The Personal Financier

A Temple Restaurant and a Clearing House for Tickets – Two Observations of New York City

noreply@blogger.com (Dorian Wales) — Sat, 07 Nov 2009 13:11:00 +0000

Best City in the World

New York City is my favorite destination in the world. Any opportunity to visit again, whether on business or pleasure is a joy. With each visit a new light is shed on some other aspect of the city. I'd like to share two such spotlights with you.

In case you have been wondering The Personal Financier is very much alive. It may not seem so but I'm doing my best on getting back on track. It's amazing how life changes once you have a child.

Peter Luger – The Mystery of Building a Lasting Brand

Peter Luger offers the best steak I've had my entire life. That's a fact on my part. I may be biased but I don't believe the brand has enough influence on me to force such a belief. It is truly remarkable.

Still, that rarely justifies the lasting brand name Peter Luger has made for itself and has been successful at maintaining for the last century. We all had great meals at great restaurants, some more hidden than others. Still, such a strong, international brand name for a steakhouse is a remarkable phenomenon.

Location? What is so great about a 15 minute train ride from Manhattan down a grimy Brooklyn Staircase only to walk 5-10 more minutes in the rather unattractive surroundings of Brooklyn's Broadway Street?

The restaurant? I've seen much better looking classic restaurants preserving the glory of days past in wooden furnishings.

The service? It may be characterized as slightly snooty with a "thank us for considering you a potential diner" attitude at times.

The food? I've already mentioned the food but that is not enough. It is probably the best Steak I've ever eaten but I've eaten ones that got pretty close to it as well.

It seems the Peter Luger charm is a complex one. And as always, the answer with complex is everything. Everything from the location to the design and attitude constitute the brand which is Peter Luger and assure my returning on any chance I get.

The relatively remote location suggests a good thing deserves the effort. It gently insinuates that the steak is that good it does not need a prime location and subtly differentiates between the connoisseurs and the herd (You being the connoisseur if you've understood the trip to be worthwhile). It suggests the steakhouse is a temple for meat lovers who would gladly take the pilgrimage to pray at the altar of porterhouse.

The restaurant's classic design supports these gentle innuendoes with classic appearance and sacred design. The temple of meat will forever be as it is. A holy place, unchanged with time.

The service is suggestive, as if you acknowledge the sanctity of the place and its guardians and decided to entrust yourself with their capable hands. They simply know their steak is that good.

TKTS – Ingenious Broadway Clearing House

I believe the first thing a tourist planning a visit to Manhattan writes down is "Get Broadway show tickets at TKTS". To his or her content a blow has been struck against the Tyranny of Broadway theaters and their exorbitant pricing. Simply wait for the last minute and the giants of Broadway will fold offering 50% discounts to the witty traveler.

The lines at 47^th Street and Broadway are always full of conscious, self-assured consumers who know how to enjoy a show at a reasonable price. I used to be one of those standing in line, content to have purchased discounted show tickets thinking I had outsmarted the world.

TKTS provides a good deal and an important service. The fact is, however, that much better deals are available with little or no line at all, and better yet, you can select the date on your own. These are ironically available at the theaters themselves. The same ones we thought we had outsmarted.

On my recent trip I learned visiting the different theaters is much more worthwhile than waiting the TKTS line. All theaters offer much cheaper Balcony prices for all available dates. Usually, for most shows, an upgrade to better seating is available once the show had started, curtsy of the usher. At TKTS you'll get good prices but on much more expensive tickets, usually ending up seating in the same location.

TKTS is ingenious. Broadway owes much to whoever came up with this successful clearing house for theater TKTS. In my opinion this is the main idea behind this initiative. Broadway tickets were standardized, seating availability made common and all that was left was centralizing the selling point in the prime location it is currently located in.

Curtsey of the Theater Development Fund Broadway theaters enjoy a great selling point, cleverly marketed and ideally located. The stress on theaters boxes is lessened and tickets are sold throughout the day assuring seating is maxed out for every show.

The selling technique also contributes to TKTS performance as the pressure on the client is significant as he or she is holding up the line. Prices are quoted rapidly for each show with little time to ask or wonder. Decisions are made and tickets are sold.

Dollar Cost Averaging – Practical Lessons From Recent Experience

noreply@blogger.com (Dorian Wales) — Sat, 15 Aug 2009 16:15:00 +0000

My recent experience with Dollar Cost Averaging and the lessons I learned

Several posts ago I discussed my considerations on Dollar Cost Averaging and why I had selected it as my long term investment strategy.

I've been at it for 4 months and have shown the necessary self restraint, avoiding any impulse buying and selling and sticking to my original investment plan which includes investing a fixed, identical sum at the start of every month into a well diversified ETF portfolio.

It hasn't been as easy as it may seem. This is a good indication on my part. "Easy" usually doesn't lead to good results.

After short 4 months I've already learned several lessons I'd like to share in case some of you have decided to try Dollar Cost Averaging as well.

Lesson #1 - Speaking about self discipline and exercising it are two different matters

The idea is simple. Invest a fixed sum of money at each given period and average out sharp movements in asset prices. Drops in prices will be smoothed out by investments made during times of low prices (and the other way around as well, of course). Dollar Cost Averaging exposes an investor to less risk and therefore less return.

The challenge begins when we decide to implement Dollar Cost Averaging. When we save for retirement we usually take the money invested each period as a given and constant sum which we don't really have to think consider since this is a life term investment.

When investing our monthly savings things change. The level of commitment required from us is higher as we are in control of the funds invested. Suddenly we have to make the investment ourselves; committing to the asset of our choice and accepting the fact we are locking money for the long term.

Keeping to Dollar Cost Averaging when markets are peaking is challenging as well. Investing when you are sure the market faces a breather and a period of earning realizations is not an easy feat.

It is important to keep in mind our initial investment strategy and stray as little as possible. Remember why you adopted it at the first place. So far I've been able to keep to decision making but it was not as easy as I had though it to be.

Lesson #2 - Timing the markets is inherent in our psychology and is difficult to root out

I simply can't avoid timing the markets. Dollar Cost Averaging is probably one of the investment strategies which offer the most temptation to time the market as investments are made periodically.

Think of a scenario in which the market has rallied for 3 months (Like the past 3 months). Would invest, yet again, knowing full well the market is scheduled to take a breather? The same goes for bearish markets during which the temptation to buy more increases significantly.

Again self discipline is crucial for succeeding. Deciding to utilize Dollar Cost Averaging means abandoning the effort to time the market and recognizing them to be futile.

Lesson #3 - The long term is an obscure concept which is counter-intuitive to the human psychology

Again, my experience has taught me the long-term is one of the most obscure concepts in investing. Often mentioned but only rarely understood.

I believe long term investment actually contradicts human psychology and is very hard to maintain. When managing your own portfolio the urge to keep tabs is enormous. I haven't met anyone who can resist the temptation to monitor the portfolio daily or at best weekly or monthly.

In all sincerity, we may say long term but hope for short term. Again, self discipline and restraint are key traits for success.

In the meantime, and due to my rather lucky starting point I've managed to generate just over 10% in returns over the past 4 months which have been exceptionally well. I hope for a long term average of a yearly return of 6%.

Making money online, Confirmation Bias and Lifestyle inflation @ Saturday Round Up

noreply@blogger.com (Dorian Wales) — Fri, 14 Aug 2009 19:00:00 +0000

2 year recap and interesting reading from fellow bloggers

It has been a hectic year. My job takes up the best part of my life and between it and my 4 month old boy I have had little time to maintain The Personal Financier as I’d like.

I have been writing, here at The Personal Financier, for almost 2 years now and would like to think I’ve gathered a small crowd that enjoys my posts. I try to be innovative in my posting and avoid the shallowness which sometimes characterizes personal finance blogging.

I would like to believe my posts are useful and hold added value. I strive to walk off the beaten path as far as personal finance blogs are concerned. I would appreciate your comments and thoughts on the matter.

Interesting reading at fellow personal finance blogs:

Beware of 'Confirmation Bias' @ The Financial Philosopher (One of my favourite blogs)
GDP, Potential, and Debt Forecasts -- and Implied Multipliers @ EconBrowser (Excellent economy blog)
Avoid Lifestyle Inflation: Create an Artificial Sense of Scarcity @ Five cent nickel (Interesting concept of lifestyle inflation)
Simple ways to make money online @ Gather Little by Little
Exotic Investing: Master Limited Partnerships @ dqydj.net (Don’t quit your day job)
The time budget @ Blunt Money

Recent personal finance carnivals of interest:

Famous money quotes edition of the COPF @ ChristianPF (made editor’s pick!)
Carnival of Financial Planning - Edition #102 - August 14, 2009 @ The Skilled Investor
Carnival Of Twenty Something Finances @ How I Save Money

Buy on the Rumor – Sell on the News: Our Psychology at Work

noreply@blogger.com (Dorian Wales) — Sat, 01 Aug 2009 10:50:00 +0000

A counter intuitive rule of thumb explained

Rumors of new products, earnings, takeovers and mergers immediately raise share prices. This is understandable as the value of the company is expected to rise as a result and so investors who believe the rumor to be true (or true enough) can buy on the rumor with the hope of generate significant returns in a short time.

Sell on the news is more intriguing. Usually this tested rule of thumb works. Many times after the news the share’s price shows signs of uncertainty and fear of the recent height it had attained. The reasons why can shed some light on how our psychologies play yet another trick on us.

Shouldn’t buying on the news be more appealing?

Solid investors should not buy on the rumor. Rumors have a tendency to turn out to be false and the share’s price soon follows to previous or lower levels. Still, buying on the news is more often than not too late for any short-term profit. Shouldn’t buying on the news be more appealing?

It seems rumors excite the imagination of investors so that by the time the news gets out it’s often disappointing by the mere fact it is grounded to a certain reality. I think something deeper, rooted in our psychology is at work, and I will expand on it shortly.

For the value investor buying on the news is the sound path for the long term. It is understandable how buying on the rumor may generate higher short-term returns as the associated risk is much higher since rumors may turn out to be false. Still, if you are not a speculator look for the hidden value in the news.

It is important to remember that many times the thought or idea of a certain takeover or merger is more exciting than the actual results. As we know everything is personal and merging two companies, two boards and two managements is hardly an easy task. An idea of a merger may be brilliant at first but if the operational and practical side is weak the merger is doomed.

Buy on the rumor sell on the news – the psychology at work

The more interesting aspect of buy on the rumor – sell on the news is the psychological aspect at play. This rule gives us another good example of how fragile our minds are and why the market is a place for the more rational.

Over and under corrections and the confidence bias – Think of the first think that comes to your mind when you hear a rumor regarding a company. We all believe the share prices will sky rocket and are sorry for missing the opportunity. A rumor of an opportunity has a very strong effect on us. Our psychology usually leads us to see the up side of such an event ignoring the limits and limitations that exist. Our optimistic view is quickly generated into a peak in the share’s price only to later face reality and correct the price back downwards to reflect reality and overshooting.

Expectations and reward pursuit – Strangely enough we seem to value some thing more when we wait for it to come true than we do when it finally does. This psychological bias has been demonstrated in research and is rather intuitive once you consider it.

When you plan a trip and consider all the wonderful activities you will enjoy your perceived utility is much higher than it actually is when participating in these activities. When expecting a raise, for example, its perceived value is higher than when you’ve already received it. The mechanism seems to be intuitive as well. Evolution has programmed us to constantly seek new rewards and never settle for what we already achieved.

Therefore, the perceived value of a certain rumor is more often higher than the actually value once it turns out to be true.

Psychology and investing go hand in hand. I find this connection fascinating and I’ve written quite a few posts about it exploring the different aspects and tricks our minds play on us. We can’t always control our psychologies but we can try to offset some of the bias and use it for our benefit.

Related posts:

Challenging Happiness – Exploring the Irony of Human Nature

Behavioral Finance in Everyday Life – The Lottery as a Case Study

Is Rationalization the Key to Happiness?

How Can they Possibly Afford That? Or Is Money in the Eye of the Beholder?

Coming To Terms with Never Getting Rich – A Look at the Pre-Requirements

Past week Round Up

noreply@blogger.com (Dorian Wales) — Sat, 01 Aug 2009 10:28:00 +0000

The finance carnivals were, as usual, very productive. I'd like to note the following two:

Carnival of Personal Finance: The House of Rose Edition @ Good Financial Cents
The 98th Carnival of Finanical Planning @ Living Almost Large

Other great posts of the past week include the following:

Discouraging News about SP 500 @ The Financial Blogger - Presenting another look into the lost decade of the US stock markets through one simple chart. An important lesson to all of us.
Great Stock Market Performace, But Will Dow 9,200 Hold? @ The Digerati Life - A good fundemental review of the market. Rememebr the trend is your friend.
Been down so long it looks like up @ Econbrowser - Another good fundemental review.
How to Brew Your Own Beer and Maybe Even Save Some Money – Equipment @ GenX Finance - Fun post to read.

