The stock market is over.

[mangeorge]

It's served it's purpose, and now is, indeed, a casino. Perhaps it always has been.
So few shouldn't be allowed to jerk so many around. Part of the problem is that technology has outgrown the market. Things happen way too fast. There needs to be some sort of "greed buffer", a check and balance system that would slow situations like happened on Monday (9/15/08).
BTW; I suspect sculduggery.
Peace,
maneorge

[XT]

The Market rallied today btw...somewhat anyway.

It's served it's purpose, and now is, indeed, a casino. Perhaps it always has been.

Instead of saying the obvious, let me ask a different question. What do you think should replace it?

Part of the problem is that technology has outgrown the market.

How so?

There needs to be some sort of "greed buffer", a check and balance system that would slow situations like happened on Monday (9/15/08).

What would a 'greed buffer' look like exactly? How would it work? How would it be better?

BTW; I suspect sculduggery.

:dubious: What do you base that on? Where is your evidence?

-XT

[Airman Doors, USAF]

It's amazing. Millions of people have grown old and retired investing in the labor and ingenuity of US companies and their employees, but every once in a while something gets out of whack and suddenly it's unbridled greed and evil 24/7.

It's just like everything else. When things are going great people ride the gravy train without even thanking the people who made it happen for them, but they have no trouble pillorying them when things aren't going so well.

[DSeid]

mangeorge,

What do you think its purpose was?

[Marley23]

Instead of saying the obvious, let me ask a different question. What do you think should replace it?
I think somebody should ask the obvious. What exactly is the problem? Is it with public ownership of companies? If so, why?

Perhaps there are some ways that short selling or manipulation could be dealt with, or perhaps laws or regulation concerning some of the hyperspecialized financial instruments could be passed, tying them to something more 'real,' for example. I can see reasons to do something like that. "Get rid of the stock market," though? I don't see the logic, or what would be done instead.

[Jas09]

I think the OP is obviously overstating the case, but there are a few regulations that could be put in place. One would be to raise margin requirements and requirements for shorting. If you require there to be actual money backing up transactions (rather than highly leveraged loans) you can decrease speculation somewhat. Also, beefing up the SEC enforcement arm would be useful to help weed out actual corruption, I think.

Of course, as long as the financial institutions can continue to pay off politicians at the rate they are accustomed, nothing will happen. The US taxpayer will continue to backstop the losses while Wall Street takes the gains. Nothing to see here, move on, I think American Idol is back on soon...

[Huerta88]

Perhaps there are some ways that short selling or manipulation could be dealt with,
Short selling itself is a corrective mechanism. Lehman made stupid stupid decisions regarding credit. Some saw that, and shorted them all the way to the bottom.

Disappointed longs always blame the short sellers, as though there is some concerted conspiracy. Remember, with short selling, there's no limit to what you can lose, but there is a limit to what you can gain. If shorts are betting on a good stock going down, they will lose their shirt when it bucks back up. Mismanaged and overvalued companies in particular mumble darkly about shorts. If they're undervaluing your company so badly, screw them -- keep buying your stock back on the "short induced" way down, then profit when your true intrinsic value inevitably shines through.

Shorting and manipulation are not the same.

[Marley23]

Shorting and manipulation are not the same.
I wasn't trying to equate them. If shorting is out of control in some way that goes beyond correction and damages the broader market, new regulations might be justified. I suppose I was thinking more of pump and dump type manipulation.

[Jinx]

First, Lehman Bros folds, and now the US Goverment is going to bail out AIG for $85 billion? Yes, billion!?!?!? What the hay? See link: http://wjz.com/national/Fed.rescue.AIG.2.819168.html

The rich have gotten soooooo fat, there's going to be an explosion from the rich barfing all over the US middle class. They have officially killed any hope of trust in the stock market and squandered any sign of future hope of retirement for the honest and meak...the worst scandal since Enron et al, IMHO. I was reading how the big four (These two + Merrill Lynch and I forget the other pig) are ALL over-extended!

Man, Bush's term is going to end with fireworks! Then, the whole country's going to go down in flames! The bubble of all bubbles is about to burst, and it's the end of the roaring '20s all over again!

Buddy, can you spare a dime?
- Jinx

[dalej42]

This may be the very worst argument ever presented in GD.

So, what is the stock market? The stock market provides a market for trading of company shares in a secondary market. Companies issues shares of stock which represent ownership of the company. They do this in order to raise money. The shares are worth far more in the primary market because they are liquid I'm far more willing to participate in a company's IPO if I know I can immediately sell the shares should I need to do so.

Sure, some of the short term volatility we've seen is probably the result of overreaction by some investors. But, listening to nutjobs on the financial message boards whining about naked shorting isn't a solution.

The average investor should probably consider just turning off CNBC and go for a walk.

[mangeorge]

mangeorge,

What do you think its purpose was?
The stock market? Originally? To raise capital that was beyond the means of the owner of the business. Secondly, to spread the risk around.
Right?

[fruitbat]

The stock market is working precisely as it supposed to. The one thing that some very smart people appear to fail to understand is that the stock market generates superior long term returns than other investments because it is risky. If we 'fix' it so large companies don't fail and all investors get a smooth ride the return will diminish. This is the 'risk premium'. The additional return an investor expects over safe investments as compensation for the risks they take. If government intervenes too much they take away the consequences of poor decision making and reduce long term returns.

For younger investors this meltdown is great. It means that future investors will demand a higher return to compensate for the risks which have recently manifeste themselves. A well diversified investor with stocks and some bonds has lost something around 10-12% at the higher end. This is hardly catastrophic. If you invested an unwise sum into a single firm then I can hardly feel sympathy. Even the most cursory observer of Enron shuold know better.

The OP lacks a really frightening and fundametal understanding of the role the market plays in capitalizing companies and allowing people to take risks without going out and starting their own company. I am happy to watch the market work exactly as intended.

[mangeorge]

The Market rallied today btw...somewhat anyway.



Instead of saying the obvious, let me ask a different question. What do you think should replace it?



How so?



What would a 'greed buffer' look like exactly? How would it work? How would it be better?



:dubious: What do you base that on? Where is your evidence?

-XT
I addressed most of this, except the last, in the OP.
I suspect, not accuse, shady dealings. According to the experts so do many more.

