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Before You Take Any Investment Advice, Consider the Source – Version 2.0

18 Wednesday Sep 2019

Posted by wmosconi in asset allocation, Average Returns, behavioral finance, bonds, Charlie Munger, confirmation bias, Consumer Finance, emerging markets, Fama, finance, financial advice, Financial Advisor, financial goals, financial markets, Financial Media, Financial News, financial planning, financial services industry, Geometric Returns, Individual Investing, individual investors, interest rates, Internet Bubble, investing, investing advice, investing, investments, stocks, bonds, asset allocation, portfolio, investment advice, investments, Markowitz, Modern Portfolio Theory, MPT, personal finance, portfolio, risk, risk tolerance, stock market, Stock Market Returns, Stock Market Valuation, stock prices, stocks, Uncategorized, Valuation, volatility, Warren Buffett

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academics, anchoring, behavioral economics, behavioral finance, Ben Graham, Bill Ruane, Capital Asset Pricing Model, CAPM, Charlie Munger, cognitive bias, Common Stocks and Uncommon Profits, David Dodd, economics, economy, Efficient Market Hypothesis, EMT, finance, invest, investing, investments, mathematics, Modern Portfolio Theory, MPT, performance, Phil Fisher, portfolio, portfolio management, Security Analysis, stocks, uncertainty, Warren Buffett

I originally wrote about this topic five years ago.  However, I think that it may even be more relevant today.  You may have heard about behavioral finance/economics and how cognitive biases plagued individual investors when making financial and investing decisions especially during volatility times in the financial markets.

Sometimes an overlooked topic is the fact that whomever provides you with financial advice will invariably be affected by those same biases.  Yes, even the professionals cannot escape them.  One of the most prevalent and insidious cognitive biases is called “anchoring”.

In layman’s terms, “anchoring” describes the tendency of people to form a particular belief and then stick with it unless there is an incredible amount of evidence to the contrary.  It is just part of human nature; we generally do not want to admit that we were mistaken or flat out wrong.

Now when I am talking about considering the source, I am not referring to the person’s qualifications such as having a Chartered Financial Analyst (CFA), Certified Financial Planner (CFP), or Chartered Market Technician (CMT) designation.  I am referring to the person’s investing paradigm. 

For the most part, financial professionals are influenced greatly by the time period in which they first start out in the financial services industry.  The first several of years have an outsized impact on their investing recommendations throughout the rest of their careers. 

I will give you an example in life, and then I will talk about Warren Buffett and even myself.  Take special note that I am including myself in this “anchoring” cognitive bias within the context of investing.

There have been many studies that show that the kind of music you listen to most during your teen years becomes your preferred type of music.  For example, there are many people in their early 40’s that love 80’s rock.  They would prefer to listen to that over any type of new music.  My parents are in their seventies now, and they love to listen to Peter, Paul, & Mary, the Beach Boys, Neil Diamond, Motown, and lots of one-hit wonders from the 50’s and 60’s. 

Think about your own taste in music.  Does this ring a bell?  Most people fall into this category, and it is almost subconscious.  You like a certain genre of music best, and it sticks with you.  Did you have a family member that was really into music and had a collection of records?  Sometimes you get introduced to music at an even younger age, and you are drawn to it.  You listened to it during your formative years.  The same goes for investing in a rather similar way.

If we take a look at Warren Buffett, he was definitely influenced by the time period in which he started learning about investing seriously.  Buffett read Security Analysis by Benjamin Graham and David Dodd, and he knew right away that he wanted to go to Columbia to get his MS in Economics.  The themes in the book seemed to resonate with him.  I have heard stories that the value investing class with Ben Graham and Warren Buffett was really a conversation between the two of them.  The rest of the classmates just sat back and enjoyed the “show”. 

Warren Buffett also learned a lot from a lesser known gentleman, Phil Fisher.  Phil Fisher wrote the classic treatise on “scuttlebutt” called Common Stocks and Uncommon Profits.  “Scuttlebutt” is essentially trying to gain every last piece of information you can about a company prior to investing.  This technique includes, not only speaking to management and reading annual reports, but talking to competitors, suppliers, current employees, past employees, and several other sources.

Warren Buffett remarked in the past that he was “15% Fisher and 85% Graham” in terms of his investing style.  Most experts on the career of Buffett would say that the percentage has shifted toward Fisher quite a bit, especially with the massive size of Berkshire Hathaway now.

I did not pick Warren Buffett because of his long-term track record of stellar performance.  I only picked him because many individuals are familiar with Warren Buffett.  Warren started out working for Graham in the early 50’s after he graduated from Columbia in 1951.  If you look back at this time in history, the stock market had finally gained back its losses from the great crash of October 1929.  The baby boom was in full swing, and the US economy was on overdrive in terms of growth.  The Securities and Exchange Commission (SEC) was set up back in 1933 after the crash once an investigation was done regarding the causes of this debacle. 

There were two important promulgations from the SEC in 1934 and 1940 that were issued in order to ensure that company information was available to the public and not fraudulent.  Well, there were still scams, but they were harder to pull off.  (As an aside, the Investment Advisor Act of 1940 did not stop Bernie Madoff from stealing billions of dollars several years ago).  Buffett and Graham (and Graham’s partner, Newman) loved to get their hands on any piece of information they could.  In fact, Buffett used to read entire books on every single public company. 

During that time period, information was so disjointed and hard to get.  However, it was now available to the public and professional investors who could do much more thorough analyses.  The financial markets had far more inefficiencies back then. 

This time period was before the dawn of Modern Portfolio Theory (MPT), the Capital Asset Pricing Model (CAPM), and the Efficient Market Hypothesis (EMT).  Thus, there was a great deal of opportunities for individuals like Buffett who soaked up all the information he could find.

Buffett started his own investment partnership in the mid 50’s.  It was essentially a hedge fund in most respects.  Without getting into too much of the details, Buffett was able to earn 20% more on average than the Down Jones Average annually until 1969.  The stock market at this time seemed to be overpriced in his estimation, so Buffett disbanded the partnership.  He referred his partners to Bill Ruane of the famed Sequoia Fund.  Bill was a former classmate of Warren, and he amassed quite a record himself.

So if we look at Buffett’s beginning career, he saw how doing your homework really paid off.  In fact, there are even stories that Ben Graham would use examples in his lectures about companies he was going to buy.  After class let out, all the students rushed to call, or see directly, their stock brokers to buy the companies Graham presented on. 

Buffett learned from Graham the importance of valuing a company based upon verifiable evidence and not market sentiment.  Fisher’s lessons showed him the benefit of accumulating information from different sources in order to truly understand a business prior to investing.  These formative years are still with Buffett. 

Now Charlie Munger, Buffett’s Vice Chairman at Berkshire Hathaway, has been an influence as well.  What is little known is that they grew up together in Omaha, Nebraska, and they were able to meet during this same time period.  This introduction to investing left an indelible mark on Warren Buffett that permeates his investing career today.

Obviously I am no Warren Buffett, but I started investing in mutual funds at age 13 in November 1987.  What got me so interested in the stock market?  Obviously Black Monday on October 19, 1987 really caught my attention.  It was not really the crash that really piqued my interest though.  My father told me that the market drop of 508 points on that day was an overreaction (down over 20% amazed me).  I did not know much about stocks, but it seemed to me like the world was ending.  At least that was how the nightly news portrayed things.  My father said watch the market over the next several days. 

To my absolute amazement, the Dow Jones Industrial Average (DJIA) went up almost 290 points in the next two trading sessions.  Wow!  This turn of events was really weird to me.  How could stocks move around in value so greatly?

I thought that all the big money investors in the stock market really knew what they were doing.  However, most everyone was caught by surprise by Black Monday.  The other interesting thing for me was that 1987 turned out to be a positive year for the DJIA.  If you want to get your friend’s attention, you can ask them what the return of the DJIA was for 1987 (positive return) and 1988 (negative return).  Most people will get it wrong.

Well, these events left a mark on me.  When I learned more about investing and was exposed to Modern Portfolio Theory (MPT) and the Efficient Market Hypothesis (EMT), I really did not think it was true given my start in investing back in the latter portion of 1987.  How could the value of the entire U.S. economy be worth 20% less after one day of trading? 

Now, the stock market is normally efficient and stock prices are correct, but I knew that there were inflection points in the stock market where rationality was thrown out the door.  Therefore, when I learned about Mr. Market and the vicissitudes and vagaries of the stock market from Ben Graham’s books, I liked that metaphor and way to characterize volatility in the stock market. 

For better or worse, I really do not care for the academic, ivory tower analysis of behavior in the stock market.  I cling more to focus investing, value investing, and seeing the financial markets as complex adaptive systems.  I would fall into the camp of Warren Buffett and the great hedge fund investor, George Soros.  Both men have said that they would never be able to pass the Chartered Financial Analyst (CFA) exam. 

