Module 3: Establishing a sound long-term investment strategy | Blog 3-4: Patience and Persistence by David S. Krause

Here’s another controversial topic – passive versus active investing. And right at the start of this discussion I’ll tell you that a believe in a hybrid approach: some passive and some active investments.

Time and again, individual investors have discovered how difficult it is to predict the next winning stock or the market’s next turn or cycle. And active investing by the small guy has been called a loser’s game, according to Charlie Ellis.

Charlie Ellis, Winning the Loser's Game

Charlie Ellis, Winning the Loser’s Game

Recently we’ve seen that two-thirds of the actively managed mutual funds under-perform their benchmarks over a 5 year period – and that both individual investors and the investment professionals lose more ground when they try to time market by altering their asset allocations. Academic studies have shown that the more individual investors attempt to beat the market, the less chance they have of doing it.

So, the alternative lies with passive investing – which is about reaching your investment goals by selecting the right asset mix for your needs, limiting your trading costs by owning ETFs and index funds, and rebalancing the portfolio only occasionally to return to its target allocation. This method has been shown to consistently outperform active investing on an after-cost, after-tax risk-adjusted basis.

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Jack Bogle

John “Jack” Bogle (and his Boglehead followers) believes that passive investing provides investors with the best opportunity to achieve their financial goals. This isn’t likely to make you the most popular person to talk to at the neighborhood party, but passive investing might make you the savviest investor on the block. It is hard for most people to believe that a passive approach is better than an active approach – since we have been trained to think that the harder we work, the better the outcome; however, it is the opposite when it comes to passive investing!

If you don’t want to take the full plunge by owning only index funds and ETFs – you can invest in shareholder friendly, fundamentally solid mutual funds. Avoiding high cost funds and those that charge entry and exit fees can help you preserve more of your capital.

Another approach is to use passive index funds for large cap stocks and an active approach for mid- and small cap stocks. Whatever approach you take, be aware that you should think about your after-tax and after-transactions cost return. In the long-run you’ll be glad you followed this advice.

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News: Thoughts about the best approach to selecting active investment managers

If you believe that active investment management can provide returns in the long-term that will surpass the market averages, then here are some straightforward thoughts to always bear in mind:

Keep your transactions costs and fees low. As Jack Bogle, founder of Vanguard and the strongest proponent of indexing, has stated, the most important factor affecting long-run total returns is not whether you should hold index funds or active funds, but instead the focus should be on low cost versus high cost funds. The general rule, that has considerable academic empirical support, is that lower cost funds tend to generate higher total returns than more expensive funds over time.

It should be noted that this rule tends to apply to all investment categories – regardless of whether a fund is indexed or actively managed. As stated in the online course: Introduction to Applied Investing, over time most Vanguard index funds have outperformed the majority of active funds when total returns (net of fees) are considered.

Have patience if you are using active managers. If you are going to use active funds (with reasonable fees and a solid investment process) then you need to be aware that over the long-run (say 15 years), a majority of these funds will suffer at least one stretch of three consecutive years of under-performance during that period. Investors who follow a simple sell baseball rule of “three strikes and you are out” would have erred. Almost all active funds will have a period where they lag their benchmark or more the top half of their peer group. Again, a sensible strategy of staying with an active manager over a reasonable time period – rather than chasing returns – is more purulent than dropping under-performers in the short-term.

Set flexible sell rules. You can’t be expected to stay with a sub-par performer forever – so how do you know when to fire a fund manager and more on to another? Something that triggers a sell for me is if there is a higher than normal turnover rate of the fund’s managers and analysts. If there is high turnover, you are probably looking at a fund that is having difficulty maintaining its strategy over the long-term. Successfully managed companies (in any industry) tend to have stability within their organization – and mutual funds are no different. You should consider a rule that sells an actively managed fund that has weaker than average total return performance, an inconsistent investment strategy, and a high employee-manager turnover rate.