Diversification is Dead. Long live Diversification

noreply@blogger.com (Dorian Wales) — Sat, 25 Jul 2009 16:59:00 +0000

Don’t give up on diversification through asset allocation just yet

A short introduction to asset allocation and diversification

Assets allocation is said to be the optimal investment method for household investors. As household investors we lack both the time and knowledge to handpick assets and build and maintain a long term investment portfolio on our own. Unless you have a significant enough portfolio brokers and financial consultants will also professionally manage your portfolio through one asset allocation or another.

Asset allocation relies on diversification and the benefits it presents. If finance diversification is aimed to lower the specific risks of an investment and capture only the market risk, which cannot be eliminated. Specific risks are the risks associated with a single investment and include the risk the company we invested in will lose a major client, for example, or lose their successful CEO.

Diversifying is aimed to maximize the return with a given level of risk. The math behind this model is based on the correlation between the assets we invest in and this is one of the ways portfolios are built.

The bad news

If you’ve managed such a diversified and allocated portfolio over the past couple of years you must have noticed diversification didn’t quite work, to say the least. Each and every portfolio crashed and burned, regardless of the asset allocation (unless you went short on the market).

All major stock indices, commodities, oil and almost every asset that comes to mind plummeted. Diversification over assets, geographies and currencies hasn’t saved our portfolios from significant losses.

Some hoped that the emerging markets will be strong enough and independent enough to balance out the devastating impact of the recent crisis. Another economic motor would have created two semi-correlated financial drivers which might have offset some of the damages. It appears that it is too early to nominate China (and the European Union) as the next economic powers that be.

The reasons may be abundant but it seems that with globalization came increased correlation between assets and swept our precious diversification away. What are we to do now? How can household investors invest in such a turbulent market atmosphere?

Well, aside from increasing the risk free asset portion of the portfolio (such as deposits and government bonds) I believe there are also good news to be had.

The good news

First and foremost what crashed and burned together would probably rise back together. As such, anything we’ll put our hands and money on will probably generate decent returns on the upcoming investment horizon.

Some of us remember the good times back at 2005-2007 where all the assets generated decent returns and stock picking was never as needless.

Moreover, on the geo-political side of things, the increased co-dependence between our countries’ economies will hopefully lead to increased cooperation and mutual consideration of our impacts on one another.

How should households invest?

I’ve tried answering this question in my previous posts. I’m still a big supporter of good asset allocation. As I’ve written before good asset allocation includes allocation of investments over time not just over assets. Time allocation or dollar cost averaging helps us smooth the behavior of our portfolio by constantly averaging the buying price of shares and bonds.

I believe that other markets will emerge as economic engines of growth and will hopefully serve the world economy alongside the USA.

Related Posts:

Personal Finance Management: Budget vs. Net Worth

noreply@blogger.com (Dorian Wales) — Sat, 20 Jun 2009 09:50:00 +0000

While it may be recommended to manage both a budget and net-worth sometimes focus leads to better results.

I've been keeping a detailed budget for over two years now. My budget served me mostly in tracking my family's expenditures and investments rather than in setting goals but I tried to "course correct" whenever I noticed exaggerated expenditures in any area.

Another aspect of my financial management is tracking my net worth. A budget can be considered more of a profit and loss statement while net worth could be considered the balance sheet of household finances.

Still, since I took my recent job, I had very little time to invest in my budgeting efforts (and writing, unfortunately) and I had to focus my efforts on what I considered most valuable in terms of personal finance management.

My main consideration where the nature of my financial goals, the time and effort required and the marginal contribution I believed these tools had for me. The following discussion presents, in a concise manner the key considerations in net worth management and budget management.

Net worth management or budget management?

As any complex questions the answer is: it depends.

Personal finance management should complement one's lifestyle and financial goals. Considering my own led me to the conclusion net worth management is more suitable than budgeting (Still, had I the time I'd do both). Here are my considerations:

Personal finance management through budgeting is more of a short-term management focusing on specific goals, such as meeting one's financial abilities, paying off a credit card or short-term loan, regaining financial balance and generally meeting timely financial goals such as saving $1,000 a month, for example.

The key considerations for budget management are:

Profit and loss management.
Useful for achieving short term goals.
Requires a significant time investment and management.
Should be performed on a monthly basis, at the most.
Budget management requires attentive analysis of the breakdown of expenses and creative thinking on how to lower them.
Budget management keeps you focused on the savings side, leading to penny pinching and frugality which are good tools for savings as they have a cumulative impact.
Budget management without goal setting is simply tracking expenses with no corrective action.

Personal finance management in terms of net worth is more long-term management focusing on major life goals such as retirement, children savings, portfolio management and others.

The key considerations for net worth management are:

Balance sheet management – Capital as a function of assets and liabilities.
Useful for achieving medium and long term goals.
Requires little maintenance but significant time in portfolio management.
Net worth requires tracking various balances of assets and liabilities on a timely basis - bank balance, deposits, investment portfolio, value of a house on one side and mortgage, loans and other liabilities on the other.
Net worth management is focused on the long term on or growth of capital through investments. Net worth management may ignore the short term and does not aid in managing a budget – Just the bottom line of money saved at each period.
As with budget, net worth management without goal setting is simply tracking various balances.
Net worth management can be performed on a quarterly basis. Shorter periods may lead to frustration as funds and investments take time to grow.

My conclusion

While many recommend financial management which looks at both the short term and long term I believe that one may distract you of the other. For me, time invested in budgeting meant less time to invest in portfolio management and analysis.

Managing net worth when trying to meet a budget and repay loans may very well end in frustration seeing net worth on the negative side of the balance sheet.

Related Posts:

Image by: OneBlackBird

How Should Households Invest? Sharing My Asset Allocation

noreply@blogger.com (Dorian Wales) — Sat, 30 May 2009 13:56:00 +0000

Investing without an asset allocation in mind is more likely gambling than actual investing

A sound asset allocation is a key component in any investment portfolio. To put it bluntly investing without an asset allocation in mind is more likely gambling than actual investing.

Two weeks ago I wrote about my decision to gradually increase my exposure to the stock market as the low interest rate levels make it impossible to generate any real return on investment. Some may say low interest rates are a poor advisor. Still, I am quite confident in my decision to increase exposure to stocks in the long term using dollar cost averaging.

Having made up my mind on the question of when I turned to the question of what should I invest in or in other words: what would be a good asset allocation for me?

Asset allocation actually answers the very basic question of investing: What is the return I expect on my investment and, hand in hand, what is the risk I am willing to take?

A short introduction to asset allocation

I feel a short introduction is in order for those less familiar with the concept of asset allocation. I will avoid a deeper methodological discussion at this time.

Asset allocation is the strategy chosen by an investor to distribute his or her investment portfolio among various financial assets to achieve the investment goals. Asset allocation is the corner stone to investing.

Asset allocation has several goals the most important of which is to express the risk appetite of the investor in terms of allocation of funds to different financial assets through which the investment will achieve its goal taking into account the risk involved.

In finance theory, asset allocation is a means of minimizing the specific risk a certain financial asset has. Since various financial assets are not perfectly correlated diversification of the portfolio to several financial assets may (and perhaps should) result in a portfolio which is complete diversified with as little specific risk as possible (specific risk is the risk a certain stock has such as the death of a successful CEO). The diversified portfolio remains with the market risk only – the risk that characterizes the entire market.

Assets may and should be allocated according to several parameters for adequate diversification:

The level of risk of the financial asset – From derivatives to government bonds financial assets holds varying levels of risk. Through asset allocation one risky instrument may offset another.
Specific characteristics of the financial asset (usually associated with risk) – Stocks of different types vary immensely in risk and return. Large-caps are usually considered more conservative while small-cap or emerging markets are traditionally considered riskier. Risk levels in bonds vary as well with government bonds on the safer side (depends on government of course) and high-yield junk bonds are sometimes riskier than stocks.
Foreign currencies – Allocation across currencies is important as well to reduce exposure to a single currency and increase exposure to other powerful or promising currencies.
Other parameters such as industries, geographies, commodities, real estate and more.
Asset allocation holds infinite possibilities. The guideline, as I mentioned, should be the risk appetite of the investor.

My asset allocation

If you've read my previous post on my decision to return to stocks you are aware of my choice to invest through ETF's and index funds. I believe that household investors with as little time on their hands to manage investments should not try to identify value investments in stocks simply because we don't have the time.

Chances of beating the market are slim to none so my recommendation to household investors, such as myself is to join the market (other than try and beat it).

Thus the allocation I will present will be achieved through investing in ETF's and index funds which track a certain index which suits my desired allocation.

It is important to remember that the following allocation is one I built for my own risk appetite and financial situation. Is may serve as an example but should be adapted for anyone else. The purpose of this post is to share my investment management with my readers.

The following is the asset allocation I have chosen for my investment portfolio:

I plan on reaching this asset allocation within 6 months of gradually increasing my exposure to ETF's and index funds in each category.

My considerations for choosing this asset allocation

My considerations for allocating my assets as such are comprised of the following:

I believe the US will emerge first from the current crisis with Europe lagging behind. I believe that the US economy is much more flexible and open to allow for rapid return to growth. The European economy is heavier and less flexible and will suffer more through the coming period. The level of money printed by the US government and the low interest rate environment are frightening as inflation my quickly be upon us. Still, I believe the US economy is resilient enough to withstand such impacts. Hopefully the situation would allow for rapid correction of interest rates to combat inflation after growth has been achieved.

Emerging markets present a long term opportunity which I would hate to miss. This is quite a risky investment but for the longer term (over 15 years) emerging markets such as China, India and others look very promising.

The financial sectors should rebound first if it survives. Banks are usually the first to capitalize on return to growth through credit issued and investments made.

As I mentioned I don't believe in beating the markets so I've decided to join them by investing the rest in ETF's and index funds which track country leading indices such as the S&P500, FTSE, DAX and others.

Monitoring my asset allocation

Setting up an asset allocation is not enough. As values of assets change the allocation shifts. Imagine a strong bullish period in stock markets. The percentage of investment in stock increases as stocks rise thus slowly shifting your asset allocation towards this instrument.
I've written a post in the past on how to monitor a portfolio which I strongly recommend as a supplement to this post.

Related Posts:

Carnival of Financial Planning - May 16, 2009 Edition

noreply@blogger.com (Dorian Wales) — Sun, 17 May 2009 19:01:00 +0000

Welcome to the May 16, 2009 edition of the Carnival of Financial Planning.

Today I'm having the pleasure of hosting the Carnival of Financial Planning on The Personal Financier. The Carnival of Financial Planning takes a long-term view of personal financial planning for individuals and families. We focus on efficient and sustainable personal financial planning ractices that can lead to lifetime financial security.

If this is your first time here, at The Personal Financier, welcome! Please check out my Top Posts and consider subscribing to RSS Updates.

This edition is arranged by subject heading, so that you can browse efficiently.

Enjoy!

This Edition of the Carnival was kindly edited by The Skilled Investor.

Budgeting

Barry presents Tips To Curb Impulse Buying posted at Associate Money.

Beth Dargis presents What to Do When Laid Off posted at My Simpler Life - Simple Living, saying, "What steps can you take to help your finances when you get laid off"

Silicon Valley Blogger presents The Dave Ramsey Budget: Budgeting Tips For Successful Savers posted at The Digerati Life

Pasadena Financial Advisor presents Financial Planning Reading List posted at Pasadena Financial Advisor, saying "When I work with clients to develop their customized lifetime
financial and investment plans, they often ask what they should read to improve their financial literacy. This article provides a list of recommended reading from among the many hundreds of articles that I have authored in the past several years."

Economics

Dana presents Is the Era of Rising Real Estate Prices Over? posted at Investoralist, saying, "Is this the end of rising real estate prices? Some demographic factors to consider."

Dorian Wales presents On Causality and Correlation in Economics posted at The Personal
Financier, saying, "Causality is perhaps the most fundamental element of empirical evidence available to economists. However, it is also the source of many misconceptions due to its elusive nature."

PicktheBrain presents Gallows Humor: 21 Economy Inspired Cartoons posted at School Loans.

Estate Planning

jim presents Comparing Fixed Annuities & Certificates of Deposit posted at Blueprint for Financial Prosperity.

Tushar Mathur presents Getting finances in order posted at Everything Finance,
saying, "Keeping organized records is a gift to your family and to yourself. It helps ensure that your wishes are followed, that your assets are accounted for, and that your money is available to meet your family's needs in a timely fashion."

Financial Planning

jim presents What Is A Good Credit Score? posted at Blueprint for Financial Prosperity.

The Dough Roller presents Dave Ramsey Unleashed: How to Apply Ramsey’s ‘Baby Steps’ to Grown Up Finances posted at The Dough Roller, saying, "See how to apply Dave Ramsey's Baby Steps for those already on their way to retirement."

Todd presents FMyLife Financial Advice posted at Gloomberg News, saying, "Some of the most valuable lessons are learned when things hit rock bottom. FMyLife & Gloomberg present you with 3 Financial Mistakes and How to Prevent them!"

Jeff Rose presents How Long Should You Keep Your Financial Statements? posted at Jeff Rose.
Chris McClelland presents 10 Reasons Your Bank Never Wanted You to Read This posted at Lucrative Investing.

FMF presents Free eBook -- Everything You Ever Really Needed to Know About Personal Finance On Just One Page posted at Free Money Finance, saying, "The key's to financial success are very simple to detail and understand."