[mangeorge]

It's amazing. Millions of people have grown old and retired investing in the labor and ingenuity of US companies and their employees, but every once in a while something gets out of whack and suddenly it's unbridled greed and evil 24/7.

It's just like everything else. When things are going great people ride the gravy train without even thanking the people who made it happen for them, but they have no trouble pillorying them when things aren't going so well.
Gravy train? Nobody gives me anything. All I get is due to my compensation. The entities you mention are in it for themselves. Nothing wrong with that, but they're using my resources. If I was costing them, they'd get rid of me.
I should thank them? :confused:

[Airman Doors, USAF]

Gravy train? Nobody gives me anything. All I get is due to my compensation. The entities you mention are in it for themselves. Nothing wrong with that, but they're using my resources. If I was costing them, they'd get rid of me.
I should thank them? :confused:

What do they owe you? You made what was presumably an educated guess and risked your money, and now you're blaming them because it didn't pay off for you. If I bet on a company and it fails, the responsibility lies with me. There is no "just compensation", I am not "owed", the market knows no justice. What it does know is what businesses will and will not fail, and those businesses get exposed eventually. Right now is one of those times. The market is shaking out, and what remains afterwards will be stronger for it.

You bet wrong. Sorry about your luck. I trust you did your homework and anticipated this years ago when the companies were giving you crazy returns, right? You were invested in gold and oil and other commodities, right? Oh, but those people are greedy, too. Boy, they get you coming and going, don't they?

[mangeorge]

The OP lacks a really frightening and fundametal understanding of the role the market plays in capitalizing companies and allowing people to take risks without going out and starting their own company. I am happy to watch the market work exactly as intended.
Read the first part of your first sentence here. :p
You're partly right, though. I do lack a fundamental understanding of economics. As evidenced in this thread.
I also lack an understanding of how my car works, but I suspect something's broken if it isn't running up to par.

[XT]

I addressed most of this, except the last, in the OP.

Not really...you made some fairly vague statements but didn't really go into any detail. I'm asking you to expand on your points.

Gravy train? Nobody gives me anything.

No? Look around. See all those roads? See all those stores? See all that food? Notice all those cars? Do you have any of those things? If so...where do you think they came from? They came because our country is wealthy and prosperous. They aren't gifts of the gods.

So, after a century (or more) of prosperity basically built on the market you want to toss it out now that there has been a down turn. I'm trying to understand your logic on this. After all, it's capitalism that built all that good stuff.

All I get is due to my compensation.

If you were in Africa, do you think you'd get the same 'compensation'? How about in some South American hell hole? What if you were born in Mexico without a silver spoon in your mouth? Why is it your 'due' exactly?

Nothing wrong with that, but they're using my resources.

Who is 'they' and what 'resources' of yours are they using exactly? Do you realize what BUILT our society? Do you figure it's the little guy who built it in spite of the rich fat cats?

If I was costing them, they'd get rid of me.

Well, to be sure. But...the taxes they pay would probably provide you with a nice little safety net to save you from starving, so, it's not a total wash. And...since presumably you have some worthwhile skills 'they' wouldn't be losing money on you...thus giving you employment, ehe?

I should thank them?

Well, you probably should, but I doubt you will. For that matter, are 'they' ASKING for your thanks...or for your labor? My guess is 'they' are more concerned with your ability to be worthwhile than your thanks.

-XT

[mangeorge]

What do they owe you? You made what was presumably an educated guess and risked your money, and now you're blaming them because it didn't pay off for you. If I bet on a company and it fails, the responsibility lies with me. There is no "just compensation", I am not "owed", the market knows no justice. What it does know is what businesses will and will not fail, and those businesses get exposed eventually. Right now is one of those times. The market is shaking out, and what remains afterwards will be stronger for it.

You bet wrong. Sorry about your luck. I trust you did your homework and anticipated this years ago when the companies were giving you crazy returns, right? You were invested in gold and oil and other commodities, right? Oh, but those people are greedy, too. Boy, they get you coming and going, don't they?
Me???
Where did I give the idea that I lost anyrhing? Didn't mean to. I'll likely come out way ahead on this mess.
My company does indeed owe me my compensation though, including bennies. My pay is always well behind my work. I let them get away with it because I realize the difficulty in paying in advance.
No, I'm feeling kinda sorry for those who did lose, and won't get it back. Especially the workers.

[dalej42]

Read the first part of your first sentence here. :p
You're partly right, though. I do lack a fundamental understanding of economics. As evidenced in this thread.
I also lack an understanding of how my car works, but I suspect something's broken if it isn't running up to par.

But you wouldn't argue that the automobile be abolished because you're having problems with your car.

[Scylla]

Generalizations like the one in the OP are almost to vague and ignorant to respond to meaningfully.

In short, the stock market is almost assuredly "not over." These kind of events are par for the course on a historic basis. They've happened before and they'll happen again. The basic ingredients are greed, stupidity (in the form of short-term thinking and foolish extrapolation,) and inefficiency.

What happens is an inefficiency is found, widened, exploited, and tons of money gets pumped into with tightening margins. Those margins are exceeded and the thing collapses taking a bunch of people with it. After it collapses a bunch of rules are put into place to stop that inefficiency from being exploited again, which is kind of besides the point since it's no longer a danger. Everybody has moved on to the next one and the boom/bust cycle goes on. One of the main problems, and why this keeps recurring is that nobody has generated a reasonable mathematical expression of risk that can be used. Instead they use a substitute, something that is almost like risk, or looks a lot risk. This is called "beta" and it's a measure of historic volatility.

The problem with Beta is this. If a giant boulder were perched precariously over a path, and it had sat there for a million years being eroded by wind and rain so that it was teetering, than according to the concept of beta it would be safe to walk under that rock. After the rock falls, according to beta it's very dangerous. This sounds counterintuitive and stupid, and it is. The problem though is that beta often works very well for long periods of times. It's a good indicator for small repeating risks. It's a bad indicator for large nonrepeating events.

These kind of events are systemic to the market. Some even view them as a kind of monetary ethnic cleansing, stress to strengthen the strain.

One issue that the OP seems to not notice is that the current correction actually has very little to do with the stock market. It's merely being reflected in the stock market.

Given the larger general pattern, let's take a look at what actually happened this time around, and then we'll see if we can't draw some inferences about what the future holds.