There are many capable and strong active managers. You need to be smart in selecting them and patient in evaluating their performance – be careful not to chase returns. That’s refereed to as a loser’s game!

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Module 2: Investment Basics | Blog 2-1: Overview of the Financial Markets by David S. Krause

800px-Flash_Crash 2.1

Flash Crash of 2010

In the first module of the course (Introduction to Applied Investing) and again in Lesson 2-1, a discussion of the functioning of the U.S. financial markets was conducted. It was also noted that public opinion about the ‘fairness and effectiveness’ of the securities market is disturbingly low at present time.

The low confidence in the financial markets is understandable. The “Flash Crash” which occurred on May 6, 2010, in which the Dow Jones Industrial Average fell more than 5% in a about 5 minutes and then rebounded, has never been adequately explained. Michael Lewis in Flash Boys also opened our eyes to the potential system-wide risks of high frequency trading.

On March 23, 2012, the third largest securities exchange in the U.S., BATS, withdrew its IPO after technical issues derailed its trading. Then two months later, on May 18, 2012, technical issues marred the Facebook IPO – and finally on August 1, 2012, a technology issue at Knight Capital Group resulted in massive losses of over $400 million in less than 30 minutes.

Partly as a result of these technology-related market failures, many investors, practitioners, and regulators remain concerned about the complexity of today’s market structures, This concern seems to be focused on the impact of high frequency trading on the markets; however, a major study released recently underscores the health and efficiency of the U.S. equity markets.

In June 2013, Knight Capital Group (NYSE: KCG) released a study: “Equity Trading in the 21st Century: An Update.” The study authored by professors James Angel of Georgetown University, Larry Harris of the University of Southern California, and Chester Spatt of Carnegie Mellon University, concluded that “the U.S. markets continue to be healthy with low transaction costs, ample market depth and high execution speeds.”

800px-Day_12_Occupy_Wall_Street_September_28_2011_Shankbone_17 2.1They also stated that “gains in market quality documented in 2010 continue and the markets remain significantly more liquid than they were before the growth of electronic trading. They also noted improvements in market quality that have benefited small traders as well as institutional traders executing very large orders over many days.”

Among other findings, their study showed that the intraday volatility of individual stocks, as measured by the high/low range, remains below the levels of the pre-electronic 1990s. While empirical results show that the markets remain healthy, their study concluded that there is room for further improvement of market structures to better serve investors.

The study warned against certain proposals to reform market structures, citing as examples, proposals that impose transaction taxes or costs on trading and minimum resting times on quotes, which the study concludes would hurt liquidity without producing the desired improvements in market quality.

The study is good news for those opposed to increased regulation of the financial markets.  It provides an unbiased and thorough examination of the functioning of the U.S. equity markets. While investors have a legitimate concern about the soundness of the financial markets given the recent hiccups, this study helps to allay some of those concerns.

 

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Module 2: Investment Basics | Blog 2-2: Securities Market by David S. Krause

120px-Jersey_City_-_Flickr_-_Peter_Zoon 2.2 investment bankIn Lesson 2-2, there was a general discussion about investment banking. Entry level investment banking positions have long been prized by finance majors and MBAs from prestigious universities. Prior to the 2008 financial crisis, the investment banking industry was literally on top of the world with eye-popping salaries and high profit margins. Investment bankers were referred to as the ‘masters of the universe’ and the ‘titans of Wall Street.’

Since the crisis, investment banks’ return on capital have collapsed. Return on equity ratios for the world’s biggest investment banks have been halved, to about 10% in Europe and 13% in America. The near-term outlook is even worse, with returns likely to fall to single digits as new “Too Big To Fail” regulations take effect. As a result, the investment banking industry faces a leaner, humbler future.  The Economist ran a story recently about the decline of the investment banking industry – much of the following derived is from this article.