The CFA is now the standard designation for all portfolio managers of stocks and bonds.  I tried studying for it, but a lot of it made little sense to me.  I guess that is why I think it is funny when Buffett says he wants to gift money to universities to install permanent chairs in business schools to teach Modern Portfolio Theory forever.

Most of the financial professionals you meet will range in age from twenties to sixties.  You should always ask them when they started investing or their career as a Financial Advisor.  Here are the ten major events that will cover those individuals:

  • The 1973-1974 severe bear market;
  • The Death of Equities article from Business Week magazine in 1979;
  • Black Monday in October 1987;
  • The Bond Bubble Bursting in 1994;
  • The Asian Contagion and Long Term Capital Management (LTCM) incidents in 1997-1998;
  • The Barron’s article in December 1999 that questioned the relevance of the Oracle of Omaha, Warren Buffett;
  • The Bursting of the Internet Bubble in April 2001;
  • The Financial Crisis and ensuing Great Recession of 2008-2009;
  • The “Lost Decade” of Returns from the S&P 500 from 2001-2010 when stocks averaged approximately 2% annually.
  • Managing Money is Easy. Look at my investing record over the past 10 years (2009-2018).  Note that the annualized return of the S&P 500 index over that period was 13.13%.

These major inflection points in the financial markets will have a great effect on your financial professional’s recommendations for investment portfolio allocation.  In fact, I met a Financial Advisor that tells his clients that they can expect to earn 12% annually from stocks over the long term.  He uses this return for modeling how much clients need to invest for retirement.  He was introduced to investing around 1996 which is when the stock market went gangbusters. 

I know another Financial Advisor that tells his clients to never put more than 50% of their money in common stocks.  He tells this to all of his clients, even if they are in their thirties and have 30+ years until retirement.  He started advising clients in 2007, and he lost a great many clients in 2008.  Therefore, he wants to have limited downside risk for two reasons. 

First, he has seen how much the stock market can drop in one year.  Second, this gentleman wants to ensure that his clients do not close accounts and flee to other financial professionals because the stocks in their portfolio go down 30-40% in a single year.

The importance today of the long, extended bull market of the past 10 years is extremely important to take into account for all individual investors.  A recent stretch of 13.13% annualized stock returns makes it seem that investing systematically over the long term is the correct investment strategy.  I would not disagree with that thought. 

However, Financial Advisors with 10 years of experience or less will only tell clients what they would do hypothetically in the event of a major market decline in the stock and bond markets.  Hypotheticals and backtesting are all well and good. 

But it has been my experience, that there is no substitute for actually investing during periods of extreme volatility and major stock market declines (20% or more).  For example, what was the best stock investment strategy right after the Internet Bubble implosion in terms of the asset class?  The best performing asset class for the next decade was to have a larger than normal allocation to emerging market stocks (think Ticker Symbol EEM or VWO).  Do you think that your Financial Advisor would have the stomach to recommend this investment to you after seeing the NASDAQ index fall by over 50%?

As you can see, the start of anyone’s investing career has an impact on their outlook for the financial markets and how to set up a portfolio properly.  I am not saying that any of this advice is “wrong” per se. 

My only point is that you need to probe your Financial Advisor a little bit to understand the framework he/she is working with.  Thus, you can refer to the aforementioned list of ten major events in the history of the financial markets.  These events really shape the investment paradigm of all of us.  And, of course, I will admit that I am no different.

With that being said, most investment strategies recommended by Financial Advisors are borne out of those individuals first few years with the financial markets.  Some financial professionals are more bullish than others.  Others focus on downside risk and limiting volatility in investment portfolios.  Still others utilize complicated mathematics to build investment portfolios that are optimized. 

Therefore, you need to understand your risk tolerance and financial goals very well.  You have your own personal experience with the market.  If your Financial Advisor is somewhat myopic and focused on the past repeating itself in the same way over and over, you need to be careful. 

History does repeat itself, but the repeating events will be caused by much different factors in most cases.  Unfortunately, the financial markets and market participants are always adapting to changing investment strategies, global economic GDP growth, interest rates, geopolitical events, stock price volatility, and a whole host of other things. 

You can learn from the past, but I urge you not to be “stuck” in the past with your Financial Advisor’s “anchoring” cognitive bias at the expense of setting up an investment portfolio that will allow you to reach your financial goals and match your risk tolerance.

A New Paradigm for Investing Available on Amazon.com – FREE for Thanksgiving Holiday

27 Wednesday Nov 2013

Posted by wmosconi in asset allocation, Bernanke, bonds, business, Charlie Munger, Consumer Finance, Education, Fed, Fed Taper, Fed Tapering, Federal Reserve, finance, financial advisor fees, financial planning, GIPS, GIPS2013, Individual Investing, interest rates, investing, investing, investments, stocks, bonds, asset allocation, portfolio, investment advisory fees, investments, math, Modern Portfolio Theory, MPT, personal finance, portfolio, risk, statistics, stock prices, stocks, Suitability, volatility, Warren Buffett, Yellen

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bonds, Charlie Munger, consumer finance, economics, education, Fed, Fed taper, finance, financial advisor fees, Financial Advisors, financial planning, financial services, free books, interest rates, investing, investment advisory fees, investments, retirement, stocks, volatility, Warren Buffett

Greetings to all my loyal readers of this blog.  In keeping with the Thanksgiving spirit, I have decided to make my first two books absolutely FREE for the rest of the week.  These two books on Amazon.com are available for download onto a Kindle.  Additionally, there is a Kindle app for iPhones and Android devices which is free to download.  Please feel free to check out the titles below.  I have provided links to make it easier.   My email address is latticeworkwealth@gmail.com.

The books are as follows:

1)      A New Paradigm for Investing:  Can Your Financial Advisor Answer These Questions?:

http://www.amazon.com/New-Paradigm-Investing-Financial-ebook/dp/B00F3BDTHW/ref=sr_1_1?s=books&ie=UTF8&qid=1381107823&sr=1-1&keywords=A+New+Paradigm+for+Investing+by+William+Nelson

2)       Spend 20 Hours Learning About Investing to Prepare for 20+ Years in Retirement

http://www.amazon.com/Learning-Investments-Prepare-Retirement-ebook/dp/B00F3KW9T2/ref=sr_1_1?s=books&ie=UTF8&qid=1379183661&sr=1-1&keywords=William+Nelson+Spend+20+Hours

The first book listed is normally $9.99 but available for FREE until November 30th.  The other book is normally $2.99, but it is also FREE for the same time period.

I would like to thank my international viewers as well.  I also wanted to especially thank some selected followers of my @NelsonThought and @LatticeworkWlth Twitter accounts (each of whom I would recommend following for the content and insight):

Followers on @NelsonThought:

The Wealth Report @wsjexperts – #wsjexperts

The Royce Funds @RoyceFunds

Research Magazine @Research_Mag

Barron’s Online @BarronsOnline

Vanguard FA @Vanguard_FA

Cleveland Fed Research @ClevFedResearch

Pedro da Costa @pdacosta

Muriel Siebert & Co. @SiebertCo

Roger Wohlner, CFP® @rwohlner

Ed Moldaver @emoldaver

Sylvia Maxfield @sylviamaxfield

The Shut Up Show @theshutupshow

Berni Xiong (shUNG) @BerniXiong

Followers on @LatticeworkWlth:

Euro-banks @EuroBanks

Direxion Alts @DirexionAlts

Charlie Wells @charliewwells

AbsoluteVerification @GIPStips

Investment Advisor @InvestAdvMag

Gary Oneil @GaryONeil2

MJ Gottlieb @MJGottlieb

Bob Burg @BobBurg

Melody Campbell @SmBizGuru

TheMichaelBrown @TheMichaelBrown

Phil Gerbyshak @PhilGerbyshak

MuniCredit @MuniCredit

D.J. Rob-Ski @DJRobSki

You Purchased a Stock: Now What?

27 Sunday Oct 2013

Posted by wmosconi in asset allocation, Bernanke, bonds, business, Charlie Munger, Education, Fed, Fed Taper, Fed Tapering, Federal Reserve, finance, financial planning, Individual Investing, interest rates, investing, investing, investments, stocks, bonds, asset allocation, portfolio, investments, math, Modern Portfolio Theory, MPT, personal finance, portfolio, risk, statistics, stock prices, stocks, volatility, Warren Buffett, Yellen

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$WU, asset allocation, bonds, business, Charlie Munger, equity, equity selection, finance, individual stocks, investing, investments, momentum stocks, portfolio, stock pickers market, stockpicking, stocks, value investing, Value Masters, Warren Buffett, Western Union

One of the questions that I have been asked is about individual stocks, and, more specifically, how to monitor developments after the purchase.  Now I have mentioned before that I strongly recommend that you do not start off trying to buy individual stocks.  ETFs and index mutual funds are a better way to start off investing and will generally garner you higher returns in the long-run.  Why?  Well, please continue reading, and you will see how I approach the decision to purchase a stock and when I decide to sell.  Now my method is strictly my own, but you will see it closely mirrors Warren Buffett’s style of investing.  There are many other market participants that use a variation of the Buffett and Graham paradigm.  Moreover, there are literally tens of thousands of portfolio managers, hedge fund investors, research analysts, and others that value stocks every second of every day in response to company, economic, and geopolitical news.  Once you see how much work it takes, I am hopeful that you do NOT try it to begin with.

