Bubbles are a product of human overreaction.

Intially the bubble occurs because the idea had fundamental and logical reasons why it should go up. However the general public may see the asset as too risky. This is when the asset starts making very quick returns in a short time period.

Then the media starts paying attention to the move, you hear about it on tv, in the newspapers, the asset continues running upward without looking down. Now the general public is thinking about investing it. It’s no longer “risky” but it is now a bit “pricey” but absolutely worth it because “so and so is in it”.

Then you have everyone who largely missed the entire rally jump in. It could be your neighbor, coworker, family friend or even dear old grandma.

How do you know if it’s a bubble? Doctors, lawyers, rappers start investing in it.

Everyone is watching it, discussing it, and you probably hold it. But it is most likely going nowhere.

Likely bubbles:
Gold ?
Paulson the one hit wonder who made tens of billions in the subprime crisis started a gold fund. First month it opened, down 14%.
Oil ?

Stocks?

Incentive structure
The problem with hedge funds is the fact that their incentive structure is wrong. Hedge Funds collect their 2/20. A typical hedge fund has a 2 percent management fee an also collects 20 percent of total profits earned.

Hedge Funds are asset managers that collect a management fee of 1-2% a year as well as 15-25% of the profits. Portfolio managers of these funds are trying their best to have better results than their competitors.

Why HF don’t hedge
Assume you are a professional racer that has the choice of three different cars.

Car A is your muscle car, great horsepower, no real control. This car would be great in a straightaway track. (in a hf world it’d be your long only fund that invests in high momentum, high beta with enormous leverage of course). A straightaway track would be a market environment that only seems to head in one direction, up.

Car B is your 4 wheel drive, medium horsepower car with great handling. (This would be your long/ short, relative value fund that tries to balance out it’s exposure) car B would be great in a period where the track has twists and turns (volatile market)

Car C is actually not a car at all but instead it’s a tank. Slow steady but pretty much invincible. You can assume that Car C is your treasury or investment grade bond fund. The tank usually doesn’t win unless if there is a market calamity (think late 2008, when treasuries rose 40% that year)

What car would you pick? I’d say most people would pick either car A or car B. However the choice really depends on what type of track and weather conditions will be present on race day.

Before we continue in our theoretical example, we will assume that skill level of the three race car drivers are equivalent.

If the race occurred on a straightaway. car A would win hands down. If the race were on a track with a lot of twists and turns then car B would win. If the track were in a war zone, car C would win by default because it would be the only one that survived the race.

The problem with the markets is that we do not know what the environment we will encounter in the future (going back to the race track example, we dont know what track we will race on before the race occurs). To be “safe”, we ideally would need to play it conservative.

The HFs that do not hedge are similar to car A on a track with twists and turns. When obstacles appear, they are usually due for a bad accident.

Why you should hedge

Risk Management is like having brakes on your bike. You generally don’t notice that you are missing brakes until you really need it. 99.9% of the time, people without brakes and or risk management usually get injured pretty badly.

Don’t put all your eggs in one basket. If you do make sure to watch the basket and/or hen very carefully.

1. “Don’t invest in the stock market, it’s not acting well recently.”

It’s never a good time to invest in the market. A rational investor with imperfect knowledge will have to act to the best of his or her abilities. Since we can’t accurately predict the future, we can only invest in situations where there is a margin of safety just in case the future really is as bad as everyone thinks. This is called buying a dollar with 50 cents.

Volatile markets create great uncertainty. Volatile markets also create great opportunities. The best deals are found when there are limited buyers (less competiton always leads to higher profits).

2. “Technical Analysis works in theory but I haven’t made money from it because I don’t have the time to trade.”

Technical Analysis may or may not work. Every technical analyst I’ve met has not be able to consistently make money in all market environments. I also don’t know famous market technicans, except for people who write about TA books, or sell TA systems.
Does it work? My friend claims yes but doesn’t know anyone who has made money from it, theoretically someone out there is implementing it correctly.

3. “Stocks are too risky, buy CDs”.

Yes, stocks have more risk than CDs (certificate of deposit). CDs also have negative returns after factoring in for inflation. The reason why we invest in stocks is to maintain purchasing power for the future. Inflation and taxes are the enemy here. Any interest recieved from the bank will be taxed. A stock investment is ideal since you can theoretically hold it for a lifetime if you wish, gains will be taxed when you sell. Also long term gains and dividends are taxed at a lower tax rate than interest from CDs.

You know when you are getting old when people tell you to have a happy and “healthy” new year. I hope everyone has a low vol, positive alpha new year.