***

If we're looking to place blame, a good place to start is with me and the rating companies, Moodys and S & P.

Many years back, in the 1980s some folks at Salomon Bros. started work on a holy grail type problem. If you could solve this one, than untold riches would be yours. This problem is like antigravity in it's complexity, lure, and potential.

The problem is this: Mortgages are a lot like bonds in reverse. Bonds can be very attractive investments since they provide permanence and definition and there true risk is theoretically assessable, or at least it seems simpler to assess than many other vehicles. The more you can make a mortgage look like a bond and act like a bond, the more saleable it is.

The problem with doing this is that people will move, refinance, or payoff mortgages whenever they feel like it. Let's say you have a billion dollars worth of 30 year mortgages guarranteed by the Government through GNMA or somesuch, and they are all paying 7%.

If you could sell these to somebody than the company that originated the mortgages would have another billion dollars that they could use to originate more mortgages, and do more business, and somebody else could have a nice safe instrument paying 7% and you would get a nice big commission. A lot of people would have new houses due to the freeing up of capital. Everybody would be happy, and you would get rich while making the world a better place.

If you try to do this, you have a major problem. If interest rates go down so that mortgage rates are 5% in the next two years than everybody with those thirty year mortgages is going to refinance. The guy that thought he was going to get 7% for thirty years, now has all his money back, no more interest, and needs to reinvest at lower rates . He's pissed.

At Salomon Bros, they invented something called a CMO or Collateralized Mortgage Obligation. What this did was divide a pool of mortgages into tranches.

Again, start with a billion dollar pool of 7% mortgages backed by the Gov. Deciding on what you think will happen with interest rates over the next several years, divide this pool into groups. The first group will get their money back first, the second second, and so on and so on. You know that historically 10% of people refinance in a year no matter what. These assumptions are collectively known as PSA assumptions. Set them accurately and the A tranche might look an awful lot like a 5 year bond, the B tranche, like a 10 year bond, and so on and so on.

These PSA assumptions historically weren't very good, but everybody knew it, so it wasn't such a big problem. You could make them more accurate by fiddling with the interest rates of the various tranches. You might make the earlier tranches pay less than 7% and have a more defined maturity, and make the other tranches pay more and have a less defined maturity by assuming the early payoff risk.

This also didn't work very well, but it was a step towards making mortgages look more like bonds. Around 1990-91 I was a trader on Wall Steet with trading CMOs, and one of many bitching about their lack of bondliness (that's the part where it's partly my fault.) We bitched at length and to the right people, and they listened to us, and asked us a lot of questions. The end result was that the VADiM tranche of CMOs was essentially perfected. Very Accurately Determined Maturity tranches had existed before, but none of them had really worked. This one worked. It was for all intents and purposes exactly like a bond. Because it was made up of Gov insured mortgages the ratings company pronounced it triple A as they did all other such instruments.

Much money was made. I quit two years later, burned out, and moved to the country, but the party continued in my absence.

The unholy offspring of the VADiM tranche was the Z tranche. This was the tranche that did absolutely nothing but absorb the risk of all the other tranches to make them act more like bonds. The Z tranche was incredibly volatile and acted like nothing else that had ever existed. It was pure risk, and I mean that in the sense of that mathematically undefinable risk that almost by definition is unknowable. Moodys and S&P also rated this insane instrument AAA.

It was very very sexy.

(part II) coming up.

[MOIDALIZE]

Doom! DOOOOOOOOOOOM!

Seriously though, the market is working. Markets ebb and flow. You have to remain optimistic in the U.S. because we've always found a way to recover.

[gravitycrash]

It's served it's purpose, and now is, indeed, a casino. Perhaps it always has been.
So few shouldn't be allowed to jerk so many around. Part of the problem is that technology has outgrown the market. Things happen way too fast. There needs to be some sort of "greed buffer", a check and balance system that would slow situations like happened on Monday (9/15/08).
BTW; I suspect sculduggery.
Peace,
maneorge

Do you even know how the stock market works? Yes, we took a beating. Guess who else takes a beating if it gets worse. Not us. I'll let you figure that out for yourself.

[Scylla]

Because these Z trances behaved so unpredictably and were maginfiers of risk you could make a lot of money with them over a very short period time. At about the time I left people had the bright idea of making a Z squared tranche. What that means is that you take a pool of these Z tranches, and put them together and then cut them up in new and different ways to get yourself even more risk.

Routing the risk in certain directions made them even sexier, and instead of just being really cool they became useful. You could use a small amount of them to hedge other risks relating to interest rates, and thus make yourself and the world more predictable and efficient by channeling the volatility through specific instruments.

An analogy might be that we were distilling risk, they way people distilled booze. We were just rarifying it more.

The party really took off when people started writing options and futures on these things. This led to our good friends Long Term Capital who had won the Nobel Prize for defining risk in terms of option valuation in certain credit instruments. As it turns out they were wrong and they killed things for a while in 1998. Lehman almost got destroyed then and never really recovered as they were a prime manufacturer of these types of instruments.

The damage was done though. There was a huge appetite for these things and huge incentives to create them. It fueled liquidity which fueled the housing and real estate booms through ready access to capitol, and provided folks and institutions with superior returns with high credit quality. When the tech bubble burst in 2000 the triple A quality of these types of instruments made them even more attractive.

By now, CMOs no longer existed as such (or what did were considered quaint). You didn't have to use just mortgages. You could hybridize CMOs by incestuously combining them back with these orphaned Z tranches and related derivatives, and a few other unholy ingredients and make the whole damn thing a VADiM except even better. You could truly securitize them through trust type instruments and manufactured holding companies and issue honest to God bonds and other things.

Collectively, these are known as CDOs or Collaterallized Debt Obligations. These thing were so complex and hybridized with so many other complex derivatives that really nobody actually understood them. Each one of them's components of these instruments had its own huge prospectus. Each one of those was made up of tons of other pieces each with its own prospectus and so on and so on. To understand one, you'd need to read and understand millions of pages of legalese and math.

So, the rating companies called them all triple AAA and accepted their fees for doing so.

As soon as they started not to work, the defficiencies and problems with these things becaome immediately apparent to all concerned, and the whole thing blew up, killing the housing market. Everybody that was in the process of making and trading these things got stuck with billions of dollars of unsalable inventory, and has been taking losses ever since.

