Credit Default Swap, diversification, diversified portfolio, en.wikipedia.org, fixed income, Flash crash, high net worth, High speed trading, index fund, inflation targeting, margin call, market bubble, money market fund, new economy, passive investing, Ponzi scheme, prediction markets, risk tolerance, stocks for the long run, survivorship bias, technology bubble, transaction costs, Vanguard fund

The purpose of a balanced allocation is so that when one asset unexpectedly begins performing poorly there will be other assets to take up the slack and protect against serious losses. Taking too much risk in one asset class is gambling, not investing. Assets Sharing Similar Risks Another common problem in many portfolios is that asset classes that appear to be diversified can be subject to the same risks under certain market conditions. In particular, many portfolios concentrate risks into one particular asset type (usually stocks). But, because the portfolio holds different stock asset classes or sectors such as international, emerging markets, large company, small company, technology, etc. an investor may think that he has a diversified portfolio. However, such portfolios are really only providing the illusion of diversification. When a serious problem comes along affecting an asset class like stocks, an investor often finds that all stocks may drop in value at once, including stock funds focusing on different segments of the economy and investments in stock markets around the world.

As a result of the 1972–1999 correlation data, investors were told to avoid U.S. long-term bonds because these bonds were “positively correlated” to U.S. stocks. Investors who followed this advice missed out on the diversification power of U.S. long-term bonds during the poor stock market performance from 2000 to 2009. The notion that asset class correlations are a good indicator of portfolio diversification had simply failed. The lesson from this review of asset correlation data is that stocks and bonds move for very specific reasons having to do with what is going on in the overall economy and not what each other is doing as asset class correlations assume. Stocks do not go up because bonds are going down, and stocks do not go down because bonds are going up. These assets move in price for very specific reasons in the economy. To make a conclusion based upon asset class correlations alone is going to eventually lead to a bad outcome when that correlation variable suddenly shifts.

The Permanent Portfolio assumes the future is uncertain and the strategy it employs leverages this uncertainty to drive profits. The diversification of the Permanent Portfolio also protects against catastrophic losses from a world that is always full of surprises. By investing based on economic conditions, the portfolio has a strategy to deal with uncertain markets no matter what is happening. Recap Many diversification strategies fail because investors: Take too much risk in a single asset class. Hold assets that are exposed to the same types of risk. Use false assumptions about asset class correlations. Hold no hard assets. Have little or no cash reserves. The Permanent Portfolio is different because it derives its diversification from investing based on changing economic conditions. The four economic conditions are: Prosperity, Deflation, Recession, and Inflation and they cover all possible economic environments.


All About Asset Allocation, Second Edition by Richard Ferri

activist fund / activist shareholder / activist investor, asset allocation, asset-backed security, barriers to entry, Bernie Madoff, buy and hold, 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, stocks for the long run, survivorship bias, too big to fail, transaction costs, Vanguard fund, yield curve

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

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

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


Systematic Trading: A Unique New Method for Designing Trading and Investing Systems by Robert Carver

asset allocation, automated trading system, backtesting, barriers to entry, Black Swan, buy and hold, cognitive bias, commodity trading advisor, Credit Default Swap, diversification, diversified portfolio, easy for humans, difficult for computers, Edward Thorp, Elliott wave, fixed income, implied volatility, index fund, interest rate swap, Long Term Capital Management, margin call, merger arbitrage, Nick Leeson, paper trading, performance metric, risk tolerance, risk-adjusted returns, risk/return, Sharpe ratio, short selling, survivorship bias, systematic trading, technology bubble, transaction costs, Y Combinator, yield curve

Second level grouping Within asset class Bonds: 25% to emerging markets (constrained) and 25% to inflation linked (constrained); leaves 50% left over for developed markets. Developed equities: 25% to each of US, UK, Europe, Japan. Row 3. All other groups have a single asset, with 100% allocation. Row 1. Equities: 30% to emerging markets (constrained), leaves 70% to developed markets. Top level grouping Across asset classes 40% in bonds (constrained), leaves 60% in equities. 231 Systematic Trading You can see the final weights in table 41. Using these weights, the correlations and the formula on page 297, I get an instrument diversification multiplier of 1.61. TABLE 41: WHAT INSTRUMENT WEIGHTS SHOULD YOU USE FOR THE ETF PORTFOLIO? Within region/sub class Within asset class Across asset classes Final weight US bonds 33.3% 50% 40% 6.67% Euro bonds 33.3% 50% 40% 6.67% UK bonds 33.3% 50% 40% 6.67% EM bonds 100% 25% 40% 10% Inflation bonds 100% 25% 40% 10% Euro Stoxx 50 25% 70% 60% 10.5% S&P 500 25% 70% 60% 10.5% UK equities 25% 70% 60% 10.5% Japan equities 25% 70% 60% 10.5% EM equities 100% 30% 60% 18% The table shows the handcrafted instrument weights for the asset allocating investor.

Remember that the law of active management shows that diversification is the best source of additional risk adjusted returns. Both traders and investors should hold more positions when they can; ideally across several asset classes to get the greatest possible benefit. With larger portfolios you’re also less exposed to instrument specific problems such as bad data or temporary liquidity issues. However smaller portfolios make sense for semi-automatic traders or for those running entirely manual systems. As I’ll discuss in chapter twelve, ‘Speed and Size’, those with relatively small accounts also have to limit the number of positions they take. To make them tractable the examples in this book have relatively small numbers of instruments. But I trade over 40 futures contracts across multiple asset classes in my own fully automated system since I firmly believe in diversification.

Thank you for that, and for everything. 301 Index 2001: A Space Odyssey, 19f 2008 crash, 170 Active management, 3 AIG, 2 Algorithms, 175, 199 Alpha, 3, 37, 106, 136 Alternative beta, 3-4 Amateur investors, 4, 6, 16, 48, 177, 210 and lack of diversification, 20 and over-betting, 21 and leverage, 35 and minimum sizes, 102 as day traders, 188 Anchored fitting: see Back-testing, expanding out of sample Annual returns, 178-179 Annualised cash volatility target, 137, 139, 149, 151, 159, 161, 171, 230, 250 Asset allocating investors, 3, 7, 42, 69, 98, 116, 147, 188, 225-244, 259 and Sharpe ratios, 46 and modular frameworks, 96 and the ‘no-rule’ rule, 116, 167, 196, 225, 228 and forecasts, 122-123, 159 and instrument weights, 166, 175, 189, 198-199 and correlation, 170 and instrument diversification multiplier, 175 and rules of thumb, 186 and trading speeds, 190-191, 205 and diversification, 206 Asset classes, 246&f Automation, 18-19 Back-testing, 5, 13-15, 16, 18, 19&f, 28, 53, 64, 67, 87, 113, 122, 146, 170, 182f, 187, 197, 205 and overfitting, 20, 29, 53f, 54, 68, 129f, 136, 145, 187 and skew, 40 and short holding periods, 43 in sample, 54-56 out of sample, 54-56 expanding out of sample, 56-57, 66, 71f, 84, 89f, 167f, 193-194 rolling window, 57-58, 66, 129f and portfolio weights, 69-73 and handcrafting, 85 and correlations, 129, 167&f, 175 and cost of execution, 179 simple and sophisticated, 186 need for mistrust of, 259 See also: Bootstrapping Barclays Bank, 1-2, 11, 31, 114 Barings, 41 Barriers to entry, 36, 43 Behavioural finance, 12 Beta, 3 Bid-Offer spread, 179 Block value, 153-154, 161, 182-183, 214, 219 Bollinger bands, 109 303 Systematic Trading Bond ETFs, 226 Bootstrapping, 70, 75-77, 80, 85-86, 146, 167, 175, 193-194&f, 199, 230, 248, 250 and forecast weights, 127, 205 see also Appendix C BP, 12, 13 Braga, Leda, 26 Breakouts, 109 Buffett, Warren, 37, 42 Calibration, 52-53 Carry, 67, 119, 123, 126, 127-128, 132, 247 and Skew, 119 Koijen et al paper on, 119f Central banks, 36, 103 Checking account value, recommended frequency, 149 Clarke, Arthur C, 19f ‘Close to Open’, 120-121 Cognitive bias, 12, 16, 17, 19-20, 28, 64, 179 and skew, 35 Collective funds, 4, 106, 116, 225 and derivatives, 107 and costs, 181 Commitment mechanisms, 17, 18 Compounding of returns, 143&f Contango: see Carry Contracts for Difference, 106, 181 Contrarians, 45 Corn trading, 247f Correlation, 42, 59f, 63, 68, 70, 73, 104, 107, 122, 129, 131, 167-168, 171 and Sharpe ratios, 64 and trading subsystems, 170 and ETFs, 231 Cost of execution, 179-181, 183, 188, 199, 203 Cost of trading, 42, 68, 104, 107, 174, 178, 181, 230 Credit Default Swap derivatives, 105 Crowded trades, 45 Crude oil futures, 246f Curve fitting: see over-fitting Daily cash volatility target, 137, 151, 158, 159, 161, 162, 163, 172, 175, 217, 218, 233, 254, 262. 270, 271, 217 Data availability, 102, 107 Data mining, 19f, 26-28 Data sources, 43-44 Day trading, 188 Dead cat bounces, 114 Death spiral, 35 DeMiguel, Victor, 743f Derivatives, 35 versus cash assets, 106 Desired trade, 175 Diary of trading, for semi-automatic trader, 219-224 Diary of trading, for asset allocating investor, 234- 244 Diary of trading, for staunch systems trader, 255- 257 Diversification, 20, 42, 44, 73f, 104, 107, 165, 170, 206 and Sharpe ratios, 65f, 147, 165 of instruments rather than rules, 68 and forecasts, 113 Dow Jones stock index, 23 Education of a Speculator, 17 Einstein, 70 Elliot waves, 109 Emotions, 2-3 Equal portfolio weights, 72-73 Equity value strategies, 4, 29, 31 Equity volatility indices, 34, 246, 247 Eurex, 180 Euro Stoxx 50 Index Futures, 179-180, 181, 182, 187-188, 193, 198 Eurodollar, trading recommendation, 247 Exchange rate, 161, 185 Exchange traded funds (ETFs), 4, 106, 183-184, 189, 197, 200, 214, 225, 226-228 holding costs of, 230 daily regearing of, 230f correlations, 231 Exchanges, trading on, 105, 107 Exponentially Weighted Moving Average Crossover 304 Index (EWMAC), 117-123, 126, 127-128, 132, 247 see also Appendix B Human qualities of successful traders, 259-260 Hunt brothers, 17 Fannie Mae and Freddie Mac, 2 Fees, 3 Fibonacci, 37, 109 Forecasts, 110-115, 121-123, 159, 175, 196, 211 scaling of, 112-113, 115, 133 combined, 125-133, 196, 248, 251 weighted average of, 126 and risk, 137 and speed of trading, 178 and turnover, 185 not changing once bet open, 211 see also Appendix D Forecast diversification multiplier, 128-133, 193f, 196, 249, 251 see also Appendix D Foreign exchange carry trading, 36 Fortune’s Formula, 143f FTSE 100 futures, 183, 210 Futures contracts, 181 and block value, 154-155 ‘Ideas First’, 26-27, 52-54, 103, 146 Ilmanen, Antti, 30f Illiquid assets, 198 Index trackers, 106 Inflation, 67 Instrument blocks, 154-155, 175, 182-183, 185, 206 Instrument currency volatility, 182-183, 203, 214 and turnover, 185, 195, 198 Instrument diversification multiplier, 166, 169-170, 171, 173, 175, 201, 206, 215, 229, 232, 253 Instrument forecast, 161, 162 Instrument riskiness, 155, 182 Instrument subsystem position, 175, 233 Instrument weights, 166-167, 169, 173, 175, 189, 198, 201, 202, 203, 206, 215, 229, 253 and Sharpe ratios, 168 and asset allocating investors, 226 and crash of 2008, 244 Gambling, 15, 20 Gaussian normal distribution, 22, 32&f, 39, 111f, 113, 114, 139f German bond futures, 112, 155, 181, 198 Gold, 246f Google, 29 Gross Domestic Product, 1 ‘Handcrafting’, 78-85, 116, 167-168, 175, 194, 199, 230, 248, 259 and over-fitting, 84 and Sharpe ratios, 85-90 and forecast weights, 127, 205 worked example for portfolio weights, 231-232 and allocation for staunch systems traders, 253 Hedge funds, 3, 177 High frequency trading, 6, 16, 30, 36, 180 Holding costs, 181 Housekeeping, daily, 217 for staunch systems traders, 254 Japan, 36 Japanese government bonds, 102, 112, 114, 200 JP Morgan, 156f Kahn, Richard, 42 Kaufman, Perry, 117 Kelly, John, and Kelly Criterion, 143-146, 149, 151 ‘Half-Kelly’ 146-147, 148, 230, 260 Koijen, Ralph, 119 Law of active management, 41-42, 43, 44, 46, 129f and Sharpe ratios, 47 Leeson, Nick, 41 Lehman Brothers, 2, 237 Leverage, 4, 21&f, 35, 95f, 138f, 142-143 and skew, 44-45 and low-risk assets, 103 and derivatives, 106 and volatility targeting, 151 realised leverage, 229 Life expectancy of investor, and risk, 141 305 Systematic Trading Limit orders, 179 Liquidity, 35, 104-105, 107 Lo, Andrew, 60f, 63f Long Term Capital Management (LTCM), 41, 46 Sharpe ratio of, 47 Low volatility instruments, need to avoid, 143, 151, 210, 230, 260 Lowenstein, Roger, 41, 46f Luck, need for, 260 Lynch, Peter, 37 Markowitz, Harry, 70, 72 Maximum number of bets, 215 Mean reversion trading, 31, 43, 45, 52, 213f ‘Meddling’, 17, 18, 19, 21, 136, 260 and forecasts, 115 and volatility targets, 148 Merger arbitrage, 29 Mid-price, 179, 181 Minimum sizes, 102, 107 Modular frameworks, 93, 95-99 Modularity, 5 Momentum, 42, 67, 68, 117 Moving averages, 94, 195, 197 MSCI, 156f Narrative fallacy, 20, 27, 28, 64 NASDAQ futures, 188 Nervousness, need for, 260 New position opening, 218 Niederhoffer, Victor, 17 Odean, Terence, 13, 20f Odysseus, 17 Oil prices, standard deviation of, 211 O’Shea, Colm, 94f Online portfolio calculators, 129f Overbetting, 21 Over the counter (OTC) trading, 105, 106, 107, 183f Overconfidence, 6, 17, 19f, 54, 58, 136 and lack of diversification, 20 and overtrading, 179 306 Over-fitting, 19-20, 27-28, 48, 51-54, 58, 65, 68, 121f, 156, 259 and Sharpe ratios, 46f, 47, 146 avoiding fitting, 67-68 of portfolio weights, 68-69 possibility of in ‘handcrafting’, 84 Overtrading, 179 Panama method, 247&f Passive indexing, 3 Passive management, 3, 4 Paulson, John, 31, 41 Pension funds, 3 ‘Peso problem’, 30&f Position inertia, 173-174, 193f, 196, 198, 217 Position sizing, 94, 153-163, 214 Poundstone, William, 143f Price movements, reasons for, 103, 107 Portfolio instrument position, 173, 175, 218, 254, 256, 257 Portfolio optimization, 70-90, 167 Portfolio size, 44, 178 Portfolio weighted position, 97, 99, 101, 109, 125, 135, 153, 165, 167, 177, 267 and diversification, 170 Price-to-earnings (P/E) ratios 4 Prospect theory, 12-13, 37 and momentum, 117 Quant Quake, the, 46 Raspberry Pi micro computers, 4 Relative value, 30, 43, 44-46, 213f Retail stockbrokers, 4 Risk, 39, 137-148, 170 Risk targeting, 136 Natural risk and leverage, 142 Risk parity investing, 38, 116&f Risk premia, 31, 119 RiskMetrics (TM), 156&f Roll down: see Carry Rolling up profits and losses, 149 Rogue Trader, 41 Rounded target position, 173, 175, 218 Index Rules of thumb, 186, 230 see also Appendix C Rumsfeld, Donald, 39&f Safe haven assets, 34 Schwager, Jack, 94f Self-fulfilling prophecies, 37 Semi-automatic trading, 4, 7, 11f, 18, 19f, 37, 38, 98, 163, 169, 209-224, 259 and portfolio size, 44, 203 and Sharpe ratios, 47, 147-148 and modular frameworks, 95 and trading rules, 109 and forecasts, 114, 122-123, 159 and eyeballing charts, 155, 195, 197, 214 and diversification, 166, 206 and instrument weights, 166, 175, 189 and correlation, 169 and trading subsystems, 169 and instrument diversification multiplier, 171, 175 and rules of thumb, 186 and overconfidence, 188 and stop losses, 189, 192 and trading speeds, 190-192, 205 Sharpe ratios, 25, 31-32, 34, 35, 42, 43, 44, 46-48, 53, 58, 60f, 67, 72, 73, 112, 184, 189, 210, 214, 250, 259 and overconfidence, 54, 136, 151 and rule testing, 59-60, 65 and T-Test, 61-63 and skew, 62f, 66 and correlation, 64 and diversification, 65f difficulty in distinguishing, 74 and handcrafting, 85-90 and factors of pessimism, 90 and risk, 137f, 138 and volatility targets, 144-145, 151 and speed of trading, 178-179, 196, 204 need for conservative estimation of, 195 and asset allocating investors, 225 and crash of 2008, 240 Schatz futures: see German bond futures Shefrin, Hersh, 13&f Short option strategies, 41 Short selling, 30, 37 Single period optimisation, 71, 85, 89 Skew, positive and negative, 32-34, 40-41, 48, 105, 107, 136, 139-141, 247, 259 and liquidity, 36 and prospect theory, 37 and risk, 39, 138 and leverage, 44-45, 142 and Sharpe ratios, 47, 62f, 146 and trend following, 115, 117 and EWMAC, 119 and carry, 119 and V2TX, 250 ‘Social trading’, 4f Soros, George, and sterling, 36f Speed of trading, 41-43, 47, 48, 104, 122, 174f, 177-205, 248 speed limits, 187-189, 196, 198-199, 204, 213, 228, 251, 260 Spread betting, 6, 106, 181, 197, 214 and block value, 154-155 and UK tax, 183f oil example, 214 Spreadsheets, 218 Stamp duty, 181 Standardised cost estimates, 203-205, 210, 226, 230 Standard deviations, 21-22, 31-32, 38, 40, 70, 103, 107, 111f, 129 and skew, 105 and forecasts, 112, 114, 128 recent, 155-158 returns, 167 and standardised cost, 182, 188, 192 and stop losses, 211 Static and dynamic trading, 38, 43, 168, 188 Staunch systems trading, 4, 7, 51-68, 69, 98, 109, 117-123, 167, 245-257 and Sharpe ratios, 46, 146, 189 and forecasts, 110-114, 122-123, 189 and instrument forecast, 161 and instrument weights, 166, 175, 198-199 and correlation, 170 and rules of thumb, 186 and trading speeds, 191-192, 205 307 Systematic Trading and back-testing, 193 and diversification, 206 Stop losses, 94-5, 115, 121f, 137f, 189, 192, 214, 216f, 217, 218 and forecasts, 211-212 and different instruments, 213 and price volatility, 216 Survivorship bias, 29 Swiss franc, 36, 103, 105, 142-143 System parameters, 186 Systematica hedge fund, 26 Taking profits and losses, 13-15, 16-18, 58, 94-95, 149 and trend following, 37 see also Appendix B Taleb, Nassim, 39f, 41 Tax (UK), 106, 183f Technical analysis, 18, 29 Technology bubble of 1999, 35 Templeton, John, 37 The Black Swan, 39f The Greatest Trade Ever, 31f, 41 Thorpe, Ed, 146f Thriftiness, need for, 260 Timing, 2 Too much/little capital, 206, 246f Trading capital, 150-151, 158, 165, 167, 178, 192, 199-202 starting low, 148 reducing, 149 and turnover, 185 daily calculation of, 217 Trading rules, 3-4, 7, 16, 25-26, 78, 95, 97-98, 101, 109, 121, 125, 135, 159, 161, 187, 249, 259 need for small number of, 67-68, 193 Kaufman, Perry’s guide to, 117 and speed of trading, 178, 205 cost calculations for, 204 see also Appendix B Trading subsystems, 98-99, 116, 159, 162, 163, 165, 166, 167&f, 169, 171f, 172, 175-176, 185, 187, 230, 251-252, 260 and correlation, 170 308 and turnover, 196 cost calculations for, 204 Traditional portfolio allocation, 167 Trend following, 28, 30, 37, 45, 47f, 67, 117, 137f, 194f, 212f, 247 and skew, 105, 115, 117, 213 Turnover, 184-186, 195, 197, 198, 205, 228, 260 methods of calculation, 204 back-testing of, 247-248 Twitter, 29 V2TX index, 246, 247, 249 Value at risk, 137 VIX futures, 105 Volatility, 21, 103, 107, 116, 129, 150, 226, 229 and targets, 95, 98, 106, 158, 159, 185 unpredictability of, 45 price volatility, 155-158, 162-163, 189, 196, 197, 200, 205, 214, 228, Appendix D and crash of 2008, 240-244 instrument currency volatility, 158, 161 instrument value volatility, 161, 172, 250 scalars, 159-160, 162, 185, 201, 206, 215, 217, 218, 229 look-back period, 155, 195-197 and speed of trading, 178 Volatility standardisation, 40, 71, 72, 73, 167, 182, 185 and forecasts, 112, 121, 129 and block value, 155 Volatility standardized costs, 247 Volatility targeting, 135-151, 171f, 188, 192, 201f, 213-215, 230, 233, 250, 259 Walk forward fitting: see Back testing, rolling window Weekly rebalancing process, for asset allocating investors, 233 When Genius Failed, 40, 46f Women as makers of investment decisions, 17&f www.systematictrading.org, 234 Zuckerman, Gregory, 31f THANKS FOR READING!


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

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

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

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

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


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

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, business cycle, buy and hold, 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, G4S, 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, London Interbank Offered Rate, 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, stocks for the long run, 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 persistence may reflect some of the same influences that are seen in traditional asset classes, but stale prices and return smoothing are also likely to have contributed. Figure 14.2 shows how well a simple trend-following strategy performed in four asset classes. In each class I simulate the one-year moving average rule for about 15 liquid assets (the interest rate and bond futures are all within G10 markets; currencies and equity indices also include a handful of countries outside the G10). The approach is again deliberately naive except that I apply volatility weighting. Diversification both within and across asset classes smooths returns (I target 10% volatility for each asset class). For example, all four asset classes have respectable SRs between 0.7 and 1.0, but the composite has a volatility of only 6% and an impressive SR of 1.4.

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

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


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

asset allocation, Bretton Woods, business cycle, 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, stocks for the long run, superstar cities, survivorship bias, transaction costs, Vanguard fund

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

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

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


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

asset allocation, asset-backed security, buy and hold, 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, stocks for the long run, survivorship bias, technology bubble, the market place, transaction costs, Vanguard fund, yield curve, zero-sum game

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

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

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


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Smarter Investing by Tim Hale

Albert Einstein, asset allocation, buy and hold, buy low sell high, capital asset pricing model, collapse of Lehman Brothers, corporate governance, credit crunch, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, Donald Trump, equity premium, Eugene Fama: efficient market hypothesis, eurozone crisis, fiat currency, financial independence, financial innovation, fixed income, full employment, implied volatility, index fund, information asymmetry, Isaac Newton, John Meriwether, Long Term Capital Management, Northern Rock, passive investing, Ponzi scheme, purchasing power parity, quantitative easing, random walk, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, South Sea Bubble, technology bubble, the rule of 72, time value of money, transaction costs, Vanguard fund, women in the workforce, zero-sum game

Growth-oriented equity market diversifiers, such as global commercial property, may help to smooth shorter-term equity market falls, as well as providing some comfort over the long-term, if Siegel’s warning comes true over your investing lifetime. You need to decide if you want to include these asset classes or if you wish to ignore them, sticking with equities and simply reducing the risk you take by diluting your equity exposure with defensive assets. Read up about each in Chapter 12 and make your own mind up. The degree to which each asset class helps to smooth the portfolio returns, i.e. how effective their diversification benefit is, depends on how highly correlated their returns are. If you could find four uncorrelated asset classes with equity-like returns, you could halve the risk of the portfolio without giving up any return. The problem lies in finding them! Global commercial real estate provides useful potential diversification benefits. Making sensible allocations Again, any allocation should be material enough to make a difference, but not too large as you will be forgoing the higher expected returns from equities which you are having to shed to accommodate the diversifying asset class.