Before delving into the process of following a stock after your purchase, I will go through the steps I take prior to a purchase.  I strive for a turnover of 15-20%.  Turnover measures how long an investor holds a particular stock.  A turnover of 100% means that an investor holds a stock for one year.  Thus, my turnover equates to a holding period of 5.0 to 7.5 years.  So if I am willing to hold a stock for that long, I better make sure I am confident that it is a good investment.  How do I start?  I have a list of stocks that I am interested in purchasing.  If I decide to possibly invest, I go through a lengthy process.  Now I am not recommending any security.  However, I want to put some meat surrounding the discussion.  Therefore, I will talk about my process in terms of my decision to purchase Western Union (WU).  Western Union is now my top holding.  Should you buy WU?  Maybe so.  Maybe not.  You must do your own homework and not take my word for it.  As a show of good faith, I encourage you to look at my Twitter account:  @NelsonThought.  I have been posting information about WU for several months, so I am not “cherry-picking” to make me look good.  Let’s begin.

Regardless of where I get my ideas of stocks to analyze, I start off my analysis by learning everything I can possibly get my hands on.  You would be amazed at how much information is out there.  Prior to deciding to even value WU, I took a number of steps.  First, I read the last three annual reports for WU.  What do I focus on?  The most important part of any annual report is a section called Management Discussion & Analysis (MD&A).  MD&A is indispensable because management has a chance to be open and honest with investors.  Now when you purchase a stock, you should view yourself as a fractional owner in the actual company.  You do not own a piece of paper that says you have x number of shares.  You own a claim to the future cash flows and dividends of that firm.  Contained within the MD&A is management’s discussion is a review of the most recent financial developments, their strategy, and what management thinks is the future direction of the company.  WU’s management team talks a great deal about emerging markets.  WU relies upon the wiring of money between individuals.  The most important, growing income stream comes from immigrants sending money back home to their families.  For example, did you know that 30% of the Gross Domestic Product of El Salvador comes in the form of these remittances?  Wow!  That fact always gets to me.  Obviously you can see that the emerging markets are a great way for WU to grow earnings.  Additionally, WU has a huge market share in the correctional system.  If family members or loved ones of prison inmates need money to purchase items behind bars, they can use WU to transfer money into their accounts to buy food, hygiene products, and even other items like TVs and radios.  WU’s management speaks at length about these opportunities, and they also focus on growing their network of facilities that provide their services.  There is a “network effect” for WU.  The more money transfer centers there are, the more people in general will use their services.  For instance, if a local WU outlet is right near your house, and you need to wire some money to an individual or business, you are more likely to use it.  Well, if you need to wire money to a friend, and the nearest WU outlet is 50 miles from that person, WU is probably not a good option for you.  Therefore, it makes sense for WU to provide good incentives to build up their network.

Now I really focus on MD&A going back in time because management is telling you what they intend to do in the future.  Think about it in these terms.  Have you ever had a friend who tells you that they are going to quit working and start a business?  I know that I have.  More often than not, when I see that person in several years, they tell me that they are still working but they are starting the business soon or they found a better business to start.  It is great to have ideas, but, unless you act upon them and do it, there really is no point.  Well, the same scenario happens very often with a business.  Management might describe great plans to grow the business back in 2010.  If they never speak about it again, or they have new and better ideas when you read the 2012 annual report, that should be a red flag for you.  Now changing strategy is sometimes warranted, but management should be transparent with you.  If a strategy is no longer relevant, or it did not work out, they should explain why.  It is only fair.  You own the stock; you own part of the company.  Always take the time to compare prior MD&A with current MD&A.  This technique can save you a lot of time.  Why value a stock if management does not seem to know what they are doing?

After you feel comfortable with management and still have strong beliefs that the business is well-positioned, you can look at the financial statements of the company.  Every publicly traded company is required to file financial statements with the Securities and Exchange Commission (SEC).  The reports are called 10-Ks on an annual basis and 10-Qs on a quarterly basis.  The SEC even has a website that you can go to when you look for them.  It is called the EDGAR system can be found here:  http://www.sec.gov/edgar.shtml.  The financial statements will include the income statement, balance sheet, and statement of cash flows.  Which part is most important to me?  Well, that is a trick question.  I go to the back of the financial statements and look at the notes to the financial statements.  Do not feel bad if you got the question wrong.  When I pose the question to undergraduate students during presentations that I give, I have never had a finance student give the correct answer.

 Why do I say the notes?  For one, I have an accounting undergraduate degree, so I am interested in them.  You can always get financial statement ratios and earnings expectations online, but they rarely incorporate information from the notes.  Now the notes to the financial statements tend to be boilerplate to begin with.  The accounting firm that audits the financial statements of a firm will explain that the company used generally accepted accounting principles (GAAP) and disclose the accounting methodology utilized when GAAP allows different choices.  After all these disclosures, you will find lesser known items.  The second reason why I look at the notes to the financial statements is to see if there is something I do not understand.  What do I mean by this?  You may remember the downfall of Enron.  The downfall of Enron was right in plain sight all along.  Enron had a disclosure “buried” in the notes that talked about Special Purpose Vehicles (SPVs).  What is a SPV?  I still really have a vague understanding, but here are the basics without getting too technical.  A SPV is a separate legal entity that is set up to own assets and incur liabilities.  It is really like a subsidiary of a company but, since it is a separate entity, the assets and liabilities of the SPV are not required to be reported on the company’s balance sheet.  What?  This phenomenon is called off-balance sheet reporting.  Essentially it is a way to not disclose liabilities.  Think about it in terms of the federal government.  The federal government does not consider future Social Security and Medicare benefits to be necessary to be reported in the current budget.  Thus, the $50+ billion of future payments of benefits is not reported; only think tanks talk about it periodically.  Now I do not want this to be a political discussion.  That is not my intent.  I simply bring it to your attention as a more familiar example of this topic.  Thus, Enron had liabilities that it had to repay in the future, but, if you only examined the financial statements, the future payments were not on the balance sheet.  The auditors did not look too closely.  Why?  I liken it to this.  No one wanted to raise his/her hand and say what is this SPV thing.  In general and in business, people do not want to look uninformed or “dumb”.  If you see something in the notes to the financial statements that you do not understand, I would suggest that you pass on the purchase of that stock.  When I look at the notes for WU, there is nothing that bothers me in particular.

After I look at the notes, I focus on the statement of cash flows, balance sheet, and then the income statement.  I look at them in that exact order.  Now I do not prepare a model at this point to value the company.  Rather, I do some calculations in my head.  Is the company actually generating cash from the operations of the business?  Does the company have enough assets to invest in the business?  Are earnings coming from sources that will either never occur again or have nothing to do with its core business?  These are very vital questions to ponder.  Why do you not value the company at this point?  Now I really have a number in mind for what the stock is worth, you still need to compare that to the sub-industry and industry that the company operates within.

As one reader commented, he was probably going to use this discussion to cure his insomnia ailment.  Hopefully you made it this far.  Are we having fun yet?  I promise we will get to the discussion of how to follow a stock after making a purchase, but I need to lay the foundation to ensure that my method makes sense.  Not that it is right, but the logic of the paradigm is plausible.  As it relates to the sub-industry and industry, I perform what is referred to as a SWOT analysis.  SWOT stands for Strengths, Weaknesses, Opportunities, and Threats.  Now I already know the S and W part from my review of MD&A and the review of the financial statements issued by the company.  The O and the T refer to the industry and competitors.  The main competitors in this space to WU are MoneyGram International and Euronet Worldwide.  How does WU match up against these two?  These two companies are smaller than WU, but bigger is not always better.  These two firms are constantly innovating and trying to make inroads into the niche of WU.  They are referred to as firms within the sub-industry.  The industry as a whole is the financial services industry.  Now WU is able to grow significantly in the emerging markets because the banking industry is not very developed in these countries.  It is easier at this point to simply pick up a wire transfer at a Western Union outlet than to open a checking accounting.  I can assure you that banks have noticed taking note.  Banks are trying to come up with ways to make it easier to open an account and simply have the money deposited there.  That is the most common way to look at the industry.  Now sometimes it is easier to ignore other developments, but I try to take everything into account.  Did you know that you can make wire transfers at most Wal-Mart stores now?  That development might be a game-changer.  Think about it this way.  Why should you go to WU when you can simply do your normal shopping at Wal-Mart and then send your wire transfer?  Remember that there are a plethora of Wal-Mart stores, so they already have a built in “network effect”.  They are a definite competitor even though they are technically in the retail industry.