(part 3) coming up

[Scylla]

People lost money, the stock market took a hit. The monoline insurers who insured these things based on their ratings almost got killed (and still may die,) But it was not an especially terrible correction. A bad year, a bunch of losses, but not a total global disaster.

By now you may be wondering about these rating companies and how stupid they were, just accepting fees and slapping triple A ratings on everything. They caught a lot of shit for this.

The ratings companies basically admitted they were incompetent. They decided that their own incompetance was so bad that it was incurable. Instead of actually trying to understand these things and assign an appropriate rating, they gave up and chose a proxy. That proxy was market price.

This was up there as one of the worst ideas anybody ever had. Seriously.

Let's say XYZ company has a market cap of 50 billion and a AA rating. If there market drops to 25 billion the rating companies decide that that means there's something wrong with the company and lower the rating. The partial logic of this is that this means that there is less of a market cap for that company to tap versus liquidity needs.

Hedge funds were already having a bad year and looking to recap losses. Short sellers were in a feeding frenzy. This was like ringing the dinner bell.

If you shorted a stock and drove its price down, it's rating would drop. Most credit covenants require additional collateral when a rating drops which means the company has to put up more money. Of course they can't get it easily because their rating just dropped. This makes the stock go down. The short sellers go nuts, and maybe the rating gets cut again. They need more liquidity, can't get it, and the whole thing becomes a self-fulfilling prophecy. The act of shorting the company kills it. It becomes almost a true one way bet.

Thus dies Bear Stearns and Lehman Bros. They got sick on CDOs but the cause of death was liquidity suffocation at the hands of panicking investors and manipulative predatory short-selling.

Merrill, having gotten very sick off of CDOs very fast finally did something smart. They saw this coming, and raised tons of capitol any way they could. Last week they had over 100 billion in cash on hand. This was more than enough according to most anyone to see them through.

It didn't matter though. The short selling was on. The cash on hand didn't matter if the drop in market cap meant unending credit downgrades. They had lots and lots of existing obligations that would be affected and which they would have to prop up. Almost no amount of cash could protect you if your existing debt became worthless. Nobody would give you even overnight credit terms. Without that you can't trade or conduct business, and you die.

So, Merrill blinked it's big blue eyes, and Bank of America, the largest bank in the country took notice. It showed a little leg, and suddenly Bank of America forgot about bailing out frumpy old Lehman, and took them Merrill over.

Lehman declared chapter 11.

Now the short sellers have set their baleful gaze on AIG.

My guess, and it's only a guess is that AIG already has its white knight lined up. I guess this because if it doesn't and they go under we have really huge problems. Problems that are difficult to even imagine in terms of the consequences.

If AIG goes under, I'm thinking our new economic system is going to be indistinguishable from that in the Road Warrior. Basically we'll just spend the rest of our lives being chased around a post apocalyptic wasteland by a dude in a hockey mask riding a dune buggy.

"Just walk away."

[Scylla]

That felt like giving birth.

[Scylla]

So anyway, it's not so much the stock market that's over, but the mortgage backed market, monoline insurers and rating agencies. Assuming we avoid the apocalypse and the rapture, the market will recover, probably better than ever because money will preferentially run there as dividend based returns seemingly provide less risk and higher returns than either the bond market or the smouldering radioactive corpse of the mortgage market.

[Scylla]

Heh.

And while I was writing that, the Gov bailed out AIG with a huge loan:

http://news.yahoo.com/s/ap/20080917/ap_on_bi_ge/aig


See, I told you so.
:)

[DSeid]

The stock market? Originally? To raise capital that was beyond the means of the owner of the business. Secondly, to spread the risk around.
Right?
Yeah, that's my understanding too.

So. Has it stopped doing that? When you say it's over, that it's served its purpose, you seem to imply that the need to raise capital beyond the means of the original owner of the business and the utility of spreading the risk (for loss and gain alike) no longer exist. Do you really believe that to be the case? Or perhaps you believe that some other superior means of meeting that need now exists?

Nah. The same need still exists. The market still serves its purpose. Its purpose was never to make me money or to fund my retirement. I, as an informed investor, took on risk. When Lehman had dropped more than 50% from its usual baseline I made the choice to risk a few thousand believing that the potential gain outweighed the potential risk. I lost that bet and I have no sour grapes. A swing and a miss. Other bets have paid off enough to offset that miss but even if my overall return was behind the indices and I was over the years losing, well, the market is still serving its purpose and I see no other mechanism that meets that need as well.

Now mind you today the markets serve other purposes as well. They provide a means for entities (companies, funds, individuals) across the world to invest in economies elsewhere in the world and thus to help form new economic equilibria. This purpose also is still being met.

Oversight? Better regulation? Yes. But companies folding, indices falling, funds collapsing, none of these are signs that the market isn't serving its purpose. The market is doing what it should do - spreading the risk and reassessing the value in real time as information becomes available and based on individuals making reasoned assessments of how much risk they want to take for how much potential return and what they believe those odds actually are.

[Maera]

Thanks Scylla, very easy to read and understand post (and simplified for my benefit) I'll sound like Cliff Clavin tomorrow at work when I try to regurgitate it :p

[Cyberhwk]

For younger investors this meltdown is great.Twenty-five. I started my IRA with $500 of AIG. :(

Got out at $32 after losing 40% though. My $500 would be worth $20 right now had I not made the move. Now I'm just in an index fund. No muss, no fuss.

[asterion]

Twenty-five. I started my IRA with $500 of AIG. :(

Got out at $32 after losing 40% though. My $500 would be worth $20 right now had I not made the move. Now I'm just in an index fund. No muss, no fuss.

That's bad, but not a huge loss. Good choice on the index fund. Besides, we're both young (26 here.) My IRA right now is an asset allocation fund run by USAA that has a nice mix of stocks, bonds, and commodities, so I don't think I've been hurt too bad in the short term. Of course, I'm down 12% and a couple hundred dollars YTD, but I'm still not too worried. I'm hoping, if I can actually get out of school and into a real job soon, that I'll manage to get in close to the bottom of the housing market and start pumping up my IRA and (theoretical) 401k with more aggressive investing, though I think I will keep my asset allocation fund as a fairly large percentage.