During two particularly tough periods for investors: 2000–2002 (the Tech Wreck) and 2007–2009 (the Credit Crunch) – as you can see, diversification helped to reduce the cumulative losses incurred over this period. While this illustrates that diversification is an important decision, in periods like the early 1990s, when property fell substantially and global markets fared worse than the UK, it did not pay off; but that does not make it invalid. Investing is an imperfect science. What is interesting to note is that while the risk has been the same, when measured by volatility, it appears that the downside impact of the worst-case periods has been reduced by the diversification into other asset classes. Returns have stood up well. Diversification is a tool worth using. Smarter investing requires that you simply stack the odds of success in your favour by making sensible decisions along the way.

These are simply reasonable guesses and you should probably model in some more disappointing outcomes into your plans. Table 6.5 On-menu asset class assumptions – return and risk Building block Expected real return Premium Risk Growth-oriented, risky assets Developed equity markets 5% p.a. 20% Emerging equity markets 7% p.a. +2% p.a. 30% Value (less healthy) equities 7% p.a. +2% p.a. 25% Smaller company equities 7% p.a. +2% p.a. 25% Global real estate 4% p.a. 15% Defensive assets Shorter-dated bonds (AA min) 1% 5% Shorter-dated inflation linked bonds (AA min) 0.5% 8% Table 6.6 Correlations between asset classes References Bernstein, W. J. (2000) ‘The 15-Stock Diversification Myth’ (www.efficientfrontier.com). Breakwell, G. and Barnett, J. (2007) The Psychology of Risk: An Introduction. Cambridge University Press, p. 1.


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

asset allocation, backtesting, buy and hold, 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, stocks for the long run, survivorship bias, the rule of 72, the scientific method, time value of money, transaction costs, Vanguard fund, Yogi Berra, zero-coupon bond

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

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

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


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

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

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

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

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


Capital Ideas Evolving by Peter L. Bernstein

Albert Einstein, algorithmic trading, Andrei Shleifer, asset allocation, business cycle, buy and hold, buy low sell high, capital asset pricing model, commodity trading advisor, computerized trading, creative destruction, Daniel Kahneman / Amos Tversky, David Ricardo: comparative advantage, diversification, diversified portfolio, endowment effect, equity premium, Eugene Fama: efficient market hypothesis, financial innovation, fixed income, high net worth, hiring and firing, index fund, invisible hand, Isaac Newton, John Meriwether, John von Neumann, Joseph Schumpeter, Kenneth Arrow, London Interbank Offered Rate, Long Term Capital Management, loss aversion, Louis Bachelier, market bubble, mental accounting, money market fund, Myron Scholes, paper trading, passive investing, Paul Samuelson, price anchoring, price stability, random walk, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, Sharpe ratio, short selling, Silicon Valley, South Sea Bubble, statistical model, survivorship bias, systematic trading, technology bubble, The Wealth of Nations by Adam Smith, transaction costs, yield curve, Yogi Berra, zero-sum game

Investors have learned from CAPM that they must recognize the fundamental distinction between investing in an asset class and selecting individual securities on which they hope to earn an extra return. The choice of asset classes—for example, stocks, bonds, emerging market equities, real estate, or subdivisions of those markets—is in essence the choice of beta risks, or the volatility of entire markets rather than their individual components. The search for alpha, or residual and uncorrelated risks, means taking an extra risk beyond the beta risk in the hope of earning a return over and above the expected returns from the asset classes in the portfolio. It is important to note the frequency with which the word “risk” appears in this discussion. As mentioned at the outset, the key elements in the pricing process are risk and the central role of diversification, or risk management.

Along the way, Swensen has been faithful to one of Harry Markowitz’s favorite observations about asset allocation: “It’s not the variance you have to worry about, it’s the covariance.” Diversification is an obsession with Swensen, but he pursues it in his own way. In the 1995 endowment report, he summed it up in a few words: “Yale seeks diversification without the opportunity costs of investing in fixed-income by identifying high-return asset classes that are not highly correlated with domestic marketable securities. . . . [Under these conditions], a portfolio can be constructed that offers both high returns and diversification.” In other words, you can hold plenty of risky assets with high expected returns as long as they f luctuate independently rather than in step with one another. This is nothing more than Markowitz’s theory of diversification. From the very beginning of Swensen’s régime, Yale has consistently aimed for the maximum possible level of diversification while selecting assets with expected rates of return higher than returns available from conventional asset classes.

The combination of small allocations and weak correlations among the alternative asset classes adds the third and equally surprising feature of the analysis: “The benefit from multiasset diversification is to be found not in reduced volatilities, but rather in enhanced fund returns.” Essentially, these enhanced returns are the result of choosing asset classes that produce more return than would be expected merely on the basis of their betas. Assuming, for the sake of example, that returns on REITs have no correlation with equities, moving cash—a zero-beta asset—into REITs has no impact on portfolio volatility, but REITs do have a higher return than cash. This example is extreme, but it illustrates Leibowitz’s point that the attraction of multiasset diversification is in higher returns rather than lower volatility. As usual, there are no free lunches.


pages: 537 words: 144,318

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

Albert Einstein, Asian financial crisis, asset allocation, asset-backed security, backtesting, banking crisis, Bernie Madoff, Black Swan, Bretton Woods, BRICs, British Empire, business cycle, business process, buy and hold, 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, Kickstarter, 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, stocks for the long run, stocks for the long term, 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

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

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

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


Triumph of the Optimists: 101 Years of Global Investment Returns by Elroy Dimson, Paul Marsh, Mike Staunton

asset allocation, banking crisis, Berlin Wall, Bretton Woods, British Empire, buy and hold, capital asset pricing model, capital controls, central bank independence, colonial rule, corporate governance, correlation coefficient, cuban missile crisis, discounted cash flows, diversification, diversified portfolio, dividend-yielding stocks, equity premium, Eugene Fama: efficient market hypothesis, European colonialism, fixed income, floating exchange rates, German hyperinflation, index fund, information asymmetry, joint-stock company, negative equity, new economy, oil shock, passive investing, purchasing power parity, random walk, risk tolerance, risk/return, selection bias, shareholder value, Sharpe ratio, stocks for the long run, survivorship bias, technology bubble, transaction costs, yield curve

In section 4.5, we examine the distribution of annual real asset returns for the United States from 1900–2000, and document the risk of US equities, bonds, and bills. Our figures for equity risk are based exclusively on market indexes that represent highly diversified portfolios. Section 4.6 shows that individual stocks tend to be much riskier than this, and demonstrates the importance and power of diversification for equity investors. Finally, in section 4.7 we present risk comparisons both across asset classes and countries. We show that over the long haul, risk and return have gone hand-in-hand. In the chapters that follow, we then examine each asset class in greater detail—bills and inflation in chapter 5, bonds in chapter 6, currencies and common-currency asset returns in chapter 7, international investment in chapter 8, stock returns in chapters 9–11, and the equity risk premium in chapters 12 and 13. 4.1 The US record The United States is today’s financial superpower.

Just as they can reduce risk domestically by diversifying across stocks, they can further reduce risk by diversifying internationally. Later, in chapter 8, we explore the benefits of international diversification. Figure 4-12: Selected periods of large losses on equities around the world 0 -20 Real returns (%) -14 -23 -40 -37 -60 -60 -71 -80 -91 -100 US: Sept 11, 2001 US: October 1987 Crash US: 2000–01 bear market US: Wall Street Crash UK: 1973–74 bear market Germany 1945–48 -97 Japan 1944–47 59 Chapter 4 International capital market history 4.7 Risk comparisons across asset classes and countries For the United States, we have seen that for the major asset classes—equities, bonds, and bills—risk and return went hand in hand. Equities performed best, giving a compound annualized (i.e., geometric mean) real return of 6.7 percent, and an average annual (i.e., arithmetic mean) real return of 8.7 percent between 1900–2000.

To Helen, Steff, and our parents Contents Preface xi Part One: 101 years of global investment returns 1 Chapter 1 3 Introduction and overview 1.1 Need for an international perspective 3 1.2 The historical record 5 1.3 Inside the markets 7 1.4 The equity premium 1.5 Sixteen countries, one world Chapter 2 8 10 World markets: today and yesterday 11 2.1 The world’s stock markets today 11 2.2 The world’s bond markets today 14 2.3 Why stock and bond markets matter 18 2.4 The world’s markets yesterday 19 2.5 The US and UK stock markets: 1900 versus 2000 23 2.6 Industry composition: 1900 versus 2000 23 2.7 Stock market concentration 28 2.8 Summary 32 Chapter 3 Measuring long-term returns 34 3.1 Good indexes and bad 34 3.2 Index design: a case study 36 3.3 Dividends, coverage, and weightings 38 3.4 Easy-data bias in international indexes 40 3.5 Measuring inflation and fixed-income returns 43 3.6 Summary 44 Chapter 4 International capital market history 45 4.1 The US record 45 4.2 The UK record 48 4.3 Stock market returns around the world 50 4.4 Equities compared with bonds and bills 51 4.5 Investment risk and the distribution of annual returns 54 4.6 Risk, diversification, and market risk 56 4.7 Risk comparisons across asset classes and countries 59 4.8 Summary 61 vii viii Chapter 5 Inflation, interest rates, and bill returns 63 5.1 Inflation in the United States and the United Kingdom 63 5.2 Inflation around the world 65 5.3 US treasury bills and real interest rates 68 5.4 Real interest rates around the world 71 5.5 Summary 72 Chapter 6 Bond returns 74 6.1 US and UK bond returns 6.2 Bond returns around the world 79 6.3 Bond maturity premia 81 6.4 Inflation-indexed bonds and the real term premium 84 6.5 Corporate bonds and the default risk premium 87 6.6 Summary 89 Chapter 7 Exchange rates and common-currency returns 74 91 7.1 Long-run exchange rate behavior 91 7.2 The international monetary system 93 7.3 Long-run purchasing power parity 95 7.4 Deviations from purchasing power parity 96 7.5 Volatility of exchange rates 98 7.6 Common-currency returns on bonds and equities 100 7.7 Summary 103 Chapter 8 International investment 105 8.1 Local market versus currency risk 105 8.2 A twentieth century world index for equities and bonds 108 8.3 Ex post benefits from holding the world index 111 8.4 Correlations between countries 114 8.5 Prospective gains from international diversification 117 8.6 Home bias and constraints on international investment 120 8.7 Summary 123 Chapter 9 Size effects and seasonality in stock returns 124 9.1 The size effect in the United States 124 9.2 The size effect in the United Kingdom 126 9.3 The size effect around the world 129 9.4 The reversal of the size premium 131 9.5 Seasonality and size 135 9.6 Summary 138 ix Chapter 10 Value and growth in stock returns 139 10.1 Value versus growth in the United States 139 10.2 Value and growth investing in the United Kingdom 142 10.3 The international evidence 145 10.4 Summary 148 Chapter 11 Equity dividends 149 11.1 The impact of income 149 11.2 US and UK dividend growth 152 11.3 Dividend growth around the world 154 11.4 Dividend growth, GDP growth, and real equity returns 155 11.5 Dividend yields around the world and over time 157 11.6 Disappearing dividends 158 11.7 Summary 161 Chapter 12 The equity risk premium 163 12.1 US risk premia relative to bills 163 12.2 Worldwide risk premia relative to bills 166 12.3 US risk premia relative to bonds 169 12.4 Worldwide risk premia relative to bonds 171 12.5 Summary 173 Chapter 13 The prospective risk premium 176 13.1 Why the risk premium matters 177 13.2 How big should the risk premium be?


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

asset allocation, backtesting, Bernie Madoff, Black Swan, business cycle, buy and hold, 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: Challenger O-ring, risk tolerance, risk-adjusted returns, risk/return, selection bias, Sharpe ratio, short selling, statistical model, stocks for the long run, 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

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

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

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


pages: 345 words: 87,745

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

asset allocation, backtesting, Bernie Madoff, buy and hold, 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

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

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

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


pages: 162 words: 50,108

The Little Book of Hedge Funds by Anthony Scaramucci

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, Thales and the olive presses, Thales of Miletus, the new new thing, too big to fail, transaction costs, Vanguard fund, Y2K, Yogi Berra, zero-sum game

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

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

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


pages: 407 words: 114,478

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

asset allocation, Bretton Woods, British Empire, business cycle, butter production in bangladesh, buy and hold, 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, stocks for the long run, stocks for the long term, 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

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

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

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


pages: 335 words: 94,657

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

asset allocation, buy and hold, 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, stocks for the long run, survivorship bias, the rule of 72, transaction costs, Vanguard fund, yield curve, zero-sum game

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

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

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


pages: 337 words: 89,075

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

accounting loophole / creative accounting, airline deregulation, Andrei Shleifer, asset allocation, Bretton Woods, business cycle, buy and hold, 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, low cost airline, 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, stocks for the long run, survivorship bias, the market place, transaction costs, Y2K, yield curve, zero-sum game

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

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

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


pages: 236 words: 77,735

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

affirmative action, asset allocation, backtesting, barriers to entry, Bernie Madoff, Bretton Woods, business cycle, buy and hold, 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, stocks for the long run, stocks for the long term, too big to fail, trade route, Vanguard fund, walking around money

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

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

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


The Handbook of Personal Wealth Management by Reuvid, Jonathan.

asset allocation, banking crisis, BRICs, business cycle, buy and hold, 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

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

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

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


pages: 250 words: 77,544

Personal Investing: The Missing Manual by Bonnie Biafore, Amy E. Buttell, Carol Fabbri

asset allocation, asset-backed security, business cycle, buy and hold, diversification, diversified portfolio, Donald Trump, employer provided health coverage, estate planning, fixed income, Home mortgage interest deduction, index fund, Kickstarter, money market fund, mortgage tax deduction, risk tolerance, risk-adjusted returns, Rubik’s Cube, Sharpe ratio, stocks for the long run, Vanguard fund, Yogi Berra, zero-coupon bond

If you want to learn more about asset allocation, check out the SEC (Securities and Exchange Commission) article “Beginner’s Guide to Asset Allocation” at http://tinyurl.com/SEC-assets. Manage Your Portfolio 161 Other Ways to Diversify If you’re just starting out in personal investing, you can keep diversification plain and simple, as you learn on page 166. With time and a larger portfolio, you may decide to diversify your investments in several ways: by different-sized companies, by market sectors and industries, or by geographic regions. The following table explains how these types of diversification can help your portfolio. Diversification by Effect Asset class A mixture of stocks, bonds, REITs, and cash offers better overall returns with more dependable year-to-year performance. Company size Large companies often grow more slowly but more consistently than small companies.

Some types of investment do well in environments that put other types of investments into a tailspin. For example, high market interest rates mean more income for investors who buy and hold bonds, but high rates drag stock prices down. (That’s because investors would rather buy bonds, which are less risky than stocks, when bonds deliver a return that’s close to that of stocks.) With a mixture of asset classes, your portfolio returns from year to year are more consistent. If you buy individual stocks or bonds, diversification means no one investment can seriously harm your portfolio. Regardless of how thoroughly you research investments, some do better than you expect, some do worse, and most perform about on target. If you own one stock and it drops 50%, you lose 50%. If you own 10 stocks and one drops 50%, your portfolio loses only 5%. If another one of those 10 stocks does spectacularly well, you may still come out ahead.

It has five risk profiles, from conservative to aggressive. When you point to a profile, a pie chart shows the suggested asset allocation and provides some details about it, such as the time horizon and the average annual return. To see mutual funds that Schwab suggests for each asset class, click “See sample portfolio” below the pie chart. Manage Your Portfolio 165 Asset Allocation Made Ridiculously Easy In Chapter 5, you learned how index funds are a low-cost way to diversify your portfolio among all sorts of investments. They provide instant diversification, because they own many individual investments within categories like large and small companies, industries and sectors, bonds, and geographical regions. Because they follow indexes, their expenses and turnover are low. In this chapter, you’ve learned how allocating your money to different types of investments is the biggest factor in balancing the return and risk of your portfolio.


pages: 249 words: 77,342

The Behavioral Investor by Daniel Crosby

affirmative action, Asian financial crisis, asset allocation, availability heuristic, backtesting, bank run, Black Swan, buy and hold, cognitive dissonance, colonial rule, compound rate of return, correlation coefficient, correlation does not imply causation, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, Donald Trump, endowment effect, feminist movement, Flash crash, haute cuisine, hedonic treadmill, housing crisis, IKEA effect, impulse control, index fund, Isaac Newton, job automation, longitudinal study, loss aversion, market bubble, market fundamentalism, mental accounting, meta analysis, meta-analysis, Milgram experiment, moral panic, Murray Gell-Mann, Nate Silver, neurotypical, passive investing, pattern recognition, Ponzi scheme, prediction markets, random walk, Richard Feynman, Richard Thaler, risk tolerance, Robert Shiller, Robert Shiller, science of happiness, Shai Danziger, short selling, South Sea Bubble, Stanford prison experiment, Stephen Hawking, Steve Jobs, stocks for the long run, Thales of Miletus, The Signal and the Noise by Nate Silver, tulip mania, Vanguard fund

One of the most important rules of behavioral investing is that results matter less than the process; you can be right and still be a moron. Diversification has become such a broadly accepted good in asset management that it seems many have forgotten the underlying reasons for doing it. Considered from a behavioral lens, diversification is humility made flesh, the embodiment of managing ego risk. Diversification is a concrete nod to the luck and uncertainty inherent in money management and an admission that the future is unknowable. As evidenced by the JP Morgan research in the following table, single stock ownership can indeed be harrowing, with nearly half of all stocks suffering catastrophic losses in their lifetime. But diversification is a lot like medicine (or candy, or children) in the sense that some is good but more is not always better. In fact, diversification can be achieved with fewer holdings than most understand and over-diversification can be an impediment.

The results for small capitalization stocks, often considered to be less efficiently priced and therefore more favorable to active management, are just as damning: 87.75% of small cap managers were bested by passive approaches. Diversification is likewise rooted in an ethos of, “you can’t be sure of anything so buy everything” and is proof that conceding to uncertainty does not have to mean compromising returns. In fact, broad diversification and rebalancing have been shown to add half a percentage point of performance per year, a number that can seem small until you realize how it is compounded over an investment lifetime. For evidence of the efficacy of diversification and rebalancing take, for example, the case of European, Pacific and US Stocks cited in A Wealth of Common Sense. From 1970 to 2014, the annualized returns were as follows: European Stocks: 10.5% Pacific Stocks: 9.5% US Stocks: 10.4% Similar returns, but let’s examine what happens when all three markets are combined, equally weighted and rebalanced each year-end to maintain consistent portfolio composition.

One of the earliest studies to refute this misconception was conducted by John Evans and Stephen Archer of the University of Washington. Evans and Archer found that the benefits of diversification dropped off precipitously when more than 20 stocks were added to a portfolio. Reilly and Brown second this idea in their book, Investment Analysis and Portfolio Management when they note, “…about 90% of the maximum benefit of diversification was derived from portfolios of 12 to 18 stocks.” Further, billionaire investor Joel Greenblatt says in his book You Can Be a Stock Market Genius that nonmarket (i.e., diversifiable) risk is reduced by 46% by owning just two stocks, 72% with four stocks, 81% with eight stocks and 93% with as few as 16 stocks. Greenblatt’s work shows just how quickly most of the benefits of diversification can be achieved and also how quickly they begin to erode after about the 20 stock point.


pages: 321

Finding Alphas: A Quantitative Approach to Building Trading Strategies by Igor Tulchinsky

algorithmic trading, asset allocation, automated trading system, backtesting, barriers to entry, business cycle, buy and hold, capital asset pricing model, constrained optimization, corporate governance, correlation coefficient, credit crunch, Credit Default Swap, discounted cash flows, discrete time, diversification, diversified portfolio, Eugene Fama: efficient market hypothesis, financial intermediation, Flash crash, implied volatility, index arbitrage, index fund, intangible asset, iterative process, Long Term Capital Management, loss aversion, market design, market microstructure, merger arbitrage, natural language processing, passive investing, pattern recognition, performance metric, popular capitalism, prediction markets, price discovery process, profit motive, quantitative trading / quantitative finance, random walk, Renaissance Technologies, risk tolerance, risk-adjusted returns, risk/return, selection bias, sentiment analysis, shareholder value, Sharpe ratio, short selling, Silicon Valley, speech recognition, statistical arbitrage, statistical model, stochastic process, survivorship bias, systematic trading, text mining, transaction costs, Vanguard fund, yield curve

If the bootstrapped drawdown is controlled, it is safer to believe that the underlying distribution will not produce extreme drawdowns. 108 Finding Alphas CONTROLLING RISKS Diversify When Possible Because different instruments are exposed to different types of risk and volatility scales like the square root of the number of independent variables, the extrinsic and intrinsic risks of an alpha or portfolio can generally be reduced by diversification, as long as the position concentrations are under control. For example, alphas constructed only on the FTSE 100 have lower diversification than alphas constructed on the entire set of UK and European stocks. Diversification can include new instruments, new regions or sectors, and new asset classes. The lower the correlations between the instruments, the better the risk approximates the ideal central limit theorem. However, there are limits to diversification. If the instruments are too diverse, the volatilities may be too heterogeneous to allow all the instruments to contribute meaningfully without excessive concentration risk, or the instruments may simply behave too differently for the same alpha ideas to be relevant.

After they play out one area, they need to move on to find and explore other mines. TAP is really just a tool to organize the complex, multidimensional alpha space. It offers a number of advantages for portfolio diversification. The alpha space is vast, with a high and growing number of degrees of freedom, and there is an almost unlimited number of possible alphas, with each region or cluster of alphas possessing different topographies that require discovery and exploration. A quant has a plethora of choices. She can make predictions to trade over intervals ranging from microseconds to years. She can make predictions on different asset classes, most commonly equities, bonds, commodities, and currencies. But the set of possible elements that a quant can manipulate is growing all the time – more datasets, more parameters, more ideas.

New quants can easily be overwhelmed by the challenge of trying to develop alphas. They ask themselves, “How do I find alphas? How do I start the search?” Even experienced quants working with many alphas can miss key components required to build a robust, diversified portfolio. For instance, one of the most difficult aspects of alpha portfolio construction is the need to optimize the level of diversification of the portfolio. In automated trading systems, decisions on diversification make up a major area of human intervention. It’s not easy to visualize the many pieces of the portfolio, which contain hundreds or thousands of alphas, and their interactions. TAP emerged from those concerns. When new quants start conducting alpha research, many begin by searching the internet for articles about developing alphas. Most of those articles focus on reversion and momentum, and as a result, beginners may initially spend a lot of time building reversion or momentum alphas.


pages: 356 words: 51,419

The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns by John C. Bogle

asset allocation, backtesting, buy and hold, creative destruction, diversification, diversified portfolio, financial intermediation, fixed income, index fund, invention of the wheel, Isaac Newton, new economy, passive investing, Paul Samuelson, random walk, risk tolerance, risk-adjusted returns, Sharpe ratio, stocks for the long run, survivorship bias, transaction costs, Upton Sinclair, Vanguard fund, William of Occam, yield management, zero-sum game

NOTE: Little Book readers interested in reviewing the sources for the “Don’t Take My Word for It” quotes found at the end of each chapter, other quotes in the main text, and the sources of the extensive data that I present can find them on my website: www.johncbogle.com. I wouldn’t dream of consuming valuable pages in this small book with a weighty bibliography, so please don’t hesitate to visit my website. Notes 1 Keep in mind that an index may also be constructed around the bond market, or even “road less traveled” asset classes such as commodities or real estate. Today, if you wish, you could literally hold all your wealth in a diversified portfolio of low-cost traditional index funds representing every asset class and every market sector within the United States or around the globe. 2 Over the past century, the average nominal return on U.S. stocks was 10.1 percent per year. In real terms (after 3.4 percent inflation) the real annual return was 6.7 percent. During the next decade, both returns are likely to be significantly lower.