Tushar Mathur presents How to choose a financial planner posted at Everything Finance,
saying, "There's retirement to plan for and college tuition for the kids. Insurance. Estate planning. And, oh, don't forget a wedding for your daughter. If all this sounds familiar, it may be time for you to start shopping around for a financial planner."

Financing a Home

Dan Green presents Trends: Mortgage Rates Tend To Rise Between May And August posted at The Mortgage Reports, saying, "If history is an indicator, mortgage rates won't be this low again until after the summer."

Alex Fotopoulos presents When is it Smart to Refinance a Mortgage? posted at My Trader's
Journal, saying, "Some key points to consider when refinancing your home."

Financing Education

Patrick @ Military Money presents Watch Out For Stimulus Check and Government Grant Fraud! posted at Military Finance Network, saying, "Tips on how to guard your identity and avoid online rip off scams like the infamous government grant scheme."

Ted presents Saving Money: 50 Tips for College Students posted at CampusGrotto, saying, "50 ideas on ways to save money as a college student."

Income

KCLau presents The Most Common Habit of Rich People posted at KCLau's Money Tips, saying, "About the common habits of the rich".

Investing

ABC presents Commodities posted at ABCs of Investing, saying, "A brief explanation of commodities."

Manshu presents Value Traps posted at OneMint.

Zach Scheidt presents Synaptics Staying Ahead of Expectations posted at ZachStocks,
saying, "Synaptics Incorporated (SYNA) manufactures touchscreen and touch pad technology used on iPhones and laptop mouse applications. The company is beating estimates and the stock should offer an exceptional opportunity."

Frank Vertin presents Just Buy Index Funds Directly posted at No Load Index Funds, saying, "Buying an S&P 500 index fund through an investment counselor can substantially increase your initial purchasing costs and and drive up your annual management expense fees. Unfortunately, the vast majority of individual investors buy mutual funds and ETFs through
brokers and investment advisers. Rarely do financial advisors recommend that you buy index funds with low fees. This is because low cost, no load mutual funds do not pay them as well as loaded, high fee mutual funds.".

Four Pillars presents BMO InvestorLine Discount Brokerage Review posted at Quest For Four Pillars, saying, "Review of BMO InvestorLine discount brokerage."

Dividends4Life presents PepsiCo Sustains Its String Of Dividend Increases posted at Dividends Value, saying, "Dividend investors love companies that can sustain consistent
dividend growth through the good times and the bad. For three years in a row PepsiCo (PEP) has been named to the Dow Jones Sustainability Index in recognition of the company’s economic, environmental and social performance."

Four Pillars presents Asset Allocation - Include Future Contributions? posted at Quest For Four Pillars, saying, "Can a small investor ignore asset allocation?"

Alex Fotopoulos presents SPY Chart - Premarket posted at Chart Analysis, saying, "Chart of the large S&P 500 ETF, SPY. Alex analyzes the SPY chart using trend lines, moving averages and the Williams %R indicator."

Larry Russell presents 7 Ways to Pick the Best Noload Mutual Funds and ETFs posted at NoLoad Mutual Funds, saying, "Taken as a whole, the vast body of investment research studies show that there really are better approaches to buying and owning mutual funds and ETFs. You do not need to frantically chase fund performance. Performance chasing simply does not work."

Four Pillars presents Transfer In Kind posted at ABCs of Investing, saying, "An explanation of transfering your investments "in kind"."

Praveen presents Successful Trading is About More than Generating A Buy Signal.. posted at Stock Trading Riches, saying, "FINBLOGGER - When buying stocks, your initial purchase is the
least important part of successful investing. Your return is determined by how well you manage the trade - i.e. knowing when to add to your position and when to take profits."

ABC presents Warning - Not All Index Funds and ETFs Are Low Cost posted at ABCs of Investing, saying, "Some index funds and etfs are too expensive."

Wally Fouse presents 7 Ways to Pick the Best Noload Mutual Funds and ETFs posted at Best Index Funds, saying, "The vast body of investment research studies show that there really are better approaches to buying and owning mutual funds and ETFs. You do not need to frantically chase fund performance. Performance chasing simply does not work."

Praveen presents Options Basics posted at Stock Trading Riches, saying, "FINBLOGGER - A blog reader asked me this question: Can any one explain about options trading in a simple manner?"

Richard M. Rothschild presents Low Cost Taxable Bond Mutual Funds posted at Best Bond Index Funds, saying, "The top 14 low cost taxable US fixed income funds with a $10,000 or lower initial deposit. Low investment management fees are very important with fixed income funds. Simply put, if you pay higher bond mutual fund fees, then these bond management expenses tend just to be a deadweight loss to you. When you pay more in bond mutual fund
fees, you are just wasting your money."

Zach Scheidt presents IntercontinentalExchange (ICE) Sharply Higher on Earnings posted at ZachStocks, saying, "IntercontinentalExchange, Inc. (ICE) reported earnings and investors bid the stock higher. Futures clearing and Credit Derivatives Swaps accounted for much of the strength. Management has an excellent track record with acquisitions."

MoneyNing presents TradeKing Review posted at Money Ning, saying, "TradeKing is quickly becoming one of the best stock brokers out there. Find out why."

Alex Fotopoulos presents DIA 3 Month Chart - April 29, 2009 posted at Chart Analysis,
saying, "Alex charted the Dow Jones tracking ETF, DIA, this week and highlights where near term resistance could surface."

Alex Fotopoulos presents RSP Chart - May 7, 2009 posted at Chart Analysis, saying, "Alex analyzes the RSP chart for the past three months to attempt to pick an entry point."

Zach Scheidt presents Bankruptcies, M&A, and Playing Defense posted at ZachStocks,
saying, "A discussion on current economic reports and their effect on the markets, Bank stress tests as a catalyst for selling, and defensive strategies to protect your portfolio from losses."

Managing Debt

Madison presents Making Home Affordable Q & A posted at My Dollar Plan.

Pinyo presents 7 Steps Debt Reduction Illustrated posted at Moolanomy, saying, "Illustrative guide to help you effectively manage and pay down your credit card debt"

KCLau presents Do You Have a Wedding Debt? posted at KCLau's Money Tips, saying, "Most couples want to begin their married life auspiciously and free from the problems. However, it is not uncommon to hear about married couples who go into debt just to get married. Article explores the reasons."

Miscellaneous

GrrlScientist presents Tough Love for City's Homeless: Pay Rent or Get Out! posted at Living the Scientific Life, saying, "Sounding like a story that is fresh out of the satirical newspaper, The Onion, the eighth richest person in America tells thousands of homeless families in NYC to pay rent to live in a shelter or GET OUT!"

Retirement Planning

Darwin presents Start Investing Today: An Amazing Comparison of 25 vs 35 Year Old Starters posted at Darwin's Finance, saying, "This article shares some poignant numerical and graphical
representations of the stark differences between an investor/saver starting at 25 vs 35 years old."

Mike Pastore presents Ways to Stress Test Your Retirement posted at Mikes Millions.com.

Risk Management and Insurance

nickel presents How to Save Money on Car Insurance posted at fivecentnickel.com, saying, "Six surefire tips for reducing your car insurance premiums."

puneetkapoor presents UNDERSTANDING RISK posted at KuberKhana -Indian Stock Fundamental Analysis, saying, "If we understand risk, we prosper."

Silicon Valley Blogger presents Lower Your Car Insurance Rates! How To Cut Insurance Premiums In Half posted at The Digerati Life, saying, "I offer some suggestions and tips for lowering your car insurance and keeping your car related costs (and budget) to a minimum."

KCLau presents Bad Experience of Car Insurance Claim posted at KCLau's Money Tips,
saying, "a story of bad experience with vehicle insurance claim"

MoneyNing presents 20 Different Areas to Think About for a Cheaper Auto Insurance Policy
posted at Money Ning, saying, "Insurance is something we usually forget, yet we pay quite a
bit for it regularly. If you can spend a few minutes and save big, why not?"

Savings

The Skilled Investor presents Most Individual Investors Are Poor Personal Portfolio Managers Personal Investment Management posted at Personal Investment Manager,
saying, "Investors more easily understand investment costs that are directly measurable, such as fees deducted on investment statements. However, many investors ignore or are unaware of the opportunity costs of their sub-optimal investment behaviors. Opportunity costs are usually much more difficult to measure directly, but these investment costs can be even higher than more visible investment fees."

Taxes

Robert D Flach presents HERE’S SOMETHING TO THINK ABOUT posted at THE WANDERING TAX PRO.

Barb A. Ryan presents Asset Allocation, Investment Asset Tax Location, and Emergency Cash Management posted at Independent Financial Planner, saying As you move your cash, bond, and stock financial assets into lower cost, more broadly diversified investment mutual funds and/or ETFs, you should also consider how to locate your investment asset allocation with respect to more optimal taxation. This article will discusses some ideas about where and how to hold your cash assets and how to make emergency cash available."

That concludes this edition. Submit your blog article to the next edition of Carnival of Financial Planning using our carnival submission form. Past posts and future hosts can be found on our blog carnival index page.

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carnival of financial planning, blog carnival.

What is the Recommended Investment Strategy for Household Investors?

noreply@blogger.com (Dorian Wales) — Sat, 16 May 2009 12:22:00 +0000

I've promised to update you, my readers, on my investment decisions. I've decided.

After months of deliberation I've finally decided on getting my feet wet again and bought some stocks on Monday. As readers of The Personal Financier know I am a big fan of investment vehicles that track certain indices such as index funds or ETF's so I've decided on gradually increasing my exposure to the markets via these financial instruments.

Needless to say I have a gift for timing the market, the other way around. Since my recent purchase leading indicators, such as the S&P500 had shed over 5%. That was rather expected as the markets rallied these past couple of months.

In this post I'll share my personal considerations behind my recent decision to increase exposure to stocks. If I breakdown my decision into three main lines of consideration they would be:

My considerations regarding my desired investment style.
My considerations regarding the market environment.
My decision to use index funds and ETF's and invest gradually using dollar cost averaging (Investing a certain sum each period).

My considerations regarding my desired investment style

So why did I decide to reinvest in stocks again? The reasons behind my newly discovered enthusiasm about the markets and why I decided on gradually increasing my exposure to stocks has a lot to do with what I consider a desired or suitable investment style for me and many other household investors (in my opinion, of course).

During the past couple of years I've been fortunate enough (ironically) to not have to worry about my savings and investments as I had none. I'd bought an apartment and literally invested my funds there releasing me of my need to consider alternative investments. Luckily enough the apartment I had bought has yet to suffer the impact of the housing crisis.

Now, two years later I've managed to save up a sum which necessitates more serious consideration regarding where to invest it and how to both preserve it and grow it, if possible.
Naturally, the state of the markets was enough cause of concern for me to seriously consider my investment plans. Losing my hard earned money is not an option.

The more I thought of it I understood I was failing to obey my view on investments, a view that I had learned after paying "tuition" in investment losses in my early investment years.

#1 I decided sitting on the fence won't get me far
I find out I was literally sitting on the fence. Avoiding decision allowed me to remain unscathed during the recent plummet but I did not earn anything either. I've written a post titled "Who Dares Wins" but failed to follow it.

There is no need to take huge risks for huge profits, just thought out risk for a better chance of meeting my personal financial goals.
Sitting on the fence is not a solution to anything. It's a very easy way out. Usually when I avoid deciding I know something is wrong. So I decided to slowly climb down from the fence.

It does feel much better to have decided and to have the feeling of taking a path and having a purpose. My savings were idling in a short term deposit which barely covers the bank's fees with the low interest rate environment. I had to do something and feel like I'm doing something.

#2 I was guilty of timing the market
I just can't help it. I don't think many can. I always try and time the market. Since one does not usually keep objective score of one's efforts of timing the market we never know whether we are any good at it. I most certainly am not.

No one thought the market would rally 50% after Citi's March earning release. Missing out on such a rally is very costly in terms of investment. And now, having raced 50% up the more probable scenario is a downward technical correction in prices… and then? Timing the market almost never works so I've decide to stop and just invest a portion at a time thus averaging these corrections out and enjoying the long trend in prices which will hopefully be a bullish one.

#3 I finally remembered I am a long term investor
It took some time but I've finally remembered I'm actually a long term investor. I think it's hard on humans to invest for the long term. We are programmed to be impatient and impatience is a bane for investors.

I think the birth of my baby boy had something to do with it. I've decided on treating my investments as his. An 18 year investment term should be enough to be considered long term (some may argue).

My considerations regarding the market environment

In my recent posts I've written about a correction in prices which is probable to follow the recent rally. I had thought the stress tests will give enough reason for sophisticated investors to realize profits and change the trend. This hasn't happed, yet. Markets have shed 5% but this can be considered only profit taking on an uptrend.

I still believe a correction is in order but since I've decided on quitting my market timing efforts I've decided to ignore this belief. This is actually a great relief. No one seems to really know what's going on anyway.

It certainly wasn't short-term considerations regarding the economy which got me to reinvest. There seem to be fundamental reasons to believe the global economy will get better in the near future (2-3 years).