Some anecdotal experiences with technical analysis. One friend (which shall remain un-named) in a trading contest out of 11, finished dead last with daily losses based on a TA system (close to last place since day 1). The allure is there, no research or understanding needed in the markets you trade, essentially a money printing machine. Another friend reluctantly admitted that technical analysis must work…for other people out there.

Technical Analysts try to bring some credibility to their religion by trying to introduce math, physics, and even nature into the equation. For some reason, very intelligent people are likely to believe in this religion.

The most absurd part of the TA’s religion is that they believe in Fibonacci ratios. The underlying rationale is that these patterns exist in nature so therefore should exist in the stock market. This paticular sect of the TA religion calls themselves the Elliot Wave Chartists.

CNBC always plays these vector vest commericals, the commericals claim that they can allow you to time and beat the market. First question that comes to mind is that if this trading system works so well why are they trying to sell it to the tens of millions of viewers on CNBC? When things sound too good to be true they usually are.

The sad fact of the matter is, there are suckers born every minute(literally). Most newborns 21 years later, go on to do things with negative expected value. Negative expected value actions include (playing slots, playing the lotto, trading on TA systems, driving while intoxicated, and so on and so forth).

For all the readers, please remember not all formula driven investing is technical analysis. Quantitative hedge fund strategies are not included in the technical analysis camp since they analyze and subsquently bet on different things such as market factors, convergence bets, arbitrage strategies.

The morale to the story? Everyone needs something to believe in from time to time. I believe that two things will always occur, death and taxes.

Happy New Year everyone, may they have a healthly, happy and profitable new year.

Paying the price to get Michael Jordan on your team is definitely worth it and would add value for the entire team by making the whole team play better. Just like a good stock minimizes portfolio fluctuations in a downside scenario. But the question remains, how many Micheal Jordans are there? I only know of one. You may be tempted to pay a Michael Jordan price for a player that might not pan out, you have as a result wasted all that money that could have gone to another player that might have been able to make your team incrementally better.

Boring vs Exciting, the faster the revenue growth, the more mysterious the business, the more known unknowns, the more speculative the business the more people like it. People at parties would rather hear about the exciting up and coming biotech company or how fast google is growing rather than the unexciting oil and gas exploration business.

There are two main problems with successful companies at the forefront of innovative trends. The first problem is that success has competition, any successful business will eventually have competitors that will shrink profit margins. For example look at Apple computers, Apple turned the mobile phone industry in their heads when they came out with the touchscreen iPhone. Their success invited competition from Blackberry, Palm, and Google. It will take some time for RIMM, GOOG, PALM to catch up but honestly it is only a matter of time before they do.

The question remains, how do we get something worth more than what you orginally paid for? Simply, how do you buy it on sale?

The answer lies within the inner shopper. There are certain times of the year that clothes go on sale. We all know that the time to buy summer clothes is in August/September. Retailers are forced to sell their merchandise at a discount (one example of forced selling) so that they can make space for the fall season clothingline.

Forced selling is your friend, it is an event that occurs from time to time for various reasons. It is an opportunity that allows you to potentially buy a stock on sale. A company ratings downgrade, negative newspaper article, bad earnings quarter, news that xyz hedge fund is short the stock, are all possible reasons for forced selling.

As my wise coworker once famously said, it can always get worse!

Misunderstanding risk, people feel more comfortable with unknown unknowns than known unknowns. Reread that statement again and think about it.

A stock with problems is unattractive, too many problems plague this company for investors to feel excited about it’s prospects. Since the company’s problems are well known, it’s also sold down very heavily by mutual finds that can’t afford to let investors see that they held such an underperforming bad stock.

Everyone would rather hold the high flying stock than the trouble plagued stock.

Would you rather own : Apple Computers or Research in Motion

Would you rather invest in the emerging biotech industry or the tobacco industry?

Use of leverage at the wrong time. When dealing with money, people at one point or another experience the two extremes of greed or fear. When markets are running hot (only going up), everyone is comfortable with borrowing on margin, trading derivatives, all resulting in more leverage. This newfound leverage translates to portfolio risk, which makes your portfolio more vunerable to stock market fluctuations.

Chasing winners is something everyone loves doing. There is more comfort in holding a winner than a loser. The rationale behind this urge to buy winners is that it can continue moving up and has the possibility of quick returns and “easy” money This was the logic behind the dot com bubble, stocks seemed to only move in one direction and you couldn’t go wrong holding Yahoo or Cisco because everyone else held it. As my dentist told me back during the late 1990s, “it was very exciting to watch Cisco go up everyday until it stopped going up”.