Bogle also mentions that while dividends are not guaranteed, they have gone down more noticeably only a couple of times in the past. . . . “I really love his overall message on staying the course, focusing on dividends, keeping investment costs low, and ignoring stock prices. He also believes in keeping things simple. Bogle is against the widespread practice today of building portfolios that consist of 10–15 asset classes, whose sole purpose is to create complexity to generate fees for greedy asset managers. Keeping it simple means owning stocks and some bonds. It also means not getting too fancy and too carried away by adding fashionable asset classes whose merits are derived from a backtested computer model.” Chapter Seven The Grand Illusion Surprise! The Returns Reported by Mutual Funds Are Rarely Earned by Mutual Fund Investors. IT IS GRATIFYING THAT industry insiders such as Fidelity’s Peter Lynch, former Investment Company Institute (ICI) chairman Jon Fossel, Mad Money’s James Cramer, and AQR’s Clifford Asness agree with me, as you may recall from Chapter 4.

Simply put, the ETF is an index fund designed to facilitate trading in its shares, dressed in the guise of the traditional index fund. If long-term investment was the paradigm for the original TIF designed 42 years ago, surely using index funds as trading vehicles can only be described as short-term speculation. If the broadest possible diversification was the original paradigm, surely holding discrete—even widely diversified—sectors of the market offers far less diversification and commensurately more risk. If the original paradigm was minimal cost, then this is obviated by holding market-sector index funds that carry higher costs, entail brokerage commissions when they are traded, and incur tax burdens if one has the good fortune to trade successfully. But let me be clear. There is nothing wrong with investing in those indexed ETFs that track the broad stock market, just so long as you don’t trade them.


pages: 130 words: 32,279

Beyond the 4% Rule: The Science of Retirement Portfolios That Last a Lifetime by Abraham Okusanya

asset allocation, diversification, diversified portfolio, high net worth, longitudinal study, market design, mental accounting, Paul Samuelson, quantitative easing, risk tolerance, risk-adjusted returns, Robert Shiller, Robert Shiller, transaction costs

I want to pick out these key drawbacks: Fig. 18: First year’s, lowest, mean and highest real natural income over the entire 30-year period for various start dates Fig. 19: Cumulative total returns during the global financial crisis (12 Oct.,2007 to Mar., 2009) a) High-yield asset classes such as commercial property/ REITs, equities and high-yield bonds tend to have large drawdowns, particularly during stressful market conditions. Fig. 19 is taken from the Vanguard paper referred to earlier and it shows the total returns of major asset classes, including high-yield ones during the financial crisis of 2008. As you can see, income-yielding asset classes experienced larger losses. b) Overweighting high-yield asset classes invariably increases concentration risk and reduces diversification in the portfolio. c) There’s some empirical evidence to suggest that high dividend stocks tend to outperform over the very long term. This is essentially known as ‘value premium.’

Commodities and alternatives What about other asset classes? Many people have questioned whether including other asset classes like commercial property and commodities improves withdrawal rates. We can’t make an assertion one way or the other, because historical records for these asset classes don’t go back far enough. Cassaday (2006)50 indicated that adding other asset classes, such as REITs, commodities and international exposures, potentially has a positive impact on sustainable withdrawal rates. However, this research was limited in its scope; the authors only used US historical data since 1972 and assumed 3% static inflation. So, the period covered in the research excluded some of the more severe periods like the early 1900s and 1936. It’s not clear whether these asset classes would add much value under such stressful market conditions.

This is the question One common question is around the impact of global diversification on SWR. We’ve known for some time that most investors exhibit a strong degree of home bias and allocate a higher proportion of their portfolio to their home market. But, the benefit of global diversification is generally accepted in the investment community. So, what’s the impact of global asset allocation on SWR? Pfau 201449 conducted perhaps the most extensive study on the impact of global diversification on SWR. He calculated the local currency returns on stocks and bonds in 20 different nations for the same global portfolio. The portfolio consisted of the 20 countries in the dataset. This allowed for 20 different perspectives on the role of international diversification. Previous studies on withdrawals rates with international diversification have only looked within the context of US-based investors.


Mastering Private Equity by Zeisberger, Claudia,Prahl, Michael,White, Bowen, Michael Prahl, Bowen White

asset allocation, backtesting, barriers to entry, Basel III, business process, buy low sell high, capital controls, carried interest, commoditize, corporate governance, corporate raider, correlation coefficient, creative destruction, discounted cash flows, disintermediation, disruptive innovation, distributed generation, diversification, diversified portfolio, family office, fixed income, high net worth, information asymmetry, intangible asset, Lean Startup, market clearing, passive investing, pattern recognition, performance metric, price mechanism, profit maximization, risk tolerance, risk-adjusted returns, risk/return, shareholder value, Sharpe ratio, Silicon Valley, sovereign wealth fund, statistical arbitrage, time value of money, transaction costs

Family offices and endowment funds have lower liquidity needs and on average make substantial, double-digit allocations to the asset class. Exhibit 18.2 shows PE target allocations as a percentage of AUM for different types of institutional investors over the years. Exhibit 18.2 PE Target Allocation by Investor Type Source: Preqin DIVERSIFICATION: The degree of diversification within a PE portfolio and specific allocation decisions depend on an LP’s risk appetite, its target return for the asset class and the resources available to build and manage a PE portfolio. LPs diversify their PE allocation across a range of factors including manager, investment strategy (venture, growth, buyouts), geography, industry and vintage year. Aside from the “risk smoothing” common to all diversification efforts, allocation across vintage years in particular helps create a steadier investment program, especially in light of the J-curve effect from individual fund allocations.

Exhibit 5.4 Real Assets Project Stage Mature real assets provide not only a steady dividend stream but also diversification benefits to any investment portfolio given their historically uncorrelated returns with other asset classes. This has made them an attractive target for large institutional investors with a long-term investment horizon and an appetite for cash distributions to offset regular funding demands from their investment programs. Real asset investments also provide an effective hedge against inflation, as the real asset pricing risk is effectively transferred to the consumer. Sovereign wealth funds and pension plans have also begun to invest directly6 in mature infrastructure and real estate projects, thereby competing with the general partners at PE firms. It is therefore little surprise that the assets under management in the alternative asset classes listed below have grown steadily in recent years.7 REAL ESTATE: Real estate funds employ three main strategies—core-plus, value-add and opportunistic—and invest across the four main subsectors of real estate: residential, office, retail and industrial properties.

Benefits of Investing in the PE Asset Class RETURNS AND ALPHA: By foregoing exposure to PE, investors may miss out on alpha or excess returns over a market portfolio. Top-quartile PE funds in particular have produced robust and consistently superior performance relative to other asset classes in the past and have done so over different market cycles. Exhibit 18.1 compares the 5-, 10- and 15-year returns generated by the broad PE asset class with those of public equity and global bond markets.2 Exhibit 18.1 PE in an Institutional Investor's Portfolio Source: Bloomberg, INSEAD-Pevara, Author Analysis CORRELATION AND DIVERSIFICATION: In theory, adding a PE allocation—and therefore exposure to the private, unlisted companies in PE funds—to a broad portfolio will diversify an LP’s source of returns and, in turn, reduce portfolio volatility and the overall risk of a large negative performance move. This argument needs to be carefully tested against an investor’s existing portfolio with the result naturally depending on the correlation between its existing investments and the PE funds it targets.


pages: 504 words: 139,137

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

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, business cycle, buy and hold, 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, stocks for the long run, stocks for the long term, 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

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

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

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


pages: 416 words: 118,592

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

accounting loophole / creative accounting, Albert Einstein, asset allocation, asset-backed security, backtesting, beat the dealer, Bernie Madoff, BRICs, butter production in bangladesh, buy and hold, capital asset pricing model, compound rate of return, correlation coefficient, Credit Default Swap, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, dogs of the Dow, 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, stocks for the long run, survivorship bias, The Myth of the Rational Market, the rule of 72, The Wisdom of Crowds, transaction costs, Vanguard fund, zero-coupon bond

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

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

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


Trading Risk: Enhanced Profitability Through Risk Control by Kenneth L. Grant

backtesting, business cycle, buy and hold, commodity trading advisor, correlation coefficient, correlation does not imply causation, delta neutral, diversification, diversified portfolio, fixed income, frictionless, frictionless market, George Santayana, implied volatility, interest rate swap, invisible hand, Isaac Newton, John Meriwether, Long Term Capital Management, market design, Myron Scholes, performance metric, price mechanism, price stability, risk tolerance, risk-adjusted returns, Sharpe ratio, short selling, South Sea Bubble, Stephen Hawking, the scientific method, The Wealth of Nations by Adam Smith, transaction costs, two-sided market, value at risk, volatility arbitrage, yield curve, zero-coupon bond

For example, if you are trading equities, you can assume that in order to achieve a meaningful level of diversification, it will be necessary to hold positions across a number of industries—ideally those that are subject to different business cycles. Similarly, if you are trading commodities, a portfolio of materially different asset classes (e.g., grains and energies) is likely to generate higher levels of diversification than one that is focused in a single set of “substitutable” product types (e.g., wheat and corn). These dynamics also carry forward to the remaining segments of global capital markets, most notably fixed income and foreign exchange. In addition, it is important to be aware of the actual, statistically observable correlations among the securities you are trading, which will be inversely related to the level of diversification you are able to achieve in your portfolio.

However, it is still possible for longterm investors to use holding periods as a means of controlling exposures, specifically by increasing and decreasing their position sizes around the anticipated release of economic information that may be pertinent to their position profile, as suggested earlier. DIVERSIFICATION One proven way to control portfolio exposure is through the manipulation of diversification. While the mathematics of this concept are vague at best, the idea itself is intuitive: The more diverse the portfolio, the lower its risk profile. In turn, diversification itself can be diffused into two separate components: (1) the number of securities included in a given portfolio, and (2) the similarity of the pricing characteristics across these securities. As is the case with the other methods to adjust portfolio exposure, diversification can be used as a tool for two-way risk control, allowing investors to adjust their risk profiles upward or downward as the specific situation requires.

In addition (and at the risk of stating the obvious), the more positions you have in 146 TRADING RISK your portfolio, the more work you have to do with respect to both analysis and position management; and this implies a diminishing edge with every incremental position that you add in the name of diversification. Presumably, if diversification never enters your mind, you will only put on trades that you believe have met the full measure of your criteria for effective return generation. As you add positions in order to diversify, by definition, you begin to relax these criteria. At some point, this will begin to cut into your profit profile; and in extreme cases, you run the risk of obliterating any opportunities you might have otherwise had to make money from your original investment hypothesis. For these reasons, I suggest that you establish a base level of positions that you are comfortable managing and increase/decrease your diversification levels by nominal amounts as a means of adjusting your exposure at the margin.


pages: 482 words: 121,672

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

accounting loophole / creative accounting, Albert Einstein, asset allocation, asset-backed security, beat the dealer, Bernie Madoff, bitcoin, butter production in bangladesh, buttonwood tree, buy and hold, capital asset pricing model, compound rate of return, correlation coefficient, Credit Default Swap, Daniel Kahneman / Amos Tversky, Detroit bankruptcy, diversification, diversified portfolio, dogs of the Dow, Edward Thorp, Elliott wave, Eugene Fama: efficient market hypothesis, experimental subject, feminist movement, financial innovation, financial repression, fixed income, framing effect, George Santayana, 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, stocks for the long run, survivorship bias, the rule of 72, The Wisdom of Crowds, transaction costs, Vanguard fund, zero-coupon bond, zero-sum game

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

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

It is easy to carry the lessons of this illustration to actual portfolio construction. Suppose you were considering combining Ford Motor Company and its major supplier of new tires in a stock portfolio. Would diversification be likely to give you much risk reduction? Probably not. If Ford’s sales slump, Ford will be buying fewer new tires from the tire manufacturer. In general, diversification will not help much if there is a high covariance (high correlation) between the returns of the two companies. On the other hand, if Ford was combined with a government contractor in a depressed area, diversification might reduce risk substantially. If consumer spending is down (or if oil prices skyrocket), Ford’s sales and earnings are likely to be down and the nation’s level of unemployment up. If the government makes a habit during times of high unemployment of giving out contracts to the depressed area (to alleviate some of the unemployment miseries there), it could well be that the returns of Ford and those of the contractor do not move in phase.


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

asset allocation, buy and hold, 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

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

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

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


pages: 433 words: 53,078

Be Your Own Financial Adviser: The Comprehensive Guide to Wealth and Financial Planning by Jonquil Lowe

AltaVista, asset allocation, banking crisis, BRICs, buy and hold, correlation coefficient, cross-subsidies, diversification, diversified portfolio, estate planning, fixed income, high net worth, money market fund, mortgage debt, mortgage tax deduction, negative equity, offshore financial centre, Own Your Own Home, passive investing, place-making, Right to Buy, risk/return, short selling, zero-coupon bond

The ideal for investors is to combine asset classes that have low or negative correlations, say, less than 0.5. The global financial crisis that hit the world in 2007 demonstrated that, in some situations, the relative independence of the asset classes can break down, with all delivering poor performance simultaneously. Even before M10_LOWE7798_01_SE_C10.indd 300 05/03/2010 09:51 10 n Managing your wealth 301 this, investment professionals have been on the hunt for new asset classes and it is variously claimed that gold (see p. 331), art (see p. 332), hedge funds (see p. 328) and a variety of other investments all fit the bill. In practice, it is not always clear that they do provide the benefits of diversification that are claimed. For example, the global crisis cast doubts on the ability of hedge funds to deliver uncorrelated returns.

We upheld this complaint on the grounds that the firm’s advice had been inappropriate and had exposed Mr M to too great a degree of financial risk, in view of his circumstances. Source: Financial Ombudsman Service, Ombudsman News, March 2003. M10_LOWE7798_01_SE_C10.indd 294 05/03/2010 09:51 10 n Managing your wealth 295 Diversification At its simplest, diversification means: don’t put all your eggs in one basket. However, underlying this statement is a tricky question: if not one basket, what others should you should use? Diversification can mean choosing a range of investments (see below), a range of asset classes (see p. 299) and also a range of timing (see p. 304). Investment diversification Chapter 9 suggests that, for superior returns over the long term, you need to look at investing in shares (equities). Which shares should you choose and how many companies should you invest in? Suppose you invest £10,000 in the shares of Taylor Wimpey (a house builder) and the price falls by 10 per cent, you will make a loss of £1,000.

You can compare betas for shares only in the same market. Betas calculated relative to different stock-market indices are not comparable. Asset allocation Although investment diversification has been described above in the context of shares, it applies equally to any other type of investment that is traded on a market, such as bonds and even residential property (see the discussion of buy-to-let on p. 330). Diversification also applies across the boundaries of different investments. Just as combining uncorrelated or weakly correlated shares reduces risk for any given level of return, combining different types of investments – called asset classes – also improves the risk-return balance, provided the classes are uncorrelated or only 3 www.advfn.com. Accessed 3 October 2009. 4 www.advfn.com. Accessed 3 October 2009.


pages: 280 words: 79,029

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

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, longitudinal study, 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 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, Thales of Miletus, transaction costs, Tunguska event, unbanked and underbanked, underbanked, Vanguard fund, web application

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

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

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


Work Less, Live More: The Way to Semi-Retirement by Robert Clyatt

asset allocation, backtesting, buy and hold, delayed gratification, diversification, diversified portfolio, employer provided health coverage, estate planning, Eugene Fama: efficient market hypothesis, financial independence, fixed income, future of work, index arbitrage, index fund, lateral thinking, Mahatma Gandhi, McMansion, merger arbitrage, money market fund, mortgage tax deduction, passive income, rising living standards, risk/return, Silicon Valley, Thorstein Veblen, transaction costs, unpaid internship, upwardly mobile, Vanguard fund, working poor, zero-sum game

Investment Terminology Explained For many people, one of the mystifying things about the investment world is the strange language spoken there. Here are some simple definitions for common terms and strategies, along with some basic advice for building your own autopilot along Rational Investing principles. Asset classes are types of financial instruments broken into logical groups—for example, small U.S. stocks, large U.S. value stocks, foreign medium-term bonds, commercial real estate, commodities. Diversification means owning different securities within an asset class, as well as owning several different asset classes. When one asset class tends to go up when another generally goes down or sideways, this pair of asset classes are said to be less correlated. Including both in a portfolio will make it less volatile—its value will move more like an ocean liner than a speedboat. chapter 3 | Put Your Investing on Autopilot | 167 Fees.

During good times, the fund underperforms the index; during bad times, its better-quality bonds hold up better than those in the index. This may be a tradeoff you would feel comfortable making. In other cases, such as the private equity, oil and gas, market neutral hedge fund, and even commercial real estate asset classes, the fullest diversification and best returns may come, paradoxically, by moving outside the universe of indexes and funds entirely and making individual, illiquid investments—that is, investments in carefully researched private companies, partnerships, or buildings which cannot be readily sold. Later in the chapter, you will find a list of good choices of index and other funds for each asset class. Choose from among these and compare them to other favorite or new funds as you set about implementing the Rational Investing Method for yourself. chapter 3 | Put Your Investing on Autopilot | 185 TiP Not all index funds are created equal.

With just eight funds and a money market account, you can achieve substantial diversification while meeting all of the Rational Investing goals. Your expected return, measured since 1988 at 8.6%, will undershoot that of the Rational Investing portfolio, with about the same standard deviation of 6.7%, but you will be on firm ground going forward and have a “real portfolio” to tend and rebalance. Perhaps most important, you will be able to easily implement this portfolio within a single brokerage or mutual fund account. The Sandwich portfolio will get you coverage of all the major asset classes in percentages roughly similar to those in the Rational 190 | Work Less, Live More Investing portfolio. Missing will be just four of the 16 asset classes: commodities, high-yield, private equity, and market neutral hedge funds.


pages: 385 words: 128,358

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

Albert Einstein, asset allocation, Berlin Wall, Bonfire of the Vanities, Bretton Woods, business cycle, buy and hold, buy low sell high, capital controls, central bank independence, 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

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

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

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


pages: 192 words: 72,822

Freedom Without Borders by Hoyt L. Barber

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

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

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

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


pages: 305 words: 98,072

How to Own the World: A Plain English Guide to Thinking Globally and Investing Wisely by Andrew Craig

Airbnb, Albert Einstein, asset allocation, Berlin Wall, bitcoin, Black Swan, bonus culture, BRICs, business cycle, collaborative consumption, diversification, endowment effect, eurozone crisis, failed state, Fall of the Berlin Wall, financial deregulation, financial innovation, index fund, information asymmetry, joint-stock company, Joseph Schumpeter, Long Term Capital Management, low cost airline, mortgage debt, negative equity, Northern Rock, offshore financial centre, oil shale / tar sands, oil shock, passive income, pensions crisis, quantitative easing, road to serfdom, Robert Shiller, Robert Shiller, Silicon Valley, smart cities, stocks for the long run, the new new thing, The Wealth of Nations by Adam Smith, Yogi Berra, Zipcar

As we shall see, over time it is actually best to own a mixture of all the above types of financial vehicle. If you only have property, there is a risk you will fail to become wealthy in your lifetime. To give yourself the best chance of becoming truly wealthy, you need to ensure that you are aware of, and are exposed to, the other asset classes – particularly shares, bonds and commodities. General considerations common to all asset classes Each of the above types of investment vehicle has certain individual characteristics, but the two most important considerations when we look at any of them are: How safe your money is when invested in that asset class. What sort of percentage return you might expect to make. Put another way, when we consider the relative merits of an investment vehicle or financial product, we are concerned with both the return of our money and the return on our money.

If the market or the sector has gone up 20 per cent in two months and your analysis tells you that this might correct, then you might wait a little longer before buying your shares. Fundamental analysis of other asset classes We have just had a very quick look at the idea of using fundamental analysis to find a good company to invest in. It may be obvious to you that the metrics we used to look at shares cannot be applied to the other asset classes. Bonds, property and commodities have their own distinct characteristics and we must evaluate them in a different way as a result. As such, it is worth saying a little bit about how we might perform a fundamental analysis of each of the other asset classes. BONDS We looked at the basics of what a bond is in chapter 7. A bond does not have a P/E ratio or book value. What a bond does have, however, are two fundamentally important metrics: credit quality and yield.

This means that there are relatively few who are able, or even inclined, to see the big picture – and it is truly the big picture that you need for consistent investment success. Many investment professionals are just like doctors who tell you how bad drinking and smoking are and then nip to the pub for several drinks and a few cigarettes at the end of their day. Over the years, I have lost count of the number of smart City folk I know who have all their money in the one asset class they know about, with the result that they are heavily punished during any bad year for that asset class. At the risk of being a little on the repetitive side, I must reiterate that one of the most successful investing strategies over many years is being properly diversified. This means that you should ensure you own a wide variety of assets rather than just shares or just property, for instance. To repeat an example but to make a subtly different point, you will recall that over the last fifteen years or so gold has performed exceptionally well (even accounting for its weakness more recently).


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MONEY Master the Game: 7 Simple Steps to Financial Freedom by Tony Robbins

3D printing, active measures, activist fund / activist shareholder / activist investor, addicted to oil, affirmative action, Affordable Care Act / Obamacare, Albert Einstein, asset allocation, backtesting, bitcoin, buy and hold, clean water, cloud computing, corporate governance, corporate raider, correlation does not imply causation, Credit Default Swap, Dean Kamen, declining real wages, diversification, diversified portfolio, Donald Trump, estate planning, fear of failure, fiat currency, financial independence, fixed income, forensic accounting, high net worth, index fund, Internet of things, invention of the wheel, Jeff Bezos, Kenneth Rogoff, lake wobegon effect, Lao Tzu, London Interbank Offered Rate, market bubble, money market fund, mortgage debt, new economy, obamacare, offshore financial centre, oil shock, optical character recognition, Own Your Own Home, passive investing, profit motive, Ralph Waldo Emerson, random walk, Ray Kurzweil, Richard Thaler, risk tolerance, riskless arbitrage, Robert Shiller, Robert Shiller, self-driving car, shareholder value, Silicon Valley, Skype, Snapchat, sovereign wealth fund, stem cell, Steve Jobs, survivorship bias, telerobotics, the rule of 72, thinkpad, transaction costs, Upton Sinclair, Vanguard fund, World Values Survey, X Prize, Yogi Berra, young professional, zero-sum game

At his core, Swensen is an inventor and a disruptor. His Yale model, also known as the endowment model, was developed with his colleague and former student Dean Takahashi, and is an application of modern portfolio theory. The idea is to divide a portfolio into five or six roughly equal parts and invest each in a different asset class. The Yale model is a long-term strategy that favors broad diversification and a bias toward equities, with less emphasis on lower-return asset classes such as bonds or commodities. Swensen’s position on liquidity has also been called revolutionary—he avoids rather than chases liquidity, arguing that it leads to lower returns on assets that could otherwise be invested more efficiently. Before his days as the rock star of institutional investing, Swensen worked on Wall Street for bond powerhouse Salomon Brothers.

You not only have to diversify between your Security and your Risk/Growth Buckets, but within them as well. As Burton Malkiel shared with me, you should “diversify across securities, across asset classes, across markets—and across time.” That’s how you truly get a portfolio for all seasons! For example, he says you want to invest not only in both stocks and bonds but also in different types of stocks and bonds, many of them from different markets in different parts of the world. (We’ll talk about diversifying across time in chapter 4.4, “Timing Is Everything?”) And, most experts agree, the ultimate diversification tool for individual investors is the low-fee index fund, which gives you the broadest exposure to the largest numbers of securities for the lowest cost. “The best way to diversify is to own the index, because you don’t have to pay all these fees,” David Swensen told me.