After my entire analysis, I was confident that the purchase of WU would be a good investment.  How do I go about valuing any stock?  As I mentioned previously, I use a method that Warren Buffett has perfected over the years.  Trust me, I am no Warren Buffett.  If I were as good as Warren Buffett, I would not be writing this blog.  However, his method (coupled with Phil Fisher, David Dodd, Charlie Munger, Bill Ruane, and a few others) makes sense to me.  Think about stocks like bonds.  Bonds are much easier to value.  Why?  They are a promise to pay back money loaned to them.  The only return from a bond held to maturity comes from the coupon.  The coupon is simply the interest rate.  As an aside, you will hear coupon over and over again.  Where does the term come from?  Back in the older days, when you would purchase a bond, the company would give you a certificate that actually had coupons.  When a payment was due from the company, you would take the coupon to your local bank and get your money.  The bank would collect all the coupons and present them directly to the company.  This was prior to the introduction of computer systems to monitor who owned which bond.  That is why you will hear the term coupon.  Anyway, the interest rate of the bond does not vary over time.  A bond is worth a set amount that you will receive upon maturity and the periodic interest payments, but you need to remember that the payment is fixed.  What if interest rates fall?  If you purchased a bond that had a 6% coupon and the prevailing interest rate for the same type of bond rises to 8%, how are you able to sell the bond?  Why would I buy your bond if I can simply buy one with an 8% coupon?  You can sell me that bond by lowering the price.  A corporate bond is usually issued in $1,000 increments, so, if interest rates rise, you can simply lower the price to make its return equivalent to owning an 8% percent bond.  This is what is referred to as an inverse relationship.  It works the same way in reverse if interest rates fall.  If prevailing interest rates fall to 4%, you can afford to charge what is referred to as a premium because buyers in the marketplace cannot find a better opportunity with your 6% coupon.  Therefore, you can charge more than $1,000.  How does this relate to stocks?  Stocks are nothing more than bonds with variable cash flows.  Now if you ignore the fact that owning a bond makes you a creditor and holding a stock makes you an owner of the firm, you really need to value it in the same way.  However, it is infinitely more difficult.  Why?  You do not know how the company will fare in the long-term.  Will the strategies work out, will they be executed properly, will another competitor overtake the company, or will a new technology displace the service provided by the company?  I have already talked about the competitors of WU, banks knocking at the door, and the “invasion” of Wal-Mart into the space.  All of these elements cause the future earnings of WU to be unknown and variable.  I am still confident with the prospects of WU, so I move to valuing the company and approach it in the same manner as I would a bond.

To me (and many others), a stock is only worth what a company can earn in the future.  If you have a friend that has a business idea but you can see that it is unlikely to work, would you invest in the firm?  Probably not.  When I look at WU, I see that it is likely to earn money far into the future.  What are earnings?  You will hear many different terms because there are many different types of market participants and other stakeholders.  I focus on a concept called owner earnings.  Owner earnings are a combination of Free Cash Flow (FCF) and changes in Plant, Property, and Equipment (PP&E) and working capital.  FCF is simply the cash that comes from ongoing operations of the firm.  However, you need to remember that the firm needs to make future investments in technology and other items.  Thus, when you look at depreciation of PP&E which is only an accounting convention, the company may need to make more or less investments into the business in order to keep competing.  Additionally, the company needs cash to simply pay current bills that come due which relates to working capital.  If you calculate FCF and adjust for PP&E additions and working capital, you come up with owner earnings.  Once you calculate owner earnings, you know that the firm will be able to grow owner earnings over time.  If they cannot grow owner earners in the future, you probably would not be at this point in the analysis right now.  Well, you also need to remember that these earning will occur in the future.  Why is this important?  Think about loaning $100 to a friend for a year.  If he/she tells you that they will pay you the $100 back sometime next year, you will most likely want more than $100.  For one, you automatically know that under normal economic conditions, it will cost more than $100 to buy the same amount of products or services next year.  Additionally, you could have bought something else with the $100 and enjoyed it right away.  This is the concept of utility.  For example, you could have purchased 5 or 6 Blu-Ray discs and enjoyed watching these movies.  You are forgoing that consumption because you loaned out the money.  In order to make it worth your while, you might tell your friend that you will loan him/her $100, but you want them to pay you $110 next year.  This will compensate you for inflation and delaying your consumption.  The same economic principle applies to the purchase of stocks.  You could spend your money, or you could invest in another stock.  Therefore, you will only purchase a stock if the price will increase satisfactorily in the future such that you can make money.  You need to discount these future owner earnings.

How do you discount the owner earnings?  I come up with my financial model at this point.  I determine how much WU will earn over the next five years, the five years after that, and then for the rest of its existence.  Once you have calculated the next five years, you need to remember something.  If a certain company is earning what is referred to as “excess profits”, other firms will come into the market and try to do the same thing because it is lucrative.   Additionally, there might be other technological advances which make the wire transfer business of WU less attractive or obsolete, which is even worse.  Thus, I assume that WU will grow at a certain rate for five years, a lower rate for the next five years, and then a growth rate similar to the general economy forever.  The last part is somewhat of a plug figure.  Most stock analysts will say that WU (or any other company) cannot keep growing at high rates forever, it will eventually grow owner earnings very similar to GDP growth in perpetuity.  Now I use an assumed growth rate of 3.5% which is higher than the domestic economy because WU has a significant presence in the emerging markets which are growing at a faster clip.  Now that I have a stream of owner earnings, I need to discount them to the present.  The discount rate is a subject of much debate.  I use a rate of 7% or the equivalent of the yield on the 10-year US Treasury.  Other investors will use a higher rate.  I won’t get into a debate about the proper discount rate to use.  I simply follow the advice of Warren Buffett.  Here is a link to see his rationale:  http://www.sherlockinvesting.com/help/faq.htm.  If I discount that owner income stream back to the present at that discount rate, I come up with what is referred to as an intrinsic value.  Intrinsic value is a concept that was coined and explained at length by the father of value investing, Benjamin Graham.  The intrinsic value is what I think WU is worth right now given the current business environment and likely future prospect.  Now since I am fallible and the future is uncertain, I use the margin of safety concept also introduced by Benjamin Graham.  I take the intrinsic value figure and reduce it by a certain amount.  For WU, since it is in a somewhat stable industry and finance is my background, I use a margin of safety of 20%.  Therefore, I multiply my intrinsic value figure by 80% (100%-20%).  If the current stock price of WU is lower than my calculation, I am inclined to buy.  The intrinsic value I get for WU is significantly above the current stock price.  I purchased WU at $14.24 average cost, and it now trades at $18.36 as of August 9, 2013.  I still hold the largest portion of my portfolio in WU because I see the intrinsic value of WU as being higher than that presently.

As you might imagine, this entire process took me roughly 55-60 hours.  Surprisingly, there are many stock analysts that may say that I was not thorough enough.  An example would be the famed hedge fund investor Bill Ackman.  I am willing to bet that I spent more time prior to the purchase of WU than you will spend on financial planning over the course of your lifetime.  I do not mean this in a condescending manner.  I only point this out to simply show why the purchase of an individual stock is not right for everyone.  I tend to refer to myself as a “dork”.  I am passionate about investing, and I love to perform this type of analysis and calculations.  If you are not willing to put in that type of time to do your homework, I would stop at this point.  I will repeat again that ETFs and index mutual funds are much better choices for individual investors.  If you would like the chance to beat the index averages, I would rather see you invest in actively managed mutual funds or separate accounts than try your hand at selecting individual securities.  With that being said, I will now turn to what I promised to in the beginning.  Please forgive me for what might seem to be a circuitous route.

I intend to hold WU for a long time.  I have a set intrinsic value, and I am willing to stick to holding the stock through all the “visiccitudes and vagaries” of the stock market.  My emotional intelligence is higher than most investors.  I view investing as an intellectual exercise.  The money is secondary.  As soon as you start focusing on the money, you may be tempted to sell your stock if it falls in price significantly for what might seem like no apparent reason.  If I need to wait for 5-10 years for WU to reach its intrinsic value, I am willing to do so.  Does this sound like fun?  Well, it is to me.  Unfortunately, this has really nothing to do with what you read in most financial news publications or see on financial media.  However, you need to remember that I am an investor in the company and not trading pieces of paper.  I can confidently say that the way investing is portrayed in the financial media is much more akin to speculation.  My suggestion is to go to the casino if you want to try to double your money.  You will have more fun.  Investing in stocks to gain significant riches immediately is a fool’s game in my opinion.

What do I focus on after the purchase?  The first thing I do is to read all the earnings transcripts of the firm.  After each quarter, the company will file a 10-Q with the SEC and announce financial results to the public.  Management will then talk to analysts on an earnings call to recap the quarter and then answer questions from a selected group of research analysts.  I try to see if the earnings results match up with MD&A and if management uses any “excuses”.  An example of a typical excuse is the weather.  If a retail outlet has depressed earnings, they tend to use bad weather as an excuse at times.  It may be likely, but, more often than not, it is a way to hide poor execution by management.  Any particular quarter should not affect your intrinsic value calculation much.  In the short-term, there can be developments that affect earnings for a temporary time.  I do not worry about quarterly earnings, but I am interested in how the company is doing.