Jamie_Dimon,_CEO_of_JPMorgan_Chase 2.2

JP Morgan’s CEO, Jamie Dimon

Regulatory and structural forces are at work to throttle back the investment banking industry. The most immediate of these is a bevy of new regulations that will fundamentally change the business of investment banking. Higher capital ratios and tightened credit standards, that have already been agreed to, but are not yet fully in place, are forcing banks to shrink their balance sheets and will make their businesses far less profitable.

Regulations that are still largely on the drawing board will make investment banks easier to break up, less able to use cheap retail deposits to fund their trading business and to take risks and, as a consequence, operate less profitably.

Another threat facing the investment banks is the march of progress. Just as competition has made cars, air flights and computers cheaper and better over time, investment banking is also under pressure to offer more and charge less. Thanks to new technologies such as algorithmic trading systems, many of the jobs formerly done by bankers are now carried out by computers that do not leave and join rival firms or demand large bonuses. Moreover, many of these systems are being bought by banks’ clients, allowing them to trade directly with one another or to demand better foreign-exchange rates or cheaper interest-rate swaps.

Commissions and spreads, the revenues that banks can make from trading, have already been relentlessly compressed in the less complex areas of their business, such as trading common stock or exchanging currencies. The squeeze on margins is now spreading to more complex businesses, such as bond trading and derivatives.

While the industry’s revenues are likely to bounce back from the low levels observed immediately after the financial crisis, it is not likely that the profitability levels will return to their robust pre-crisis levels of 25+% given the array of new regulations. It appears that the ‘masters of the universe’ have been tamed for the time being.

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Module 3: Establishing a sound long-term investment strategy | Blog 3-3: Market Timing and Day Trading by David S. Krause

Market timing and day trading have been discussed in several of the lessons I’ve presented within the course: Introduction to Applied Investing. These are two of the most controversial topics in all of investments. Can the stock market be timed and can an individual ‘beat’ the market by day trading? Here we’ll focus on the topic of day trading.

day tradingSome of my students initially find it objectionable that most of the investment text books have a negative view toward day trading – and refer to it as a loser’s (or negative sum) game.

For every successful trader that beats the market there will be unsuccessful ones that, on average, under-perform the overall market. Successful traders only exist at the expense of unsuccessful or below average market timers and traders. Clearly, it is impossible for everyone to be above average, so the entire lot of investors has to earn market performance, minus trading costs. Therefore it is mathematically impossible for there to be any more than a small number of investors to beat the market because trading is expensive – transactions costs and taxes are significant.

If trading didn’t cost anything, half of all traders would beat the index and half would lose (either that, or a few would make a lot and the majority would make only a little bit less than average); however, trading is very expensive. And the income tax system penalizes traders’ earnings with higher short-term capital gains taxes.  Not only does your chance of earning above average performance dramatically decrease when you trade, but when you get hammered with a high tax rate when you are successful, making it even harder to beat the market on a post-tax basis.

As I stated earlier, many students initially enter an investment program with the belief that they can outperform the market and have a high opinion of their trading abilities. But to the 10,000+ hedge funds and full-time professional traders and money managers, it is the millions of small traders out there that are the fodder. The unsophisticated individual day traders tend to get slaughtered!

Therefore, for a trader to do nothing more than simply match the after-tax return of an index fund, it is not sufficient to beat the market by a small amount, it is necessary to crush it. To beat the market after taxes and transactions costs, you must massively outperform the index.

So while you eventually learn that there is no Santa Claus, Easter Bunny or Tooth Fairy; it should also be obvious to most investors that you have little chance of beating the market by trading. The probability of you succeeding in this activity, to the extent of achieving the apparently modest goal of beating a market ETF investor after tax, is extremely low.

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Module 3: Establishing a sound long-term investment strategy | Blog 3-2: Diversification by David S. Krause

In Lesson 3-2, you were introduced to Harry Markowitz and Modern Portfolio Theory (MPT). As stated, this theory was initially under attack by academics and practitioners in the 1960s; however, it eventually became the cornerstone of much of today’s accepted financial theories.

