What’s the capital of Iceland?

A: About €3.51.

Although Gianluca reminds us not to try to catch falling knives , I am definitely a buyer in these markets. This has not been a traditional bear market so far — which are normally characterised by weak rallies and gradual slow downs — rather than intense plunges like the ones we’ve been experiencing in the last few weeks. The rallies that follow bear markets are often quick, so without trying to time the bottom, it’s actually good to get in when there’s blood on the streets. I don’t reckon I’ll be making a quick profit, but in five or 10 years, I do think these will look like bargain prices. Buy from the fearful and sell to the greedy.

I saw some great credit crunch jokes posted on Facebook (thanks Manos!) and they’ve all made me laugh e.g.

“Q: What’s the difference between an investment banker and a large pizza?

A: The pizza can still feed a family of four.”

Some recycled lawyer jokes too:

“Q: What do you call five hedge fund managers at the bottom of the ocean?
A: A good start.”

Since I know a couple of hedge fund managers, I have to admit I don’t really subscribe to this one. I find it peculiar that the media portray this as something different from that which has always happened. It’s just another bear market. 90% of my net worth is in funds from Dimensional Fund Associates who are very dogmatic about leaving your money in the market to do what it does best. They have produced a great presentation showing just how similar the current market is to others problematic times in the past, and how similar the media’s presentation of it is too.

I have been doing some research into a trend following market timing approach, that seems to work very well over the last 30 years, but having just my moved my money over to DFA a couple of years back, I wanted to continue the research until I fundamentally change my approach — again. Most investors get killed not from bear markets but from pulling their money out at bottoms and putting it back in at tops. I don’t intend to change my approach until everything is locked and loaded. And having said that, the greatest benefit of a market timing approach comes predominately from missing big downturns — and this is one of the largest across a variety of asset classes.

Hey ho, let me leave you with another one: “Overheard in a City bar: ‘This credit crunch is worse than a divorce. I’ve lost half my net worth and I still have a wife.'”

Arbitraging Microsoft

Great post in Think-Through on an arbitrage scheme using Microsoft’s recently introduced cashback approach.

 

I love the very idea of arbitrage — ‘risk-free money’. Anywhere else, this would be called a scam and the would be overtones of theft. But in the world of finance, where it is understood that markets are (mostly) efficient and that there can be no such thing as a free lunch (mostly), nobody seems to mind if you happen to find a lunch that’s free because they are safe in the knowledge that it won’t be free for long. Interestingly, some of the thought leaders in capital markets theory do describe a number of free lunches. But because they know that free lunches are not possible, they describe it as reward for extra risk taken.

 

I spent a year or two working with a treasury derivatives trader building treasury derivative arbitrage models. These were humungous Excel sheets loaded to the gills with add-in functions, some custom C code, and pulling in realtime data, detecting small differences in pricing between synthetic and real securities. An example: if you take a euro-swiss franc swap and a swiss franc-dollar swap you can create synthetic euro-dollar swap. This has (just about) all the characteristics of a real euro-dollar swap but it might have slightly different cost. Where the difference exists, it’ll be tiny but if you have a billion euros on your books overnight, it may be something you can take advantage of ‘for free’. Most of this simple type of arbitrage really does not exist in the markets any more, but when we used more complex treasury derivatives, and worked out all the permutations across a basket of ten currencies, there were more opportunities.

 

I still remain interested in financial arbitrage, and on the lookout for simpler ways of consistently making money — but that’s for another post.

The only three questions that count

I’ve listened to the audio version of Ken Fischer’s wonderful book, The Only Three Questions That Count: Investing by Knowing What Others Don’t. He explains simply, insightfully, with a good deal of wit and a healthy dose of cynicism how to think about investing. He points out that most people learn investing as a blacksmith learns their craft — at the foot of a great master. Although there is little wrong with this, investing is only partly craft and the rest is cannot be learnt but must be discovered. (What he seems to omit is that the process of discovery is another sort of craft). It is this process of discovery that he teaches in the book. Fischer calls the results of the discovery Capital Markets Technologies. You can think of them as tools, inventions or as technology, but Fischer warns against the dangers of considering them immutable laws. Markets change and so do the tools that work.

The only way to make money in the markets, according to modern financial theory, is to know something that others don’t. In trading, this is typically called an ‘edge’. Initially this smacks of insider trading, but this does not have to relate to knowledge about a company, but could more plausibly be discovering a technology that few else understand. The best secrets are those that are hidden in plain view. Many investors acquire beliefs about trading by reading financial media, talking to other investors or at the foot of the master of their craft. Some of these beliefs are indeed powerful technologies but many are either false or false when taken out of context. The first step is to get a good handle on the root assumptions that lie beneath many beliefs.