#1 Very low interest rate environment leaves little choice
There is money out there looking for reasonable returns. With interest rates this low this money has little choice of investment and will turn, eventually, to the stock market. Interest rates on deposits are so ridicules many investors will find it very hard to accept.

This low interest rate environment will hopefully serve to set the markets back in motion with cheaper credit more motivation to capitalize on this opportunity.

There are risks to such a low interest rate environment, together with increasing influx of money into the markets. Inflation will follow and will have to be controlled but hopefully we'll be on a correct course by then.

#2 Risk appetite seems to be returning to the markets
One of the effects of the recent crisis has been a dramatic impact on risk appetite. When risks seem to be that high no return is justifiable. Risk appetite is perhaps the most important thing for the stock market which is, in essence, a risk-return tradeoff.

Recently there seems to have been a shift in trend and the risk appetite is reappearing. The public's share in the stock markets is increasing through institutional investors and, hopefully, it won't be long before the mass market will find stocks appealing again.

#3 Cyclicality
As my market timing days are over I am better equipped to use one of the characteristics of financial markets in my advantage. Cyclicality is a common trait of financial markets. Though it never seems so in times of prosperity or times of depressions, the tide will turn and the markets will change.

Keeping a presence in the market is vital for long term success and profiting of cyclicality.

My decision to use index funds and dollar cost averaging

My considerations should be clear by now in light of my investment style and market beliefs.

#1 Beating the market is as hard as timing it
Chances are you or the institutional investor you've chosen though a fund or IRA cannot beat the market. For this reason buying the market is the way to go. Fees and commissions paid are often unjustified and hurt portfolio performance with no real abnormal returns over the market.

Index funds are cheap in fees, are simple to follow I believe serve best the needs of household investors.

#2 Dollar cost averaging is a good way to gradually increase exposure
Uncertainty rules the markets, especially today. I would be very nervous had I invested my entire savings in one period. The market is still very fickle and dangerous. Naturally the risk – return equations dictates that averaging investments over time will yield lower returns, and it does, but it is important for sleeping at night.

Dollar cost averaging enables me to remain content even when markets correct themselves downwards. I'll just buy more, cheaply. When markets are bullish again I'll profit on the average investment.

I believe the outlines I've described to be the optimal solution for independent household investors under the current market conditions. I am not recommending anything to anyone. I'm simply describing my strategy as I've promised to do in the past.

I would not like to expose the size of my investments but rather the portion. I've invested 10% of my portfolio in stocks (US Index) and will continue to do so on a monthly basis.

I will update my readers on how my portfolio progresses. By next week I will hopefully have finalized my planned asset allocation and will share it as well.

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Stress Tests and Capital Adequacy Explained

noreply@blogger.com (Dorian Wales) — Sat, 25 Apr 2009 10:07:00 +0000

The highly anticipated FED stress test results may very well serve as fuel for further gains or, more likely in my opinion, as a sought after excuse for turning the tide (in the short run).

The idea of stress testing is an intuitive one. You test something to determine whether or not it is able to withstand various types of shocks without falling apart. The recent financial crisis has brought the issue of stress testing of financial institutions, predominantly banks, closer to the public eye but what really lies behind these stress tests?

The notion of capital adequacy

Banks and other financial institutions are, in their basic form, mediators of money accepting deposits from the public on one hand and issuing credit on the other. Banks earn, again very basically, from a financial spread between the interest rate of credit issued to that paid on deposits accepted. As any other corporation the net of a bank's asset and liabilities is the bank's capital.

This capital plays a very significant role in assuring the soundness and viability of a bank as it can be perceived as a cushion, of sorts, which absorbs various losses the bank may have due to the risks involved in its operations.

Regretfully, I don't have to explain the importance the soundness and viability of the banking system has in any economy. Therefore, the capital held by banks is highly regulated by the government.

Any company, when bankrupt, may cause heavy losses to its close economic environment. But the companies that were in business with the bankrupt company had, or should have had the ability to manage the risks in doing business with that particular company and were compensated for that risks by profits generated through that business.

When a bank goes bankrupt the general public, which had trusted the bank to be conservative enough to keep the deposit side intact, suffers. The public has very little in the way of tools to ensure and manage the risks in their dealings with banks (other than carefully choosing our bank).

Capital adequacy in banks is therefore highly important and closely monitored. A bank should have, in essence, adequate capital to cover the risks it incurs in its lending and financing operations.

Risks are abundant in banks and include mainly the credit risk incurred in lending activities of not being repaid by the lender but also significant market risks due to the financial nature of the business and significant operational risks due to the complexity of banks' operations.
Banks are also exposed to many other risks such as legal risks, liquidity risk, business risk, reputational risk and endless others.

How is capital adequacy regulated?

In order to regulate capital adequacy very detailed requirements of how a bank should handle its capital are issued by regulators everywhere. The most famous of these regulations are the Basel regulations published by the Basel committee of the Bank for International Settlements (BIS) which is an international organization that promotes international cooperation in monetary and financial issues and which central banks turn to for regulatory guidance and insight.

The regulation regarding capital adequacy issued by the BIS are known as Basel I and Basel II and contain detailed requirements and guidance on capital adequacy.

Essentially, this guidance break down the bank's off and on balance sheet items and translates these items into what are known as Risk Weighted Assets (RWA) where each asset receives a certain weighting dependant on the risk associated with it.

For example, a US government bond will receive a negligible risk weight while credit issued to a non-ranked company will be weighted as 100% risky asset. These risk weighted assets are than summed to receive the total risk weighted assets of the bank and are translated into a capital requirement accordingly.

The regulation is very detailed and includes requirements both on the risk weighted asset side and the capital side. Banks cannot recognize, for example, any sort of capital as regulatory capital for the purpose of demonstrating capital adequacy.

Banks are expected to have capital buffers which are excess capital a bank holds, over the regulatory requirements, to withstand unexpected risks and scenarios.

The problem, as we've experienced, begins when banks get involved in business that has not yet received proper regulatory treatment. This issue will always be an open issue as regulators usually react to market developments, thus always lagging behind.

For the purpose of calculating capital adequacy a detailed and common segmentation of business is published and regulated by the regulator. When something does not fit the mold it usually receives a treatment that is not necessarily appropriate or no treatment at all.

This is how financial crisis spring to life.

What are stress tests?

Stress tests are tests performed by banks and regulators to examine the capital adequacy of a bank under various stressed scenarios which may present difficulties for the bank's business. The goal of the stress test is to examine whether a bank has sufficient capital buffers to withstand the impact certain economic and business scenarios may have on it.

Stress tests are conducted by banks on a routine basis to make sure they can adequately handle adverse changes in their business and positions in the market and withstand any reasonable impact unexpected materializations of risks may have.

The results of stress tests serve banks in determining the capital buffer they should hold, as a function of the banks conservatism and regulatory environment.

Most regulators have published specific generic scenarios banks should use for stress testing their capital adequacy. These include adverse market conditions, usually in the form of combinations of historic worse case macro-economic parameters. This, however, is not enough.
Banks must adopt stress tests which specifically target the weakest points in the bank's strategy and balance sheet to ensure the viability of the bank's business in more turbulent times.

For example, in a utopian world banks that issues complex financial instruments would have considered the ramifications a liquidity problem may cause thus limiting this once very profitable business. Alas, we are not living in a utopian world and banks went bankrupt for all intents and purposes only to be bailed out by the government.

The BIS (Basel Committee) has recently published the Principles for sound stress testing practices and supervision (after the crisis had stuck, naturally). According to these principles stress tests play a role in:

providing forward-looking assessments of risk;
overcoming limitations of models and historical data;
supporting internal and external communication;
feeding into capital and liquidity planning procedures;
informing the setting of a banks’ risk tolerance; and
facilitating the development of risk mitigation or contingency plans across a range of stressed conditions.

Stress tests are a very important tool for risk management in banks and serve many aspects of it as demonstrated above.

The Supervisory Capital Assessment Program - The Fed's stress tests

The FED has conducted stress tests in the biggest banks in the US to determine their capital adequacy and the adequacy of their capital buffers under the current crisis. The NY times had published the guidance on How to Design and Conduct a Bank Stress Test as released by the FED.

The results are highly expected in the market and will be published in May, 4. So far the Fed had hardly commented on the results of the tests conducted.
The scenarios examined include changes in Real GDP, unemployment rate and housing prices.

Black Swans – The problem with stress tests

Conducting stress tests is very much like preparing future wars based on the experience gathered in past wars. Future wars will always be different and scenarios will always be surprising.

There are two basic types of stress tests: Historically based stress tests which are essentially worst case scenarios and User defined stress tests which are more fitted to each bank but are usually limited to the imagination of banks and, again, their experience.

The black swan theory, which has gained increased popularity in the recent crisis, targets the key weakness of stress tests. The black swan theory argues, in this context, that models cannot capture hard to predict, large scale and rare events which are exactly the events that shape our world and our financial markets (like the recent crisis).

Model must assume certain distributions and assumptions and will always miss on something. Usually the even they were built to capture.

Awaiting the results

The stock market anxiously awaits the results of stress tests and their impact on the capital of the largest banks in the US. It is important to note that failing a stress test does not mean the bank is bankrupt, or in trouble. It is a measure of how prepared banks are to handle adverse economic situations.

I believe the results will be highly ambiguous and will be taken by the markets depending on sentiment. If market plays want to sell the results will be interpreted as terrible and if a continuation of the recent rally is in order that the results will be surprisingly good.

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On Causality and Correlation in Economics

noreply@blogger.com (Dorian Wales) — Sat, 18 Apr 2009 11:46:00 +0000

Causality is perhaps the most fundamental element of empirical evidence available to economists. However, it is also the source of many misconceptions due to its elusive nature.

There are some things we take for granted. The relationship between cause and effect is so deeply rooted in us we sometimes forget they are merely a result of a clever induction made through observation on the repetitive nature of the two.

Causality is a fundamental corner stone to any empirical science. In economics causality is the basis for models and theories observed ranging from basic supply and demand curves to the most sophisticated economic models around.

The social science of Economics is more formal than other social sciences in the sense it includes theoretical models which are not directly dependent on correlations but rather on assumptions of maximization of utility at their basis. Nevertheless, at the end, utility maximization and its behavioral associations are bound to end include causality as a central assumptions of the coherency of nature.

More intricate relationships between various economic indicators such as interest rates, inflation, expectations, government spending, private consumption and many others are based on observations on different correlations between these parameters over time.

The problem of induction

David Hume is a famous Scottish philosopher known for its strict empiricism (A theory in philosophy which asserts all knowledge arises from experience rather than innate ideas and reason). The following may clear up this issue of the sources of knowledge a bit more.

David Hume, being the strict empiricist that he was, pointed out the problem with the logical problem embedded within the inductions we make based on experience. To put it simply, any attempt at proving our inductions to be correct will ultimately be based on induction itself and therefore cannot be constituted a logical reasoning. The argument would look something like:

Every time I've dropped an object it fell to the ground
Hidden statement: Nature is coherent/consistent or "that which has been is that which will be".
Therefore, when dropped, all objects fall to the ground.

To justify my hidden statement I must turn to the same statement assuming that if nature has been consistent so far it will continue to be.

In Hume's eyes there is no logical justification to assume the sun will rise tomorrow simply because it had done so in the past.

Needless to say induction is crucial to science and the problem of induction presented by Hume has received great attention from philosophers ever since. Karl Popper, a famous philosopher of science (among others) suggested a clever way out of this problem by stating science will advance through efforts of disproving existing theories thus strengthening the correct ones and correcting the false ones. For example, the argument that all swans are white is correct until a black swan will be spotted.

Causality and Correlation

David Hume also took a swing at Causality or Causation following his treatment of induction. Hume stays committed to his reasoning all the way to the skeptic conclusion which is unavoidable according to which causality as a concept has no meaning as we cannot conceive the connection between cause and effect in any means available to us (I will explain shortly).

"…It appears that, in single instances of the operation of bodies, we never can, by our utmost scrutiny, discover anything but one event following another, without being able to comprehend any force or power by which the cause operates, or any connection between it and its supposed effect… All events seem entirely loose and separate. One event follows another; but we never can observe any tie between them. They seemed conjoined, but never connected. And as we can have no idea of anything which never appeared to our outward sense or inward sentiment, the necessary conclusion seems to be that we have no idea of connections or force at all, and that these words are absolutely without meaning, when employed either in philosophical reasoning or common life".

Trying to explain cause and effect in terms of experience is bound to lead us to Hume's reasoning. The connection between cause and effect can be described as either proximity in time, proximity in space, an obligatory connection or any combination of these. Still there will always be examples of events which answer to all these criteria and are not cause and effect. Hume gives us the example of the rooster that believes he bring out the sun with his cry every morning.

In order to lead our lives we all assume causality exists and will hopefully continue to govern our structured world. Many false theories however, are the result of assuming causality where only correlation exists. In economics and other social sciences the risk of erring in this way are very significant.

From the explanation above and the rooster example the difference between correlation and causality should be clear by now. The fact two phenomenon display certain similarities in their behavior, either in time, space or a connection does not mean they are, indeed, cause and effect. They may be simply correlated.