The second thing I do is to keep up with general economic conditions.  I visit the Bureau of Labor Statistics (BLS) website on a periodic basis.  The link is as follows:  http://www.bls.gov/.  The BLS is the agency of the government that monitors and releases economic statistics like GDP growth, new housing starts, the trade deficit, and a lengthy amount of others.  I focus on leading indicators, but I also am interested in the so-called lagging and coincident indicators released by the BLS.  Why do I pay attention to this?  I do so for one primary reason.  I am very confident in my calculations of future owner earnings for WU.  However, I usually extend that to include a three-part probability exercise.  For example, the likely path of owner earnings for WU is definitely affected by the current/future state of the economy.  I have a percentage for normal, boom, and bust scenarios.  The normal part gets the highest weight, and I then attribute different percentages to the other two.  Now I will admit that these are very subjective, but they are imperative.  How does the calculation work?  Well, I assume that WU will earn more money if the economy does better than expected or less money if the economy enters a recession.  Therefore, I multiply these scenarios by three different percentages.  For example, I currently weight my estimates of future owner earnings by 80% normal, 15% boom, and 5% bust.  Therefore, if the state of the economy changes or its future trajectory, I alter the percentages.  Since WU relies so much on remittances across borders, if global growth slows significantly, I need to weight the stream that assumes a recession much higher.  Using this approach, I do not have to recalculate owner earnings for WU again.  I simply use the three different scenarios and weight them differently.  Trust me, it saves a lot of time.

The next thing I do is to follow the developments of competitors.  I read the earnings transcripts of these firms, do a cursory review of financial statements, and look at how the industry is possibly changing (for better or for worse in terms of WU’s positioning).  It is extremely valuable to be constantly testing your investment thesis.  You need to be ready to admit that you made a mistake.  You can lose a lot of money otherwise.  I can attest to that via Best Buy (BBY) and Citigroup (C) stock holdings in the past.  With that being said though, you need to do that without referencing the case laid out by speculators.  If someone tells me that WU will have a bad third quarter, I really do not care.  I am willing to ride out stock price volatility because I know that WU is worth more than the current market price.  The advice from speculators relates to traders of stocks (owning pieces of paper) and not investors.

I also follow market developments.  Although I do read the Wall Street Journal and Financial Times, I try not to get too hung up on the current news of the day.  You can get in trouble that way by feeling itchy and pulling the proverbial trigger and selling in a panic.  I commented on this in more detail in a previous blog as it relates to the entire stock market.  The link is as follows:  https://latticeworkwealth.com/2013/08/04/todays-news-should-prompt-you-to-adjust-your-entire-investment-portfolio/.  I tend to put more weight in The Economist, Barron’s, Bloomberg Businessweek, and trade journals.  I even read a few publications that seem unrelated but can make all the difference.  One great source is the Harvard Business Review.  This magazine is technical and “heavy duty”, but it can be a great way to identify mistakes that WU management is making or how they are behind the curve when it relates to business strategy.  This information helps me to determine whether or not my calculation of future owner earnings is correct and will come to fruition.

My next technique is a little odd to some.  I have found that I can learn a great deal about investing from other disciplines.  In fact, I will devote an entire post to the name of my firm.  I use what Charlie Munger, whom I lovingly refer to as Warren Buffett’s sidekick, calls the latticework of mental models.  This approach is to acknowledge that ideas from other discipline are germane and pertain to investing.  A perfect example is psychology.  There has been an explosion of ideas in the disciplines of behavioral finance and behavioral economics.  These fields do not assume that market participants are rationale.  Humans have innate biases and make consistent mistakes.  As an investor, you can use this to your advantage.  The one adage along these lines comes from Warren Buffett:  “Be fearful when others are greedy and greedy when others are fearful”.  If everyone is telling me that WU is going to the moon, I start to question my investment thesis.  Now as a contrarian investor, if everyone is selling WU for reasons that are temporary or are related to general market selling, I perk up and even look to add to my position.  You can read more about the latticework of mental models in an excellent book by Robert Hagstrom called Latticework:  The New Investing.  I use the concept of complex adaptive systems from biology, and the concept of nature searching for equilibrium from physics all the time.  In fact, there is an entire website that you can learn a great deal from.  It is called the Sante Fe Institute.  This think tank is not devoted to investing at all, but they are looking for common themes among different disciplines.  Take a look; I promise you will not be disappointed:  http://www.santafe.edu/.  I now will turn to the little talked about decision to sell a stock.

I think about WU in these terms.  If I come across another investment opportunity that is better than WU, I will sell WU.  If management or the state of the economy changes, I will sell WU.  If you are in a tax-deferred account (401(k), 403(b), Roth IRA, etc), you do not need to worry about taxes.  However, my individual stocks are in a taxable account.  While taxes should not guide your sell decision, you must take them into account when deciding if another opportunity is truly better.  Why?  You should only care about terminal values.  If you sell WU and buy another stock, that purchase should increase the value of your portfolio in the future.  That makes sense intuitively.  However, your mind can play tricks on you.  What if I am expecting to earn 9% a year from WU and another stock comes along that I can earn 13%?  Should I sell WU and earn the 13%?  The answer is that it depends.  Here is a typical scenario.  Let’s say I now own $20,000 of WU and purchased WU with an original investment of $10,000.  Thus, I have a $10,000 capital gain that is now subject to a 20% capital gains tax.  If I decide to sell WU and receive $20,000, I have to pay $2,000 ($10,000 * 20%) to the federal government come tax time.  Let’s look at the scenario in terms of expected yearly results.  If I sell WU to earn 13% in another stock, I am really only investing $18,000.  If I decide to keep WU, I still earn the 9% and avoid a capital gains tax.  What happens at the end of the year?  If my scenario holds true, I will have $21,800 ($20,000 + $20,000 * 9%) in my brokerage account at the end of a year if I earn 9% from owning WU.  If I decide to sell WU and buy the other stock, I will have $ 20,340 ($18,000 + $18,000 * 9%).  Yes, I earned 13% on my new stock, but I have a lower amount in my brokerage account.  Why is this a common phenomenon?  Well, most people file their taxes and pay any capital gains tax from their checking account.  The money does not come out of the brokerage account directly.  Your net worth goes down overall, but your brokerage account “misleads” you into thinking you made a great selection because you earned an extra 4% by owning this other stock.  In fact, you would need to earn 21.1% in order to have $21,800 in my brokerage account by being able to pay the capital gains tax and then have the same terminal value as I would by simply holding WU and earning 9%.  If you ever wondered why Warren Buffett holds onto Coca-Cola (KO) and American Express (AXP), taxes factor in greatly.

Now for all of you readers that are not asleep, I appreciate you bearing with me.  As I mentioned before, investing is not meant to be fun or exciting.  It is only fun and exciting if you like the intellectual challenge.  For all of us “dorks”, we go through this analysis because it is truly fun to us.  For most people, they would much rather not spend 60 hours finding a stock to buy and then 20-25 hours per year following your stock after the purchase.  Luckily, you can own an ETF or index mutual fund and likely match my investment return in WU or even beat it over the long term.  For more information on the style of Warren Buffett, I refer you to the following series of books by Larry Hagstrom (mentioned him before):

1)       The Warren Buffett Way

2)       The Warren Buffett Portfolio

3)       The Essential Buffett

4)       Security Analysis by Benjamin Graham the sixth edition

You will note that my investing style is similar to Warren Buffett, but I have incorporated elements from other famous investors and from other disciplines.  I will never be another Warren Buffett.  However, I can strive to use a similar investing paradigm.  Hopefully this discussion was helpful in thinking about one possible way to monitor your stock purchases.  Yes, it is a great deal of work and time consuming.  You will have much better investment results though, if you know as much as you can about your stock.

When It Comes to Your Investments, Are You Smarter than a 14 year-old?

12 Saturday Oct 2013

Posted by wmosconi in asset allocation, Bernanke, bonds, business, Charlie Munger, Consumer Finance, Education, Fed, Fed Taper, Fed Tapering, Federal Reserve, finance, financial planning, GIPS, GIPS2013, Individual Investing, interest rates, investing, investing, investments, stocks, bonds, asset allocation, portfolio, investments, math, Modern Portfolio Theory, MPT, NASDAQ, personal finance, portfolio, risk, statistics, stock prices, stocks, volatility, Warren Buffett, Yellen

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That is a great question.  I will save you the suspense and give you the answer.  You are as smart as a 14 year-old when it comes to your knowledge of your investments.  What 14 year-old teenager am I referring to?  I am referring to myself.  I started investing when I was 13 back in November 1987.  (If you do the math, you can figure out how old I am).  After spending a year studying the financial markets, I had amassed quite a bit of understanding.  How does this relate to you?  Well, if you have been following my blog, I have not revealed any information that I did not already know by then.  Now my writing style has improved and I have incorporated innovations introduced after 1988, the topics I have written about are not that complicated.  Before you continue reading, I would like to state at the outset that I was not some sort of child prodigy when it came to finance.  I was good at math and retained what I learned.  I am no genius and have no delusions of grandeur.  As I sometimes tell my friends, “If I really knew what I was talking about, I would be running a $10 billion hedge fund”.