That’s one of the beauties of the index fund, and it’s one of the wonderful things Jack Bogle did for investors in America. He gave them the opportunity in a low-cost way to buy the whole market. But from an asset-allocation perspective, when we talk about diversification, we’re talking about investing in multiple asset classes. There are six that I think are really important and they are US stocks, US Treasury bonds, US Treasury inflation-protected securities [TIPS], foreign developed equities, foreign emerging-market equities, and real estate investment trusts [REITs]. TR: Why do you pick those six versus others? And what’s your portfolio allocation? DS: Equities are the core for portfolios that have a long time horizon. Equities are obviously riskier than bonds. If the world works the way it’s supposed to work, equities will produce superior returns.


pages: 353 words: 88,376

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

Albert Einstein, asset allocation, asset-backed security, Brownian motion, business cycle, business process, buy and hold, 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, dogs of the Dow, equity premium, fixed income, implied volatility, index fund, intangible asset, interest rate swap, inventory management, London Interbank Offered Rate, margin call, 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

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

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

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


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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

activist fund / activist shareholder / activist investor, Admiral Zheng, banking crisis, Basel III, Bernie Madoff, Black Swan, buy and hold, 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, Kickstarter, light touch regulation, London Whale, Long Term Capital Management, moral hazard, Myron Scholes, Northern Rock, passive investing, performance metric, Ponzi scheme, post-work, principal–agent problem, rent-seeking, Ronald Coase, shareholder value, Silicon Valley, South Sea Bubble, sovereign wealth fund, statistical model, Steve Jobs, the market place, The Wealth of Nations by Adam Smith, transaction costs, Upton Sinclair, value at risk, WikiLeaks

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

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

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


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Cryptoassets: The Innovative Investor's Guide to Bitcoin and Beyond: The Innovative Investor's Guide to Bitcoin and Beyond by Chris Burniske, Jack Tatar

Airbnb, altcoin, asset allocation, asset-backed security, autonomous vehicles, bitcoin, blockchain, Blythe Masters, business cycle, business process, buy and hold, capital controls, Carmen Reinhart, Clayton Christensen, clean water, cloud computing, collateralized debt obligation, commoditize, correlation coefficient, creative destruction, Credit Default Swap, credit default swaps / collateralized debt obligations, cryptocurrency, disintermediation, distributed ledger, diversification, diversified portfolio, Donald Trump, Elon Musk, en.wikipedia.org, Ethereum, ethereum blockchain, fiat currency, financial innovation, fixed income, George Gilder, Google Hangouts, high net worth, Jeff Bezos, Kenneth Rogoff, Kickstarter, Leonard Kleinrock, litecoin, Marc Andreessen, Mark Zuckerberg, market bubble, money market fund, money: store of value / unit of account / medium of exchange, moral hazard, Network effects, packet switching, passive investing, peer-to-peer, peer-to-peer lending, Peter Thiel, pets.com, Ponzi scheme, prediction markets, quantitative easing, RAND corporation, random walk, Renaissance Technologies, risk tolerance, risk-adjusted returns, Robert Shiller, Robert Shiller, Ross Ulbricht, Satoshi Nakamoto, Sharpe ratio, Silicon Valley, Simon Singh, Skype, smart contracts, social web, South Sea Bubble, Steve Jobs, transaction costs, tulip mania, Turing complete, Uber for X, Vanguard fund, WikiLeaks, Y2K

The point is not to bash regulators but to show how hard it is to classify a brand-new asset class, especially when it is the first digital native asset class the world has seen. WHAT IS AN ASSET CLASS, ANYWAY? While people accept that equities and bonds are the two major investment asset classes, and others will accept that money market funds, real estate, precious metals, and currencies are other commonly used asset classes,4 few bother to understand what is meant by an asset class in the first place. Robert Greer, vice president of Daiwa Securities, wrote “What Is an Asset Class, Anyway?”5 a seminal paper on the definition of an asset class in a 1997 issue of The Journal of Portfolio Management. According to Greer: An asset class is a set of assets that bear some fundamental economic similarities to each other, and that have characteristics that make them distinct from other assets that are not part of that class.

See also The DAO Deloitte, 270 Demographics, 281 Derivatives, 219 Deutsche Bundesbank, 12 Devaluation, 116 Developers, 54 community and, 182 miners and, 112 rewards for, 60 software and, 194–198 Devil Take the Hindmost: A History of Financial Speculation (Chancellor), 138, 157 DigiCash, 34 Digital Asset Holdings, 25 Digital Currency Council, 243 Digital Currency Group (DCG), 231 Digital payment systems decentralization and, 35 ecash as, 34 Dimon, Jamie, 267 Discounting method risk and, 180 valuation and, 179–182 Disruption, xiv, 9 for incumbents, 271 portfolios and blockchains as, 263–277 public blockchains and, 21 resilience to, 65 technology and, 28, 264 Distributed ledger technology (DLT), 266, 269–270, 274 Distribution, 13–14, 42 Diversification cryptoassets and, 102–105 risk and, 101 Divestment, 271 DJIA. See Dow Jones Industrial Average DLT. See Distributed ledger technology DNS. See Domain naming service Documents, 258. See also Articles Dodd, David, 139 Dogecoin, 43–44 Dollar, U. S. (USD), 114 Bitcoin and, 122 Velocity of, 178 Domain naming service (DNS), 39 Domingos, Pedro, 19 Dow Jones Industrial Average (DJIA), 85, 87, 100 Duffield, Evan, 48, 49 Dutch East India Company, 121, 161 shares of, 141–142 Dutch Republic, 141, 143 Economics, 140 asset classes and, 111–120 The Economist, 143 Economy, 32 as global, 37 Internet and, 176 Edelman, Ric, 244–245 Education, 286 Efficient frontier, 71 correlation of returns and, 74–76 Emergency Economic Stabilization Act of 2008, 8 Encryption, 14 Endpoint sensitivity, 84 Enterprise Ethereum Alliance, 273 Equities, 76, 102, 116, 137 as asset class, 108, 110 ETC.

ETFS AND MUTUAL FUNDS ARE WRAPPERS, NOT ASSET CLASSES It should be noted that when we talk about asset classes we are not doing so in the context of the investment vehicle that may “house” the underlying asset, whether that vehicle is a mutual fund, ETF, or separately managed account. With the growth of financial engineering and securitization of nearly every asset—and especially with the growing popularity of ETFs—one may find every type of asset at some point housed within an ETF. For example, ETFs for bitcoin and ether are already in the filing process with the SEC. For the purpose of our definition of asset classes, we are distinguishing the asset class from the form within which they are traded. Delineating the separation between asset classes is no easy task. Greer gives us one solid point to distinguish assets, the economic similarities, but then leaves the rest to “characteristics that make them distinct.”


pages: 117 words: 31,221

Fred Schwed's Where Are the Customers' Yachts?: A Modern-Day Interpretation of an Investment Classic by Leo Gough

Albert Einstein, banking crisis, Bernie Madoff, corporate governance, discounted cash flows, diversification, fixed income, index fund, Long Term Capital Management, Northern Rock, passive investing, Ralph Waldo Emerson, random walk, short selling, South Sea Bubble, The Nature of the Firm, the rule of 72, The Wealth of Nations by Adam Smith, transaction costs, young professional

And even people who are good at business can be bad – frequently very bad – at investment, so avoid ‘hot tips’ from rich people who seem to be in the know. 20 DIVERSIFICATION ‘[The] claim is that by buying trust shares the modest investor is not forced to ‘put all his eggs in one basket’. This argument sounds a good deal more reasonable than it actually is.’ Small investors are generally advised to diversify – i.e. to spread their money across a range of investments – and it is often said that by investing in a unit trust or an investment trust you can obtain better diversification than you could on your own. This is of course true, because these funds control millions of pounds which they can spread across a very large number of different companies and, indeed, asset classes. DEFINING IDEA… Wide diversification is only required when investors do not understand what they are doing

DEFINING IDEA… Wide diversification is only required when investors do not understand what they are doing. ~ WARREN BUFFETT To understand diversification, let’s suppose there is an island with only two businesses, umbrellas and swimwear. When it rains, the umbrella company does well and when it is sunny, the swimwear company does well. The weather is unpredictable, so if you are completely invested in swimwear in a year when it rains all the time, your returns are going to be awful. By investing permanently in both the umbrella company and the swimwear company, you can be sure of making some kind of return whatever the weather – but it won’t be as much as, say, investing in the swimwear company in a year with no rain. What this doesn’t tell us is how much diversification we actually need. More diversification is not necessarily better for us. Suppose you bought a share in every company on a stock exchange, including the secondary markets where small, often iffy, companies are quoted.

Suppose you bought a share in every company on a stock exchange, including the secondary markets where small, often iffy, companies are quoted. You would then have a lot of diversification, you might think, but it would cost you a fortune in transaction fees. One celebrated theory, known as Modern Portfolio Theory, tells us that you don’t really need to do this because a holding of as few as 20 shares will give you the diversification you really need. The aim is really to diversify away the risk of something truly awful happening to your portfolio. When you diversify more than that, so the theory goes, all you are doing is reducing the returns you are likely to get without reducing the risk. So, for example, people who try to diversify by investing in lots of different unit trusts are wasting their time. As long as you have, say, £20,000 to invest, then you can obtain adequate diversification on your own. But if you don’t want the bother of managing your investments yourself, then by all means invest in a few unit trusts or investment trusts – remember, though, that some of them are highly specialised and therefore do not provide good diversification.


pages: 368 words: 145,841

Financial Independence by John J. Vento

Affordable Care Act / Obamacare, Albert Einstein, asset allocation, diversification, diversified portfolio, estate planning, financial independence, fixed income, high net worth, Home mortgage interest deduction, money market fund, mortgage debt, mortgage tax deduction, oil shock, Own Your Own Home, passive income, risk tolerance, the rule of 72, time value of money, transaction costs, young professional, zero day

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

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

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


pages: 333 words: 76,990

The Long Good Buy: Analysing Cycles in Markets by Peter Oppenheimer

"Robert Solow", asset allocation, banking crisis, banks create money, barriers to entry, Berlin Wall, Big bang: deregulation of the City of London, Bretton Woods, business cycle, buy and hold, Cass Sunstein, central bank independence, collective bargaining, computer age, credit crunch, debt deflation, decarbonisation, diversification, dividend-yielding stocks, equity premium, Fall of the Berlin Wall, financial innovation, fixed income, Flash crash, forward guidance, Francis Fukuyama: the end of history, George Akerlof, housing crisis, index fund, invention of the printing press, Isaac Newton, James Watt: steam engine, joint-stock company, Joseph Schumpeter, Kickstarter, liberal capitalism, light touch regulation, liquidity trap, Live Aid, market bubble, Mikhail Gorbachev, mortgage debt, negative equity, Network effects, new economy, Nikolai Kondratiev, Nixon shock, oil shock, open economy, price stability, private sector deleveraging, Productivity paradox, quantitative easing, railway mania, random walk, Richard Thaler, risk tolerance, risk-adjusted returns, Robert Shiller, Robert Shiller, Ronald Reagan, savings glut, secular stagnation, Simon Kuznets, South Sea Bubble, special economic zone, stocks for the long run, technology bubble, The Great Moderation, too big to fail, total factor productivity, trade route, tulip mania, yield curve

Note 1 The output gap is usually described as the amount by which the actual output of an economy falls short of its potential output. Chapter 4 Asset Returns through the Cycle Chapter 3 looks at how the equity market tends to deliver different returns across the phases of the cycle. It is also possible to illustrate a tendency for equities to vary their pattern of relative returns in comparison to other asset classes through the cycle, and for different asset classes to respond to both growth and inflation in different ways. These characteristics help to make diversification across assets such a useful tool in seeking to reduce risks in an investment portfolio over time. Assets across the Economic Cycle For example, one simple way of thinking about the relative performance of assets as an economic cycle matures is to look at their average monthly real returns in early and late phases of both an economic expansion and contraction (these are shown for the US in exhibit 4.1 in total real terms, adjusted for inflation).

At the time, equities did not look particularly cheap versus bonds, but over the following 5 years they significantly outperformed bonds, although this reflected the onset of the technology bubble. Although valuation is clearly not the only factor driving relative returns, it is nonetheless significant. The Impact of Diversification on the Cycle Because equities and bonds can move in different directions (although they do not always do so), or at least have different risk and volatility profiles, it is often considered wise to combine these two major asset classes when building a portfolio. In this way, the volatility can be reduced by reducing the impact of sharp corrections in equities (even if bond prices fall when equity prices do, they are likely to do so by a smaller degree) but typically aggregate returns would be lower. By the same token, this may reduce the upside returns in a portfolio.