[fruitbat]

Twenty-five. I started my IRA with $500 of AIG. :(

Got out at $32 after losing 40% though. My $500 would be worth $20 right now had I not made the move. Now I'm just in an index fund. No muss, no fuss.

Which is great, that is where you should be. One thing we do know is that recent poor returns will tend to make the future long term returns better. We also know that if an investor could choose when to have the bad years he would choose them all in the beginning.

[Scylla]

Twenty-five. I started my IRA with $500 of AIG. :(

Got out at $32 after losing 40% though. My $500 would be worth $20 right now had I not made the move. Now I'm just in an index fund. No muss, no fuss.

Index funds suck. WIG is a component of both the Dow and S&P.

Financials and energy are going I be about 40% of your portfolio. By definition you will have the highest weightingss in the most overbought sectors.

So is down 17.35% ytd. Hardly admirable. Again, by definition index funds do poorly in bear markets.

[ColonelDax]

The stock market is over.

The stock market may be "over" for the moment in terms of selling shares for more than the purchase price, which I would argue is the way most people view equity investment. However, the current rout is throwing up some great opportunities for people who buy shares for income (dividends) rather than capital gains, because stock prices and dividend yields move inversely. And a lower share price doesn't automatically imply a dividend cut.

Indeed, just today during my lunch break I used some cash in my brokerage account to buy stock in oil company BP Plc, whose shares touched 650 pence in May and now are below 480 pence. The decline has driven the dividend yield up to almost 5.5%, which is terrific for that stock. BP's share price may rise from here, or it may fall further - I don't particularly care either way, as there's almost no chance that the company would be unable to pay its dividend, and that's cold hard cash going into my account four times a year.

Of course, one has to be careful, as companies in the worst-hit industries (banking and retailing, for example) have been cutting or eliminating dividends left and right. However, there's a good reason for that - many of them are screwed. There are lots of companies out there, though, and the ones in my portfolio are still raising their dividends, some by quite a bit more than the rate of inflation, even though their share prices are lower.

[msmith537]

So is down 17.35% ytd. Hardly admirable. Again, by definition index funds do poorly in bear markets.

By definition, index funds do whatever the market is doing.




If AIG goes under, I'm thinking our new economic system is going to be indistinguishable from that in the Road Warrior. Basically we'll just spend the rest of our lives being chased around a post apocalyptic wasteland by a dude in a hockey mask riding a dune buggy.


and there's no car better suited to ruling a gasoline scarce wasteland than a supercharged V-8 '73 Ford Falcon.

[pulykamell]

Index funds suck.

Everything I've ever read says that for 95%+ of investors, buying and holding index funds for the long haul is the best investment strategy. What's your take?

[HMS Irruncible]

*shrug* I'm having a hard time feeling sorry for those who are losing shirts right now in stocks. The phrase "buy low, sell high" is so shopworn as to be an outright cliche that can be quoted by even the most benighted investing troglodyte.

Yet when it's time to put your money where your mouth is, what do you try to do? Follow the herd, buy high, sell higher, which often doesn't work out as you expected.

I'm not going to pretend I've always been some sort of investing genius. I lost a lot in the dot-com boom. What I learned from that was to be extremely cautious during the boom times, and buy when everyone else is scared. I mostly sat out the last boom, keeping my powder dry, and I'm now just waiting until it seems like the herd can't get any scared-er. I'm not going to tell you I know when the choice moment will be, but I don't think it will be before spring of 2009.

[NurseCarmen]

So Scylla, the stock market is not a casino because the casino is regulated? What is your take on Cox's approach here? Don't you think his hands off approach is what doomed these institutions?

[Scylla]

Everything I've ever read says that for 95%+ of investors, buying and holding index funds for the long haul is the best investment strategy. What's your take?

They suck.

They're based on market cap, which means you tend to be buying the companies that have gone up the most and are most expensive and selling the ones that have gone down the most and are the cheapest.

Works fine in a bull market, not so much in a bear.

You want to buy low/sell high. You don't do that in an index.

[HMS Irruncible]

So Scylla, the stock market is not a casino because the casino is regulated? What is your take on Cox's approach here? Don't you think his hands off approach is what doomed these institutions?
The stock market is not a casino because it isn't a casino, period. Casinos employ machines that ensure that each round of betting is entirely probabilistic to ensure nobody has any advantage other than knowing the odds on a particular game or machine. Stocks are much more deterministic; investors have real information that can help them forecast a company's performance. That doesn't mean it's risk-free... sometimes the information is not perfect and it is not timely, but it's not based on probability the way a casino is.

That doesn't mean that ignorant people don't see it as a casino or try to play it that way. There are some bookmakers who take odds that Vladimir Putin is the Antichrist. If something has an uncertain outcome, people can and do bet on it. But that doesn't bear whether the event is deterministic or probabilistic, just people's capacity and desire to bet on it.

In short, if you think the stock market is a casino, you probably shouldn't be participating in it or talking about it.

[Henrichek]

For me it is over. I will never again be stupid enough to invest my savings in something which value depends mostly on people's superstition.

[XT]

What will you invest in then? Bonds? CD's? Or will you just stuff your savings under the mattress? Serious question here.

-XT

[Henrichek]

What will you invest in then? Bonds? CD's? Or will you just stuff your savings under the mattress? Serious question here.

-XT

Well, as you probably already figured out from my post I am not very economically inclined, so I don't have a good answer. I would think something with a fixed interest rate would be better. I am really disillusioned after losing quite some money due to something the people fears might happen. Or shares dropping when a company makes huge profits, but still a few million short of projected values. The market is way too knee-jerky to be relied upon. I guess it means I lose the chance of making big profits with little effort, but at least I won't lose my money. It feels like a big scam anyway.

[HMS Irruncible]

For me it is over. I will never again be stupid enough to invest my savings in something which value depends mostly on people's superstition.
I hate to break it to you, but all value depends on people's superstition. After all, what do you think money is? All your money could disappear tomorrow if China starts feeling like like the US can never repay its debt obligations.

[Henrichek]

I hate to break it to you, but all value depends on people's superstition. After all, what do you think money is? All your money could disappear tomorrow if China starts feeling like like the US can never repay its debt obligations.

Not that I own any dollars, but then again I'm sure it would still affect me somehow since the markets are way too dependent on each other.