With that being said, you also have the good fortune of learning from approximately 25 years of mistakes in investing and misunderstanding about the financial markets and the impacts of exogenous and endogenous events.  I could go on and on about my mistakes; however, I will mention a few here.  First, I had the opportunity to invest in two shares of Berskshire Hathaway Class A (BRK.A) stock back in 1991 when it traded a little above $8,700 per share.  Of course, Berkshire Hathaway is the company run by the famous investor Warren Buffett.  As of August 5, 2013, BRK.A’s closing stock price was $177,300 or a bit over $350,000 if I would have purchased those two shares back in 1991.  Why did I miss out on this opportunity?  I did learn everything I could about Warren Buffett once my economics teacher talked about him and his investing paradigm.  It really made sense to me from the start.  Unfortunately, I pass up on purchasing the shares because I would only be able to own those two shares and one other mutual fund.  As a young man, I was hyped and yearning to pick a number of different investment choices.  Best Buy is one of the best performing stocks in the financial markets and trades over $30 now.  I purchased Best Buy about 7 years ago and paid $42.  I did sell quite some time ago, but I took a huge capital loss.     Second, I wrote a paper during my MBA program that talked about the risk management procedures of Citigroup.  As I look back on that paper written in 2005, it is curious to note that, besides AIG, Citigroup went through the pain of learning the limits of risk management and it had a bailout of epic proportions.  I guess my paper was not the best in retrospect.  Finally, I had a terrible habit of picking the current “hot hand”.  I tended to switch my mutual fund holding way too often when I was in my teens.  It was really attractive to calculate how much money I could earn in a mutual fund that made 20% per year.  Wow, I could double my money in less than four years!  As you always see now, past performance is not indicative of future returns.  I really ignored that statement and invested many times based upon hopes and extrapolation instead of rational thought.  My emotions got the best of me.

I did have quite a few wins along the way.  For example, I was invested in the famous Fidelity Magellan mutual fund when it was run by Peter Lynch.  Peter Lynch is a legend among mutual fund managers.  At one point in time, Fidelity Magellan had more assets than any other mutual fund in the country.  Oddly enough, that was its eventual downfall.  Another example would be that I was able to learn how to successfully manage my father’s 401(k) portfolio from 1988 to the present.  I have seen many bull and bear markets and never had his eventual retirement portfolio take a significant hit in terms of poor returns.  My experience investing over the last 25 years has shown me that there will be many times when the financial pundits say this time is different, new industries are going to blow away the Old Economy, or that news events should cause investors to reallocate investment portfolios dramatically.  Even though I have been investing for 25 years, there have been very few seminal financial market events, the global economy may be different but the laws of finance and economics still hold (or they eventually bring prices back to earth), and new industries tend to bring more innovation and tools for existing, mature industries.  An illustration would be the early Internet companies lost money and burned through enormous amounts of cash.  However, the technologies they introduced allowed existing businesses to use the Internet in unique ways to either generate additional revenue or improve productivity.  A direct example would be how airplanes revolutionized leisure and business travel, but the airlines have been a wealth-destroying industry.  On the other hand, there are a myriad of business that used the services of airlines.

My overall point is that if you take one hour per week for about four months, you will be able to get through the five books I recommended on investing.  Additionally, you can spend another 30 minutes looking at a few financial websites just to increase your knowledge of investment products, finance terms, and keep abreast of news in general.  As a reminder, the list of five books can be found here:  https://latticeworkwealth.com/2013/07/23/spend-20-hours-learning-about-investments-to-prepare-20-years-of-retirement-2/ .  As another reminder, some recommended financial websites can be found here:  https://latticeworkwealth.com/2013/08/04/todays-news-should-prompt-you-to-adjust-your-entire-investment-portfolio/ .

My entire goal with this blog is to save you lots of time.  Rather than being bombarded by disparate information regarding the financial markets and how to approach investing, I am trying to give you a shortcut.  I am hopeful that, if you have a roadmap that is clear, you will be more motivated to learn about investments and eventually become more comfortable with the process of building an investment portfolio to meet your financial goals, while ensuring that your emotions do not get the best of you.  At the end of the day, many individual investors pay fees to financial professionals to save themselves from enemy #1.  Who?  I mean that sometimes individual investors act rashly and keep buying and selling stocks and bonds at inopportune times just because a bad news event comes along or via peer pressure.  Remember that, if you have read all my previous posts, you are more than likely in the 90th percentile of individuals understanding of how the financial markets work.  Keep in mind there have not been that many posts to my blog, so I hope you realize that it is not as painful as you might have once thought learning about managing your investment portfolio and the financial markets is.

As an aside, please feel free to reach out to me if you have a recommendation for a topic I can discuss.  Please remember that this is a website geared toward individual investors who are novices or have not been investing for too long.   Thus, I am not looking to discuss how one might use ARIMA modeling to understand how macroeconomic variables affect the financial markets or individual stocks/bonds.  I appreciate you keeping it relatively simple.  With that being said, if enough people contact me in regard to one specific topic, I will definitely take a closer look.  Thank you in advance for your participation and time thinking about what would be more useful to you.  Furthermore, I am hoping that I cover topics that apply to everyone.  If the collective investment intelligence of the group steps up a few notches, I will cover the topic.  Please send me an email:  latticeworkwealth@gmail.com

A New Paradigm for Investing Available on Amazon.com

06 Sunday Oct 2013

Posted by wmosconi in asset allocation, Bernanke, bonds, business, Charlie Munger, Consumer Finance, Education, Fed, Fed Taper, Fed Tapering, Federal Reserve, finance, financial planning, GIPS, GIPS2013, Individual Investing, interest rates, investing, investing, investments, stocks, bonds, asset allocation, portfolio, investments, math, NailedIt, NASDAQ, personal finance, portfolio, risk, statistics, stock prices, stocks, volatility, Warren Buffett, Yellen

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I am happy to announce that I have published two books on Amazon.com that are available for download onto a Kindle.  Additionally, there is a Kindle app for iPhones and Android devices which is free to download.  Please feel free to check out the titles below.  I have provided links to make it easier.   The books explain how to select a Financial Advisor, and I provide a list of five books which can help you learn more about investing, respectively. I explain issues about investing as an individual in plain language and without the jargon normally associated with the financial markets. Please feel free to contact me should you have any questions/comments/feedback. My email address is latticeworkwealth@gmail.com.

The books are as follows:

1)      A New Paradigm for Investing:  Can Your Financial Advisor Answer These Questions?:

http://www.amazon.com/New-Paradigm-Investing-Financial-ebook/dp/B00F3BDTHW/ref=sr_1_1?s=books&ie=UTF8&qid=1381107823&sr=1-1&keywords=A+New+Paradigm+for+Investing+by+William+Nelson

2)       Spend 20 Hours Learning About Investing to Prepare for 20+ Years in Retirement

http://www.amazon.com/Learning-Investments-Prepare-Retirement-ebook/dp/B00F3KW9T2/ref=sr_1_1?s=books&ie=UTF8&qid=1379183661&sr=1-1&keywords=William+Nelson+Spend+20+Hours

The first book listed is normally $9.99 but available for a limited time at $7.99.  The other book is normally $2.99, but I dropped it down to $0.99 for the rest of October 2013.