Index 100 year bond 34 1920s, United States 148, 154, 157, 160 1945-1968, post-war boom 129–131 1960s ‘Nifty Fifty’ 114, 130–131, 233, 235 structural bear market 130 1970s Dow Jones 131 equity cycle 56 oil crisis 108 1980s bull markets 131–133 Dow Jones 15–16, 131–132 equity cycle 56–57 Japan 114, 148–149, 155–156, 158, 160–161, 162, 164 technology 12–15 1990s 16–17 Asia crisis 108, 133 equity cycle 57 S&P concentration 114 technology bubble 33, 93–94, 149–150, 156–157, 158–159, 161, 164 2000-2007 equity cycle 57 2007-2009 financial crisis 169–174 emerging markets 171–173 forecasting 19–21 growth vs. value company effects 94–96 impact 169–170 phases 171–174 quantitative easing 173–174, 178–179 sovereign debt 170, 171–173 structural bear market 110, 118–119 A accounting, bubbles 163–165 adjustment speed 74, 89–90 Akerflof, G.A. 23 American Telephone and Telegraph (AT&T) 154, 225, 235–236, 238 Asia crisis, 1998 108, 133 ASPF see Association of Superannuation and Pension Funds asset classes across phases 66–68 contractions and expansions 63–65 cyclical 83–89 defensive 83–89 diversification 42, 45–47, 178–179 growth 83–84, 90–96 and inflation 65–66, 70 levels of yield 74–76 relationship through cycle 68–76 returns across cycle 63–79 speed of adjustment 74 structural shifts 76–79 value 83–84, 90–96 see also bonds; commodities; equities Association of Superannuation and Pension Funds (ASPF) 77 AT&T see American Telephone and Telegraph austerity 239 Austria, 100 year bond 34 B bank margins 214–215 bear markets 49, 99–125 1960s 130 characteristics 100–106, 117–118 cyclical 105, 106–107 deflation 109, 113 duration 100–101, 106–111, 117 employment 121–124 event-driven 105, 107–109 false negatives 119–120 financial crisis 118–119 growth momentum 122–123 indicators 106, 108, 109–110, 119–125 inflation 101–103, 109, 121–122 interest rates 106, 111–113 prior conditions 121–124 private sector financial balance 124 profitability 115–117 recovery 101 risk indicator vs MSCI index 124–125 S&P 500 103–105 structural 105 triggers 101–105, 106, 108, 111 valuations 123 yield curve 122 behavioural factors 5, 22–25 Berlin Wall, fall of 133 Bernanke, B. 133 betas 65, 85 ‘Big Bang’ deregulation 12 Bing 237 Black Monday 16, 102, 148 Black Wednesday 16–17 ‘bond-like’ equities 96 bonds, 100 year 34 bond yields across phases 66–68, 72–76 current cycle 95–96, 191–193, 201–220 cyclical vs. defensive companies 87–88 and demographics 215–217 and equity valuations 72–76, 206–208 and growth companies 92–94 historical 43, 202 and implied growth 210–215 and inflation 65, 70 quantitative easing 173–174, 202–205 and risk asset demand 217–220 S&P 500 correlation 72–73 speed of adjustment 74, 89–90 ultra-low 201–220 and value companies 92–94 vs. dividends 78–79 vs. equities 43–45, 68–76, 78–79 Bretton Woods monetary system 102, 130–131 broadcast radio 154, 225 Bubble Act 147, 157 bubbles 143–165 1920s US 148, 154, 157, 160 1980s Japan 114, 148–149, 155–156, 158, 160–161, 162, 164 accounting 163–165 canal mania 152 characteristics 145–146 deregulation 157–159 easy credit 160–161 famous 145 financial innovation 158–159 government-debt-for-equity swaps 151–152 Mississippi Company 147, 151 ‘new eras’ 150–157 personal computers 155 psychology 144–145 radio manufacturing 154 railways 148, 152–154, 157, 160, 163 Shanghai composite stock price index 156 South Sea Company 147, 151, 153 structural bear markets 113 sub-prime mortgages 70, 102, 118, 133, 145, 159 technology, 1990s 33, 93–94, 149–150, 156–157, 158–159, 161, 164 tulip mania 146–147 valuations 161–162 bull markets 49, 127–142 characteristics 127–141 composition 138 cyclical 134–136 disinflation 131–133 duration 136–138, 139–141 equity performance 135–136 Great Moderation 133–134, 187–189 non-trending 138–141 post-war boom 129–131 quantitative easing 134 secular 127–134 United States 136 C canal mania 152 CAPE see cyclically adjusted price-to-earnings ratio capital investment, Juglar cycle 3 CDO see collateralised debt obligations characteristics bear markets 100–109, 111, 117–118 bubbles 145–146 bull markets 127–141 cyclical bear markets 106–107 event-driven bear markets 108–109 structural bear markets 111 China 15, 156 Cold War 14–15, 133 collateralised debt obligations (CDO) 159 commodities across phases 66–68 Kitchin cycle 3 composition of bull markets 138 concentration structural bear markets 115 and technology 238–240 contractions asset performance 63–65 mini cycles 60 see also recessions Cooper, M. 162 corporate debt 65, 110, 114, 160–161 corporate profitability bear markets 107, 115–117 current equity cycle 185–186 monetary policy 239 credit crunch 78–79, 170, 171 crowds, psychology of 21–22, 144–145 cult of the equity 77–78 current equity cycle 57–58, 167–240 bank profitability 214–215 bond yields 191–193 demographic shifts 215–217 drivers 179–180 earnings per share 195–196 employment and unemployment 183–185 equity valuations 206–208 ‘first mile problem’ 226–227 future expectations 246–247 global relative performance 193–196 growth momentum 174–178, 182–183, 227–231 growth and value companies 190–196, 239–240 implied growth 210–215 inflation 180–182, 203–205 interest rates 180–182, 239–240 Japan, lessons from 196–200 lessons from 244–245 market and economy incongruence 174–178 monetary policy 178–179, 201–205 opportunities 230–231 profitability 185–186 quantitative easing 202–205 returns 174–179 risk asset demand 217–220 structural changes 76–79, 93–96, 169–200 technology 189–190, 221–241 term premium collapse 204–205 ultra-low bond yields 201–220 valuations 233–235 volatility 187–189 cycles 1970s 56 asset returns 63–79 cyclical vs. defensive companies 85–89 equities 49–62 growth vs. value companies 90–96 investment styles 81–96 long-term returns 29–47 riding 11–27 sectors 83–85 valuations 53 cyclical bear markets 105, 106–107, 117, 118 vs. event-driven 109 cyclical bull markets 134–136 cyclical companies bond yields 193 inflation 88 sectors 83–84 vs. defensive 85–89 cyclical growth 83–84 cyclically adjusted price-to-earnings ratio (CAPE) 37–38, 44–45 cyclical value 83–84 D DDM see discounted dividend model debt levels bubbles 160–161 structural bear markets 110, 114 decarbonization 13 defensive companies 63–65 bond yields 193 inflation 88 Japan 198 sectors 83–84 vs. cyclical 85–89 defensive growth 83–84 defensive value 83–84 deflation bear markets 109, 113 Volker 102, 131 delivery solutions 226–227 demographics and zero bond yields 215–217 deregulation 12, 132–133, 157–159 derivative markets 158–159 design of policy 25–26 despair phase 50–52, 53, 55–56, 60, 66–68 cyclical vs. defensive companies 86, 88 growth vs. value companies 92 Dice, C. 161 Dimitrov, O. 162 discounted dividend model (DDM) 36, 69 discount rate 68 disinflation 131–133 disruption 1980s 12–15 current equity cycle 189–190, 221–241 electricity 226 historical parallels 222–227 printing press 223–224 railway infrastructure 224–227 telecoms 225–226 divergence, and technology 238–240 diversification 42, 45–47, 178–179 dividends asset yields 38–41, 69 reinvestment 38–40 value of future streams 209 vs. bonds 78–79 Dodd, D. 163, 164 domain registrations 12–13 dominance of technology 231–233 dotcoms 12–13, 33, 93–94, 102, 161, 237 Dow Jones 1970s 131 1980s 15–16, 131 Black Monday 16, 102, 148 Draghi, M. 17, 173 drivers of bull markets 138 current equity cycle 179–180 duration bear markets 100–101, 106–111, 117 bull markets 135–138, 139–141 cyclical bear markets 106–107, 117, 118 cyclical bull markets 135–136 dominance of technology 231–233 event-driven bear markets 108–109, 117–118 non-trending bull markets 139–141 structural bear markets 109–111, 117 term premia 204–205 DVDs 227 E earnings per share (EPS) bear markets 115–117 historical 189 since pre-financial crisis peak 195–196, 209–210 easy credit, and bubbles 160–161 ECB see European Central Bank Economic Recovery Act, 1981 132 efficient market hypothesis 4 electricity 226 email 13 employment 121–124, 183–185 Enron 164 environmental issues 13 EPS see earnings per share equities across phases 66–68 ‘bond-like’ 96 and bond yields 72–73, 74–76, 206–208 bull market performance 135–136 CAPE 37–38, 44–45 dividends 38–41, 69, 78–79, 209 and inflation 65–66, 70 mini/high-frequency cycles 58–61 narrowing and structural bear markets 114–115 overextension 36–37 phases of investment 50–58 quantitative easing 173–174, 178–179 S&P 500 historical performance 42 valuations and future returns 43–45 vs. bonds 43–45, 68–76, 78–79 equity cycle 49–62 1970s 56 1980s 56–57 1990s 57 2000-2007 57 current 57–58, 76–79 historical periods 56–58 length 49 mini/high-frequency 58–61 phases 50–56 structural shifts 76–79 equity risk premium (ERP) 35–38, 69–72, 210 ERM see exchange rate mechanism ERP see equ ity risk premium ESM see European stability mechanism Europe dividends 39–40 exchange rate mechanism 16–17, 111 Maastricht Treaty 17 market narrowing in 1990s 115 privatisation 132 quantitative easing 17, 204–205 sovereign debt crisis 170, 171–173 European Central Bank (ECB) 17, 171, 173 European Recovery Plan 129–131 European stability mechanism (ESM) 173 event-driven bear markets 105, 107–109, 117–118 vs. cyclical 109 excess see bubbles exchange rate mechanism (ERM) 16–17, 111 exogenous shocks 108 expansions, asset performance 63–65 F false negatives, bear markets 119–120 fat and flat markets 128, 139 features see characteristics Federal Reserve 16, 102, 131, 134, 150–151, 157, 203 financial crisis, 2007–2009 169–174 forecasting 19–21 growth vs. value company effects 94–96 impact 169–170 structural bear market 110, 118–119 financial innovation 158–159 ‘first mile problem’ 226–227 Fish, M. 19 fixed costs 84–85, 173–174 fixed income assets 35, 65, 69–70, 205 flat markets 138–141 see also non-trending bull markets forecasting 2008 financial crisis 19–21 bear markets 106, 108, 109–110, 119–125 behavioural aspects 22–25 difficulties of 18–22 future growth 211–212 neuroeconomics 24–25 and policy setting 25–26 recessions 20–21 and sentiment 21–25 short-term 17–18 weather 18–19 France Mississippi Company 147, 151 privatisation 132 Fukuyama, F. 15 future expectations 246–247 G Galbraith, J.K. 160 GATT see General Agreement on Tariffs and Trade General Agreement on Tariffs and Trade (GATT) 129 Germany Bund yield 207 fall of Berlin Wall 133 wage inflation 185 Glasnost 14 Glass-Steagall Act, 1933 132 global growth 182–183 globalisation 14–16 global relative performance 193–196 global sales growth 212 global technology bubble 33, 93–94, 149–150, 156–157, 158–159, 161, 164 Goetzmann, F. 151 ‘Golden Age of Capitalism’ 129–131 Gold Standard 130 see also Bretton Woods monetary system Goobey, G.R. 77 Google 237 Gorbachev, M. 14 Gordon Growth model 209 government-debt-for-equity swaps 151–152 Graham, B. 161, 163, 164 Great Britain South Sea Company 147, 151, 153 see also United Kingdom Great Depression 4 Great Moderation 133–134, 187–189 Greenspan, A. 16, 113, 150–151 gross domestic product (GDP) cyclical vs. defensive companies 87 labour share of 185, 238–239 phases of cycle 52–53 profit share of, US. 186 growth bear markets 122–123 current equity cycle 174–178, 182–183, 227–231 technology impacts 227–231 and zero bond yields 208–210, 210–215 growth companies bond yields 92–94, 191–193 current cycle 190–196 definition 90–91 since financial crisis 94–96 interest rates 92–94 outperformance 239–240 sectors 83–84 vs. value 90–96 growth phase 50–52, 54–56, 67–68 cyclical vs. defensive companies 86 growth vs. value companies 92 Gulf war 102 H herding 21–22, 144–145 high-frequency cycles 58–61 historical performance 10 year bonds, US 43 bonds 43, 202 equities cycles 49, 56–58 S&P 500 38–39, 42 trends 29–31 holding periods 31–34 Holland, tulip mania 146–147 hope phase 50–52, 53–54, 55–56, 66–67 cyclical vs. defensive companies 86 growth vs. value companies 92 housing bubble, US 70, 102, 118, 133, 145, 159 Hudson, G. 163 I IBM 13, 155, 236 IMAP see Internet Message Access Protocol IMF see International Monetary Fund impacts of diversification 42, 45–47 financial crisis, 2007-2009 169–170 technology on current cycle 221–241 ultra-low bond yields 201–220 Imperial Tobacco pension fund 77 implied growth 210–215 income, Kuznets cycle 3 indicators bear markets 106, 108, 109–110, 119–125 cyclical bear markets 106 event-driven bear markets 108 structural bear markets 109–110 industrial revolution 224–226 industry leadership, S&P 500 232–233, 237–238 inflation asset performance 65–66, 70 bear markets 101–103, 109, 121–122 current equity cycle 180–182, 203–205 cyclicals 88 Volker 102, 131 Institute of Supply Management index (ISM) 59–61 bear markets 123 cyclical vs. defensive companies 86–87 interest rates bear markets 106, 111–113 current equity cycle 180–182, 239–240 growth vs. value companies 92–94 structural bear markets 111–113 and yield 69, 74–76 International Monetary Fund (IMF) 129 internet 12–13, 225–227 search 237 see also dotcoms Internet Message Access Protocol (IMAP) 13 inventories 84–85 Kitchin cycle 3 investment, Juglar cycle 3 investment cycle bear markets 122–123 current 57–58, 76–79 historical periods 56–58 lengths 49 mini/high-frequency 58–61 phases 50–56 structural shifts 76–79 see also cycles ISM see Institute of Supply Management index J Japan bubbles 114, 148–149, 155–156, 158, 160–161, 162, 164 defensive companies 198 dividends 39–40 lessons from 196–200 John Crooke and Company 160 Juglar cycle 3 K Kahneman, D. 22–23 Kennedy Slide bear market 102 Keynes, J.M. 22 Kindleberger, C.P. 22 Kitchin cycle 3 Kondratiev cycle 3 Kuznets cycle 3 L labour share of GDP 185, 238–239 land and property bubble, Japan 114, 148–149, 155–156, 158, 160–161, 162, 164 laptop computers 13 largest companies S&P 500 237–238 technology 234–237 light touch regulation 157–159 see also deregulation Live Aid 13–14 Loewenstein, G. 21–22 long-term returns 29–47 M Maastricht Treaty 17 Mackay, C. 21 market forecasts short-term 17–18 see also forecasting market narrowing structural bear markets 114–115 and technology 238–240 markets current equity cycle 174–178 psychology of 21–25, 144–145 see also bear markets; bubbles; bull markets market timing 41–43 market value of technology companies 234, 235–238 Marks, H. 6–7 Marshall Plan 129–131 MBS see mortgage-backed securities Microsoft 12, 236–237 mini cycles 58–61 Mississippi Company 147, 151 monetary policy 157–159, 178–179, 201–205, 239 austerity 239 European Central Bank 17, 171, 173 Federal Reserve 16, 102, 131, 134, 150–151, 157, 203 quantitative easing 17, 70–71, 119, 133–134, 173–174, 178–179, 202–205 Montreal Protocol 13 mortgage-backed securities (MBS) 159 MSCI indices 91 N narrow equity markets 114–115, 238–240 NASDAQ 149–150, 161 negative bond yields 201–220 demographics 215–217 and equity valuations 206–208 and growth 208–210 implied growth 210–215 monetary policy 201–205 quantitative easing 202–205 risk asset demand 217–220 neuroeconomics 24–25 ‘new eras’ 113–114, 150–157 ‘Nifty Fifty’ 114, 233 non-trending bull markets 138–141 nudges 26 O oil 108, 226 opportunities, technology 230–231 optimism phase 50–52, 54–56, 67–68 cyclical vs. defensive companies 86 growth vs. value companies 91–92 output gaps 4 Outright Monetary Transactions (OMT) 171, 173 overextension 36–37 ozone layer 13 P pension funds 77, 218–219 Perestroika 14 Perez, C. 159 performance bull markets 134–136 current equity cycle 174–179 and cycles 53–56 diversification impacts 42, 45–47 dividends 38–41 equities vs. bonds 43–45 factors 41–45 historical trends 29–31 holding periods 31–34 interest rates 69, 74–76 long-term 29–47 market timing 41–43 risks and rewards 35–38 valuations 43–45 volatility 30–31 personal computing introduction 12–13, 155 phases 2007-2009 financial crisis 171–174 asset classes 66–68 bear markets 123 cyclical vs. defensive companies 86 of equities cycle 50–56 growth vs. value companies 91–92 Phillips curve 182 Plaza Accord, 1985 148–149, 158 PMI see purchasing managers’ index policy, design of 25–26 population decline 216 post-financial crisis see current equity cycle post-war boom 129–131 prediction see forecasting price-to-earnings ratio (P/E) 53–56 printing press 223–224 prior conditions to bear markets 121–124 private sector debt 65, 110, 114, 160–161 private sector financial balance 124 privatisation 132 productivity growth 227–230 profit labour share of 185, 238–239 share of GDP, US. 186 profitability banks 214–215 bear markets 107, 115–117 current equity cycle 185–186 property and land bubble, Japan 114, 148–149, 155–156, 158, 160–161, 162, 164 psychology bubbles 144–145 of markets 21–25 policy setting 25–26 public ownership 132 purchasing managers' index (PMI) 59–61, 86–87, 89–90 Q QE see quantitative easing Qualcom 149–150 quality companies 193 quantitative easing (QE) asset returns 70–71, 119, 178–179 bond yields 173–174, 202–205 start of 17, 133–134, 171 United Kingdom 17, 204–205 United States 134, 171, 202–204 R radio, expansion of 154, 225 Radio Corporation of America (RCA) 154 railways bubbles UK 148, 152–153, 157, 163 US 153–154, 160 infrastructure development 224–227 Rau, P. 162 RCA see Radio Corporation of America Reagan, R. 14, 131–132 real assets 68 real estate bubble, US 70, 102, 118, 133, 145, 159 recessions bear markets 101–103 current equity cycle 174–178 forecasting 20–21 recovery bear markets 101 current equity cycle 174–178 reinvestment of dividends 38–40 return on equity (ROE) 43–45 returns bull markets 134–136 current equity cycle 174–179 cycles 53–56 diversification impacts 42, 45–47 dividends 38–41 equities vs. bonds 43–45 factors 41–45 historical trends 29–31 holding periods 31–34 interest rates 69, 74–76 long-term 29–47 market timing 41–43 risks and rewards 35–38 valuations 43–45 volatility 30–31 reverse yield gap 77 risk assets, demand for 217–220 risk-free interest rate 68 risk indicators bear markets 119–125 event-driven bear markets 108 structural bear markets 110–111, 113–114 risk premia equity 35–38, 69 neuroeconomics 25 term premia 204–205 ROE see return on equity Rouwenhorst, G. 151 Russian debt default, 1997 108 S S&P 500 bear markets 103–105 and bond yields 72–73 concentration in 1990s 115 dividends 38–39 historical performance 38–39, 42 industry leadership 232–233, 237–238 and ISM 60 largest companies 237–238 US Treasury yields 206 sales growth 212 savings, current equity cycle 182 Schumpeter, J. 150 search companies 237 ‘search for yield’ 217–220 secondary-market prices 229–230 sectors across the cycle 83–85 dominance 231–233 secular bull market 127–134 disinflation 131–133 Great Moderation 133–134, 187–189 post-war boom 129–131 secular stagnation hypothesis 181 sentiment 5, 21–25 see also bubbles Shanghai composite stock price index 156 Shiller, R.J. 4–5, 23 short-term market forecasts 17–18 skinny and flat markets 139–140 smartphones 226, 229–230 Solow, R. 229 South Sea Company 147, 151, 153 sovereign debt crisis 170, 171–173 Soviet Union 14–15, 133 speed of adjustment 74, 89–90, 122–123 Standard Oil 235 structural bear markets 105, 109–115 1960s 130 bubbles 113 debt levels 110, 114 deflation 113 duration 109–111, 117 financial crisis, 2007 118–119 interest rates 111–113 narrow equity markets 114–115 ‘new eras’ 113–114 risk indicators 110–111, 113–114 triggers 111 volatility 105, 115 structural changes 6 1980s 12–15 current equity cycle 76–79, 93–96, 169–200 sub-prime mortgage bubble 70, 102, 118, 133, 145, 159 Summers, L. 181 Sunstein, C.R. 26 ‘super cycle’ secular bull market 127–134 see also secular bull market T technology 1920s America 154 bubble in 1990s 33, 93–94, 149–150, 156–157, 158–159, 161, 164 current equity cycle 189–190, 221–241 and disruption in 1980s 12–15 dominance 231–233 and growth 227–231 historical parallels 222–227 industrial revolution 224–226 Kondratiev cycle 3 largest companies 234–237 market value 234, 235–238 opportunities 230–231 personal computers 12–13, 155 printing press 223–224 railway bubbles 148, 152–154, 157, 160, 163 railway infrastructure 224–227 and widening gaps 238–240 telecommunications 13, 154, 225, 235–236, 238 telegrams 225 term premium collapse 204–205 TFP see total factor productivity growth Thaler, R.H. 26 Thatcher, M. 14, 132 Tokkin accounts 158 ‘too-big-to-fail’ 133 total factor productivity (TFP) growth 238–240 triggers bear markets 101–105, 106, 108, 111 cyclical bear markets 106 event-driven bear markets 108 structural bear markets 111 tulip mania 146–147 Tversky, A. 22–23 U ultra-low bond yields 201–220 demographics 215–217 and equity valuations 206–208 and growth 208–210 implied growth 210–215 monetary policy 201–205 quantitative easing 202–205 risk asset demand 217–220 UNCTAD see United Nations Conference on Trade and Development unemployment 121–124, 183–185 unexpected shocks 108 United Kingdom (UK) Black Wednesday 16–17 bond yields, historical 202 canal mania 152 deregulation 132 exchange rate mechanism 16–17, 111 privatisation 132 quantitative easing 204–205 railway bubble 148, 152–153, 157, 163 South Sea Company 147, 151, 153 United Nations Conference on Trade and Development (UNCTAD) 129 United States (US) 10 year bond returns 43 Black Monday 16, 102, 148 bull markets 136 credit crunch 78–79, 170, 171 disinflation 132 dividends 38–39 Dow Jones 15–16, 131 equities in current cycle 207–208 housing bubble 70, 102, 118, 133, 145, 159 labour share of GDP 185, 238–239 market narrowing 114 NASDAQ 149–150, 161 ‘Nifty Fifty’ 114, 130–131, 233, 235 post-war boom 129–131 profit share of GDP 186 quantitative easing 133–134, 171, 202–204 radio manufacturing 154, 225 railway bubble 153–154, 160 stock market boom, 1920s 148, 154, 157, 160 vs.


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Market Sense and Nonsense by Jack D. Schwager

3Com Palm IPO, asset allocation, Bernie Madoff, Brownian motion, buy and hold, collateralized debt obligation, commodity trading advisor, computerized trading, conceptual framework, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, 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

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

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

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


pages: 339 words: 109,331

The Clash of the Cultures by John C. Bogle

asset allocation, buy and hold, 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, post-work, 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

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

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

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


pages: 517 words: 139,477

Stocks for the Long Run 5/E: the Definitive Guide to Financial Market Returns & Long-Term Investment Strategies by Jeremy Siegel

Asian financial crisis, asset allocation, backtesting, banking crisis, Black-Scholes formula, break the buck, Bretton Woods, business cycle, buy and hold, buy low sell high, California gold rush, capital asset pricing model, carried interest, central bank independence, cognitive dissonance, compound rate of return, computer age, computerized trading, corporate governance, correlation coefficient, Credit Default Swap, Daniel Kahneman / Amos Tversky, Deng Xiaoping, discounted cash flows, diversification, diversified portfolio, dividend-yielding stocks, dogs of the Dow, equity premium, Eugene Fama: efficient market hypothesis, eurozone crisis, Everybody Ought to Be Rich, Financial Instability Hypothesis, fixed income, Flash crash, forward guidance, fundamental attribution error, housing crisis, Hyman Minsky, implied volatility, income inequality, index arbitrage, index fund, indoor plumbing, inflation targeting, invention of the printing press, Isaac Newton, joint-stock company, London Interbank Offered Rate, Long Term Capital Management, loss aversion, market bubble, mental accounting, money market fund, mortgage debt, Myron Scholes, new economy, Northern Rock, oil shock, passive investing, Paul Samuelson, Peter Thiel, Ponzi scheme, prediction markets, price anchoring, price stability, purchasing power parity, quantitative easing, random walk, Richard Thaler, risk tolerance, risk/return, Robert Gordon, Robert Shiller, Robert Shiller, Ronald Reagan, shareholder value, short selling, Silicon Valley, South Sea Bubble, sovereign wealth fund, stocks for the long run, survivorship bias, technology bubble, The Great Moderation, the payments system, The Wisdom of Crowds, transaction costs, tulip mania, Tyler Cowen: Great Stagnation, Vanguard fund

But correlations are usually calculated over relatively short periods of time, say one week or one month. Long-term correlations between asset returns are significantly lower than short-term correlations. This means that long-term investors should continue to diversify even though such diversification does not lead to significant reductions in the short term volatility of portfolio returns. Decreased Correlations In contrast to commodities, which have increased their correlation with stocks since the financial crisis, there are two notable asset classes whose returns have become significantly less correlated with equities: U.S. Treasury bonds and the U.S. dollar. The price of a dollar in foreign exchange markets is impacted by the strength of the U.S. economy and the safe-haven status that international investors accord the U.S. dollar.

Impact of the Financial Crisis on Asset Returns and Correlations One of the principal conclusions of financial theory is that to attain the best return for a given risk, investors should seek to diversify their holdings not only within an asset class but also among asset classes. For that reason investors put a premium on assets whose prices are negatively correlated with the market, and discount assets that are positively correlated with the market. Figure 3-3 shows the correlations of various asset classes with the S&P 500 over all five-year windows from 1970 through 2012. One can see that the financial crisis had a significant impact on the correlation between asset classes, in most cases accelerating trends that had taken place before the crisis. The correlation between both developed economies’ equity markets (EAFE) and emerging economies’ equity markets (EM) with the U.S. stock market has grown significantly, reaching 0.91 for EAFE and 0.85 for EM.

But this result begets the question: If faster growth is not the reason to buy international stocks, what is? DIVERSIFICATION IN WORLD MARKETS The reason for investing internationally is to diversify your portfolio and reduce risk. Foreign investing provides diversification in the same way that investing in different sectors of the domestic economy provides diversification. It would be poor investment strategy to pin your hopes on just one stock or one sector of the economy. Similarly it is not a good strategy to buy the stocks only in your own country, especially when developed economies are becoming an ever smaller part of the world’s market. International diversification reduces risk because the stock prices of different countries do not rise and fall in tandem, and this asynchronous movement of returns dampens the volatility of the portfolio.


pages: 701 words: 199,010

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

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

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

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

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


pages: 571 words: 105,054

Advances in Financial Machine Learning by Marcos Lopez de Prado

algorithmic trading, Amazon Web Services, asset allocation, backtesting, bioinformatics, Brownian motion, business process, Claude Shannon: information theory, cloud computing, complexity theory, correlation coefficient, correlation does not imply causation, diversification, diversified portfolio, en.wikipedia.org, fixed income, Flash crash, G4S, implied volatility, information asymmetry, latency arbitrage, margin call, market fragmentation, market microstructure, martingale, NP-complete, P = NP, p-value, paper trading, pattern recognition, performance metric, profit maximization, quantitative trading / quantitative finance, RAND corporation, random walk, risk-adjusted returns, risk/return, selection bias, Sharpe ratio, short selling, Silicon Valley, smart cities, smart meter, statistical arbitrage, statistical model, stochastic process, survivorship bias, transaction costs, traveling salesman

At some point, the condition number is so high that numerical errors make the inverse matrix too unstable: A small change on any entry will lead to a very different inverse. This is Markowitz's curse: The more correlated the investments, the greater the need for diversification, and yet the more likely we will receive unstable solutions. The benefits of diversification often are more than offset by estimation errors. Figure 16.1 Visualization of Markowitz's curse A diagonal correlation matrix has the lowest condition number. As we add correlated investments, the maximum eigenvalue is greater and the minimum eigenvalue is lower. The condition number rises quickly, leading to unstable inverse correlation matrices. At some point, the benefits of diversification are more than offset by estimation errors. Increasing the size of the covariance matrix will only make matters worse, as each covariance coefficient is estimated with fewer degrees of freedom.

The mathematical proof for HRP's outperformance over Markowitz's CLA and traditional risk parity's IVP is somewhat involved and beyond the scope of this chapter. In intuitive terms, we can understand the above empirical results as follows: Shocks affecting a specific investment penalize CLA's concentration. Shocks involving several correlated investments penalize IVP's ignorance of the correlation structure. HRP provides better protection against both common and idiosyncratic shocks by finding a compromise between diversification across all investments and diversification across clusters of investments at multiple hierarchical levels. Figure 16.7 plots the time series of allocations for the first of the 10,000 runs. Figure 16.7 (a) Time series of allocations for IVP. Between the first and second rebalance, one investment receives an idiosyncratic shock, which increases its variance. IVP's response is to reduce the allocation to that investment, and spread that former exposure across all other investments.

Let us review some of the stations involved in the chain of production within a modern asset manager. 1.3.1.1 Data Curators This is the station responsible for collecting, cleaning, indexing, storing, adjusting, and delivering all data to the production chain. The values could be tabulated or hierarchical, aligned or misaligned, historical or real-time feeds, etc. Team members are experts in market microstructure and data protocols such as FIX. They must develop the data handlers needed to understand the context in which that data arises. For example, was a quote cancelled and replaced at a different level, or cancelled without replacement? Each asset class has its own nuances. For instance, bonds are routinely exchanged or recalled; stocks are subjected to splits, reverse-splits, voting rights, etc.; futures and options must be rolled; currencies are not traded in a centralized order book. The degree of specialization involved in this station is beyond the scope of this book, and Chapter 1 will discuss only a few aspects of data curation. 1.3.1.2 Feature Analysts This is the station responsible for transforming raw data into informative signals.


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

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 cycle, business process, butter production in bangladesh, buy and hold, 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 Stallman, risk-adjusted returns, risk/return, shareholder value, Sharpe ratio, short selling, Silicon Valley, six sigma, sorting algorithm, statistical arbitrage, statistical model, stem cell, Steven Levy, stochastic process, systematic trading, technology bubble, The Great Moderation, the scientific method, too big to fail, trade route, transaction costs, transfer pricing, value at risk, volatility smile, Wiener process, yield curve, young professional

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

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

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


pages: 229 words: 61,482

The Gig Economy: The Complete Guide to Getting Better Work, Taking More Time Off, and Financing the Life You Want by Diane Mulcahy

Affordable Care Act / Obamacare, Airbnb, Amazon Mechanical Turk, basic income, Clayton Christensen, cognitive bias, collective bargaining, creative destruction, David Brooks, deliberate practice, diversification, diversified portfolio, fear of failure, financial independence, future of work, gig economy, helicopter parent, Home mortgage interest deduction, housing crisis, job satisfaction, Kickstarter, loss aversion, low skilled workers, Lyft, mass immigration, mental accounting, minimum wage unemployment, mortgage tax deduction, negative equity, passive income, Paul Graham, remote working, risk tolerance, Robert Shiller, Robert Shiller, Silicon Valley, Snapchat, TaskRabbit, Uber and Lyft, uber lyft, universal basic income, wage slave, Y Combinator, Zipcar

It’s also powerful to share our ideas. We can’t anticipate the ways that others can contribute to moving our ideas forward. The Risk of Over-Diversification One question to consider when building your portfolio of gigs is, how much is too much? How many gigs should you have? You want to be careful to realize the benefits of diversification but not over-diversify. The easiest way to think about diversification concretely is to use a simple financial example. If you had a total of $25,000 in savings, you wouldn’t invest it all in one company. There are too many reasons, none of which you can control or accurately predict, why the company could perform poorly, leaving you worse off. Lack of diversification is risky. But what happens if you over-diversify the portfolio and invest ten dollars each in 2,500 stocks? It turns out that over-diversifying can be just as bad; it may constrain your losses, but it also limits your gains.

The challenge for each of us is to find the right level of diversification for ourselves. Can We Diversify and Build Expertise? Diversification has connotations of breadth, but it can also be deployed for depth. Malcolm Gladwell asserts in his book Outliers that it takes at least 10,000 hours of deliberate practice to obtain mastery in a cognitively demanding field.3 But we can stretch out our 10,000 hours over the course of our lives, achieving mastery later in life. Or we can devote any single decade (i.e., our 20s, our 30s) to practice and mastery, which leaves many other decades left to dabble, explore, experiment, and pursue other interests. If we consider a long enough time horizon, we can achieve both mastery and variety. Diversification can also provide us with information to help us decide where to specialize.

It turns out that over-diversifying can be just as bad; it may constrain your losses, but it also limits your gains. Excess diversification eliminates the risk that any one company’s poor performance will tank the portfolio but also limits the gain you’ll realize from any outperformance. Over-diversified portfolios generate average returns that mirror, rather than outperform, the general market because the performance of any single stock doesn’t meaningfully impact the performance of the whole portfolio. We risk over-diversification if we spread ourselves too thin and do too much. If we over-diversify, we risk achieving less than we hoped and expected. We put ourselves in a low-risk, low-reward situation. We underinvest in every activity, which increases our risk of mediocre outcomes. It’s only worth making the investment in an activity if we can invest the right amount of time, energy, and attention to realize a meaningful reward.


pages: 478 words: 126,416

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

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, buy and hold, 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, disruptive innovation, 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 airline, low cost carrier, M-Pesa, market design, millennium bug, mittelstand, money market fund, moral hazard, mortgage debt, Myron Scholes, NetJets, 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, risk tolerance, road to serfdom, Robert Shiller, Robert Shiller, Ronald Reagan, Schrödinger's Cat, shareholder value, Silicon Valley, Simon Kuznets, South Sea Bubble, sovereign wealth fund, Spread Networks laid a new fibre optics cable between New York and Chicago, Steve Jobs, Steve Wozniak, The Great Moderation, The Market for Lemons, the market place, The Myth of the Rational Market, the payments system, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, Tobin tax, too big to fail, transaction costs, tulip mania, Upton Sinclair, Vanguard fund, Washington Consensus, We are the 99%, Yom Kippur War

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

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

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


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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

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

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

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


pages: 225 words: 61,388

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

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

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

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

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


pages: 320 words: 33,385

Market Risk Analysis, Quantitative Methods in Finance by Carol Alexander

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

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

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

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


pages: 272 words: 19,172

Hedge Fund Market Wizards by Jack D. Schwager

asset-backed security, backtesting, banking crisis, barriers to entry, beat the dealer, Bernie Madoff, Black-Scholes formula, British Empire, business cycle, buy and hold, 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, Jones Act, 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

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

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

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


pages: 357 words: 91,331

I Will Teach You To Be Rich by Sethi, Ramit

Albert Einstein, asset allocation, buy and hold, 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

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

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

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


pages: 467 words: 154,960

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

Albert Einstein, Atul Gawande, backtesting, beat the dealer, Bernie Madoff, Black Swan, buy and hold, 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, 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, William of Occam, zero-sum game

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

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

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


Concentrated Investing by Allen C. Benello

activist fund / activist shareholder / activist investor, asset allocation, barriers to entry, beat the dealer, Benoit Mandelbrot, Bob Noyce, business cycle, buy and hold, carried interest, Claude Shannon: information theory, corporate governance, corporate raider, delta neutral, discounted cash flows, diversification, diversified portfolio, Edward Thorp, family office, fixed income, high net worth, index fund, John von Neumann, Louis Bachelier, margin call, merger arbitrage, Paul Samuelson, performance metric, random walk, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, shareholder value, Sharpe ratio, short selling, survivorship bias, technology bubble, transaction costs, zero-sum game

The additional gains beyond 30 securities are minimal, and the costs of acquiring and monitoring those securities likely outweigh the benefits of any further risk reduction. When Buffett was asked by business students in 2008 about his views on portfolio diversification and position sizing, he responded that he had “two views on diversification:”13 If you are a professional and have confidence, then I would advocate lots of concentration. For everyone else, if it’s not your game, participate in total diversification. If it’s your game, diversification doesn’t make sense. It’s crazy to put money in your twentieth choice rather than your first choice. . . . [Berkshire vice-chairman] Charlie 96 Concentrated Investing [Munger] and I operated mostly with five positions. If I were running $50, $100, $200 million, I would have 80 percent in five positions, with 25 percent for the largest.