In The Only Three Questions That Count Mr Fischer looks at three ways to get an edge on your fellow investor: find things that are false that others think are true, work out things that others can’t or work out ways to work with the market more rationally. These three imperatives are three questions of the title.

The essence of many of the ‘things’ are correlations between commonly occuring financial instruments: do high oil prices mean low stock prices? Does the VIX, the investor’s volatility thermometer drive prices down? Is a weak dollar bad for US stocks? Is a strong dollar bad for European stocks? Mr Fischer shows how to do the investigative work yourself using freely available data. What is fascinating about this is that even when you discover that a new rule (e.g. oil is not actually correlated with stock returns), people keep on believing the opposite (e.g. high oil prices mean low stock prices) giving you an edge that will keep on paying out, until the majority understand what you understand and the market prices it in before you.

Analysing technical analysis

For instance, browsing through my copy of Options, Futures and Other Derivatives (in section 10.1) , I was delighted to find

If the weak form of market efficiency were not true, technical analysts could make above-average returns by interpreting charts of the past history of stock prices. There is very little evidence that they are in fact able to do this.

Now, I’ve just finished The Way of the Turtle which is a great compilation of wisdom on how to use very simple technical analysis to make above-average returns by interpreting charts of the past history stock and commodity prices. These are the self-same techniques that commodity traders have been using to good effect for the past three decades.

Technorati Tags: emh, options, trading, turtletrading

Buy and hold overbought?

In an 2001 article on Barclay Group’s site (requires registration) entitled “Buy and Hold: A Different Perspective” Richard Rudy, a hedge fund manager states that

The “buy and hold” investor has been led to believe (perhaps by an industry with a powerful conflict of interest) that if he has tremendous patience and discipline and “stays with it” he will make a good long term return. These investors fully expect that they will make back most, if not all, of recent losses soon enough. They believe that the best place for long-term capital is the stock market and that if they give it 5 or 10 or 20 years they will surely do very well. Such investors need to understand that they can go 5, 10 and 20 years and make no return at all and even lose money

If, however, investors can uncover an approach that can earn 12% to 15% a year with little correlation to the market and without the kinds of historical drawdowns offered by the market, then, when compared to the market, they should think about the choice very carefully indeed.

If you compare this to a standard portfolio allocation approach with funds Dimensional Fund Associates, e.g. choose four or five standard asset classes which are not very well correlated with each other, then buy investment vehicles for each, and hold them for the long term. It is important that the investment chosen — like those DFA funds — have low expense fees, pay as little as possible in commission and slippage, and do not follow the crowd in order to find stocks for that asset class. The results are very impressive.

Technorati Tags: buy and hold, dfa, emh, hedge funds, running money

Buy and hold overbought?

In an 2001 article on Barclay Group’s site (requires registration) entitled “Buy and Hold: A Different Perspective” Richard Rudy, a hedge fund manager states that

The “buy and hold” investor has been led to believe (perhaps by an industry with a powerful conflict of interest) that if he has tremendous patience and discipline and “stays with it” he will make a good long term return. These investors fully expect that they will make back most, if not all, of recent losses soon enough. They believe that the best place for long-term capital is the stock market and that if they give it 5 or 10 or 20 years they will surely do very well. Such investors need to understand that they can go 5, 10 and 20 years and make no return at all and even lose money

If, however, investors can uncover an approach that can earn 12% to 15% a year with little correlation to the market and without the kinds of historical drawdowns offered by the market, then, when compared to the market, they should think about the choice very carefully indeed.

If you compare this to a standard portfolio allocation approach with funds Dimensional Fund Associates, e.g. choose four or five standard asset classes which are not very well correlated with each other, then buy investment vehicles for each, and hold them for the long term. It is important that the investment chosen — like those DFA funds — have low expense fees, pay as little as possible in commission and slippage, and do not follow the crowd in order to find stocks for that asset class. The results are very impressive.

Technorati Tags: buy and hold, dfa, emh, hedge funds, running money

Efficient markets

There are three broad dogmas in finance:

• That markets are efficient
• That markets are inefficient
• That it does not really matter whether markets are efficient or not

At any one time, I have been known to hold one, two or all three views. Depending which site or book or article you read, you will typically find one of the first two views held so dogmatically that you would think any one crazy to believe in its opposite. Generally, this is accompanied by some logical consequences. e.g. if the market is efficient, you cannot make money from its inefficiencies, at least not in the long term. Or similarly, if the market is inefficient, a long-term buy and hold approach to stocks simply cannot work.

Technorati Tags: finance, puppy