Correlation

Correlation is an important statistical figure which indicates the strength and direction of a relationship between two phenomenon or variables. For example, the price of wheat and bread are correlated. Putting the philosophical discussion aside, we believe these prices are correlated because the price of wheat serves as a cause for the price of bread. However, the prices of bread may be correlated with the daily yield on the Iranian government bond. There is no justification to assume causality here.

No less dangerous is assuming, perhaps, that the prices of bread influence the price of wheat. Getting the direction of the correlation wrong is a very easy mistake. Especially when we are researching variables we don't know much about.

Rudi Giuliani's fight against crime

A good example of the problems with assuming causality and using correlation is that of the significant decrease in crime in New York in the 1990's. The crime rate in New York had dropped significantly seemingly due to Mayor Giuliani's strict zero tolerance policy and the "broken window" thesis.

Researches today argue as to the real cause behind the decrease in crime rates in 1990's NY. Apparently some researches today claim Giuliani's success had merely been coincidental and that crime rates all over the country were dropping due to the economic growth in the 1990's and the decrease in the relative share of certain age-groups in the population. Several cities across the US have shown even more dramatic decrease in crime rates whit out Giuliani's fight against crime.

In their fascinating book Freakonomics (which is a must for any economics enthusiast) Steven Levitt and Stephen Dubner are presenting a very unconventional approach to economics and have presented a theory correlating legalization of abortions in America with the famous decrease in crime presented above. According to Levitt and Dubner the legalization of abortions has led to fewer unwanted births and to a decrease of the number of youths in the population exactly in the 1990's which in turn led to less crime and Giuliani's credit for the fight.
Although I agree with Giuliani's "broken window" thesis there is no real way to know what the cause behind the effect was.

This example serves to show how difficult and confusing it can be to prove causality between two variables and to incorporate that into any successful theory.

Conclusion

As always, all theories, especially when it comes to the social sciences need to be taken with a grain, or a whole bag, of salt. Adopting a skeptic attitude towards surprising findings will quickly sharpen your instincts and ability to tell reasonable from fantasy.

Understanding the problems with induction and causality and also the difference between correlation and causality is, perhaps, one of the most important aspects in leading a rational life. It will also help you quickly turn the page on that recent study which shows the amazing relationship between children who ate peanut butter sandwiches and their success in business later in life.

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Challenging Happiness – Exploring the Irony of Human Nature

noreply@blogger.com (Dorian Wales) — Wed, 15 Apr 2009 16:30:00 +0000

The irony of human nature - anxiety for those that have everything and depression for those that have nothing

The human state of mind has been cleverly characterized by someone to be either anxiety or depression. It seems that either you have attained what you desire and you are constantly afraid of losing it or you haven't and therefore you are depressed.

I've read this rather bleak outlook on life yesterday along with another I'd like to share.
It seems that many successful individuals, who are and had "lived their dream", are frustrated and unhappy, even more, perhaps more than the rest of us, common folk, if I may generalize. There is no shortage of examples of successful people who were not able to cope with success and had cracked under it.

Still, I'd like to avoid the course of cliché or the common argument true happiness exists only in the more "noble" things in life like reason, religion, art, love or anything else that comes to mind.
Rather I'd like to question the idea of happiness in itself and hopefully draw some conclusions in the end.

Is there happiness to be had?

Philosophers of language enjoy dissecting words and meanings and happiness is defiantly one of the most interesting concepts we have.

To put is in very simple terms – Is there happiness to be had at all? Couldn't happiness be just a concept embedded in our language misleading us all?

The question of meaning is deep and challenging. Concepts such as happiness, along with truth, god, soul, mind and others are under constant scrutiny. The idea in itself is simple and powerful – The fact a word exists does not deduce any sort of meaning what so ever.

I think we can all agree, empirically speaking, that happiness is not an enduring state of mind but rather comprised of moments. We sometimes feel happiness surging through us but that may well be the effect of our body chemistry. This notion of experienced utility has been discussed and researched by Noble Laureate Daniel Kahneman which argued happiness is the subjective feeling in each moment defined, in turn, as the minimum range of time a person is self-aware of his or her feeling. Readers of The Personal Financier know I'm very fond of his work on psychology and economics.

Hollywood has probably contributed to the western notion of happiness more than any other influence by putting happiness into terms of family, love, success, money, power, freedom etc.
In fact, the state of happiness in individuals, or the capability to be happy, as we relate to it, is considered to be more than 50% genetic in its source. This simply means not all of us were cut out to be happy.

Happiness and worldly possessions

The notion material achievements do no lead to happiness, as demonstrated, with some humor, in the anxiety-depression paradigm is very deeply rooted in human civilization.

The bible, philosophers and modern day cliché coachers have all discussed the inability of worldly possessions to make us happy. While the latter maybe selling something the former have genuinely tried to demonstrate the way to a happier existence.

Contemporary theories reinforce earlier views according to which money, as the essence of worldly possessions has a much lower contribution to happiness that is usually attributed.

The reason, as modern psychologists have demonstrated in empirical experiments, is not that money isn't important. Money plays a significant role, but only up to a certain minimum point. After the point basic needs have been fulfilled it's how much money one has in comparison with others that matters most. People have demonstrated destructive behavior in experiments where one was willing to lose 25% of his or her capital to "destroy" 50% of another's.

Career is very much the same. We measure ourselves on the social scale. How can one be happy when there's always someone younger and ahead?

Frustration – The irony of the human psyche

Our frustration ironically increases when we achieve our dreams and goals. Suddenly the gap in expectations explodes in our faces and we are overwhelmed by the emptiness of the peak.

More often than not our expectations are much grander than reality. Imagine your last vacation, for example, to a beautiful destination. Did its beauty surpass your expectations? It does sometimes, but usually reality has its surprises in store for us.

The irony of human nature and our psyche is apparent. We were programmed, either by God or evolution (take your pick) to constantly seek out new challenges and new goals. We are quickly accustomed to any situation that is, at the moment, our current situation and we always believe happiness is right around the corner.

By constantly striving we (arguably) better ourselves but fail, again and again, to find peace of mind and the sought after happiness.

Conclusions

Well, it seems that if you are lucky genetics has already assured you 50% chance at happiness. The rest of us may have to work a bit harder.

My personal belief is that being aware of our psychological "deficiencies" is one of the better ways to tackle the issue of happiness. By acknowledging the elusive nature of happiness, the need to constantly set and conquer new goals and by learning to appreciate the more humble states of calmness, tranquility and long-term satisfaction we may find peace of mind and general well being.

My personal tendency is to agree with the philosophic arguments according to which reason is the source of long-term well being (I avoid using happiness). The little exercise I suggest here is exactly that. Gaining awareness and employing reason into understanding the elusive nature of happiness and our human limitations.

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The Recent Rally in Stock Prices is Nearly Over

noreply@blogger.com (Dorian Wales) — Sat, 11 Apr 2009 13:59:00 +0000

Stock markets around the world have surged by over 25% during March and April. I believe market players are already looking for a good excuse to start selling again…

During the past month we've witnessed an amazing good old rally in stock prices. The S&P jumped from its recent new low of 676 points to 856 points in a month's time (that's 26%).
A rally like this is typical to a stock market that has taken such severe blows. Unfortunately there is no way of timing it.

Those of us with decent short term memory surely remember a similar rally that took place during December and January 2009 where the S&P rose from its second recent low of 752 to 931 only to crash back to 676, as we know now. That was 23% rally by the way.

Obviously these rallies are impossible to time. Still, I'm sensing something in the air. The financial papers and headlines are usually good proxies for a change in atmosphere. I believe I detected a change in what had recently been a surge in optimism to more sinister financial news.

Recent Developments

To start things off several "financial gurus" have expressed their opinion on the recent rally in stock prices and have characterized it as a "bear market rally". Do not be tempted to believe these guys really know what they're talking about. I believe they don't know where the markets are headed any better than the rest of us. What do they know?

First and foremost we must remember these individuals and institutions hold certain positions in the market and these positions speak for themselves. I am most certainly not accusing anyone of fraud or deliberate misguidance. We just need to keep in mind the facts.

Second, they are probably aware of the influence of their opinion and use it wisely. Third and maybe most important these "predictions" also serve as a method of communicating between the different institutions and market players. Ironically reality is created through these predictions.

Here are some examples of opinions recently published:

The French Bank Societe General had defined the recent rally "a dash for trash" as the stocks that everyone was looking to sell only a month ago have shown price increases of over 60%.
American Investor Marc Faber had expressed his opinion according to which the markets will suffer another 10% drop before rising again.
Famous investor George Soros had stated the recent rally is a bear market rally as the American economy is still struggling with a difficult recession. Furthermore the American banking industry is literally in a state of bankruptcy.
Morgan Stanley analysts have predicted the market is still bearish as corporate profits, housing prices and bank balance sheets have yet to recover adequately.

Bad financial news plays a significant role in setting the course of the markets in either direction. Surprisingly, or not, financial news tends to side with the opinions of leading market players and financial institutions. The following is a collection of the news gathered over the weekend so far:

Goldman Sachs is expected to issue $10 Billion in stocks next week in order to repay government aid funds. From a first glance this seems like good news. The problem is what happens with other financial institutions that are yet unable to repay the government? What does this say about their financial condition? Several articles have taken this tone in reporting about Goldman Sachs' intention.
The Fed and Federal government have asked banks to avoid publishing stress test results and wait for the formal report to be submitted by the government. Such news could be considered ordinary as well but have been speculated upon fearing that several banks may not have enough capital to withstand their stress tests.
The budget deficit of the US has soared in the last six months to unfathomable highs amounting to $956.8 Billion. Apparently this deficit has only been equaled by that of the Second World War.
Two more banks in the US have collapsed. This brings the total of collapsed banks to 23 in 2009 vs. 25 in 2008.

What does this have to do with the long term?

All of these circumstantial evidence points, in my humble opinion only, to the upcoming end of the current rally in favor of a cooler period. Hopefully we won't witness any further sharp declines in stock prices and this might be a good time for me to re-enter the markets after a long period of waiting. I'm guilty of timing the markets, I know. It's simply irresistible.

We must remember that every period of one way movement in the markets is often corrected by an opposing period, however short, which represents capitalization of profits and "taking air" before conquering new highs.

These are only a handful of opinions regarding the state of the markets. We must keep in mind that the stock market, in theory, doesn't care much about the balance sheets of the upcoming quarter but rather what these represent in the long term.

Soon enough the tide will turn and someone will decide we've had enough. Stock prices will rise expecting the economy to recover and the economy will recover because stock prices are rising in a beautiful, ironic circle of forged reality. The markets are all about expectations. That is why they are unexpected and unforeseeable.

It's a Boy!

noreply@blogger.com (Dorian Wales) — Sat, 04 Apr 2009 11:43:00 +0000

Dear readers,

I'm happy to announce that over the weekend I've become a father. We are DINKS no more. I promise not to have too many "expensive baby stuff" sort of posts.

Back to the hospital then...

Stock Surges Are Usually Unexpected – How To Make Sure You Won't Miss Out

noreply@blogger.com (Dorian Wales) — Sat, 28 Mar 2009 13:18:00 +0000

Historical market data explains why many investors, including myself, missed on the recent surge in stock prices

Since my last post the markets have astonishingly recovered over 20%. A couple of press releases by Citi and Bank of America were enough to send the financial sector sky rocketing with these two banking giants doubling their stock prices.

After witnessing such extreme movements up in stock prices I often try to review my thought and decision making process, or to put it in simpler terms, try to figure out why on earth I wasn't a part of the party?

Two weeks ago it seemed like the biggest retail banks in the US may well be on their way to nationalization. The state of the economy seemed poorer than ever and no hope was in sight. The S&P500 stood at 676 and there were no indications something is about to change.
Still, it is the nature of the markets to be cyclical and what goes down usually comes up. Even in these difficult days we've seen the markets go up by as much as 10% a day only to come crushing down again.

It can be quite frustrating to have your predictions and instincts be proved right on the market while you didn't actually have enough confidence to carry them out. Still, short term trading, whether it is performed on an hourly, daily, monthly or even longer time periods is very risky.
Catching the market at its very low is an impossible mission. No one is able to constantly identify the turning point in the markets while strangely enough many think they can. The legendary Warren Buffet had recently reinvested significantly into the market saying he is almost certain we've got a way to go before the markets turn but he is experienced enough to know that he can't time the market.

A look at the data

As readers of The Personal Financier are surely aware by know psychology plays many tricks on investors.

The human mind is not very good in handling large amounts of data over a historical period. We cannot conclude with success from market data we've heard or read through over a period of time.

Just imagine how many times you've heard of price shifts of a certain stock over a week's period, for example. Most of the time you'll be more than certain that stock's price has risen considerably while it actually didn't gain as much as you'd expect. The reason is we more attuned to positive news on stock than negative and we naturally remember and cling to up movements in prices rather than down movements.

The same phenomenon exists in long term trading. Raw data proves there are only a handful of days in which stocks actually gain or lose significantly. These, therefore, cannot be timed and identified in advance.