He believes that most securities are mostly appropriately valued, but the idea was taken to an unwarranted extreme:25 [T]he people that came up with the efficient market theory weren’t totally crazy, but they pushed their idea too far. The idea is roughly right with exceptions. When Buffett was asked by business students in 2008 about his views on portfolio diversification and position sizing, he responded that he had “two views on diversification:”26 If you are a professional and have confidence, then I would advocate lots of concentration. For everyone else, if it’s not your game, 208 Concentrated Investing participate in total diversification. If it’s your game, diversification doesn’t make sense. It’s crazy to put money in your twentieth choice rather than your first choice. . . . [Berkshire Vice‐Chairman] Charlie [Munger] and I operated mostly with five positions. If I were running $50, $100, $200 million, I would have 80 percent in five positions, with 25 percent for the largest.

While most other property and casualty insurers would invest 10 to 15 percent or less of the portfolio in equities, GEICO under Simpson held 35 to 45 percent of the portfolio in equities, and those positions were held in a concentrated manner. This high concentration meant that GEICO’s portfolio looked very little like its competitors’ portfolios. Insurance companies are institutions that must follow the “prudent man” rule—a legal maxim that precludes certain types of investments, and requires due diligence, and diversification. Most insurers interpreted the rule as requiring very broad diversification across portfolio assets. GEICO was unusual in choosing to interpret it as requiring minimal diversification, allowing it to concentrate instead.152 When the rating agencies questioned that practice, Simpson responded, “Well, so far it’s worked pretty well and hopefully it will continue to work well.”153 Though they were somewhat uncomfortable about the proportion of equities in the portfolio, and the concentration of those equities, the ratings agencies were mollified because the operating leverage of the company was so moderate.154 It was not the investment leverage that got GEICO into trouble in the 1970s, but the cost of its float.


pages: 304 words: 22,886

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

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, price discrimination, 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 reason is that stocks have significantly outperformed bonds over the time period he has been a professor. If he had invested most of his money in stocks, he would have done a lot better. Markowitz’s strategy can be viewed as one example of what might be called the diversification heuristic. “When in doubt, diversify.” Don’t put all your eggs in one basket. In general, diversification is a great idea, but there is a big difference between sensible diversification and the naïve kind. A special case of this rule of thumb is what might be called the “1/n” heuristic: “When faced with ‘n’ options, divide assets evenly across the options.”3 Put the same number of eggs in each basket. Naïve diversification apparently starts young. Consider the following clever experiment conducted by Daniel Read and George Loewenstein on Halloween night.4 The “subjects” were trick-or-treaters. In one condition, the children approached two adjacent houses and were offered a choice between the same two candy bars (Three Musketeers and Milky Way) at each house.

ERISA sets forth three fiduciary principles for retirement-plan investments: the exclusive benefit rule, requiring that plans be managed exclusively for the benefit of participants; the prudence rule, requiring that plan assets be invested according to a “prudent investor” standard; and the diversification rule, requiring that plan assets be diversified so as to minimize the risk of large losses. Most notably, company stock is exempted from the diversification requirement in defined-contribution plans—largely because, at the time ERISA was passed, large employers with profit-sharing plans lobbied Congress to exempt them from the diversification requirements imposed on defined-benefit plans.12 Employers are still expected to act prudently, however, in determining whether company stock is a suitable investment. Why did Congress give preferred standing to company stock?

Oxford: Clarendon, 1971. Read, Daniel, Gerrit Antonides, Laura Van Den Ouden, and Harry Trienekens. “Which Is Better: Simultaneous or Sequential Choice?” Organizational Behavior and Human Decision Processes 84 (2001): 54–70. Read, Daniel, and George Loewenstein. “Diversification Bias: Explaining the Discrepancy in Variety Seeking Between Combined and Separated Choices.” Journal of Experimental Psychology: Applied 1 (1995): 34–49. Read, Daniel, George Loewenstein, and Shobana Kalyanarama. “Mixing Virtue and Vice: Combining the Immediacy Effect and the Diversification Heuristic.” Journal of Behavioral Decision Making 12 (1999): 257–73. Read, Daniel, and B. Van Leeuwen. “Predicting Hunger: The Effects of Appetite and Delay on Choice.” Organizational Behavior and Human Decision Processes 76 (1998): 189–205. Redelmeier, Donald A., Joel Katz, and Daniel Kahneman.


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

asset allocation, buy and hold, 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

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

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

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


pages: 349 words: 134,041

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

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

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

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


pages: 224 words: 13,238

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

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

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

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

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


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

addicted to oil, asset allocation, backtesting, Black-Scholes formula, Bretton Woods, business cycle, buy and hold, 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, dogs of the Dow, equity premium, Eugene Fama: efficient market hypothesis, Everybody Ought to Be Rich, 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, stocks for the long run, survivorship bias, technology bubble, The Great Moderation, The Wisdom of Crowds, transaction costs, tulip mania, Vanguard fund

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

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

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


pages: 1,042 words: 266,547

Security Analysis by Benjamin Graham, David Dodd

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

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

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

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


pages: 244 words: 79,044

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

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, NetJets, new economy, Ponzi scheme, post-work, risk-adjusted returns, risk/return, shareholder value, Silicon Valley, six sigma, statistical arbitrage, Vanguard fund, zero-coupon bond

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

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

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


pages: 572 words: 94,002

Reset: How to Restart Your Life and Get F.U. Money: The Unconventional Early Retirement Plan for Midlife Careerists Who Want to Be Happy by David Sawyer

Airbnb, Albert Einstein, asset allocation, beat the dealer, bitcoin, Cal Newport, cloud computing, cognitive dissonance, crowdsourcing, cryptocurrency, David Attenborough, David Heinemeier Hansson, Desert Island Discs, diversification, diversified portfolio, Edward Thorp, Elon Musk, financial independence, follow your passion, gig economy, hiring and firing, index card, index fund, invention of the wheel, knowledge worker, loadsamoney, low skilled workers, Mahatma Gandhi, Mark Zuckerberg, meta analysis, meta-analysis, mortgage debt, passive income, passive investing, Paul Samuelson, pension reform, risk tolerance, Robert Shiller, Robert Shiller, Ronald Reagan, Silicon Valley, Skype, smart meter, Snapchat, stakhanovite, Steve Jobs, Tim Cook: Apple, Vanguard fund, Y Combinator

Vanguard UK doesn’t offer a property fund (otherwise you could use it as well), swapping iShares Emerging Markets for the Vanguard-equivalent fund. Note the global property securities fund. If you do want to invest in property, a real estate fund (compared with buying property yourself) is a no-hassle risk-diversified way to invest in this asset class. Pros: low-cost, for such specialised funds; safer, because of bonds; globally diversified; targets asset classes that outperform the market historically, eg, small-caps; you can copy Monevator. Cons: UK weighting in line with MSCI World Index at 6%, not the 25% suggested in the RESET portfolio and baked in to Vanguard’s LifeStrategy 100 fund. Bonds up at 35% decreases potential returns in the stash-building phase. D. Bogleheads’ three-fund portfolio The Bogleheads are a vibrant, mainly online – but also physical, with 60 chapters worldwide[401] – community of individuals who love passive investing and Jack Bogle.

During what he calls the “wealth accumulation stage”, he recommends investing in one fund only: the Vanguard Total Stock Market Index fund (VTSAX), arguing because of the large number of worldwide companies that generate more than 50% of their profits from overseas in this fund, this provides all the global diversification you need[395]. Writing in 2011, Pete Adeney recommended a similar approach[396]. RESET View A simple low-cost approach aimed at US investors. The equivalent UK fund is the Vanguard FTSE UK All Share – Acc, which offers similar international diversification. Nevertheless, placing all your eggs in one UK basket – however international the constituent members of the FTSE All Share index – is not recommended. B. Goldberg five funds Another one for the US investors among you: UK readers can find the Vanguard UK-equivalent funds easily enough.

However, the plan in RESET assumes you’re in salaried employment.) My partner and I aren’t paid enough to save anything. Not true, it’s possible to become a millionaire on a middling, midlife household income of £60,000 before-tax. The stock market is gambling: I know too many people who’ve been burnt. Any money I have left at the end of the month, I put in my savings account. Are you bonkers? Over long periods, the stock market outperforms all other asset classes (savings accounts, gold, property). You just need to know where to put it. Most of the investing suggestions given by the financial independence movement focus on America. That’s why RESET’s here. We’ve got two kids: do you know how much they cost to feed? There’s no denying it, kids cost a small fortune. The cost of raising a child in the UK is approximately £230,000[229]. Times that by two and, dependent on your income, you’re adding a good five years on to your early retirement date (if you’re a doctor, reduce to two[230]).


pages: 248 words: 57,419

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

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

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

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

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


pages: 130 words: 11,880

Optimization Methods in Finance by Gerard Cornuejols, Reha Tutuncu

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

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

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

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


pages: 1,202 words: 424,886

Stigum's Money Market, 4E by Marcia Stigum, Anthony Crescenzi

accounting loophole / creative accounting, Asian financial crisis, asset allocation, asset-backed security, bank run, banking crisis, banks create money, Black-Scholes formula, Brownian motion, business climate, buy and hold, capital controls, central bank independence, centralized clearinghouse, corporate governance, credit crunch, Credit Default Swap, currency manipulation / currency intervention, David Ricardo: comparative advantage, disintermediation, distributed generation, diversification, diversified portfolio, financial innovation, financial intermediation, fixed income, full employment, high net worth, implied volatility, income per capita, intangible asset, interest rate derivative, interest rate swap, large denomination, locking in a profit, London Interbank Offered Rate, margin call, market bubble, market clearing, market fundamentalism, money market fund, mortgage debt, Myron Scholes, offshore financial centre, paper trading, pension reform, Ponzi scheme, price mechanism, price stability, profit motive, Real Time Gross Settlement, reserve currency, risk tolerance, risk/return, seigniorage, shareholder value, short selling, technology bubble, the payments system, too big to fail, transaction costs, two-sided market, value at risk, volatility smile, yield curve, zero-coupon bond, zero-sum game

Investors in any financial transaction like to feel assured that the party on the other end of their transaction will fulfill his obligations. In the futures market, this assurance is provided by both the clearing service providers and their clearing member firms. Both act as the counterparty to every futures trade, guaranteeing to make good on all trades even if the counterparty fails on his obligation on the trade. Portfolio diversification is another use for futures. They enable investors to invest in asset classes that are not always easy to access. For example, if an investor wants to invest in foodstuffs, he can do so by utilizing the numerous futures that exist for that industry. The same could be said about foreign currencies, precious metals, energy products, livestock, foreign equity indexes, and many other types of interest-rate futures. FORWARD TRANSACTIONS IN THE MONEY MARKET Forward transactions are common in the money market.

Bond investors are therefore somewhat indifferent to the generally laggard returns on bonds compared to other asset classes. There is, however, a limit to this indifference: when the return on other asset classes far outpaces the returns on fixed-income securities and when it appears that the returns might be sustained, money will almost certainly be channeled away from the bond market. Bond investors won’t pull out en masse, of course, but they will reduce their allocation to bonds to take advantage of better returns elsewhere. This reduced demand for bonds pushes up real yields. Bond investors simply want compensation for the opportunity costs they are incurring when the returns on other asset classes exceed the returns on bonds. Thus, when the competition for capital is high, bond investors demand higher real yields.

One big issuer estimated that its all-in cost of issuance runs 1 bp. Diversification into Financial Services One important change in direct issuance over the years has been the expansion, especially by the auto finance companies and/or their parent companies, into other related finance services: mortgage servicing, insurance, the thrift business, leasing, and so on. The move toward such diversification made sense on a number of counts: the auto companies had strong earnings and could thus finance acquisitions of firms in financial services; the auto business is cyclical and thus produces profits that swing cyclically; diversification into related financial services appeared to offer the auto companies and their finance subs attractive, stable earnings. The diversification has, in recent years, helped to mitigate some of the problems faced by the automobile industry in the early 2000s.


pages: 354 words: 26,550

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

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

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

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

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


The Trade Lifecycle: Behind the Scenes of the Trading Process (The Wiley Finance Series) by Robert P. Baker

asset-backed security, bank run, banking crisis, Basel III, Black-Scholes formula, Brownian motion, business continuity plan, business process, collapse of Lehman Brothers, corporate governance, credit crunch, Credit Default Swap, diversification, fixed income, hiring and firing, implied volatility, interest rate derivative, interest rate swap, locking in a profit, London Interbank Offered Rate, margin call, market clearing, millennium bug, place-making, prediction markets, short selling, statistical model, stochastic process, the market place, the payments system, time value of money, too big to fail, transaction costs, value at risk, Wiener process, yield curve, zero-coupon bond

We may say that potatoes are in the asset class of perishable food and washing machines are in the asset class of domestic appliances. So the underlying process is the same but the asset classes are different. The same is true for financial products. Buying shares is intrinsically the same as buying aluminium, sovereign bonds or purchasing dollars in exchange for euros. However, since the people and trading environments of each of these trades are very different, we generally group them into different asset classes. (The examples above corresponding to equities, commodity, fixed income and foreign exchange (FX)). The processes for dealing with each of these trades will normally depend on the asset class rather than the product itself. As we have seen, some products exist in more than one asset class. Every asset class has a suite of possible products.

Although most organisations arrange trading desks according to asset class, the support and control functions are very often grouped by product type. For instance, there might be separate IT systems for spot, nonlinear and option trades – each one crossing many asset classes. 5.8 TRADE MATRIX Differences in processes arise from: different underlying asset classes different type and complexity of trades. This can be represented as a two-dimensional table with the various asset classes in one dimension and the range of trade types in the other as shown in Table 5.5. Control and support must be provided for every product type in every asset class. This can be done vertically (e.g. equities for every product type), horizontally (e.g. options for every asset class) or with a mixture of both. The decision should take into account availability of systems, distribution of knowledge, trade volumes and complexity and a range of related issues. 72 THE TRADE LIFECYCLE TABLE 5.5 Trade matrix Asset class Interest Rates Product type Foreign Exchange Equities Fixed income Commodities Credit Spot trades Forwards and Futures Swaps Vanilla options, swaptions Exotic options Structures and Hybrids 5.9 SUMMARY Financial products can be broken down into two distinct categories – linear and nonlinear.

There may also be no arbitrage, but the trading strategy is such that one is only interested in the relative positions of two different instruments or asset classes. 1 Quoted from New York Mercantile Exchange website. Asset Classes 59 Some examples: in the next six months aluminium will be more in demand than copper and its price will be relatively higher Eastern economies will fare better than European economies and hence their currencies will be stronger long-term interest rates will rise and commodity prices will fall. For trading across asset classes, it is important that the trader can book and view all parts of his portfolio for price and risk. This can be particularly challenging when different systems are used for different asset classes. Other business functions have similar aims, especially when they are monitoring risk at a trader level. Trading across asset classes may involve more than one of the support functions such as use of the interest rates’ back office and commodities’ back office and hence increase risks of miscommunication. 4.7 SUMMARY The main asset classes are interest rates, foreign exchange, equity, bonds, credit and commodities.


pages: 340 words: 100,151

Secrets of Sand Hill Road: Venture Capital and How to Get It by Scott Kupor

activist fund / activist shareholder / activist investor, Airbnb, Amazon Web Services, asset allocation, barriers to entry, Ben Horowitz, carried interest, cloud computing, corporate governance, cryptocurrency, discounted cash flows, diversification, diversified portfolio, estate planning, family office, fixed income, high net worth, index fund, information asymmetry, Lean Startup, low cost airline, Lyft, Marc Andreessen, Myron Scholes, Network effects, Paul Graham, pets.com, price stability, ride hailing / ride sharing, rolodex, Sand Hill Road, shareholder value, Silicon Valley, software as a service, sovereign wealth fund, Startup school, Travis Kalanick, uber lyft, VA Linux, Y Combinator, zero-sum game

Those are the three: the investor, the VC, and the entrepreneur. Now that we’ve got that out of the way, let’s look at how investors consider VC funds to put their money into. Venture Capital as a (Not-Very-Good) Asset Class for Investors In simple terms, an “asset class” is a category of investments to which investors make an allocation. For example, bonds are an asset class, as are public market equities; that is, investors often choose—as part of a balanced portfolio—to invest some portion of their monies into bonds or stocks of publicly traded companies. Hedge funds, VC funds, and buyout funds, among others, are also examples of asset classes. Institutional investors (i.e., professionals who manage large pools of capital) often have a defined asset allocation policy by which they invest. They might for example choose to invest 20 percent of their assets in bonds, 40 percent in publicly traded equities, 25 percent in hedge funds, 10 percent in buyout funds, and 5 percent in VC funds.

They might for example choose to invest 20 percent of their assets in bonds, 40 percent in publicly traded equities, 25 percent in hedge funds, 10 percent in buyout funds, and 5 percent in VC funds. There are numerous other asset classes for consideration and x-number of percentage allocations between the assets classes that institutional investors might pursue. As we’ll see when we talk about the Yale University endowment, the objectives of the particular investor will determine the asset allocation strategy. So, if we agree that VC is an asset class, why is it not a “good” one? Simply because the median returns are not worth the risk or the illiquidity that the average VC investor has to put up with. In fact, as recently as 2017, the median ten-year returns in VC were 160 basis points below those of Nasdaq.

Not much different from what we talked about before, but it’s important to note that capital generally first gets paid back in the same way that it came in. The final complexity that we ignored—and rightly so, because it is not that common among VC funds (though much more so in buyout funds)—involves the opportunity cost of money. Because LPs have a choice of asset classes in which to invest, they naturally want to know that investing in VC funds will pay them a premium compared to other asset classes. After all, venture capital is risky and has long time horizons during which the LP’s capital is tied up. Instead of investing in a VC fund, an LP could choose to invest in the S&P 500 or some other asset class. To account for this, some LPAs introduce the concept of a “hurdle rate” into the profits calculations. A hurdle rate says that unless the fund generates a return in excess of the hurdle rate (this is a negotiated number, but often around 8 percent), the GP is not entitled to take her carried interest on the profits.


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

"Robert Solow", 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, Blythe Masters, Bretton Woods, British Empire, business cycle, 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, different worldview, 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, Kickstarter, 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

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

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

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


pages: 519 words: 118,095

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

Airbnb, asset allocation, bank run, buy and hold, buy low sell high, car-free, Community Supported Agriculture, delayed gratification, diversification, diversified portfolio, estate planning, Firefox, fixed income, full employment, hedonic treadmill, 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, stocks for the long run, traveling salesman, Vanguard fund, web application, Zipcar

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

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

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


pages: 1,373 words: 300,577

The Quest: Energy, Security, and the Remaking of the Modern World by Daniel Yergin

"Robert Solow", addicted to oil, Albert Einstein, Asian financial crisis, Ayatollah Khomeini, banking crisis, Berlin Wall, bioinformatics, borderless world, BRICs, business climate, carbon footprint, Carmen Reinhart, cleantech, Climategate, Climatic Research Unit, colonial rule, Colonization of Mars, corporate governance, cuban missile crisis, data acquisition, decarbonisation, Deng Xiaoping, Dissolution of the Soviet Union, diversification, diversified portfolio, Elon Musk, energy security, energy transition, Exxon Valdez, facts on the ground, Fall of the Berlin Wall, fear of failure, financial innovation, flex fuel, global supply chain, global village, high net worth, hydraulic fracturing, income inequality, index fund, informal economy, interchangeable parts, Intergovernmental Panel on Climate Change (IPCC), James Watt: steam engine, John von Neumann, Kenneth Rogoff, life extension, Long Term Capital Management, Malacca Straits, market design, means of production, megacity, Menlo Park, Mikhail Gorbachev, Mohammed Bouazizi, mutually assured destruction, new economy, Norman Macrae, North Sea oil, nuclear winter, off grid, oil rush, oil shale / tar sands, oil shock, Paul Samuelson, peak oil, Piper Alpha, price mechanism, purchasing power parity, rent-seeking, rising living standards, Robert Metcalfe, Robert Shiller, Robert Shiller, Ronald Coase, Ronald Reagan, Sand Hill Road, shareholder value, Silicon Valley, Silicon Valley startup, smart grid, smart meter, South China Sea, sovereign wealth fund, special economic zone, Stuxnet, technology bubble, the built environment, The Nature of the Firm, the new new thing, trade route, transaction costs, unemployed young men, University of East Anglia, uranium enrichment, William Langewiesche, Yom Kippur War

At one point, Alexei Miller, the CEO of Gazprom, told the Europeans, “Get over your fear of Russia, or run out of gas.”16 For their part, Russia and Ukraine had had further standoffs over natural gas pricing. Even the subsequent government of President Viktor Yanukovych, which had better relations with Moscow, still continued to describe its pipeline network as “our national treasure.” DIVERSIFICATION The lasting impact of the gas controversies was to fuel a new campaign of diversification on both sides of the argument. That meant a new round of pipeline politics that was elevated to the geopolitical level. The Russians were determined to get around Ukraine and Poland with a series of new pipelines. Gazprom and ENI had already built Blue Stream, which crosses the Black Sea from Russia to Turkey and is the deepest underwater pipeline in the world.

Development of these resources could provide an alternative to gas imports, whether they come by pipeline from the east or by ship in the form of LNG.18 But it is still early days, and a great deal of effort will be required to develop such resources. Obstacles will range from local opposition and national policy to lack of infrastructure and sheer density of population. Still the imperatives of diversification will likely fuel the development of unconventional gas resources in some parts of Europe, as elsewhere—most notably in Poland and Ukraine. The new supplies will compensate for declining conventional domestic supplies. Moreover, by enhancing the sense of security and diversification around gas supplies, the development of unconventional gas could end up bolstering confidence in relying on expanded gas imports. A FUEL FOR THE FUTURE Natural gas is a fuel of the future. World consumption has tripled over the last thirty years, and demand could grow another 50 percent over the next two decades.

The first is to start with the recognition of the scale, complexity, and importance of the energy foundations on which a world economy depends, whether it is today’s $65 trillion or $130 trillion two decades from now. There is much to be said for an ecumenical approach that recognizes the contribution of the range of the energy options. Churchill’s famous dictum about supply—“variety, and variety alone”—still resounds powerfully. Diversification of oil resources needs to be expanded to diversification among energy sources—conventional and “new.” This represents a realization that there are no risk-free options and that the risks can come in many forms. Energy efficiency remains a top priority for a growing world economy. Remarkable results have already been achieved, but technologies and tools not available in earlier decades are now at hand. The real advances, whether in developed or developing nations, will be embodied in behavior and value, but especially in investment—new processes, new factories, new buildings, new vehicles.