Holding on to losers, everyone who has held a stock that has dropped more than one wanted it to. So we hope and pray and wait for it to turn around. It’s only a matter of time right? There are a few cases where stocks do rebound back to prices where it use to trade however that usually doesn’t turn out to be the case. For example, during the dot com bubble, technology companies traded with extremely high valuations. Speculators were willing to overlook these valuations because these internet companies were experiencing explosive growth and could potentially earn billions in the process.

Going back to the topic of holding on to losers, if you bought Cisco at 100-200 times earnings back in the heyday, it’ll be quite some time before you’ll be able to recoup your investment back.

This topic will be addressed with further examples in a later post.

I decided to write a series of posts in the category newbie to answer the question once.

There are a list of things newbie investors should be aware of
1. Psychology
2. Market timing
3. Valuations
4, Risk Management
5. Patience

I’ll try my best to write up a list of a few things new investors should be aware of before putting their hard earned money in the market.

The four largest custodian banks are in size order
1. JP Morgan
2. Citibank
3. State Street
4. Bank of New York Mellon

JP Morgan and Citibank ( think repayment of TARP, as well as all the bad loans still on their books) are conglomerate banks that include investment bank operations as well as retail bank operations. The bad residental and commerical mortgage loans will prevent them from engaging in any M&A activity for quite a while. State Street and BNY are pure play custodian banks, that have come out of this economic crisis relatively unscathed.

A few reasons why BNY may look towards Europe rather than Asia.
1. Europe seems to be lagging in terms of recovering from this economic crisis. Things might be cheaper on a valuation basis.
2. European politicans seem keen on splitting bank’s lending operations from their ancillary operations such as mortgage processing, investment banking, proprietary trading arms. These forced actions may provide BNY excellent businesses at firesale prices.
3. The Chinese government doesn’t allow any foreign firms 100% controll over any business in China, they have to partner up with an existing business ( this is also known as knowledge transfer).

As the financial uncertainty continues, it might be worth looking into financial firms that have profitable business lines ( custodian bank services, mortgage processing, insurance processing, electronic payment processing, anything that ends with processing will be a decent chance that these business lines come with recurring revenues and good margins).

Bank of New York Mellon link

http://us.mobile.reuters.com/mobile/m/FullArticle/CMAT/ninnovationNews_uUSTRE59Q08620091027

John Meriwether was part of the group of Nobel prize winners that created LTCM. Long Term Capital Management ironically traded short term strategy that scalped the price differences between two similar securities. This process is known as arbitrage.

Arbitrage occurs when prices of two similar securities trade at different prices. To use a simple example, let’s pretend that xyz stock trades in Europe at 10.45 USD and the exact same aecurity trades for 10.47 USD in Hong Kong. Abitrage firms would buy xyz stock in Europe and sell the same xyz stock in Hong Kong. Eventually if the process us is done correctly prices should reach 10.46 USD in both markets assuming normal market conditions.

The strategy while simplistic, works across many different asset classes (stocks, bonds , futures, derivatives). The problem is that the strategic relies on liquidity ( a topic discussed in the last post). We are assuming normal market conditions that might not always be available as we’ve seen in 2008-2009.

Another risk from this strategy is that since arbitage firms essentially scalping small profits here and there, it needs tremendous leverage for the firms to actually make a decent return. Most arbitrage firms will leverage up about 7-8 times their assets under management. LTCM reportedly used up to 25x leverage. JWM Partners reportedly used 10x leverage.

The problem with leverage is that when positions move against you, your prime broker (the financial institution that lent you the capital in the first place) will demand more collateral. If you don’t have any collateral to post, you have to liquidate positions immediately, this is known as puking. Many hedge funds puked starting from 2007-2009, selling securities left and right. Puking causes efficient markets to be inefficient and also shows the dangers of a highly levered strategy. A firm levered 25 times can only withstand a 4% hit against their portfolio before they are wiped out. The less leverage you use, the longer you are able to withstand irrational markets.

John Meriwether lost a tremendous amount of capital for LTCM investors as well as for the investors that invested in JWM partners (44% losses from 2007-2009). This strategy can be best described as picking up pennies in front of a steam roller. It will work most of the time until you get rolled over.

John Meriwether wiki profile:

http://en.m.wikipedia.org/wiki/John_Meriwether?wasRedirected=true

John Meriwether to start JM Advisors

http://www.ft.com/cms/s/0/331bae80-be93-11de-b4ab-00144feab49a.html?nclick_check=1