Harry Markowitz

Harry Markowitz

It is fair to point out that Markowitz’s Modern Portfolio Theory is based on a number of heroic assumptions. In mathematics, we believe that the results from models are correct as long as the underlying assumptions are correct. In science, we have basic theories and principles and as long as the fundamental pieces fit, equations can be utilized to provide useful insights. That’s the way we’ve been able to develop a thorough understanding of the far reaches of the universe or the predict the behavior of subatomic particles that we can’t even observe.

Since Modern Portfolio Theory is based on a basic model that’s been mathematically proven, it should be without dispute, right? Well, not exactly. There are some very significant assumptions surrounding MPT which are listed below. Here are eight of the underlying assumptions that have caused some people to reject Markowitz’s portfolio theory:

  • There are no transaction costs in buying or selling securities.
  • There is no spread between bid and ask prices.
  • No taxes of any kind are considered and only “risk” determines which securities an investor will buy or sell.
  • Investors do not consider taxes when making investment decisions and are indifferent to receiving dividends or capital gains.
  • Investors can buy or sell any amount of any security and liquidity is not issue.
  • Investors have the same time horizon.
  • Access to information is the same for all investors.
  • Investor psychology and public events have no effect on the markets.

MPTThese assumptions don’t reflect the realities of the real world. So does this invalidate Modern Portfolio Theory? No, but it muddies the water a bit and makes it less certain than Harry Markowitz modeled it in the 1950s.

Unquestionably, diversification is good, but it is not the end of the discussion – real world factors also need to be considered. During the financial crisis of 2008 it seemed as if all assets were perfected correlated and the benefits of diversification were non-evident – a clear case where the assumptions did not hold. But does this invalidate the theory and make Markowitz’s work irrelevant? No. He was clear in stating the assumptions of the model and warning that investors should be careful before accepting the theory carte blanche.

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Module 2: Investment Basics | Blog 2-4: Sources of Information by David S. Krause

In Lessons 2-4 and 2-5, you learned about the various sources of public information regarding the financial markets and individual companies. It is amazing the amount of information that is available online today – some of which is outstanding and some of which is worthless. What we didn’t discuss was the infamous ‘stock tip.’

cramer

Mad Money’s Jim Cramer (CNBC)

I believe everyone has received stock tips over time from family and friends – and every day we hear about some hot trading tips from the ‘experts’ on the TV financial networks.

Well, what exactly is a stock tip? It is loosely defined as a confidential, advance notice, or ‘legal’ piece of information on the future performance of a particular company’s stock that is intended for trading purposes.

Trading on material, inside information is not generally allowed in the United States. Insider trading is legal when corporate insiders—officers, directors, employees and large shareholders – buy and sell stock in their own companies. However, before corporate insiders can trade in their own securities, they must report their trades in advance to the SEC. Many investors and traders use this publicly disclosed information (which is available in EDGAR) to identify companies with good investment potential. The idea is that if insiders are buying their firm’s stock, they must know more about their company than everyone else, so therefore it must be a good idea to buy the stock.

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Raj Rajaratnam being arrested on illegal insider trading in 2009 (source: CNN)

Many academics believe that in any market, stock tips are a really stupid idea. They argue that if someone could offer consistently profitable tips, why wouldn’t they be discretely trading on the knowledge to become super-rich? What share it with anyone else?

It is also hard to imagine many examples of how a stock tip could be legitimate or even legal (and not a violation of insider trading laws)!

Have you ever received a stock tip – and acted on it without conducting any research? I hope not. However, I do think that tips can be useful as a prompt to research new investment ideas or to help confirm your own opinion.

A word to the wise – be careful about acting on non-public, material information – you too could be photographed in a perp walk if you violate insider trading laws.