Trade Your Way to Financial Freedom by van K. Tharp

asset allocation, backtesting, Bretton Woods, buy and hold, capital asset pricing model, commodity trading advisor, compound rate of return, computer age, distributed generation, diversification, dogs of the Dow, Elliott wave, high net worth, index fund, locking in a profit, margin call, market fundamentalism, passive income, prediction markets, price stability, random walk, reserve currency, risk tolerance, Ronald Reagan, Sharpe ratio, short selling, transaction costs

Although Brinson and his colleagues found that stock selection and other types of decisions were not that significant to the performance, the lotto bias causes many people to continue to think that asset allocation means selecting the right asset class. Yet what’s important is the how-much decision, not the investment selection decision. Let me reemphasize that what’s important about money management or asset allocation is not any of the following: • It is not that part of your system that dictates how much you will lose on a given trade. • It is not how to exit a profitable trade. • It is not diversification. • It is not risk control. • It is not risk avoidance. • It is not that part of your system that tells you what to invest in. Instead, what’s important about money management or asset allocation is that it is the part of your trading system that answers the question “How much?”

His response was, “That’s a very good question. I think it’s how one makes trading decisions.” Portfolio managers tend to talk about “asset allocation” as being important for their success. Now think about the words asset allocation. What do they mean to you? Chances are, you think they mean what asset class to select for your assets. This is what it means to most portfolio managers because by charter they must be fully (at least 95 percent) invested. Thus, they think of asset allocation as a decision about which asset class to select. Was this your definition? Brinson and his colleagues defined asset allocation to mean how much of one’s capital was devoted to stocks, bonds, or cash.2 When they defined it that way, they discovered that asset allocation, and not the what-to-buy decision, accounted for 91.5 percent of the performance variability of 82 pension plans over a 10-year period.

arbitrage The taking advantage of discrepancies in price or loopholes in the system to make consistent low-risk money. This strategy usually involves the simultaneous purchase and sale of related items. asset allocation The procedure by which many professional traders decide how to allocate their capital. Due to the lotto bias, many people think of this as a decision about which asset class (such as energy stocks or gold) to select. However, its real power comes when people use it to tell them “how much” to invest in each asset class. Thus, it is really another word for “position sizing.” average directional movement (ADX) An indicator that measures how much a market is trending. Both bullish and bearish trends are shown by positive movement. average true range (ATR) The average over the last X days of the true range, which is the largest of the following: (1) today’s high minus today’s low; (2) today’s high minus yesterday’s close; or (3) today’s low minus yesterday’s close.


pages: 576 words: 105,655

Austerity: The History of a Dangerous Idea by Mark Blyth

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

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

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

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


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

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

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

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

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


file:///C:/Documents%20and%... by vpavan

accounting loophole / creative accounting, activist fund / activist shareholder / activist investor, asset allocation, Berlin Wall, business cycle, buttonwood tree, buy and hold, corporate governance, corporate raider, disintermediation, diversification, diversified portfolio, Donald Trump, estate planning, fixed income, index fund, intangible asset, interest rate swap, margin call, money market fund, Myron Scholes, new economy, price discovery process, profit motive, risk tolerance, shareholder value, short selling, Silicon Valley, Small Order Execution System, Steve Jobs, stocks for the long run, stocks for the long term, technology bubble, transaction costs, Vanguard fund, women in the workforce, zero-coupon bond, éminence grise

But such rules of thumb are not foolproof and are meant only as rough guides. After deciding how much to allocate to stocks and to bonds, make sure that you diversify within those asset classes so that you aren't overexposed to one particular industry. The sudden downturn in the high-tech sector, for example, took many 401(k) participants by surprise in 2000 because they were not properly diversified. When you own mutual funds, the intellectual work involved in making sure you are diversified is done for you. Well, mostly. Diversification means balancing the high-risk, high-return potential of a small-cap stock fund with the steady-as-she-goes growth of a blue-chip fund, though even blue chips can lose value, as we have seen in recent years. Diversification means that if you own a fund that specializes in stocks that appear to be undervalued— so-called value stocks— you might want to balance that with a fund that looks for stocks likely to generate above-average earnings— so-called growth stocks.

Congress could help, too, by amending ERISA so that companies are subject to fiduciary rules when making matching contributions. A fiduciary has a legal obligation to make investment decisions that benefit the recipient. Because such contributions are strictly voluntary, Congress never brought them under the protective arm of ERISA. It also did not subject 401(k)s to diversification rules that traditional, defined-benefit plans must follow. In such plans, company stock cannot exceed 10 percent of total assets. Companies in the past have fought such diversification rules, arguing that it's good policy to align their employees' interests with those of the company, and the best way to do that is to require employees to own stock in the company. Some companies also have argued that matching funds are not required by law, so Congress shouldn't restrict the form or the amount of those contributions.

Diversification means that if you own a fund that specializes in stocks that appear to be undervalued— so-called value stocks— you might want to balance that with a fund that looks for stocks likely to generate above-average earnings— so-called growth stocks. Because fund names can be misleading, it's important to review the underlying stocks that make up a mutual fund to make sure it's doing what its name advertises. If you are investing in a bond fund, diversification means choosing bonds that have different interest rates and maturity dates. Remember: diversification helps you reduce risk by balancing investments that perform poorly with those that produce solid earnings. Stocks versus Bonds: How Do I Decide Between Them? Historically, stocks have outperformed bonds. As I explained earlier, the stocks that make up the S&P 500 have achieved an average annual return of 10.7 percent since 1926. Long-term corporate bonds, on the other hand, have returned about 6.5 percent.


pages: 302 words: 86,614

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

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

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

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

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


Hedgehogging by Barton Biggs

activist fund / activist shareholder / activist investor, asset allocation, backtesting, barriers to entry, Bretton Woods, British Empire, business cycle, buy and hold, diversification, diversified portfolio, Elliott wave, family office, financial independence, fixed income, full employment, hiring and firing, index fund, Isaac Newton, job satisfaction, margin call, market bubble, Mikhail Gorbachev, new economy, oil shale / tar sands, paradox of thrift, Paul Samuelson, Ponzi scheme, random walk, Ronald Reagan, secular stagnation, Sharpe ratio, short selling, Silicon Valley, transaction costs, upwardly mobile, value at risk, Vanguard fund, zero-sum game, éminence grise

David doesn’t believe that the lows of this bear market have been made. He thinks the principal asset classes, ranging from domestic marketable securities (both equity and fixed income) to private equity, are still overvalued, that the public hasn’t learned its lesson, and that the returns from stocks and bonds, particularly in the United States, will be paltry over the next 5 to 10 years.As a result,Yale’s allocation to domestic marketable securities has fallen from more than 75% in 1984 to 22.5% today. By contrast, the average U.S. educational institution has 54.3%. Instead, Yale uses diversifying asset classes like absolute-returnoriented hedge funds, capable of grinding out consistent 8% to 9% returns.Timberland and emerging market equities are the asset classes he is emphasizing now. He is convinced that alternative assets, by their very nature, tend to be less efficiently priced, providing an opportunity for active management.

A long-only manager sourly said something along the lines of the following: “The golden age for hedge funds is about over, and it will end with a bang, not a whimper.The larger capital and the bigger talent pool now being deployed by hedge funds mean that the pricing of everything from asset classes to individual securities is under intense scrutiny by manic investors, who stare at screens all day, have massive databases, and swing large amounts of money with lightning speed. This has the effect of bidding up the prices and reducing the returns of all mispriced investments. Obvious anomalies now disappear, almost instantly. In effect, the alpha available for capture by hedge funds has to be spread over more funds with bigger money, resulting in lower returns on invested capital for hedge funds as an asset class. Risks will also rise as hedge funds have to take larger, more concentrated positions. You greedy hogs are in the process of killing your own golden goose.

His record over the past 20 years is spectac- ccc_biggs_ch08_95-118.qxd 11/29/05 7:02 AM Page 109 Hedgehogs Come in All Sizes and Shapes 109 ular, although, of course, like everyone else, sometimes he gets it wrong. His fund is now around $5 billion, and he does the macro overlay. He has maybe seven or eight asset class (like biotech, Asia, junk bonds, Europe, emerging markets, etc.) portfolio managers who each run anywhere from $400 million to $100 million, depending on what Jake’s view of their sector is. Jake creates performance by allocating between the asset classes, and, in theory, the other guys add additional alpha by doing even better than their sector index. Sometimes Jake buys or sells an index to hedge them out. If one of his managers fails to perform, he or she gets cut. Jake is famous for being tough but fair and generous.


pages: 447 words: 104,258

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

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

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

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

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


pages: 461 words: 128,421

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

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, business cycle, buy and hold, 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, Social Responsibility of Business Is to Increase Its Profits, South Sea Bubble, statistical model, stocks for the long run, 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

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

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

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


pages: 414 words: 101,285

The Butterfly Defect: How Globalization Creates Systemic Risks, and What to Do About It by Ian Goldin, Mike Mariathasan

"Robert Solow", air freight, Andrei Shleifer, Asian financial crisis, asset-backed security, bank run, barriers to entry, Basel III, Berlin Wall, Bretton Woods, BRICs, business cycle, butterfly effect, clean water, collapse of Lehman Brothers, collateralized debt obligation, complexity theory, connected car, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, David Ricardo: comparative advantage, deglobalization, Deng Xiaoping, discovery of penicillin, diversification, diversified portfolio, Douglas Engelbart, Douglas Engelbart, Edward Lorenz: Chaos theory, energy security, eurozone crisis, failed state, Fellow of the Royal Society, financial deregulation, financial innovation, financial intermediation, fixed income, Gini coefficient, global pandemic, global supply chain, global value chain, global village, income inequality, information asymmetry, Jean Tirole, John Snow's cholera map, Kenneth Rogoff, light touch regulation, Long Term Capital Management, market bubble, mass immigration, megacity, moral hazard, Occupy movement, offshore financial centre, open economy, profit maximization, purchasing power parity, race to the bottom, RAND corporation, regulatory arbitrage, reshoring, Silicon Valley, six sigma, Stuxnet, supply-chain management, The Great Moderation, too big to fail, Toyota Production System, trade liberalization, transaction costs, uranium enrichment

The concentration of U.S. automobile manufacturing in the Detroit area or of microchip and semiconductor production in flood-prone regions of Thailand or Taiwan may serve these industries well during normal times but ensure that the repercussions of any local hiccup or catastrophe are especially harsh when things go wrong. A systemic approach recommends diversification, but local authorities have strong incentives to attract specialized businesses. The “diversification of strategy” is thus an important imperative for the global governance of supply chains, and one that equally applies for reforming financial regulation. Lesson 2: Negative externalities such as counterparty risk need to be recognized and addressed We have argued that the financial system is characterized by a number of externalities that prevent socially optimal outcomes and inevitably trigger financial crises.

This includes using policy levers to distribute not only airports and energy generation and distribution systems but also the necessary backup capacity. The lessons of the Japanese tsunami, Hurricane Sandy’s devastating impact on the U.S. East coast, and the Icelandic volcano need to be learned. These include, for example, the need for geographic diversification of backup routes, the stress testing of contingency plans well beyond historic experience, and diversification in fuel, communication, and other critical systems so no one source or node becomes uniquely critical for millions of people. Lesson 4: Global cooperation is required to protect the integrity of the Internet and tackle cybercrime The risk of hardware failures due to dependence on critical server systems and cables has been emphasized in this chapter.

The world is increasingly subject to geographical concentration rather than diversification, which is vital for resilience. A multinational corporation with offices, assets, and human talent located in different regions will be better able to withstand a natural disaster or an infrastructure failure than a company that has all its valuable resources concentrated in one location. If we cannot predict where the next disaster will strike and in what form, firms should prudently diversify their centers of knowledge and leadership. Although this will increase their exposure to local risks, it will also increase their resilience because when a local failure occurs, the majority of the network will remain operable. Such diversification, however, requires global coordination. Multinational companies must be supervised in such a manner that they are not all beyond the reach of national jurisdictions.


pages: 483 words: 141,836

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

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, business cycle, 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, stocks for the long run, The Myth of the Rational Market, Thomas Bayes, too big to fail, transaction costs, value at risk, yield curve

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

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

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


pages: 807 words: 154,435

Radical Uncertainty: Decision-Making for an Unknowable Future by Mervyn King, John Kay

"Robert Solow", Airbus A320, Albert Einstein, Albert Michelson, algorithmic trading, Antoine Gombaud: Chevalier de Méré, Arthur Eddington, autonomous vehicles, availability heuristic, banking crisis, Barry Marshall: ulcers, battle of ideas, Benoit Mandelbrot, bitcoin, Black Swan, Bonfire of the Vanities, Brownian motion, business cycle, business process, capital asset pricing model, central bank independence, collapse of Lehman Brothers, correlation does not imply causation, credit crunch, cryptocurrency, cuban missile crisis, Daniel Kahneman / Amos Tversky, David Ricardo: comparative advantage, demographic transition, discounted cash flows, disruptive innovation, diversification, diversified portfolio, Donald Trump, easy for humans, difficult for computers, Edmond Halley, Edward Lloyd's coffeehouse, Edward Thorp, Elon Musk, Ethereum, Eugene Fama: efficient market hypothesis, experimental economics, experimental subject, fear of failure, feminist movement, financial deregulation, George Akerlof, germ theory of disease, Hans Rosling, Ignaz Semmelweis: hand washing, income per capita, incomplete markets, inflation targeting, information asymmetry, invention of the wheel, invisible hand, Jeff Bezos, Johannes Kepler, John Maynard Keynes: Economic Possibilities for our Grandchildren, John Snow's cholera map, John von Neumann, Kenneth Arrow, Long Term Capital Management, loss aversion, Louis Pasteur, mandelbrot fractal, market bubble, market fundamentalism, Moneyball by Michael Lewis explains big data, Nash equilibrium, Nate Silver, new economy, Nick Leeson, Northern Rock, oil shock, Paul Samuelson, peak oil, Peter Thiel, Philip Mirowski, Pierre-Simon Laplace, popular electronics, price mechanism, probability theory / Blaise Pascal / Pierre de Fermat, quantitative trading / quantitative finance, railway mania, RAND corporation, rent-seeking, Richard Feynman, Richard Thaler, risk tolerance, risk-adjusted returns, Robert Shiller, Robert Shiller, Ronald Coase, sealed-bid auction, shareholder value, Silicon Valley, Simon Kuznets, Socratic dialogue, South Sea Bubble, spectrum auction, Steve Ballmer, Steve Jobs, Steve Wozniak, Tacoma Narrows Bridge, Thales and the olive presses, Thales of Miletus, The Chicago School, the map is not the territory, The Market for Lemons, The Nature of the Firm, The Signal and the Noise by Nate Silver, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, Thomas Bayes, Thomas Davenport, Thomas Malthus, Toyota Production System, transaction costs, ultimatum game, urban planning, value at risk, World Values Survey, Yom Kippur War, zero-sum game

An off-model event – the elopement of Shylock’s daughter Jessica – leads the vengeful moneylender to seek enforcement of the bond despite the intervention of a lender of last resort with ample liquidity. Third, a further off-model event, the intervention of Portia, resolves the issue in Antonio’s favour. But heedless of radical uncertainty, and over-influenced by his own probabilistic model, Antonio puts his life in danger. The narrative captures the essence of the model of diversification. And diversification is central to risk management in the face of radical uncertainty. The meaning of risk and risk aversion One of the authors attended a meeting between some business people representing major defence contractors, and a group of Treasury economists who had recently studied economics and finance before graduating from leading universities. The issue was the extent to which the contractors should be rewarded for assuming the considerable risks involved in major projects.

And all ignore – are even contemptuous of – the corpus of finance theory based on portfolio theory, the capital asset pricing model and the efficient market hypothesis. Indeed that corpus of knowledge implies that they could not have succeeded as they have. These financial models emphasise points of which all investors should be aware – the benefits of diversification, the extent to which different assets offer genuine opportunities for diversification, and the degree to which information is incorporated in securities prices. But the lesson of experience is that there is no single approach to financial markets which makes money or explains ‘what is going on here’, no single narrative of ‘the financial world as it really is’. There is a multiplicity of valid approaches, and the appropriate tools, model-based or narrative, are specific to context and to the skills and judgement of the investor.

If your concept of risk is very different from that of the market as a whole, you can minimise your risk at other people’s expense. Broad diversification becomes ‘a free lunch’ reducing risk without cost. Once you recognise that day-to-day price movements are not an indication of risk but a measure of meaningless noise in markets, you can achieve your longer-term objectives at lower cost by learning to ignore such fluctuations. There can be reward – not without risk, but with little risk – through building a diversified portfolio, turning off your computer, and thinking hard, though not necessarily frequently, about ‘what is going on here’. Broad diversification, involving building a portfolio which will be robust and resilient to unpredictable events, is the best protection against radical uncertainty, because most radically uncertain events will have a significant long-run effect on only some of the assets which you own.


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

"side hustle", asset allocation, Bernie Madoff, buy and hold, 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

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

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

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


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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

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

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

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

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


Financial Statement Analysis: A Practitioner's Guide by Martin S. Fridson, Fernando Alvarez

business cycle, corporate governance, credit crunch, discounted cash flows, diversification, Donald Trump, double entry bookkeeping, Elon Musk, fixed income, information trail, intangible asset, interest rate derivative, interest rate swap, negative equity, new economy, offshore financial centre, postindustrial economy, profit maximization, profit motive, Richard Thaler, shareholder value, speech recognition, statistical model, time value of money, transaction costs, Y2K, zero-coupon bond

“We're Diversifying Away from Mature Markets” If a growth-minded company's entire industry has reached a point of slowdown, it may have little choice but to redeploy its earnings into faster-growing businesses. Hunger for growth, along with the quest for cyclical balance, is a prime motivation for the corporate strategy of diversification. Diversification reached its zenith of popularity during the conglomerate movement of the 1960s. Up until that time, relatively little evidence had accumulated regarding the actual feasibility of achieving high earnings growth through acquisitions of companies in a wide variety of growth industries. Many corporations subsequently found that their diversification strategies worked better on paper than in practice. One problem was that they had to pay extremely high price-earnings multiples for growth companies that other conglomerates also coveted. Unless earnings growth accelerated dramatically under the new corporate ownership, the acquirer's return on investment was fated to be mediocre.

Despite this experience, there are periodic attempts to revive the notion of diversification as a means of maintaining high earnings growth indefinitely into the future. In one variant, management makes lofty claims about the potential for cross-selling one division's services to the customers of another. It is not clear, though, why paying premium acquisition prices to assemble the two businesses under the same corporate roof should prove more profitable than having one independent company pay a fee to use the other's mailing list. Battle-hardened analysts wonder whether such corporate strategies rely as much on the vagaries of mergers-and-acquisitions accounting (see Chapter 10) as they do on bona fide synergy. All in all, users of financial statements should adopt a show-me attitude toward a story of renewed growth through diversification. It is often nothing more than a variant of the myth of above-average growth forever.

Tice Associates Death duties Debt: management's attitude toward return on equity and total, constitution of total-debt-to-cash-flow ratio Debt restriction disclosures Declining growth, rationalizations: diversification, mature markets and growth back on track, new products and year-over-year comparisons distorted Defaulting on debt Default risk models Deferred profit plan: accounting discrepancies background on from bad to worse lessons learned Deferred taxes, capital and Denari, Stephen Depreciation schedules Derivatives Dex One Corporation Dilution Disclosure/audits: artful deal death duties generally systematic problems, auditing and Discount rate Discretionary uses of cash Diversification Dividend discount model: dividends and future appreciation earning or cash flow future dividends/present stock price growing company, valuing Dividends Dooner, John J.


pages: 348 words: 82,499

DIY Investor: How to Take Control of Your Investments & Plan for a Financially Secure Future by Andy Bell

asset allocation, bank run, buy and hold, collapse of Lehman Brothers, credit crunch, diversification, diversified portfolio, estate planning, eurozone crisis, fixed income, high net worth, hiring and firing, Isaac Newton, Kickstarter, lateral thinking, money market fund, Northern Rock, passive investing, place-making, quantitative easing, selection bias, short selling, South Sea Bubble, technology bubble, transaction costs, Vanguard fund

This is one of the simplest ways of spreading risk and smoothing the volatility of investment markets. The key point about pound-cost averaging is that you invest small amounts on a regular basis. So, when prices are high your monthly investment will buy fewer shares or units, but when prices are low your investment buys more shares or units. Diversification. Different types of asset tend to rise and fall in value at different times in the market cycle. So, by diversifying your portfolio across different geographies, asset classes and even across different sectors within an asset class, you can dampen much of the market’s volatility out of your portfolio. Use fund managers. While you still need to choose a fund manager, this is a lot easier and less risky than choosing individual investments. You are leaving the big decisions to them and paying them for taking the pressure off you.

For example, with a time horizon of 10 to 20 years and a medium appetite for risk, it suggests a portfolio made up of: Large-cap stocks – 35 per cent Bonds – 25 per cent Small-cap stocks – 20 per cent Overseas stocks – 20 per cent In all likelihood, as a DIY investor you need not follow these portfolio construction ideas to the letter, or rather the number. The more complex ones are generally designed for high net-worth individuals with a lot of money. As long as you get a decent level of diversification, across three or four sectors, your portfolio will be in the right ballpark. These portfolios, constructed from equities, ETFs, OEICs, investment trusts, bonds and gilts, are suitable for your core investment holdings. Once you have your bedrock investments in place in a balanced portfolio, you may start to feel adventurous and experiment with less mainstream asset classes. Medium-term investing If you are investing over the medium term, say 5 to 10 years, you should be considering a high proportion of equities, but you should not be investing as aggressively as long-term investors.

This means you need to monitor the relevance of your asset allocation strategy at least every couple of years, and ideally annually. Correlation When looking at different asset classes and sectors, it is helpful to understand how they may be correlated. Some are positively correlated – that is, they tend to move in the same direction. Others are negatively correlated, where a fall in the value of one asset class is normally accompanied by a rise in the other. Correlation is measured on a continuous scale between −1, a perfect negative correlation, 0 where there is no correlation and 1 where there is perfect positive correlation. Figure 18.2 shows the correlation between some of the major asset classes. figure 18.2 Correlation between major asset classes between July 2004 and June 2007 Source: Shares Magazine You will see that UK equities and global equities have the highest positive correlation, whereas UK equities and UK gilts have the largest negative correlation.


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

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

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

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

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


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Derivatives Markets by David Goldenberg

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

Rather, individual stocks should be held in portfolios. This has the positive effect of diversifying away some of the avoidable risk of individual stocks. However, we also know from portfolio analysis that there are limits to diversification. You can’t diversify away the non-diversifiable (market) risks of your portfolio. We also know that the maximum effect of diversification occurs when we add perfectly negatively correlated assets to our portfolio. So, the alternative ways to hedge your position are: 1. (Naive) Diversification: add securities to form a portfolio with BAC. This gets you the diversification effect. 2. Synthetically create negative correlation: find another type of security that is highly positively correlated with BAC stock and short it! Under 2., candidate hedging vehicles include standard plain vanilla call options on BAC.