There were approximately 4,559 trading days between January 1st 1990 and February 2nd 2008. Only 51 of these days yielded a price change of over 5% in the Nasdaq, and a mere 8 days in the S&P. Maybe 5% is too much to ask for? If we suffice with 3% the numbers change to 238 days for the Nasdaq's and 59 days for the S&P.

What are our chances of catching such days? Very basic statistics quickly determines we have a 1.1% chance of catching a 5% price shift and 5.2% chance of catching a 3% price shift in the Nasdaq. The S&P's statistics are even "worse" 0.2% chance of a 5% price shift and 1.3% chance of a 3% price shift.

The long tail or 80/20 principle work here as well. The numbers are a little different but the principle remains. The majority of days will end in price shifts of fewer than 1% or 1%-3%. That is the long tail of trading days or the "80%".

Smart investing

In order to really capitalize on short term market gains, as the one we had only recently witnessed one must be constantly present in the market. Adjusting portfolio exposure to stock and other financial instruments slowly and gradually is the right way to work.
Sure, you'll experience the short term losses as well but the working assumption is that on average the gain is higher than the loss.

frequent flyer miles

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Learning the financial language will save you money

noreply@blogger.com (Dorian Wales) — Sat, 14 Mar 2009 19:49:00 +0000

Proficiency in "Financialish" equals money and empowerment

According to one urban legend the score in tennis matches was meant to confuse the common bystander, safely maintaining it within the confines of aristocracy. Other explanations include a clock face used in medieval French for scoring the game moving a quarter each time and the different gun calibers of English naval ships (15-pound guns on main deck, 30 pound guns on middle deck and 40 pound lower gun deck).

I've also encountered a similar explanation as to the reason why the French language holds so many "redundant" vowels. According to this myth the French royalty added a bunch of complicated phonetic rules the French writing to make it harder for the commoners to develop reading and writing skills.

It doesn't really matter whether the aforementioned is true or false. The point of these arguments, as we all know, is that knowledge is power.

Proficiency in the financial language is directly translated to money saved or earned

Language is a form of skill and knowledge which empowers the ones proficient in it.
The current crisis, for example, has everything to do with ignorance or lack of proficiency in the more complicated aspects of the financial world. Complicated derivatives and structured products drove the world crazy, making regulatory financial reporting such as financial reports completely useless for investors.

Warren buffet had identified the problem with derivatives as early as 2002: "I view derivatives as time bombs, both for the parties that deal in them and the economic system… derivatives severely curtail the ability of regulators to curb leverage and generally get their arms around the risk profiles of banks, insurers and other financial institutions. Similarly, even experienced investors and analysts encounter major problems in analyzing the financial condition of firms that are heavily involved with derivatives contracts… ".

We don't have to as far as derivatives in order to demonstrate the importance of proficiency in the financial lingo. Many of us are completely puzzled with even the most basic conversation with our banker. The terminology is perplexing and no one really likes to admit one doesn't understand.

Be sure enough banks and financial institutions are quick to exploit on this tendency. A less known fact is that most of the bankers we meet in banks are really marketing personnel "in disguise". It's very simple really. The bank's goal is to sell financial products (loans, credit etc.) in high prices (interest). In order to be smart consumers we must first understand what this guy in a suit is talking about before we are able to be more confident in our negotiations.

It's really not that hard. Much like any other technical terminology the financial language may seem, at first, to be complex and full of subtleties and innuendos. At its higher level this is definitely the case but as with other things in life you can get a good comprehension of about 80% of the subject matter with 20% of the required investment (read this post on the 80%/20% rule). Just be confident enough and you'll be surprised of the results.

When one is proficient in a language one is confident. Suddenly bankers will start mumbling around you and will be turning much more to their manager when suddenly explanations and deviations from the standard pitch are required. This is literally worth money.

Where to start? Or is there a dictionary?

My idea for this post sprang to mind when Oxford university press were kind enough to send me a copy of "The Finish Rich Dictionary" by David Bach, an author of many other personal finance guidebooks.

While I'm less fond of the ever-promising title I did actually find the idea behind the book to be quite helpful. Much like any other language we need a "Finance to English" dictionary which will help in learning Financilsih.

David Bach has cleverly constructed this dictionary 1001 financial words "you need to know" are alphabetically organized and explained. The book is intertwined with helpful personal finance essays which discuss the issues at the very core of our personal finances including: Credit card problems, compound interest, the workings of the Federal Reserve, insurance, buying a home, money mistakes, financial plans, retirement, financial advisors and others.

The book also includes good references to other helpful resources and a interest rate risk calculator to complete the package.

I do feel the added value of this book should be articulated carefully since lack of financial resources is not something the internet is characterized by. This book is helpful as a glossary of words, combined under one roof, which maps the very basics of the financial language. If you don't know where to start this book may very well start you off in the right direction in an easy manner.

The interest offers much more diverse and deep knowledge resources of several kinds I highly recommend to anyone, no matter how proficient in the financial world:

Wikipedia is without a doubt one of the best knowledge resources available to us, free of charge. Most of the entries are very comprehensive and well articulated. I often turn to Wikipedia first to find out more on a certain subject matter.
Another helpful online dictionary is Investopedia which is centered around finance and investments.
Finance blogs are great resources for financial knowledge. Blogs, such as my modest Personal Financier, aim at expanding financial literacy and discussion and are home to many good articles and advice. My link section has many helpful blogs listed. Some of my favorites include The Digerati Life, The Financial Blogger, The Simple Dollar and other more I apologize for not being able to list here.
MSN money, Yahoo! Finance, NY Times (Your money section) and many other offer invaluable knowledge on personal finance. The problem is usually where to start from.

Whether you prefer a book to the internet or vice versa don't neglect your financial education. It's worth money.

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The Japanese Banking Crisis of the 1990's: Are We Facing a Similar Stagnation?

noreply@blogger.com (Dorian Wales) — Sat, 07 Mar 2009 19:08:00 +0000

What can we learn from the 1990's Japanese banking crisis and the long slump in the Japanese stock market? Are we facing a similar scenario?

Price levels in stock markets worldwide are increasingly becoming attractive with each day brining yet another slump. The time of the long term investors has come. Still, a relentless doubt lingers on – Does this crisis represent an unorthodox change in the economy? Have the markets set into a recession which might take more than the usual 1-3 years to recover from?

The readers of The Personal Financier are familiar with my favorite example I often use when demonstrating why long term investing in stock is not risk free, as the odds suggest. That example is of the Japanese market which hasn't really recovered from the banking crisis it had experienced in the end of the 80's and early 90's.

The Japanese stock market, represented by the NIKKEI225 index has slumped from a level of almost 40,000 points in 1990 to 7,000 in 2003, a level which the Japanese market is currently revisiting in this crisis. The market hasn't shown any real recovery and has touched the 18,000 points level briefly in 2007.

The Japanese stock market is the stuff of nightmares for all long term investors and demonstrates the significance of geographical diversification.

The big question is: are we witnessing the Japanese banking crisis all over again in the US and western economies? Will the market slump for decades before showing signs of recovery?

The intuitive answer would be: no. No crisis is like another. Still, as I'm constantly considering buying into these levels of stock prices I thought a comparison of the two will prove interesting.

The Japanese Banking Crisis of the 1990's: Sources and Lessons

In January 2000 the IMF (International Monetary Fund) published a paper titled "The Japanese Banking Crisis of the 1990's: Sources and Lessons" which examined the characteristics of the crisis. Hopefully this paper would be able to shed some light onto our current situation.

The paper traces the roots of the crisis to accelerated deregulation and deepening of capital markets without an appropriate adjustment in the regulatory framework as well as to weak corporate governance and regulatory forbearance. Sound very familiar doesn't it?

The favoring economic conditions of the late 1980's Japan which included above-trend economic growth and near-zero inflation resulted in a considerably lower risk premium for the country and a marked upward adjustment to growth expectations which in turn boosted asset prices and fueled rapid credit expansion during the period. Still familiar…

Those who forget history are bound to repeat it. The exponential growth in the derivatives market along with a weak, passive and partial regulatory framework played a major part in the current crisis as well. Weak corporate governance as demonstrated in weak risk management and lack of internal controls proved fatal again.

The foresight of the IMF paper is rather remarkable: "The Japanese banking crisis serves as a warning that such a crisis can befall a seemingly robust and relatively sophisticated financial system".

The question regarding the unusual length of the crisis is answered to some extent
According to the IMF's paper weak corporate governance and regulatory forbearance stifled any incentive for meaningful restructuring of banks as well as their corporate borrowers.

Forbearance and restricting of bad loans – The structure of the banking system in Japan is different an important to understand as it contributed to the length of the crisis. Main banks in Japan act as quasi-insider monitor of the borrowing firm and as a mediator when borrowers fall into stress. This is advantageous as the monitoring costs are lower due to scale advantages of information on borrowers. Unfortunately, these main banks were reluctant to admit they had failed in identifying bad loans and began restructuring them, including the unpaid interest in yet another credit given.

By restricting non-viable loans banks actually increased the amount of problematic credit issued in the market. The end is obvious.

Capital Base - To salvage their deteriorating capital base banks issue more subordinated debt in higher returns to institutional investors thus further increasing the exposure to bad loans throughout the market (always suspect high returns). Furthermore, banks looked to tap unrealized capital gains to increase capital base, thus selling their stock and bond holdings and real-estate.

Weak corporate governance – The ownership structure and the board of directors' composition created little in the way of motivation for sound corporate governance. Owners had been dependent on the credit issued by banks and the boards of directors were comprised of former employees which were expected to hand over the board sit to other employees at the end of every term as a sort of bonus for the years worked at the bank.

Bank management was not under pressure to maximize profitability and returns and the absence of the necessary checks and balances meant no incentive for proper restricting or dealing with problems.

Regulatory weakness and forbearance – It is argued that the strategy of the government, postponing in dealing with the problems, actually raised the fiscal cost of the final resolution of the banks.

The authorities did very little in the way of arresting the decline in the conditions of the banking systems up to 1995. Regulators feared public panic in light of the strong measures needed to salvage the banks which grew in light of the lack of insurance on deposits.

Again, the IMF paper is amazingly insightful: "By giving rise to moral hazard problems, regulatory forbearance and "too big to fail" doctrines can lead to "gamble for resurrection" which often weakens financial institutions further".

Interest rates in Japan have been very low over the past decade and the economy is stagnant. Are we facing the same market conditions?

Conclusions for the current crisis

I felt calmer after reading the IMF paper and writing the aforementioned. It seems both crises have similar characteristics from a quick glance but a deeper examination proves the two are also different.

Regulators world-wide, I'd dare say under the leadership of Bernanke, seem of have learned and implemented the lessons in full. Lehman brothers was a mistake but no one could have foresaw it at the time (it was important to let Lehman fall from the moral hazard perspective on things). Government interventions are enormous and central banks are very attentive to the markets.
Furthermore, corporate governance may have played a part in this crisis but it was lack of adequate risk management and greed that were at the root of the current fall, not forbearance, which is somewhat comforting. Greed can be associated with economic cycles and will give way to prudential management every other cycle.

As far as restructuring and bad loans are concerned banks did delay some write-offs but we are also witnessing the biggest losses in the history of the world which surprisingly serve as a comfort.

The big questions of how much more financial waste is buried deep in balance sheets of financial institutions will remain unanswered but hopefully this crisis will be resolved in less than a decade.

Nationalization of banks, including the biggest two, may be very unpopular but it seems there isn't much choice in the matter and in that case earlier is better as the Japanese example illustrates.

The US market has defiantly had a lost decade as all major stock indices are revisiting levels they hadn't seen for 13 years. Still, perhaps this is an opportunity of a life-time. I, myself, am becoming more and more agitated and I do believe I will buy my way back in the markets in the near future. As I promised before I will update on my decision on this blog as it may be an interesting test case for the long-term.

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Is Rationalization the Key to Happiness?

noreply@blogger.com (Dorian Wales) — Fri, 27 Feb 2009 13:05:00 +0000

Rationalization is a powerful defense mechanism which comes at the cost of self deception. Does honesty with oneself comes with a price in happiens?

I'm incapable of rationalization. Perhaps it would be more accurate to state I can't really rationalize well enough to convince myself (most of the times).

Rationalization arguments ranging from "Everything happens for the best" and the various versions of "I'm much better off this way" to "If that what it takes to succeed I don't want any part in it" simply don't work for me.

Would I be happier if I could better rationalize?

Rationalization as a defense mechanism

Rationalization is a powerful defense mechanism proposed initially by Sigmund Freud. In Psychology rationalization is the process of constructing logical justification for a belief, decision, action or lack thereof that was originally arrived at through a different mental process (Wikipedia).

To put it in more basic terms rationalization is a defense mechanism in which unacceptable behaviors or feelings are explained in a rational or logical manner thus avoiding the true explanation of the behavior or feeling in question.

By definition the function of such a defense mechanism is to protect our psychology from unacceptable or undesirable behaviors or situations thus enabling our "happiness".