 

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Module 1: Investment Basics | Blog 1-3: Real Rates of Return by David Krause

PAIRS_Seniors

Retirees on fixed income

It should be clear from Lesson 1-3 that inflation is an enemy of the investor because it erodes the value of money. While inflation has been low the past decade, it can always return.

Inflation is the biggest threat to someone in retirement that depends solely on the income generated from their investments. This is because a retired person can’t easily re-enter the work force and inflation can dilute their wealth’s purchasing power. It is vital that the investment income generated from a portfolio provides a return at least equal to the rate of inflation. And ideally an investor wants to see their real purchasing power increase and therefore would like to earn investment returns in excess of the inflation rate by at least two or three percent.

To ensure that an individual’s income from their investments keeps pace with inflation, there are two important principles:

  • The first is that the underlying investments should generate a continuous income that over time outperforms the inflation rate. On this basis, as well as that of historical yields on asset classes, a yield of at least two or three percentage points above the inflation rate is acceptable. This would be close to the historical total return on bonds.
  • For risky assets (common stock, real estate, etc.), the total return (capital appreciation and dividend yield) should be about five to seven percent more than the inflation rate, because such investments carry more risk than bonds.
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Long-term inflation rates

If the future inflation rate is estimated to be 3% on average for the next 5 years, this means that bonds need to deliver a total return of 5-6% over the period (3% for inflation plus an acceptable return of 2-3%). On the same assumption an investment in common stock should produce a total return of 8-10% (inflation plus 5-7%).

Currently, long-term U.S. Government bonds are only yielding a rate that is about equivalent to the expected rate of future inflation (about 2.5 – 3%) – so investors need to maintain well-diversified portfolios that include common stocks. To avoid experiencing a loss of purchasing power, investors need to have a healthy mix of stocks, bonds and other investments in their portfolio.

Another option to protect purchasing power and investment returns over the long-term is to add inflation-protected securities, such as inflation-indexed bonds or Treasury inflation-protected securities (TIPS). These bonds tend to move with inflation and therefore offer long-term immunity to inflation risk. In summary, investing only in savings accounts and money market instruments will not likely generate enough of a return to offset inflation – and individuals need to include risky assets within their investment portfolios.

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Module 1: Investment Basics | Blog 1-5: The Flash Crash of 2010 by David Krause

On May 6, 2010, the U.S. stock market crashed. The Dow Jones Industrial Average went down about 1000 basis points (or nearly 10% of its value) in about 20 minutes, and then recovered most of those losses only few minutes later. This event is known as the “Flash Crash of 2010.” The 2014 book by Michael Lewis, Flash Boys, also highlighted the dangers of computer-driven, high frequency trading.

Flash Crash of 2010

Flash Crash of 2010

Many market followers believe that what caused the stock market to crash was sophisticated computer programs that work with complex algorithms to transact a large number of market orders at very fast speeds, known as High Frequency Trading (or HFT). In addition to HFT, Dark Pool Trading (or DPT) was also pointed as one of the possible causes of the Flash Crash. Furthermore, many investors believe that these kinds of program trading strategies are making the markets highly vulnerable and volatile; and because of this, additional regulation has been sought.

There are two possible reasons for the Flash Crash of 2010:

  1. On May 6, 2010, the global financial markets were under stress due to concern about the European debt crisis. The Euro had dropped to a new 14-month low and investors were disappointed that the European Central Bank had failed to show any concern about the Greek debt. Markets were highly volatile.
  2. There was also a large transaction made late in the trading day by an investment manager, Waddell & Reed, that triggered the Crash. The firm made a sale of 75,000 e-mini futures contracts on the S&P 500 stock index that was worth $4.1B. In addition to the large size of the order, the firm wanted the transaction to be completed as fast as possible and at any price point – triggering many other sell algorithms around the globe.