I would like to thank my international viewers as well.  I also wanted to especially thank some selected followers of my @NelsonThought and @LatticeworkWlth Twitter accounts (each of whom I would recommend following for the content and insight):

Followers on @NelsonThought:

The Wealth Report @wsjexperts

The Royce Funds @RoyceFunds

Research Magazine @Research_Mag

Barron’s Online @BarronsOnline

Vanguard FA @Vanguard_FA

Cleveland Fed Research @ClevFedResearch

Pedro da Costa @pdacosta

Muriel Siebert & Co. @SiebertCo

Roger Wohlner, CFP® @rwohlner

Ed Moldaver @emoldaver

Sylvia Maxfield @sylviamaxfield

The Shut Up Show @theshutupshow

Berni Xiong (shUNG) @BerniXiong

Followers on @LatticeworkWlth:

Euro-banks @EuroBanks

Direxion Alts @DirexionAlts

Charlie Wells @charliewwells

AbsoluteVerification @GIPStips

Investment Advisor @InvestAdvMag

Gary Oneil @GaryONeil2

MJ Gottlieb @MJGottlieb

Bob Burg @BobBurg

Melody Campbell @SmBizGuru

TheMichaelBrown @TheMichaelBrown

Phil Gerbyshak @PhilGerbyshak

MuniCredit @MuniCredit

D.J. Rob-Ski @DJRobSki

How Risky Are Stocks? Do You Understand Volatility? Part 2 of 2

20 Friday Sep 2013

Posted by wmosconi in asset allocation, bonds, business, Charlie Munger, Education, finance, financial planning, Individual Investing, interest rates, investing, investing, investments, stocks, bonds, asset allocation, portfolio, investments, math, personal finance, portfolio, risk, statistics, stock prices, stocks, volatility, Warren Buffett

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asset allocation, bonds, business, Charlie Munger, education, Fed taper, finance, financial planning, investing, investments, long term investing, mathematics, Modern Portfolio Theory, MPT, portfolio, retirement, risk, statistics, stocks, Warren Buffett

In the first part of this discussion, I talked at length regarding the volatility of stock prices.  Most investors are fearful of stock prices jumping all around for seemingly random or unknown reasons.  Many times extreme volatility can be explained.  Other times different news sources will attribute these fluctuations to totally different or even opposite reasons.  No wonder it is frustrating for individual investors.  Now traders and speculators need volatility to make money.  Additionally, Wall Street trading desks generate purchase and sale orders if stock prices are constantly in flux.  However, if you have a longer timeframe for holding the underlying components of your portfolio, it is quite easy to get hung up in this daily “circus”.  It is hard to have what I term “intestinal fortitude”, which is a fancy way to say guts, in the face of this environment of information overload.

Most financial professionals will construct a portfolio and recommend purchases/sales based upon Modern Portfolio Theory (MPT).  If you have heard the terms beta, alpha, r-squared, and tracking error, you are already familiar with MPT.  I will not get into the history behind the construction of MPT, but it started over 50 years ago.  Harry Markowitz is credited with creating the outline of the theory, and there has been a plethora of academic work done since then by some of the greatest academicians of all time.  With that being said, coming up with an academic theory and applying it to the real world are two different stories.  In brief, MPT talks about how to create a portfolio on the efficient frontier which maximizes return and minimizes risk (where risk is defined as the volatility of stock prices).  The portfolio consists of a combination of the risk free asset (Treasury debt) and an additional percentage of stocks.  However, there are a number of assumptions which underlie the theory.  In order to get the mathematics to work, a number of simplifying assumptions need to be made.  Otherwise, the calculations are so difficult that only a handful of mathematicians and statisticians would be able to understand the theory.  For some background information on the issue of stock price volatility, I encourage you to reread the first part of this article:  https://latticeworkwealth.com/2013/09/08/how-risky-are-stocks-do-you-understand-volatility-part-1-of-2/.

Let’s take a look at the six key underlying assumptions of MPT as described by Dr. John C. Hull who is the Maple Financial Group Chair in Derivatives and Risk Management at the Joseph L. Rotman School of Management, University of Toronto in his book entitled Risk Management and Financial Institutions Third Edition.  As an aside, most students with an MBA in Finance or MS in Financial Engineering will recognize Dr. Hull’s name from his book on Options, Futures, and Other Derivatives, which is a standard text in most programs:  http://www.amazon.com/Options-Futures-Derivatives-DerivaGem-Package/dp/0132777428/ref=sr_1_1?ie=UTF8&qid=1379691849&sr=8-1&keywords=john+hull+options+futures+and+other+derivatives+9th .  Dr. Hull lays out the assumptions on pages 10-11 of the aforementioned book.  They are as follows:

1)       Investors only care about the expected returns and the standard deviation of their portfolios assuming the standard normal distribution (bell curve).  He admits that many academics and practitioners believe that the expected returns of stock prices are non-normal and exhibit skewness and excess kurtosis.  Without giving a formal definition of the two, suffice it to say that skewness depicts whether or not more observations are above or below the average.  Kurtosis is simply whether or not there are observations than the simple bell curve would not predict.  Investors are more concerned with extreme negative returns above and beyond what the bell curve would predict;

2)      The second assumption is that stock price changes are not correlated to each other.  However, think about the industry factors that affect Apple and Samsung.  It is likely to be that global demand for smartphones will affect both these stocks in similar ways;

3)      The time horizon for all investors is one period which is typical one calendar year;

4)      All investors can borrow and lend at the same risk free interest rate;

5)      All investors are taxed at the same rate in all locations;

6)      All investors make the same calculations about the estimated expected returns, standard deviations, and correlations between returns for all investments available to investors.

We can clearly see that these assumptions severely limit the practical application of MPT to constructing a portfolio of investments that will provide a satisfactory rate of return given ones risk tolerance and financial goals.  Why are these assumptions made?  Well, I can assure you that even with these assumptions the math gets quite complicated.  For example, ask your Financial Advisor how William Sharpe proved that you can eliminate the covariance between stocks in order to come up with portfolios that lie on the efficient frontier to “simplify” Markowitz’s original theory.  Note this is just one “easy” part of coming up with the expected return of a portfolio composed of percentages of the risk free asset and all stocks.  If your Financial Advisor can explain that concept to you, you need not read any further.  I would be quite impressed and listen more to what he/she says.  If not, I would urge you to continue reading.

If some or all of the six assumptions do not apply to you, why would you want a portfolio custom made for you that uses a 50 year-old theory?  Personally, I do not know either.  So let’s proceed with how it relates to individual investors.  I will concentrate on investors in or near retirement or saving for retirement in my discussion below.

If your time horizon is longer than one year, you can make some modifications to MPT in order to fit your financial goals, risk aversion, and timeframe.  How?  Well, if you are an individual investor, you can choose to see the world in a different manner when it comes to investing.  The day-to-day and even quarterly fluctuations of stock prices should not concern you too much.  Yes, I realize it is easier said than done.  However, you can choose to make tactical and strategic decisions about the composition of your portfolio.  Most financial professionals would tell you to invest for the long term anyway, right?  Well, tactical decisions should be made in the context of an annual review of your portfolio.  Strategic decisions should be made with an outlook on the next five years or so.  This is probably what you have heard anyway.  Here is the twist though:  if you look at the stock price fluctuations of the S&P 500 index over the last 50 years, there will be some scary results.  If we take the period April 1, 1957 through June 28, 2013 and use MPT statistics, you can expect that 1 out of every 10 quarters your quarterly return from the S&P 500 index will be less than -11.5% or greater than 15.1%.  Note the returns are based upon quarterly fluctuations.  You can expect to experience a return in any given quarter which is less than -11.5% every 5 years or so.  Given your risk tolerance, how would you feel if your portfolio lost this amount in a single quarter?  Most investors, especially retirees, would have a difficult time accepting this volatility in expect returns.  Should you sell all your stocks at this point?  Well, I try never to give portfolio advice, but, if you are fearful of losing more than 10% of your money investors in stocks, I think you should strongly reconsider your risk tolerance.  That negative return is any given quarterly window is not too extraordinary in the real world.

I talked about the standard deviation of stocks on an annual basis at great length in the first part of this article.  How can we use the same statistical techniques to look at a portfolio over the long term?  Your Financial Advisor is used to speaking with you once a quarter and at the end of the year to review the performance of your portfolio.  What if you are wondering what you should do over the next five years? If you are 43 years old, why should you worry about daily stock price returns in 2014?  You should think about stock price returns but not to the extent of watching the stock market every single day, month, or quarter to try to glean magical insight into the future direction of stock prices.  I have been investing in the stock market since 1987, and the history of the stock market is littered with incorrect predictions about the stock market.  In fact, it can be dangerous to listen to some of the market prognosticators of “gloom and doom”.  For example, if you hear that you should buy gold because the entire financial system is going to collapse, I would ask you to perform a thought experiment.  If the financial system breaks down such that we are bartering for goods with gold and silver coins, ask yourself how long that money will last.   How long will it be until there is a scene out of NBC’s television show Revolution?  If there is an armed gang of thugs roaming the streets, I am pretty sure that your coins will not be in your possession for very long.  Note that is my personal opinion, but, if you construct your portfolio based upon extreme scenarios, you have to perform extreme scenarios to “stress” your portfolio.  I think it is a better use of time to think about uncertainty as being an ongoing component of investing.  There will never be 100% certainty about economic and financial events.

We can use the same statistics invoked by the academicians who created MPT to our advantage if the time horizon is extended to five year increments.  For example, over the time period 1961-2010, the average annual return for stocks in the S&P 500 index over each five-year period was 9.7% per year.  Now the minimum and maximum annual returns for each five-year increment were 0.5% (2001-2005) and 18.2% (1996-2000), respectively.  Now please observe that the annual returns of 1973, 1974, 1987 (as shown in part 1 of 2 was actually positive), 2001, and 2008 are included in that time series.  How does this occur?  The extreme increases and decreases of stock returns are smoothed out over a long period of time.  We had the Internet Bubble in 2001 which was preceded by the period of time in the late 1990’s which former Federal Reserve Chairman, Alan Greenspan termed irrational exuberance (note that this term was coined by him in December 1996; please refer to this link for Greenspan’s famous speech:  http://www.federalreserve.gov/boarddocs/speeches/1996/19961205.htm).  The fluctuation of stocks over a particular year can be quite volatile and can persist for much longer than expected by top-notch economists and asset managers.  However, if you look at these observed returns, you come up with much smoother results.  Your financial professional encourages you to invest for the long term, so why don’t you look at the expected returns over the long term for stocks when creating your portfolio?  If you are making tactical (medium term) and strategic (long term) changes to your portfolio, doesn’t it make sense to ignore the daily changes in stock prices?  To me, these are rhetorical questions.  Given the financial advice you receive or information you receive from the financial media now, does it sound like they consider these questions to be rhetorical?