There are many examples for rationalization in day to day life. I'm sure many of us have considerable experience in rationalization efforts some successful, others aren't. Common examples of rationalization include:

Justifying all sorts of minor "theft" such as avoiding taxes or copyright infringements with arguments such as "the government just spends my taxes away on Wall-Street Crooks" or "The music companies' make a fortune off of the backs of poor artists while greed or simple financial math are the real motivators.
Justifying avoiding a conflict with arguments such as "I'll be the bigger person" while lack of courage, or fear, are the real motivators.
Explaining lack of success by arguing all successful people compromise on their principles while many other reasons may well explain it. The list goes on and on.

By rationalizing I am able to explain why I haven't made my first million by 30. I am able to explain why I'm yet another middle class average person with no distinctive mark on anything. The truth is cruel and rationalization helps put it away for a while. At least until the midlife crisis comes along and illuminates us.

Rationalization and self-deception

When I say I am incapable of rationalization I mean I can't really convince myself with my rationalization efforts.

To take my blog as an example – I put quite an effort into my posts and I believe I offer quality to my readership. Still, I am not as successful as I'd like. I could go on arguing the quality of my posts may be of less appeal to the mass market or that the fact I try to argue, in length, is not suitable for internet writing. All of these rationalizations may have some hold in reality but they do not explain why I haven't been selected to write on the NY Times for example. A much simpler explanation may be that although my initial belief is that my posts and my writing are good they simply aren't good enough.

Facing reality may be harsh and cruel but I believe it eventually serves as a great motivator. Personally, I haven't been able to translate my abilities to the success I think I deserve. I may attribute this to many factors which may explain it to an extent. Still, I always know when I'm lying to myself.

I believe avoiding self-deception through rationalization takes an effort but when you are akin to it and honest enough with yourself you will surely see through the rationalization.
Self-deception has been discussed by many philosophers such as Plato, Emanuel Kant, Wittgenstein, Nietzsche and Sartre.

Rationalization and self serving bias

Rationalization and self serving bias usually go hand in hand. A self-serving bias occurs when people attribute their successes to internal or personal factors but attribute their failures to situational factors beyond their control. The self-serving bias can be seen in the common human tendency to take credit for success but to deny responsibility for failure (Wikipedia).

The self serving bias often serves our rationalizations. What could possibly be easier than to place the blame on the recent promotion of my colleague, instead of me, on luck (or lack of), nepotism or cronyism?

By avoiding a thorough self inspection of my part in the process together with a good rationalization process I am almost assuring it will happen again.

Ignorance is Bliss

It seems we are back to this basic truth and the discussion around it. Rationalizing away may help increase our happiness but it requires a certain level of ignorance and self-deception. Some willingly adopt these and others won't.

The choice, I believe, is not up to us and is rather deterministic. Our intelligence, our experiences and our tendencies will determine how well we are able to rationalize or how happy we may be in our ignorance.

From a happiness point of view rationalization is definitely a powerful mechanism but wouldn’t the majority of people, if offered the choice, prefer the truth over the illusion? No matter the consequences?

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Capitalism with Social Equality: A Powerful Though Experiment Demonstrates Our Moral Obligations

noreply@blogger.com (Dorian Wales) — Sat, 07 Feb 2009 19:11:00 +0000

An interesting thought experiment by American philosopher John Rawls demonstrates the morality of a more socialistic version of Capitalism

I've been writing here, at The Personal Financier, for over a year and a half now. My skepticism regarding Capitalism as the best economic system, or lesser evil, should be quite familiar to my regular readers. Still, when at times I offer a more socialistic approach in my posts the comments are not late to follow.

It seems our solid conviction in the morality of Capitalism is deeply rooted in us. While pure Capitalism or the more extreme free market variations might have taken a blow recently, our indisputable belief in unadulterated Capitalism remains unscathed, not without just cause.

Capitalism has proved to be a shining beacon in the darkness of earlier economic approaches and has allowed men and women to fully express their potential. Still, we cannot ignore the destructive side-effects our economic system has on social equality (or inequality) and the erosion of the middle class which is the foundation to any solid economy.

There is no need to elaborate on the destructive force of more extreme versions of capitalism as we are witnessing, first hand, the results of greed which "pure" or unregulated capitalism leads to. Obviously the human factor is to blame and not the system, but shouldn't systems be designed to contain our human flaws?

The intuitive appeal of a more socialistic approach

Imagine a disabled person, say blind or handicapped in some fashion. Would you agree that it is society's moral obligation to support such a person? I'm sure that by support the majority would agree that basic sustenance such as a decent roof over one's head, clothes, food and decent medical care are all very reasonable considering the financial capabilities of our western governments.

To take this discussion one step further, to a more risky area, we have to consider the following arguments which I believe to be true:
1. Not all individuals are created equal.
2. Not all individuals, even if are created equal, have equal opportunity.

The socialistic point of view I wish to discuss is such that will, accordingly:
1. Assure the basic needs of all human beings
2. Strive to create equal opportunity

Obviously I can hear the comments in my head already. Why should the lazy and careless live off my taxes? It is a bit more complicated than that but to put it very clearly and basically:
I believe the state of affair where several "freeloaders" enjoy basic sustenance on "our" expense is preferable to a state of affairs where the unfortunate, of which some are lazy and others have had it bad, are taken care off.

Don't get me wrong, I'm not advocating extreme equality and I believe the relationship between ability, effort and personal gain should be rewarded to make any sort of progress. I would, however, like to make sure the less fortunate are living with minimal dignity.

Before this discussion gets more complicated I'd like to present John Rawls Veil of Ignorance which I believe is a very powerful and intuitive thought experiment that contributes to this discussion greatly.

John Rawls' Veil of Ignorance

John Rawls was a contemporary American philosopher and a leading figure in moral and political philosophy. Much like Jean-Jacques Rousseau and Thomas Hobbes Rawls set out to discuss the "state of nature" or the hypothetical human condition prior to the foundation of the state and the state.

While Thomas Hobbes's state of nature is a savage war of every man against every man Rawls uses a thought experiment to demonstrate his concept of the state of nature.

Rawls suggests that at the state of nature it is reasonable to assume the talented and strong would be able to coerce others (the weak). To overcome this "evolutionary" problem Rawls sets up the "original position" and asks us to put ourselves behind a veil of ignorance which deprives us of any information regarding ourselves and others placing us all in an equal, conscious starting point for the discussion in the social contract which we are all interested in.

Rawls argues that the representative parties in the original position would select two principles of justice (as a result of the veil of ignorance regarding their actual positions):

1. Each citizen is guaranteed a fully adequate scheme of basic liberties, which is compatible with the same scheme of liberties for all others;

Even the most egotistical would like to assure their basic rights, unknowing what their actual position is (talented and strong or weak).

2. Social and economic inequalities must satisfy two conditions:

to the greatest benefit of the least advantaged (maximin rule);
attached to positions and offices open to all. The reason that the least well off member gets benefited is that it is assumed that under the veil of ignorance, under original position, people will be risk averse. This implies that everyone is afraid of being part of the poor members of society, so the social contract is constructed to help the least well off members (Wikipedia)

And sympathy is what we need…

Rawls thought experiment is powerful. It forces the thinker to consider himself in someone else's shoes and evokes sympathy. And as the song goes: …sympathy is what we need my friends …
I'm anxious to read your great comments.

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Behavioral Finance in Everyday Life – The Lottery as a Case Study

noreply@blogger.com (Dorian Wales) — Sat, 31 Jan 2009 15:49:00 +0000

Is lottery a tax on stupidity or are our flawed psychologies playing another trick on us?

My wife and I usually enjoy strolls around our neighborhood on weekends, especially on sunny winter days. We live in the city and in our last stroll I kept noticing lottery advertisements everywhere as if they were beckoning to me.

Lottery has been deemed a tax on stupidity for a good reason. Every smart and aware consumer knows better than to throw money away on odds smaller than those of getting hit by lightning 3 times in a row.

Still, I couldn't help but buy a ticket. I felt I'd be I'd ignoring all the signals I had received that day calling out to me: buy and ye shall win. After having bought the ticket, for some reason, I'm full of hope and a very strong sensation of confidence in my chances of winning something.

I'm sure many of you have experienced that feeling before as well. Somehow, even though I am aware of the slim odds an unjustifiable feeling of optimism surges and the thoughts of all the things I'm going to do with my soon to be acquired financial independence overwhelm me.

There's a certain bias at work here and as my readers know I love psychological biases. This feeling of elation and of profits to come reminded me something. I usually get the same feeling when I make a stock investment. I simply can't be more certain this particular stock will drive my portfolio to new highs. Where does this conviction come from?

Behavioral finance and hedonic psychology - Daniel Kahneman and Amos Tversky's work

Daniel Kahneman is an Israeli psychologist and Nobel laureate, notable for his work on behavioral finance and hedonic psychology. With Amos Tversky and others, Kahneman established a cognitive basis for common human errors using heuristics and biases, and developed Prospect theory.

Kahneman and Tversky's work on behavioral finance is one of the most interesting and important to anyone who wishes to learn of the limitations of human rationality and the psychological biases that play a key part in our "rational" thinking. Their work is very relevant for investors everywhere as it ties in very tightly to stock market success and failure due to the affects of psychology on us, as investors or traders.

The Representativeness Heuristic – A wrong perception of chance

Would you choose consecutive numbers like 1,2,3,4,5 for the lottery? I'm guessing that you won't. But why not choose these numbers?

1,2,3,4,5 have the same chances of appearing than 2,8,12,23,35 but the last seems much more probable to be the winning numbers due to their randomness. Our minds are programmed in such a way as to correlate order with intention, which is mostly true. Still, there are times when this is obviously false.

The same phenomenon exists in the roulette where the combination red-red-red-black-black-black is thought of as much less likely than black-red-red-black-red-black. We have a certain expectation of nature restoring order to it, offsetting the results.

The Overconfidence effect and Optimism bias

Very common in investors the overconfidence effect is a bias in which people are correct in their judgments far less often than they think they are. For example, for certain types of question, answers that people rate as "99% certain" turn out to be wrong 40% of the time. Overconfidence is one kind of what is called the miscalibration of subjective probabilities.

You really can't get any more optimistically biased than hoping to win the lottery against unbeatable odds.

Apparently the lethal combination of overconfidence and optimism bias is very common and very hard to resist. According to Kahneman and Tversky only seasoned stock market brokers, weatherpersons and dog track analyists have shown some resistance to the effects of these biases.

I'm still hoping to win something but somehow I'm a little less confident in my guesswork. Still, people do win.

If you find judgement under uncertainty and heuristics and biases as interesting as I do please let me know. In the near future I hope to write more on these issues. In the meantime, you may be interested in Kahneman and Tversky's Judgment under Uncertainty: Heuristics and Biases

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Success: Who Dares Wins?

noreply@blogger.com (Dorian Wales) — Sat, 24 Jan 2009 15:15:00 +0000

Following the crowds won't get you there

After a couple of hours spent on a certain report or analysis I usually take 5 minutes to browse through my favorite news and finance sites to update on recent events and financial developments.

This week, to my surprise, a familiar face looked back at me from the home page of one of the most prominent financial websites around. Even more astounding was the fact that this person, once a good friend of mine, was chosen to be one of the most promising entrepreneurs in Europe.

It seems that while a distant and remote individual achieves financial success we somehow calm our envious and frustrated spirits by attributing his or her success to some magical factors unknown to us whether it is family and friends or pure luck.

When someone you're quite familiar with makes it big there are questions that need answering, all emanating from the same frustrating thought: Why him and not me?

The questions of success and financial independence and the way to achieve is perhaps one of the most troubling the minds of all of us, at least in western societies. Many of us spend long days in tiring jobs, feeling stranded and stuck. How do you weave the magic of financial independence?

I can't say I felt great at the moment I read through the article. I was naturally very happy for my friend but my mind quickly strayed off to other directions. Although I lead quite a successful life I've yet to become a success in my eyes.

I consider myself very talented and a great employee but it seems the set of skills I have is destined to leave me fighting to climb-up the corporate ladder, each exhausting step at a time.

To really succeed you need to be a visionary, to be determined enough, to have a certain hunger and to be brave enough to follow your convictions. Naturally these have to be combined with intelligence, marketing and social intelligence, hard work and luck. The combination of these traits and circumstances is obviously rare.

There's no reason to adopt a fatalistic approach. Actually most of us, including me, haven't really tried. I think I speak for many of us when I say we're just too comfortable and not hungry enough. Unfortunately we're caught in a situation we're not happy in but we don't have the courage or conviction to try and change it.

To really succeed, much like in the stock market, one has to avoid the crowds, or leverage them. You can have a pretty good life following the classic examples but in order to really stand out it seems we need to be innovative in some fashion, and dare.

The very appropriate motto of the British SAS or Special Air Service, which is one of the most famed special ops units in the world, is simple and powerful: Who Dares Wins. I, myself, intend to dare a little more.

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Valuation and Risk Measurement Models under Heavy Criticism – What Went Wrong?

noreply@blogger.com (Dorian Wales) — Fri, 16 Jan 2009 18:40:00 +0000

Are valuation and risk measurement models as the root of all evil?

In this crisis we witnessed a broken market. Financial institutions relaying on complex financial models for both valuation and risk management suffered heavy losses and saw their methodologies break before their eyes.