[Voyager]

The stock market is not a casino because it isn't a casino, period. Casinos employ machines that ensure that each round of betting is entirely probabilistic to ensure nobody has any advantage other than knowing the odds on a particular game or machine. Stocks are much more deterministic; investors have real information that can help them forecast a company's performance. That doesn't mean it's risk-free... sometimes the information is not perfect and it is not timely, but it's not based on probability the way a casino is.

Do you have any evidence that people can actually beat the market predictably? True, when the market does a random fluctuation we can assign a post hoc reason, unlike a slot machine, but on the other hand in casinos you can predict how much you will lose in the long run fairly accurately.

[Voyager]

They suck.

They're based on market cap, which means you tend to be buying the companies that have gone up the most and are most expensive and selling the ones that have gone down the most and are the cheapest.

Works fine in a bull market, not so much in a bear.

You want to buy low/sell high. You don't do that in an index.

So that's why I've always been suspicious of index funds! Many thanks for that clear explanation.

[DSeid]

They suck.

They're based on market cap, which means you tend to be buying the companies that have gone up the most and are most expensive and selling the ones that have gone down the most and are the cheapest.

Works fine in a bull market, not so much in a bear.

You want to buy low/sell high. You don't do that in an index.

Depends on the index, don't it? There are large cap indices and small cap indices, broad market indices and sector indices. You want to place a contrarian bet and you can do that, in a broad way, with indexed products as well.

Assuming someone is in the market, success can only be judged relative to the indices. By definition someone playing the broad market by indexed products cannot have either an outstanding or a sucky result. They get an average grade no matter what. Bear or bull. Now the question is how does that compare to managed funds or to individual stock-picking? Well the average player will do average, won't they? For most funds (after management fees are taken into account) the answer is that the indexed products usually outperform, because those fees eat in over the years. Can an individual investor do better and avoid fees in the process? Sure, but when we do we take on more risk. Me, I like rolling my own and my big wins have offset my big losses to the point that I am just a bit better than the indices, but not by much. If I charged myself a management fee my return would probably be just right on par. But it's a fun hobby. For someone who doesn't enjoy the process and doesn't have enough to diversify their picks and to afford a few whiffs on the way, the index funds are a dandy choice.

[Voyager]

The stock market? Originally? To raise capital that was beyond the means of the owner of the business. Secondly, to spread the risk around.
Right?

How much capital would a business raise if its investors were unable to sell their shares?

Given the turmoil over the weekend, a 4.4% drop seems pretty minor. Yeah there are issues, but what market won't have them. Are there additional regulations you'd support? In general, the market is working fine. Institutions that screw up get clobbered, and investors who don't pay attention get clobbered also. I don't see the problem.

[NurseCarmen]

The stock market is not a casino because it isn't a casino, period.I was making an analogy. The lack of regulation has allowed companies to play with loaded dice. Research can only go so far, since there is so much off the balance sheets. Transparency is a thing of the past. The investor is only allowed a tidbit of the information that he actually needs. Cox, bless his little heart, goes and says that you can't naked short sell 19 companies, while the practice runs wild elsewhere. He hasn't gone after a single failure to deliver. He has failed to regulate the nakeds, because of his nearly fanatical belief against regulation.

[Pleonast]

Great posts, Scylla, but I need to comment on these:
Index funds suck.
....
You want to buy low/sell high. You don't do that in an index.Of course you can. The market and corresponding indexes are low now. I'm putting more money into my index funds this year than I was before. When the market recovers, I'll put proportionately less into the index funds.

Index fund investments don't do better than the market. But they don't do worse, either. And their management costs are low. That can be a huge factor to someone with only little to invest.

For an investor with a small pool and not a lot of experience, they're a great place to put money. Once someone has a larger pool to work with and better understanding of how the market works, they can start risking better returns with other strategies.

As I tell my friends when extorting them to start saving seriously: you don't need to do a lot of research and try to beat the market, you simply need to beat your bank's interest rate. And index funds do that with minimal risk and cost.

[NurseCarmen]

OMG! Cox just grew a pair! (several months too late)

Washington, D.C., Sept. 17, 2008 — The Securities and Exchange Commission today took several coordinated actions to strengthen investor protections against "naked" short selling. The Commission's actions will apply to the securities of all public companies, including all companies in the financial sector. The actions are effective at 12:01 a.m. ET on Thursday, Sept. 18, 2008.

"These several actions today make it crystal clear that the SEC has zero tolerance for abusive naked short selling," said SEC Chairman Christopher Cox. "The Enforcement Division, the Office of Compliance Inspections and Examinations, and the Division of Trading and Markets will now have these weapons in their arsenal in their continuing battle to stop unlawful manipulation."

In an ordinary short sale, the short seller borrows a stock and sells it, with the understanding that the loan must be repaid by buying the stock in the market (hopefully at a lower price). But in an abusive naked short transaction, the seller doesn't actually borrow the stock, and fails to deliver it to the buyer. For this reason, naked shorting can allow manipulators to force prices down far lower than would be possible in legitimate short-selling conditions.

Today's Commission actions, which are the result of rulemaking under the Administrative Procedure Act, go beyond its previously issued emergency order, which was limited to the securities of financial firms with access to the Federal Reserve's Primary Dealer Credit Facility. Because the agency's exercise of its emergency authority is limited to 30 days, the previous order under Section 12(k)(2) of the Securities Exchange Act of 1934 expired on Aug. 12, 2008.

[Polerius]

Awesome post, Scylla. Very informative.

As someone who has worked in the field, can you tell us how pervasive the idea was that "I'll take actions to maximize my bonuses in the next couple of years, bringing in millions for myself, and I don't care if my actions will lead the company down a path that will destroy it in the long run".

That is, do the traders at Lehman Brothers and Merril Lynch, who made millions and millions when times were good, care that their companies have collapsed? (Assuming they stored their money somewhere other than their company's stocks)

Also, what the credit rating agencies did (give AAA rating to instruments they had no idea of how to evaluate) seems like gross negligence to me. Will they be held accountable by anyone for doing so?

Finally, given the fact that there are billions and billions of dollars in complex financial instruments that nobody fully knows how to value, and have caused a web of interconnectedness that threatens the whole financial system if one firm (like AIG) collapses, doesn't that make you feel that there is something seriously wrong with how the stock market/financial system is currently structured?