The last point I will leave you with is a brief look at the annual returns you might expect over any five-year holding period in stocks.  Looking at the ten observations of five-year annual returns between 1961-2010 for the S&P 500 index, you can expect that 1 year in every 100 your five-year annual return will be outside -5.9% and 25.2%.  Therefore, every 200 years, there should be a five-year annual return less than -5.9% which is otherwise thought of as downside risk.  The worst five-year annual return for stocks since 1931 was 1936-1940 in which the average annual return was a bit less than -0.5%.  The five-year annual return for stocks between 1931-1935 was 2.2% which incorporated the height of the Great Depression.  Therefore, I would argue that you are thinking about investing as a long-term exercise in helping you reach your financial goals, stocks may be less risky than you think.  Or at the very least, you should ask your Financial Advisor why they do not use annual and five-year annualized (geometric basis of course) expected returns for stocks when recommending how you should position your portfolio.  It is a valid question if you are a long-term investor.  Note that I did not even include diversification in this discussion.  Since you are able to choose small cap stocks, international stocks, high yield bonds, and real estate, you can look at an individual portfolio in an even more positive light.

Why Did I Choose to Include Latticework in my Investment Firm’s Name? Well because of Charlie Munger, of Course.

11 Sunday Aug 2013

Posted by wmosconi in bonds, business, Charlie Munger, Education, Fed Tapering, Federal Reserve, finance, financial planning, investing, investing, investments, stocks, bonds, asset allocation, portfolio, investments, personal finance, portfolio, statistics, stock prices, stocks, Warren Buffett

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bonds, business, Charlie Munger, education, finance, investing, investments, markets, stocks, Warren Buffett

I affectionately refer to Charlie Munger as Warren Buffett’s sidekick at Berkshire Hathaway. Buffett and Munger have been friends for decades and business partners as well. Charlie Munger serves as the Vice Chairman of Berkshire Hathaway and is 89 years old. He reminds me a bit of Andy Rooney. Some might classify him as eccentric and a bit of a curmudgeon. However, I heard once that Howard Buffett, Warren’s son, tells people that Charlie is the only person he knows that is smarter than his father. When I read that, it really caught my attention and piqued my interest. Smarter than the great Oracle of Omaha? Wow!

Mr. Munger is a fascinating man. You might think of him as a modern day Benjamin Franklin. The man is well-versed in most every subject imaginable. The most interesting thing about him is his “latticework of mental models”. You see Charlie views the world of investments and financial markets differently than most. In fact, he sees the entire world quite uniquely. The “latticework of mental models” is essentially using the “big” ideas and concepts from other disciplines to improve your understanding of market participants and investing in general. For example, Charlie talks a lot about the behavior of investors from a biological standpoint. One of the big concepts in biology has to do with complex adaptive systems in ecosystems. If you think about the rain forests of Brazil, there is so much diversity in life forms and interactions there. Many new species are discovered there every year. However, pollution and burning of the rain forest has caused the ecosystem to change in unexpected ways. Now Munger believes that financial markets operate in the same way. Each investor or institution is constantly trying out new investment strategies and trying to anticipate what other market participants will do and how the global economy will grow in the future. There is essentially an ever-changing disequilibrium within the financial markets which is always searching for an equilibrium. My actions in the financial markets will affect how others will react now and act in the future. It is very much akin to game theory developed by the Nobel Prize Winning economist, John Nash. This example demonstrates just one of Charlie’s insights.

I strongly suggest that you get to know Charlie Munger better. Once you listen to him, you can’t help wanting to learn more about him and the latticework. If you would like to learn more about this man, I would point you in the direction of this book: http://www.amazon.com/Damn-Right-Berkshire-Hathaway-Billionaire/dp/0471446912/ref=sr_1_1?ie=UTF8&qid=1376246794&sr=8-1&keywords=Damn+Right. The book, Damn Right, is a fabulous discussion of the man that sits beside Warren Buffett. In fact, Charlie is a lawyer, but his investment partnership had incredible returns as well. If you want to learn more about his “latticework of mental models”, here is a link that describes it briefly: http://www.psyfitec.com/2011/09/mental-models-arrayed-on-charlie.html. Now let’s move to the man that has codified Charlie Munger’s ideas into a book which focuses on investments.

There is a book out there by Robert Hagstrom. Here is the link: http://www.amazon.com/Latticework-Investing-Robert-G-Hagstrom/dp/1587990008/ref=sr_1_sc_1?ie=UTF8&qid=1376247028&sr=8-1-spell&keywords=latticwork+the+new+investing. The book is called Latticework: The New Investing. You may know Robert Hagstrom from Legg Mason fame with Bill Miller who beat the S&P 500 for over a decade straight. Mr. Hagstrom also has written extensively on Warren Buffett. In fact, I consider them the best practical books on investing like Warren Buffett. The books are The Warren Buffet Way, The Warren Buffett Portfolio, and The Essential Buffett. Since he covered Warren Buffett, he couldn’t help but notice Charlie Munger. Thus, he decided to write a book about him.

I will now try to bring this concept back down to earth and not so abstract. Have you ever met a “random” person and found out that you know the same person or grew up a few blocks away from each other? Even though you do not know the person, you have something in common. It makes the discussion easier. I will give you an example from my personal life. My best friend is an African American. We couldn’t come from more different backgrounds, level of education, family structure, and life experience. I met this gentleman at work in the financial services industry. Now we talked about finance of course, but, I cannot actually recall how it happened back then and we first really connected. Well, my friend happened to be a DJ who knows everything there is to know about hip hop music, and he is a very talented musician as well. I listened to a lot of hip hop growing up and playing basketball at the inner city parks in Milwaukee. We started to talk about music. There was an instant connection there, and I felt like I knew him forever. The odd thing is that he happens to be the smartest person I know. Why? He does not have a college degree, but he views the world very interestingly. You can have a conversation with him about Federal Reserve policy, deontological concepts from Immanuel Kant, black holes, conspiracy theories, and if Queensbridge has the best rappers from the origins of hip hop. Very diverse knowledge base to say the least. I count myself extremely fortunate to have this friend. He sees the world differently than most. He sees connections where others see silos of academic subject matters. Now if you saw us on the street, you would probably never guess that we were such good friends. Well, Charlie Munger sees the world in such a way as well.

Hagstrom’s book goes into depth about the subjects that Munger reads and learns about. He talks about physics, biology, psychology, history, literature, and other matters. It is interesting how many of the concepts and theories of these disparate topics can be used to look at financial markets and economic activity in the world. For example, you might be most familiar with the fields of behavioral finance and behavioral economics. All these fields are “simply” applying psychological concepts to the real world of investing. Are people really rationale? Do we have cognitive biases that blind us in making everyday decisions? Now psychology is easier to relate to investing. However, the equilibrium and disequilibrium theories of physics can be applied as well. I will not go into any further depth. As you can tell from my blog in general and this post, brevity and being succinct are not really my strong suits. With that being said, I would point you to a website that will “blow your mind” and really make the “latticework of mental models” come alive: http://www.santafe.edu/. The Santa Fe Institute has a group of academicians and others who look for connections between different subjects. Now I will warn you that a lot of the material is quite complex and it is not specifically about investing. However, you will learn quite a bit from looking at a few of the papers published.

Well, how do you go about building your “latticework of mental models”? Have you ever wanted to learn more about astrophysics, history, or science? There is one free way to do it. The Massachusetts Institute of Technology (MIT) has a website that provides actual information taught in the classroom and a lot of video lectures. When you hear MIT, you might automatically associate it with technology, engineering, and computer science. However, it is a great higher learning institute and has renowned professors in business, math, history, and literature. Here is the link: http://ocw.mit.edu/index.htm. The OpenCourseWare system is incredibly unique and valuable. Try it out with a topic you have heard of, but you do not know about in any detail. There are video lectures that are 20-30 minutes long. Additionally, you will have access to lecture notes and the books/articles read. So you can go to your local library and research more. You can link to one of the best schools in the world and learn from them. It is an exceptional opportunity.

I hope this explains the Latticework in my company’s name and why I use the concept in my investing and personal life as well. Once you learn about the “latticework of mental models”, it will definitely challenge how you view the financial markets. If nothing else, it might satisfy your intellectual curiosity.

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