Many valuation models and risk models literally stopped functioning and started spewing out numbers that seem to have no real connection with reality and stock market prices.

Many investors and financiers alike are losing faith in what was once held high as the hope of objective decision making based on mathematical calculations. Math and numbers provided a sense of security and scientific aura to many managers who only recently learned of their limitations, the hard way.

It is natural for us to assume complex equations and finance theory applied to the markets is much better than any subjective human judgment made. The model does over-estimate risk or influenced by market psychology. The model is no eager to sell on profit and is essentially not biased by any psychological human weakness.

So what went wrong?

Understanding models

Reality is far too complex to model. At least for us simple minded humans. As a result all models have to make assumptions which simplify reality and enable to model it while still providing powerful insights into the subject matter.

Many simple models are very powerful such as simple economic supply and demand, game-theory prisoner’s dilemma and many many others. The most important thing, then, is to be aware of the assumptions made in the model and draw the model’s limitations as a result.

In order to understand how far these limitations may go I’ll examine too very commonly used financial models: VaR, which is a commonly used risk measurement model and Black and Scholes which is a commonly used valuation model.

VAR and black swans

I’ve recently discussed the question of whether the western financial markets are just a huge Ponzi Scam. Nassim Taleb, author of the Black Swan theory suggests so (read more here: Is the Stock Market a Big Ponzi (Madoff) Scheme?).

So what do black swans have to do with value at risk? Let’s have a look at VaR and its purpose.

Value at Risk is a widely used measure of the risk of loss on a specific portfolio of financial assets. All the financial institutions in the world use VaR in their risk management efforts. For a given portfolio, probability and time horizon, VaR is defined as a threshold value such that the probability that the mark-to-market loss on the portfolio over the given time horizon exceeds this value (Wikipedia)

To put it simply VaR is the amount a certain portfolio might lose on a given probability and length of time.

For example, if a portfolio of stocks has a one-day 5% VaR of $1 million, there is a 5% probability that the portfolio will fall in value by more than $1 million over a one day period (Wikipedia).

When VaR is applied a probability has to be assumed. This is one of the main weaknesses of VaR and is crucial for understanding its limitations. When VaR is calculated a given timeframe and confidence level are assumed. For example I’d like to have a 95% confidence that in a 10 day period I will not lose over $1,000 on my portfolio.

What VaR does is take either historical or expected values for the assets and uses a statistical distribution to calculate the maximum loss on a 95% confidence level.

The problem lies with the remaining 5% which are not modeled and that’s where the black swans come into play. A black swan refers to a large-impact, hard-to-predict, and rare event beyond the realm of normal expectations. That is exactly what that remaining 5% (or 1%) represent. The chances are slim but the impact will be destructive (see sub-prime and credit crisis).

This limitation cannot be avoided. Had one modeled for 100% of occurrences than the Value at Risk would simply be the entire portfolio as there’s always a chance to lose everything.

Black and Scholes Model and non standard times

Another very commonly used model is the Black and Scholes model for option pricing. This model, sometimes under certain adjustments, is considered the gold standard for option pricing.

The model is quite complex and relays on relatively advanced mathematics but as always the model needs to make assumptions on reality which in turn limits it.

The Black and Scholes model is very powerful for option pricing and provides very interesting data on the impact of time, base asset price movements and standard deviation on the price of options.

However, the mighty Black and Scholes model assumes that the stock prices, which are the basic asset for the option, distribute normally (Normal Distribution) and that continues trading exists.

Obviously when the market is broken and trading is slim Black and Scholes simply doesn’t work. Option pricing according to Black and Scholes will usually be ridiculously high.

More complex financial instruments call for more complex valuation models along with more difficult to understand assumptions and limitations. No wonder we got lost in all the numbers.

It’s not that everyone wasn’t aware. There aren’t any better tools out there

I wouldn’t hurry to disparage financiers everywhere. Most of these individuals understand very well the limitations of models and modeling for financial assets. The problem is there aren’t any better tools out there.

Financial institutions have to quantify risk and valuate assets somehow. As such these models are the best solution available next to selling the assets altogether.

The problem stated when models weren’t accompanied with adequate skepticism, conservatism and a good infrastructure that calls for experience and judgment. It’s really not my intention to offer wisdom in hindsight. I’d make the same mistakes myself. That’s just human nature. Let’s make sure we implement these lessons in the future.

As always the industry will overshoot to access conservatism of valuations and extreme risk assessment. The ones that will make money are the ones that will be brave enough to remain calm and sound and apply the common sense we all know to be right but too afraid to apply.

Related Posts:

Know your Portfolio - Three Simple Charts Can Make a World of Difference

Key psychological factors in stock market success

The Problem With Structures - Risks and Hidden Costs

The Big Mac Index – Applying Simple Economic Common Sense

Would You Be Willing To Pay 60% Tax For a Higher Level of Social Equality?

Is the Stock Market a Big Ponzi (Madoff) Scheme?

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I Want To Be A Part Of You, New York New York

noreply@blogger.com (Dorian Wales) — Mon, 12 Jan 2009 20:19:00 +0000

I Just returned from spending two working weeks in Manhattan, one of mankind's most amazing creations. I'd like to share 7 observations I've had during my visit.

The accomplishments of mankind

Walking around Manhattan I always feel humbled by the achievement represented by this small island. I love the moment the skyline reveals itself as the taxi approaches and the feeling of driving through the streets of Manhattan for yet another time.

There are very few places in the world one can experience mankind's potential realized before one's eyes. Walking amongst the towering skyscrapers of Manhattan is just that.

They say you can recognize a tourist in Manhattan by how their heads are always tilted back. I've been to Manhattan quite a few times but I guess I'm still a tourist since I can't resist looking up at those magnificent buildings.

Makes you feel at home

From my very first visit to Manhattan I felt right at home. I'm a city dweller myself so I might be biased towards cities, although compared to New York City not many cities can claim that title.

It might be the familiar streets I'm used to seeing on the cinema coming to life before my eyes that give the welcome feeling but I doubt that. I think the high degree of accessibility and the cultural and ethnic diversity of the city play a key role.

I've been too many foreign cities and none greets you like NY City. The people may not be the most courteous but they are straightforward, to the point and usually warm towards both tourists and local residents.

You will usually be judged by one standard and that is how much money you have. This is a complement, although nothing at its extreme is good.

Social inequality and the ability to make money

Being in the state of mind I am, and that is an economic, personal finance, state of mind, I can't help but think of the many Manhattanites who can actually afford an apartment to rent or let alone buy.

Apparently there are enough very rich people in this world to populate the many luxury apartments throughout the city. I would probably have to work two lifetimes to start thinking of buying a 3 bedroom apartment in Manhattan. That social difference is amazing.

I understand many of Manhattan's residents are successful foreign individuals. Paradoxically enough the place everyone wants to live in (thus the high demand and prices) probably has a very high number of empty apartments as many of these individuals are usually out on various businesses.

Consumption as a state of mind

Shopping in New York is an entirely different experience. I've been to Macy's at least 5 different times and each and every time I get lost between the various buildings. It takes a certain skill to shop in New York as the vast array of anything and everything is mind blowing.

Floors on floors of clothes, electronics, entertainment and what not will get you dizzy in no time. It is very hard to resist the temptation of such abundance.

You can also better understand consumption as a state of mind. It isn't possible to be happy while so many good things I don't have are available, and relatively cheaply.

Recession?

When I came to New York I half expected to find amazing sales and empty lines. With recession news pumped all day long and with the financial industry badly hit I really thought I'd see a change.

Well, you can probably understand I found everything to be the same. Lines were there, sales were not. Times Square and Broadway theaters were packed full as they've always been. I heard a show or two are closing but I didn't see any supporting evidence in the field.
Manhattan is obviously more recession proof but I did expect to see some impact on the city.

The sale gambit – Psychology of sales

Shopping is a part of a visit to Manhattan. I'm not a big shopper but since everything is available is such a small area I can't resist shopping for a while as well.

As I've written already I was surprised by the lack of sales but did notice, yet again, the psychology of sales and its effect on us or "the sales gambit" if you'd like.

It seems that no matter what, the size, color and design you like is never on sale. You usually settle for something close to enjoy that "got a great deal" feeling but you also buy another item to justify your visit to the store.

I've visited 3 different department stores only to find this pattern repeat itself over and over again.

Best steak I've ever had and a lesson on brand names

Peter Luger. I've heard that name every visit to New York. Everyone insists it's the best steak in New York and probably the entire USA. I'd be careful in making that assertion but I will contribute to the reputation of Peter Luger and say it's the best steak I've ever had.

More interesting is the location of the restaurant and its ability to attract visitors despite it. The brand of Peter Luger is so strong and well known people actually make the trip to Brooklyn for the experience. It's a 30-40 minute train ride from midtown Manhattan into a not so welcoming neighborhood (though I can't really judge as I don't know the place).

It seems certain brand names, once created, have a sort of inertia that keeps them going, that and the fabulous steak. Still, I don't think such a reputation is easily maintained. They offer the guest an experience, not just a steak. That's the key to their success, in my opinion.

Is the Stock Market a Big Ponzi (Madoff) Scheme?

noreply@blogger.com (Dorian Wales) — Fri, 26 Dec 2008 16:47:00 +0000

Looking into the notion of the western financial markets as a big pyramid scheme

I'm sure many of you are familiar with the tale of monkeys and villagers that cleverly demonstrates certain aspects of the stock market. Here's a short version for those of you who aren't.

Of moneys and pyramids

Once upon a time in a village, a man appeared and announced to the villagers that he would buy monkeys for $10 each. The villagers, seeing that there were many monkeys around, went out to the forest and started catching them. The man bought thousands at $10 and as supply started to diminish, the villagers stopped their effort. He further announced that he would now buy at $20. This renewed the efforts of the villagers and they started catching monkeys again. Soon the supply diminished even further and people started going back to their farms. The offer increased to $25 each and the supply of monkeys became so little that it was an effort to even see a monkey, let alone catch it! The man now announced that he would buy monkeys at $50! However, since he had to go to the city on some business, his assistant would now buy on behalf of him. In the absence of the man, the assistant told the villagers; “Look at all these monkeys in the big cage that the man has collected. I will sell them to you at $35 and when the man returns from the city, you can sell them to him for $50 each.” The villagers rounded up with all their savings and bought all the monkeys. Then they never saw the man nor his assistant, only monkeys everywhere!

At times such as the one we are experiencing now it is very tempting to claim the stock market and western market economics are all one big Ponzi scheme as Nassim Nicholas Taleb , the author of the black swan theory, recently did.

The western financial systems as Ponzi schemes

Mr. Taleb is a philosopher and a former derivatives trader, whose black swan theory deals, in a very insightful manner, with the affect powerful yet random occurrences may have in any field (a black swan as a large-impact, hard-to-predict, and rare event beyond the realm of normal expectations).

The sub-prime crisis and the following credit crisis are huge black swans for that matter. Nassim Taleb enjoys the reputation of one of the few who foresaw the crisis.

According to Mr. Taleb, as was stated in a recent interview, the western financial society is based on a pyramid scheme, much like the Ponzi or Madoff schemes. We needn't take this statement to the letter but rather regard it as a notion to consider.

As many philosophers before him, I believe Mr. Taleb is offering a fresh perspective on an existing notion, in this case financial markets, which we should use to review our set ways of thinking.

In the headline I chose I asked whether the stock market is just a Ponzi scheme, a headline that wrongs Mr. Taleb's argument. The stock market is a means to an end: a tool to raise capital. Mr. Taleb "goes after" the western financial system that failed us.

The main argument is that investment banks and brokers usually risk other people's money and benefit on the upside only. This is a powerful argument with the results of which we can't really argue.

The tools of the trade are often complicated models which justify what they were built to justify while ignoring other important parameters. The already known end is usually a bubble busting, one size or the other. Models are simplifications of reality, that is their strength and weakness. Every model must be taken with a pile of salt.

By increasing the level of risk taken with other people's money bubbles are cyclical and are destined to explode eventually. Since the human mind is not very adept at dealing with risks objectively and is apparently very good displaying herd behavior the markets simply follow this cyclical pattern with investment bankers making a fortune every other 6 years or so.
The pyramid element is very strong. If you can either time the trend, or better yet create it, then you're one of the lucky few who put their money first. Chances are that like many other household investors, we'd be too late to really enjoy the party. What can we do? Simply be there, reserved yet present, through the good times and the rough.

Being aware is already a good starting point

There's no need to adopt a fatalistic approach to financial markets and keep all our money in ultra solid investments. Being aware of market dynamics and the structure of our "western" markets is important for financial survival and to taking advantage of the benefits they do offer.
We all enjoy the possibilities our financial markets offer. Our pensions, for example, are dependent on the market's performance. Even with bubbles bursting and crisis manifesting markets have displayed positive returns in the long term.

There is a solid basis and economic justification for the western financial markets and obviously claiming they are all a big pyramid scheme is too extreme. There is truth to the argument as I've discussed but there obviously so much more.

As the cycle continues regulation will be enforced more firmly, the fear will keep the markets at bay. Still, as the economy starts expanding again the perceived level of risk will decline again and the bubble will burst again.

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