If you can find a security that is perfectly negatively correlated with a given one (like the mutual fund of our example), then some combination of the portfolio weights will yield a portfolio with standard deviation equal to zero. Of course, it may be very hard to find such a security in the real world, because by diversifying the mutual fund you may have already exhausted your diversification possibilities. This was the situation facing mutual fund managers prior to 1982. Then stock index futures contracts were introduced. This allowed investors to further ‘diversify away’ the systematic risk of their portfolios by hedging in stock index futures. In other words, hedging is just another kind of portfolio diversification–based on synthesizing the correlation that drives the diversification effect in the extreme case. If the resulting zero risk portfolio does not have a return equal to the actual (non-synthetic) risk-free rate, then there is an arbitrage opportunity using the synthetic risk-free asset and the actual risk-free asset (US Treasury bill)

Now, looking forward to financial futures in Chapter 7, we will shift the focus away from agricultural commodities like wheat to financial ‘commodities’ like stock indexes and stock index futures contracts as their hedging vehicles. FIGURE 6.1 Long vs. Short Positions 6.1 HEDGING AS PORTFOLIO THEORY You are a mutual fund manager, which means that you manage a diversified portfolio. However, even after diversifying, market volatility remains. You don’t want to jump around between asset classes attempting to execute a risky and questionably profitable market timing strategy. We will call this the Wall Street Journal strategy. Instead, you want to maintain your position in the portfolio, but you also want to protect it against adverse price movements. The basic alternatives available to you are described in Figure 6.2. FIGURE 6.2 Synthetic Treasury Bill vs. Actual The difference between the left-hand side and the right-hand side of Figure 6.2 is that in order to get to the right-hand side you have to liquidate part or all of your mutual funds, and invest the proceeds in US Treasury bills.


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The Complete Guide to Property Investment: How to Survive & Thrive in the New World of Buy-To-Let by Rob Dix

buy and hold, diversification, diversified portfolio, Firefox, risk tolerance, TaskRabbit, transaction costs, young professional

The only real cause for concern with this strategy is that you might end up without appropriate diversification after selling whatever is necessary to shift the mortgage balances. Being left with just one or two properties that cover your expenses is nice and simple from a management point of view, but also risky: non-paying tenants in one of your properties would cut your “pension” in half until the situation is resolved. Liquidate It could be that in your old age, you want nothing to do with property at all. In that case, there’s nothing to stop you from selling the lot and investing the proceeds in another asset class. No, it’s not particularly tax-efficient because of capital gains tax, but there’s more to life than paying as little tax as possible. In terms of diversification, this isn’t a terrible idea. If you could make roughly the same net return from a couple of unencumbered properties or a globally diversified portfolio of stocks and bonds, the latter might give you better peace of mind.

It doesn’t particularly matter: the calculations you make are only for yourself, so it’s important just to be consistent with what you include so you’re always comparing like with like. Gross and net yield have their uses, but neither of them captures the entire investment equation. What we really need is a calculation that takes everything into account – and which we can use not just to compare different properties, but also to compare our return from a property investment to the returns we could get if we invested in a different asset class entirely. That calculation is Return on investment (ROI) – calculated as the annual rental profit divided by the money you put in. If you buy wholly in cash, the money you put in is the same as the cost of acquiring the asset, so your ROI and net yield will be identical. But if you use a mortgage, your ROI will be higher than your net yield. For example, our hypothetical property cost £100,000 and generates a £5,000 annual profit, giving a net yield of 5%.

Well, I said there were no downsides, but you could consider a downside to be that you’re not getting as much bang for your buck as you would if you pursued a more sophisticated strategy. For example, if you were able to save up £20,000 each year and propel your portfolio growth by buying below market value and refinancing, you could use that extra £20,000 to either buy even more properties or invest in a totally different asset class. This is true, but there’s no law that says you have to maximise everything all the time. It all comes back to having a meaningful goal in mind before you start: if two people have the same goal but one of them has a lot more cash they can invest in achieving it, the person with more cash won’t have to work as hard or accept as much risk to get to the same place. Option 2: Creating equity This is the refinancing (or “recycling”) strategy we saw in Part 1.


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

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

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

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

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


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A Man for All Markets by Edward O. Thorp

3Com Palm IPO, Albert Einstein, asset allocation, beat the dealer, Bernie Madoff, Black Swan, Black-Scholes formula, Brownian motion, buy and hold, buy low sell high, carried interest, Chuck Templeton: OpenTable:, Claude Shannon: information theory, cognitive dissonance, collateralized debt obligation, 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, risk-adjusted returns, Robert Shiller, Robert Shiller, rolodex, Sharpe ratio, short selling, Silicon Valley, Stanford marshmallow experiment, statistical arbitrage, stem cell, stocks for the long run, 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

As the contagion spread, economic activity declined sharply, US unemployment reached 25 percent, and a worldwide depression ensued. It was only in January 1945—after more than fifteen years and most of World War II—that, on a month-end basis, large-company stocks finished above their August 1929 all-time high. Again, an investment in corporate bonds more than doubled on average over this period and long-term US government bonds almost did so, showing that diversification into asset classes other than equities, though possibly sacrificing long-term return, can preserve wealth in bad times. To prevent a repeat of 1929, the Securities Exchange Act of 1934 empowered the board of governors of the Federal Reserve System to prescribe the part of the purchase price the investor has to put up to purchase a listed security. He may borrow any or all of the remainder. Since 1934 this has varied between 40 percent and 100 percent.

Whether or not you try to beat the market, you can do better by properly managing your wealth, which I talk about next. Chapter 27 * * * ASSET ALLOCATION AND WEALTH MANAGEMENT Private wealth in the industrially advanced countries is spread among major asset classes such as equities (common stocks), bonds, real estate, collectibles, commodities, and miscellaneous personal property. If investors choose index funds for each asset class in which they wish to invest, their combined portfolio risk and return will depend on how they allocate among asset classes. This also is true for investors who don’t index. Table 8 gives a rough overview of the asset categories. Investment assets held by mutual funds, hedge funds, foundations, and employee benefit funds are not included, since their underlying assets have already been counted.

Derivative securities, which include warrants, options, convertible bonds, and many later complex inventions, derive their value—as we have seen—from that of an “underlying” security such as the common stock of a company. Instead of listing them separately, they’re understood to be included as part of their underlying asset class. How are your assets divided among the categories in table 8? The big three for most investors are equities, interest rate securities, and real estate. Each accounts for about a quarter of the total net worth of US households, though the proportions fluctuate, particularly when an asset class experiences a boom or a bust. Table 8: Major Asset Classes and Subdivisions EQUITIES Common Stock Preferred Stock Warrants and Convertibles Private Equity INTEREST RATE SECURITIES Bonds US Government Corporate Municipal Convertibles Cash US Treasury Bills Savings Accounts Certificates of Deposit Mortgage-Backed Securities REAL ESTATE Residential Commercial COMMODITIES Agricultural Industrial Currencies Precious metals COLLECTIBLES (Art, gems, coins, autos, etc.)


pages: 543 words: 157,991

All the Devils Are Here by Bethany McLean

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

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

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

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


pages: 294 words: 82,438

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

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

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

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

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


pages: 237 words: 50,758

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

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

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

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

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


pages: 246 words: 74,341

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

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

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

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

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


pages: 364 words: 101,286

The Misbehavior of Markets: A Fractal View of Financial Turbulence by Benoit Mandelbrot, Richard L. Hudson

Albert Einstein, asset allocation, Augustin-Louis Cauchy, Benoit Mandelbrot, Big bang: deregulation of the City of London, Black-Scholes formula, British Empire, Brownian motion, business cycle, buy and hold, 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

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

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

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


pages: 311 words: 99,699

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

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

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

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

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


pages: 346 words: 102,625

Early Retirement Extreme by Jacob Lund Fisker

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

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

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

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


pages: 274 words: 81,008

The New Tycoons: Inside the Trillion Dollar Private Equity Industry That Owns Everything by Jason Kelly

activist fund / activist shareholder / activist investor, barriers to entry, Berlin Wall, call centre, carried interest, collective bargaining, corporate governance, corporate raider, Credit Default Swap, diversification, Fall of the Berlin Wall, family office, fixed income, Goldman Sachs: Vampire Squid, Gordon Gekko, housing crisis, income inequality, late capitalism, margin call, Menlo Park, Occupy movement, place-making, Rod Stewart played at Stephen Schwarzman birthday party, rolodex, Ronald Reagan, Rubik’s Cube, Sand Hill Road, shareholder value, side project, Silicon Valley, sovereign wealth fund

The Private Equity Growth Capital Council, the industry’s chief lobbyist, estimated in 2011 that there were roughly 2,400 private-equity firms headquartered in the United States.17 “As we’ve seen what’s happened in the market, the model has changed, and you have two kinds of players: public and diversified and private and focused,” Colony’s Tom Barrack said. Managers at the firms where private equity remains the main, or only, business argue that they’re the only ones who can generate the sort of returns that the industry originally delivered and has promised ever since. “This asset class is not going away,” said Thomas Lister, co-managing partner of Permira. “There will be people who continue to make 20 percent IRRs off a reasonable pool of capital. I’m not a believer in just making 5 points over the S&P. I believe in 2.5 times your money and 25 percent returns.” Private-equity guys talk a lot about alpha, a Greek letter that’s taken on many meanings in the modern world, especially in finance.

In 2010, Carlyle took a $500 million loan from Mubadala in large part to pay a dividend to the owners, including the founders and the California Public Employees’ Retirement System. Carlyle repaid the loan in late 2011 and early 2012, a move that helped avoid Mubadala converting the debt to equity at a discount to the IPO price. Mubadala was a key tenet of establishing the firm as global in its approach. Carlyle’s founders argued their version of diversification—geographic—put them on that path before any of their competitors, including Blackstone. That view was crucial to Carlyle’s pitch for one of its most important deals, the long-mulled initial public offering. The founders, all headed toward their sixties at the time, seriously contemplated going public back when Schwarzman got his deal done and Kravis got as far as filing an S-1, in 2007. Just as the credit crisis derailed KKR’s plans and diverted that firm into a European two-step to an NYSE listing, the state of the financial world scuttled any plans for Carlyle to gain a public listing.

Blackstone also offered the chance at times to hang on to a slice of the unit being divested, helping the selling CEO avoid potential embarrassment of selling too cheap and watching Blackstone reap huge profits down the line. It’s undeniable that the biggest private-equity firms today stand as financial behemoths given what they own and their expansion into areas beyond buying companies with borrowed money. Blackstone is the furthest along in that regard, and it was a strategy in part born of fear. Diversification is Blackstone’s long-term business plan, executives there say, in part because of the terror of watching Lehman Brothers collapse around them—the first time, in the mid-1980s. Peterson, who had come to hold various positions at Lehman Brothers including the top job, had lost a series of nasty battles with Lew Glucksman over the future of the firm that ultimately led to Peterson’s departure.


pages: 471 words: 124,585

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

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

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

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

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


pages: 218 words: 62,889

Sabotage: The Financial System's Nasty Business by Anastasia Nesvetailova, Ronen Palan

algorithmic trading, bank run, banking crisis, barriers to entry, Basel III, Bernie Sanders, big-box store, bitcoin, Black-Scholes formula, blockchain, Blythe Masters, bonus culture, Bretton Woods, business process, collateralized debt obligation, corporate raider, Credit Default Swap, credit default swaps / collateralized debt obligations, cryptocurrency, distributed ledger, diversification, Double Irish / Dutch Sandwich, en.wikipedia.org, Eugene Fama: efficient market hypothesis, financial innovation, financial intermediation, financial repression, fixed income, gig economy, Gordon Gekko, high net worth, Hyman Minsky, information asymmetry, interest rate derivative, interest rate swap, Joseph Schumpeter, Kenneth Arrow, litecoin, London Interbank Offered Rate, London Whale, Long Term Capital Management, margin call, market fundamentalism, mortgage debt, new economy, Northern Rock, offshore financial centre, Paul Samuelson, peer-to-peer lending, plutocrats, Plutocrats, Ponzi scheme, price mechanism, regulatory arbitrage, rent-seeking, reserve currency, Ross Ulbricht, shareholder value, short selling, smart contracts, sovereign wealth fund, Thorstein Veblen, too big to fail

Existing banks compete fiercely with one another and face challenges from new entrants to the sector: all major supermarkets today offer a range of financial services and products that were traditionally the prerogative of the banks. Geographically, too, the breakdown of national regulations and the rise of emerging market economies has widely expanded the number and the range of financial institutions, with the majority now operating across several jurisdictions, time zones and asset classes. In 1997 Paul Volcker, formerly the chairman of the Federal Reserve, reflected on this heightened competition. Even in the face of the intense and growing pressures of competition, Volcker noted, ‘The industry never has been so profitable’. The noted anomaly would later become known as Volcker’s paradox, and would refer to the seemingly strange coexistence of intense competition and historically high profit rates in commercial banking.4 Why was this a puzzle for one of the leading economic figures of his generation?

Bank Confidential, Letter to Treasury Select Committee, House of Commons, London, 28 January 2018, TSC/BC/WB/10118, https://bankconfidential.com/wp-content/uploads/2018/02/TSC-Final-letter-1-1.pdf. Bateman, O., ‘Bitcoin might make tax havens obsolete’, Motherboard, Vice, 22 June 2016, https://motherboard.vice.com/en_us/article/wnxzpy/bitcoin-might-make-tax-havens-obsolete. Benston, G. J., W. C. Hunter and L. D. Wall, ‘Motivations for Bank Mergers and Acquisitions: Enhancing the Deposit Insurance Put Option versus Earnings Diversification’, Journal of Money, Credit and Banking, vol. 27, 1995, pp. 777–88, https://doi.org/10.2307/2077749. Berstein, P., Against the Gods: The Remarkable Story of Risk, John Wiley and Sons, 1998. Binham, C., ‘RBS unit memo told staff to let clients “hang themselves”’, Financial Times, 17 January 2018. Binham, C., ‘MPs slam “regulatory black hole” for bank lending to small business’, Financial Times, 26 October 2018, www.ft.com/content/551fb48a-d875-11e8-a854-33d6f82e62f8.

Das, Traders, Guns and Money: Knowns and Unknowns of the Dazzling World of Derivatives, Prentice Hall, 2006. 26. M. Puri, ‘Commercial Banks in Investment Banking: Conflict of Interest or Certification Role?’, Journal of Financial Economics, vol. 40, 1996, pp. 373–401; G. J. Benston, W. C. Hunter and L. D. Wall, ‘Motivations for Bank Mergers and Acquisitions: Enhancing the Deposit Insurance Put Option versus Earnings Diversification’, Journal of Money, Credit and Banking, vol. 27, 1995, pp. 777–88. 27. J. Spindler, ‘Conflict or Credibility: Research Analyst Conflicts of Interest and the Market for Underwriting Business,’ Journal of Legal Studies, vol. 35, no. 2, June 2006, pp. 303–25. 28. The recently introduced MIFID 2 directive prohibits free advice in the financial sector. Chapter 2. Sabotage and the Cycle of Debt 1. www.imsdb.com/scripts/Margin-Call.html. 2.


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

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

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

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

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


pages: 348 words: 83,490

More Than You Know: Finding Financial Wisdom in Unconventional Places (Updated and Expanded) by Michael J. Mauboussin

Albert Einstein, Andrei Shleifer, Atul Gawande, availability heuristic, beat the dealer, Benoit Mandelbrot, Black Swan, Brownian motion, butter production in bangladesh, buy and hold, capital asset pricing model, Clayton Christensen, clockwork universe, complexity theory, corporate governance, creative destruction, Daniel Kahneman / Amos Tversky, deliberate practice, demographic transition, discounted cash flows, disruptive innovation, diversification, diversified portfolio, dogs of the Dow, Drosophila, Edward Thorp, en.wikipedia.org, equity premium, Eugene Fama: efficient market hypothesis, fixed income, framing effect, functional fixedness, hindsight bias, hiring and firing, Howard Rheingold, index fund, information asymmetry, intangible asset, invisible hand, Isaac Newton, Jeff Bezos, Kenneth Arrow, Laplace demon, Long Term Capital Management, loss aversion, mandelbrot fractal, margin call, market bubble, Menlo Park, mental accounting, Milgram experiment, Murray Gell-Mann, Nash equilibrium, new economy, Paul Samuelson, Pierre-Simon Laplace, quantitative trading / quantitative finance, random walk, Richard Florida, Richard Thaler, Robert Shiller, Robert Shiller, shareholder value, statistical model, Steven Pinker, stocks for the long run, survivorship bias, The Wisdom of Crowds, transaction costs, traveling salesman, value at risk, wealth creators, women in the workforce, zero-sum game

That said, I still suspect that aggregate portfolio turnover, which has risen sharply over the past twenty-five years, is too high. But extremely low portfolio turnover (less than 20 percent) may not provide sufficient flexibility to capture the market’s dynamics. In addition, faster clockspeed suggests the need for greater diversification. If competitive advantages are coming and going faster than ever, investors need to cast a wider net in order to assure that their portfolios reflect the phenomenon. (Ideally, of course, investors would only focus on the winners and avoid the losers. This is practically very difficult.) The data show evidence for this increased diversification. Finally, the rate of change in the business world demands that investors spend more time understanding the dynamics of organizational change. Success and failure at fast-changing companies may provide investors with some useful mental models for appreciating change at the slower evolving companies.

Said differently, investors pay attention to the narrow frame.3 If prospect theory does indeed explain investor behavior, the probabilities of a stock (or portfolio) rising and the investment-evaluation period become paramount. I want to shine a light on the policies regarding these two variables. Explaining the Equity-Risk Premium One of finance’s big puzzles is why equity returns have been so much higher than fixed-income returns over time, given the respective risk of each asset class. From 1900 through 2006, stocks in the United States have earned a 5.7 percent annual premium over treasury bills (geometric returns). Other developed countries around the world have seen similar results.4 In a trailblazing 1995 paper, Shlomo Benartzi and Richard Thaler suggested a solution to the equity risk premium puzzle based on what they called “myopic loss aversion.” Their argument rests on two conceptual pillars:5 1.

However, if price changes are not normally distributed, standard deviation can be a very misleading proxy for risk.2 The research, some done as far back as the early 1960s, shows that price changes do not follow a normal distribution. Exhibit 31.1 shows the frequency distribution of S&P 500 daily returns from January 1, 1978, to March 30, 2007, and a normal distribution derived from the data. Exhibit 31.2 highlights the difference between the actual returns and the normal distribution. Analyses of different asset classes and time horizons yield similar results.3 The figures show that:• Small changes appear more frequently than the normal distribution predicts • There are fewer medium-sized changes than the model implies (roughly 0.5 to 2.0 standard deviations) • There are fatter tails than what the standard model suggests. This means that there is a greater-than-expected number of large changes The fat tails, in particular, warrant additional comment.


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

algorithmic trading, asset-backed security, bank run, banking crisis, Bernie Madoff, Black Swan, Bretton Woods, BRICs, British Empire, business cycle, buy and hold, 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

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

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

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


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

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

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

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

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


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Willful: How We Choose What We Do by Richard Robb

activist fund / activist shareholder / activist investor, Alvin Roth, Asian financial crisis, asset-backed security, Bernie Madoff, capital asset pricing model, cognitive bias, collapse of Lehman Brothers, Daniel Kahneman / Amos Tversky, David Ricardo: comparative advantage, delayed gratification, diversification, diversified portfolio, effective altruism, endowment effect, Eratosthenes, experimental subject, family office, George Akerlof, index fund, information asymmetry, job satisfaction, John Maynard Keynes: Economic Possibilities for our Grandchildren, lake wobegon effect, loss aversion, market bubble, market clearing, money market fund, Pareto efficiency, Paul Samuelson, Peter Singer: altruism, principal–agent problem, profit maximization, profit motive, Richard Thaler, Silicon Valley, sovereign wealth fund, survivorship bias, the scientific method, The Wealth of Nations by Adam Smith, Thomas Malthus, Thorstein Veblen, transaction costs, ultimatum game

At best, the CalPERS managers would say, “Yes, it’s probably a great deal but we don’t have time for approvals,” or “Yes, it’s probably a great deal but we have no bucket in which to put it.” The billionaire tech entrepreneur, sniffing a profit, will pounce. Institutional investors manage funds more or less in accordance with a common formula. A board of trustees approves a policy that a chief investment officer (CIO) then implements. The policy usually splits the fund into “buckets,” “sectors,” or “asset classes.” Sectors can include domestic public equity, global equity, credit, illiquid credit, private equity, cash, absolute return (hedge funds), and the like. The CIO assigns specialists to look after each sector. Equity managers handle equity; credit managers handle credit. For the public equities sector, some CIOs farm out stock selection to outside managers, and others invest passively in an index fund to hold down costs.

., 210–211n2 Alexander the Great, 140, 180–181 alienation, 205, 207 alpha, 75 altruism, 4 apparently irrational, 28–29, 206 care altruism, 38, 104, 108–114, 115, 120, 135, 201 effective, 110–112, 126, 130, 135–136 in for-itself model, 19, 104, 123, 129 love altruism, 104, 116, 123–125, 203 manners and ethics in, 104, 106–108, 135 observed care altruism, 108–112 purposeful choice compatible with, 104, 113–114, 115–116 selfish, 104, 105–106, 109, 123, 125, 135 types of, 104, 123, 130 utility maximized by, 5–6 vaccination as, 59. See also mercy ambiguity effect, 24 American Work-Sports (Zarnowski), 191 Anaximander, 190 anchoring, 168 angel investors, 212–213n1 “animal spirits,” 169 Antipater of Tarsus, 134–135, 137 “anxious vigilance,” 73, 82 arbitrage, 70, 78 Aristotle, 200, 220n24 Asian financial crisis (1997–1998), 13 asset-backed securities, 93–95 asset classes, 75 astrology, 67 asymmetric information, 96, 210n2 authenticity, 32–37, 114 of challenges, 176–179 autism, 58, 59 auto safety, 139 Bank of New York Mellon, 61 Battle of Waterloo, 71, 205 Bear Stearns, 85 Becker, Gary, 33, 108–109 behavioral economics, 4, 10, 198–199 assumptions underlying, 24 insights of, 24–25 rational choice complemented by, 6 Belgium, 191 beliefs: attachment to, 51 defined, 50 evidence inconsistent with, 54, 57–58 formation of, 53, 92 persistence of, 26–28, 54 transmissibility of, 92–93, 95–96 Bentham, Jeremy, 127, 197–198 “black swans,” 62–64 blame aversion, 57, 72 brain hemispheres, 161 Brexit, 181–185 “bull markets,” 78 capital asset pricing model, 64 care altruism, 38, 104, 108–114, 115, 120, 135, 201 Casablanca (film), 120, 125 The Cask of Amontillado (Poe), 126–127 challenges, 202–203 authenticity of, 176–179 staying in the game linked to, 179–181 changes of mind, 147–164 charity, 40, 45–46, 119, 128 choice: abundance of, 172–174 intertemporal, 149–158, 166 purposeful vs. rational, 22–23 Christofferson, Johan, 83, 86, 87, 88 Cicero, 133–134 Clark, John Bates, 167 cognitive bias, 6, 23, 51, 147–148, 167, 198–199 confirmation bias, 200 experimental evidence of, 10–11, 24 for-itself behavior disguised as, 200–201 gain-loss asymmetry, 10–11 hostile attribution bias, 59 hyperbolic discounting as, 158 lawn-mowing paradox and, 33–34 obstinacy linked to, 57 omission bias, 200 rational choice disguised as, 10–11, 33–34, 199–200 salience and, 29, 147 survivor bias, 180 zero risk bias, 24 Colbert, Claudette, 7 Columbia University, 17 commitment devices, 149–151 commodities, 80, 86, 89 commuting, 26, 38–39 competitiveness, 11, 31, 41, 149, 189 complementary skills, 71–72 compound interest, 79 confirmation bias, 57, 200 conspicuous consumption, 31 consumption planning, 151–159 contrarian strategy, 78 cooperation, 104, 105 coordination, 216n15 corner solutions, 214n8 cost-benefit analysis: disregard of, in military campaigns, 117 of human life, 138–143 credit risk, 11 crime, 208 Dai-Ichi Kangyo Bank (DKB), 12–14, 15, 17, 87, 192–193 Darwin, Charles, 62–63 depression, psychological, 62 de Waal, Frans, 118 Diogenes of Seleucia, 134–135, 137 discounting of the future, 10, 162–164 hyperbolic, 158, 201 disjunction effect, 174–176 diversification, 64–65 divestment, 65–66 Dostoevsky, Fyodor, 18 drowning husband problem, 6–7, 110, 116, 123–125 effective altruism, 110–112, 126, 130, 135–136 efficient market hypothesis, 69–74, 81–82, 96 Empire State Building, 211–212n12 endowment effect, 4 endowments, of universities, 74 entrepreneurism, 27, 90, 91–92 Eratosthenes, 190 ethics, 6, 1