[Polerius]

The stock market is not a casino because it isn't a casino, period. Casinos employ machines that ensure that each round of betting is entirely probabilistic to ensure nobody has any advantage other than knowing the odds on a particular game or machine. Stocks are much more deterministic; investors have real information that can help them forecast a company's performance. That doesn't mean it's risk-free... sometimes the information is not perfect and it is not timely, but it's not based on probability the way a casino is.
Horse racing: You have information on the past performance of horses and jockeys, and have some information about their current state of health, so the outcome of the race is mostly deterministic, but there is always an element of chance, and people bet accordingly. Seems like it matches the stock market quite well.

Also, there are billions and billions of dollars in complex financial instruments that nobody knows how to value, and these instruments affect the valuation of many companies, and the value of these companies is interconnected (because they are interconnected through these complex financial instruments), so there is an unknown level of correlation in the unknown valuation of companies. That doesn't seem like there is much "information" out there. So, it is much more like gambling than people let on.

Some choice quotes from Time (http://www.time.com/time/business/article/0,8599,1841699,00.html)
"You can read through every financial statement in the world and have absolutely no clue as to the risks they are taking"

"Confused? You're not alone. The best case for the bailout seems to be that nobody has the faintest idea what the consequences of AIG's failure for financial markets would be, but the fear was that it could lead to total chaos. "

[HMS Irruncible]

Do you have any evidence that people can actually beat the market predictably? True, when the market does a random fluctuation we can assign a post hoc reason, unlike a slot machine, but on the other hand in casinos you can predict how much you will lose in the long run fairly accurately.
If you're looking at short-term fluctuations, yes. If you're looking at the long term, there are many, many people who beat the market by investing on fundamentals and holding for the long term. Warren Buffett, Peter Lynch, me. Just because Joe Average keeps pulling the handle like it's a slot machine doesn't make it one.

[HMS Irruncible]

Horse racing: You have information on the past performance of horses and jockeys, and have some information about their current state of health, so the outcome of the race is mostly deterministic, but there is always an element of chance, and people bet accordingly. Seems like it matches the stock market quite well.
I said the stock market is not a casino. Horse racing is also not a casino. Stock research is still more deterministic than horse racing anyway.

Also, there are billions and billions of dollars in complex financial instruments that nobody knows how to value, and these instruments affect the valuation of many companies, and the value of these companies is interconnected (because they are interconnected through these complex financial instruments), so there is an unknown level of correlation in the unknown valuation of companies. That doesn't seem like there is much "information" out there. So, it is much more like gambling than people let on.
Anybody who buys stocks that they don't know how to value is indeed gambling. This is not saying that the stock market is a casino or that investing is probabilistic gambling.

Again, just because Joe Average looks at the stock market and sees a slot machine and randomly pulls the crank, doesn't mean he couldn't be banking on a more deterministic outcome in the long term.

[Airman Doors, USAF]

If you want to stick to the gambling analogy, when you buy into the market you're buying into the house. Over the long run the house always wins, but there are times when there are people that cause the house to lose. When that happens all you can do is shrug and wait for the house to start coming up big again.

If you look at the market's performance over the last century, if you got in and you stayed in you're a rich man. It's the people that bet the farm on a single pull of the handle that inevitably get hammered.

[Polerius]

Anybody who buys stocks that they don't know how to value is indeed gambling.
But my point was that, with the advent of these very complex financial instruments nobody knows how to value them, because of their complexity, and because of how interconnected everything is (so that when something fails, the repercussions are almost impossible to quantify, and thus the risk almost impossible to quantify). And if nobody knows how to value them, then everybody is gambling.

This is not me saying it (i.e. that companies using these instruments are almost impossible to value). I have read it in many finance related articles (like the one from Time I linked above). There are also many books out there, and IIRC, one was from one of the people who pioneered a popular form of complex financial instrument, and now he has written a book saying essentially"we have created a monster, and nobody knows what will happen once something starts failing".

Do you disagree with the assessment that these complex, interconnected, financial instruments are difficult to describe in terms of risk, and therefore are difficult to value? Or, even if the instruments per se are easy to value, do you disagree with the fact that the combination of such instruments in a web of interconnectedness that ties many companies together, makes the valuation of these companies almost impossible to quantify?

[Polerius]

If you look at the market's performance over the last century, if you got in and you stayed in you're a rich man.
Yes... if you stayed in for a century.

If you bought an index fund for the Dow Jones on Dec 1965, when it was at 983, you would need to wait until Oct 1982 to start making money again.

That's 17 years! That's pretty "long-run" in my book.

Similarly, if you bought in on Dec 1999 (@11,500), you would be at a loss today(@10,700). That's almost nine years, and you're losing money.

[HMS Irruncible]

Do you disagree with the assessment that these complex, interconnected, financial instruments are difficult to describe in terms of risk, and therefore are difficult to value? Or, even if the instruments per se are easy to value, do you disagree with the fact that the combination of such instruments in a web of interconnectedness that ties many companies together, makes the valuation of these companies almost impossible to quantify?
I have never understood complex derivative vehicles and frankly I think they're voodoo. Accordingly, I never invested in them, and accordingly I never lost money on them. Certainly everybody is feeling the falling tide lowering all boats because some large banks failed to observe such a commonsense rule, but the overall market has always to some extent been subject to unforeseeable circumstances (wars, shortages, bubbles, etc). Acknowledging the risk in market inefficiencies, the market is still beatable by staying informed and avoiding the obvious pyramid schemes that pop up from time to time. Ask Warren Buffett, Peter Lynch, and any other market-beating investor whether they think they're completely at the mercy of random fate, or whether they just applied a consistent approach and stuck with it.

[Scylla]

Depends on the index, don't it? There are large cap indices and small cap indices, broad market indices and sector indices. You want to place a contrarian bet and you can do that, in a broad way, with indexed products as well.


I assume people are referring to the S&P 500 index when they say they're just going to buy an index fund.

[Scylla]

Great posts, Scylla, but I need to comment on these:
Of course you can. The market and corresponding indexes are low now. I'm putting more money into my index funds this year than I was before. When the market recovers, I'll put proportionately less into the index funds.


The securities your index is compised of are weighted based on market cap. You are buying the most of the most expensive securities. You are putting the most money into the securities that have performed best.