An “e-mini” is a futures contract that tracks the S&P 500 and it is traded on the Chicago Mercantile Exchange. Each 1 point move in the S&P 500 index is worth $50 per contract. Furthermore, the E-mini S&P 500 futures contract is one-fifth the size of the standard S&P 500 futures contract. Some of the advantages that this futures contract presents are greater liquidity and affordability for individual investors. A $4 billion sell order could cause short-term disruption to the pricing of this security.

The Flash Crash of 2010 was the largest intra-day point drop ever – with the major stock market indexes dropping by over 9% before a near recovery occurred only a few minutes later. Some stocks, such Boston Beer and Accenture, essentially posted a near 100% decline and rise during this short period. Even the giant firm, Procter & Gamble, saw it’s stock price plummet during the ‘crash’ – dropping by nearly 40% in the course of a few seconds.

High Frequency Trading, which is seen as one of the possible causes of the Flash Crash, involves the use of quantitative computer programs to hold short-term positions in all kinds of financial instruments that can be traded electronically such as equities, options, futures, ETF’s and currencies. Hedge funds and investment companies that own these sophisticated computer platforms aim to capture just a fraction of a cent per share or currency unit on every trade. These transactions take place many times a day, and these fractions of a penny accumulate quickly, which can lead to posting significantly positive profits at the end of every day. HFT supporters say that this trading promotes markets by making them more liquid, and as a consequence it reduces the overall cost of capital.

The whole concept of High Frequency Trading is based on the idea that programmed computers can be better traders than humans. Computers process and analyze data in a faster fashion than the human brain does, and that is the reason why many big firms are choosing this way of trading. Algorithms are the programs that trigger these rapid trades.

Nowadays, HFT of equities require more technical, rather than fundamental, analysis. And with the huge volume traded through HFT platforms (it is believed that this accounts for more than 60% of all futures volume traded and roughly 50% of all trading) mistakes can be made. After all, how could the value of one of the largest, most stable firms in the world (Procter & Gamble) drop 40% within a matter of seconds?

Dark Pool Trading is also pointed as one of the possible causes for the Flash Crash of 2010. DPT gives access to trading opportunities for institutional investors that are not available to the public. Electronic trading and sophisticated platforms have made this kind of trading become possible through crossing networks.

The key benefits of trading in Dark Pools that are cited include the ability to trade a large volume of stock quickly, providing better liquidity to institutions, and also lowering trading costs. However, even though Dark Pools benefit financial institutions with price improvement and better liquidity, this kind of trading may also increase market volatility and impair the ability of individual investors to get the best deal at the best price.

After the Flash Crash, many in the investment community sought help from the Securities and Exchange Commission (SEC) to set up some sort of regulation on transactions made by HFT and DPT so that what happened in 2010 would not happen again. Since then the SEC has been active in trying to implement “single-stock circuit breakers” that would stop trading made by computerized systems after they trade large volumes of stocks. Additionally, a Market Access Rule was adopted by the SEC that requires dealers and brokers to “implement controls and supervisory procedures to manage the financial and regulatory risks of market access, including the risks of errant trading algorithms that could seriously disrupt the markets.”

Will this stop another Flash Crash from occurring? The answer is that we do not know and therefore it is easy to see why many continue to seek additional regulation on HFT and Dark Pool transactions.

Additionally, it is important to note that there has been more than one ‘crash’ since sophisticated trading platforms appeared. In fact, as recently as April 23, 2013, the Associated Press had its Twitter hacked – and a posting appeared that there was an explosion in the White House and that President Obama was injured – which made the market plunge by over 1% within seconds. Again, many fingers pointed at HFT.

Tweet Mini-Crash of 2013

Tweet Mini-Crash of 2013

Therefore, it is important that the entities that regulate the market pay close attention to these computerized systems and how these can have a negative impact in the market. Are more regulations needed – or will technology and market efficiency prevent future ‘Flash Crashes’ from occurring? We’ll have to wait to see!

 

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