Index fund investments don't do better than the market. But they don't do worse, either. And their management costs are low. That can be a huge factor to someone with only little to invest.

They do worse than the market assuming they are a perfect reflection of their index due to expenses and management fees.

There is nothing wrong with management fees assuming you are getting value for them. Check out ABALX. This fund has been around since the crash of '29 and has substantially outperformed the S&P with much less volatility. It's expenses run somewhere under .6%

I'd much rather have that than an index as it protects me against the inherent adverse selection that exists with index funds. There are other flaws, but I don't want to get into an argument. Suffice it to say that there is no reason to own a managed fund in a bull market, but every reason in a bear. The measure of a good fund is it's upside/downside capture ratio.

For an investor with a small pool and not a lot of experience, they're a great place to put money. Once someone has a larger pool to work with and better understanding of how the market works, they can start risking better returns with other strategies.

Or you could go for less risk, less volatility and historically higher returns with ABALX.

As I tell my friends when extorting them to start saving seriously: you don't need to do a lot of research and try to beat the market, you simply need to beat your bank's interest rate. And index funds do that with minimal risk and cost.

My friends would be foolish to take the medical advice I offer as I'm not a Dr.

[Airman Doors, USAF]

Yes... if you stayed in for a century.

If you bought an index fund for the Dow Jones on Dec 1965, when it was at 983, you would need to wait until Oct 1982 to start making money again.

That's 17 years! That's pretty "long-run" in my book.

Similarly, if you bought in on Dec 1999 (@11,500), you would be at a loss today(@10,700). That's almost nine years, and you're losing money.

That's disingenuous. The DJIA, NASDAQ and S&P 500 are very consistent precisely because the companies that are counted in the index are consistent. If you peg yourself to an average that delists some and takes in others of course you're not going to see any change. That's why people buy into funds where people do the legwork for you for a small fee. If you do your research you'll find plenty of funds that consistently beat the big indices. The ones that don't die and are replaced, and the circle continues.

It is not at all hard to beat the indices.

[HMS Irruncible]

Yes... if you stayed in for a century.

If you bought an index fund for the Dow Jones on Dec 1965, when it was at 983, you would need to wait until Oct 1982 to start making money again.

That's 17 years! That's pretty "long-run" in my book.

Similarly, if you bought in on Dec 1999 (@11,500), you would be at a loss today(@10,700). That's almost nine years, and you're losing money.
Look, if you're trying to say in a roundabout way that it's bad to blindly invest your personal life savings (or the government's Social Security kitty) in the stock market, yes, I agree. Uninformed investing is bad, and it's irresponsible for anyone to pretend that it would be a great idea to shore up social security by just socking it in an index fund and letting the market work its markety magic. I couldn't agree more. If you're "investing in the market", then yes, it's a casino, you had bad luck (as often seems to be the case for you), and the market is "over" as far as you're concerned. Walk away before you lose it all, and go put your money in some ripoff stable investment like annuities or something.

But if, on the other hand, you're investing in individual companies based on a sound understanding of the fundamentals, there is absolutely no better time to be getting into the market than now (or a few months from now, give or take). There are still good companies out there which are on sale at prices that are frankly unfair to them, but a boon to investors who didn't get caught up in the latest bubble.

[Scylla]

Awesome post, Scylla. Very informative.

As someone who has worked in the field, can you tell us how pervasive the idea was that "I'll take actions to maximize my bonuses in the next couple of years, bringing in millions for myself, and I don't care if my actions will lead the company down a path that will destroy it in the long run".

That is, do the traders at Lehman Brothers and Merril Lynch, who made millions and millions when times were good, care that their companies have collapsed? (Assuming they stored their money somewhere other than their company's stocks)

We wanted to make a lot of money, but we had the strong sense that what we were doing was vital, important, and necessary. We were making the world a better place, making our company stronger, and we had a strong esprit de corps based on the fact that we were elite. Few understood what we did, or why it was so important.

All these feelings were valid. We were solving difficult problems. I am sure that the solutions that are being designed for today's problems will be taken to extremes that will cause problems decades from now. I blame the extremes, not those solving the problems.

In this case, the mortgage/bond problem was just about the most noble thing a man could work on. Real estate was depressed. People couldn't afford homes, credit was tight. By making mortgages saleable we freed up liquidity that enabled other people to buy houses at reasonable rates, started a boom in the housing market, and brought about a period of prosperity that was even able to see us through such disasters as the dot com bust, and 9/11.

These were extremely positive effects. The problem is that people extrapolate trends beyond what is reasonable, the margins got pushed farther and farther, and the whole thing collapsed.

What we did was good, and important for the most part, and I am proud of it, for the most part. We really had a sense that we were doing something very good.

Also, what the credit rating agencies did (give AAA rating to instruments they had no idea of how to evaluate) seems like gross negligence to me. Will they be held accountable by anyone for doing so?

Probably not. I can see that mistake. Personally though, I think they should hang for there new "market cap based" rating system. There is a direct cause and effect between that and the short selling that is bankrupting and distressing trillions of dollars of equities. Real companies, real people are getting hurt through this cowardly stupidity.

Finally, given the fact that there are billions and billions of dollars in complex financial instruments that nobody fully knows how to value, and have caused a web of interconnectedness that threatens the whole financial system if one firm (like AIG) collapses, doesn't that make you feel that there is something seriously wrong with how the stock market/financial system is currently structured?

No.

This is the bottom. If it's not, than this time things are different and you have a point. But each time we've had one of these corrections some people tell me the system's broke, and this time it's different.

So far they've been wrong.

Maybe this time it really is different. This feels different. Maybe this is the one that breaks the system.

Normally, these things do serve to consolidate the system, wipe out excess, and strengthen things over the long haul.

They had that big fire where like half of Yosemite burned down in '98, or so. I remember that being heralded as an unprecedented ecological disaster. Now the park is greener and more beautiful than ever.

Perhaps this is one of those "purifying fires." A natural check on a useful feature of the credit markets that needs rebalancing.

Or, maybe it's the end of the world. Who knows?

The funny thing is that they will end up putting a whole bunch of rules and regulations to stop this from happening again. What few understand is that we don't have to worry about this happening again. Not for a long long time, at least.

What we have to worry about is the next disaster which will be different and unexpected and only obvious in hindsight.

[msmith537]

So that's why I've always been suspicious of index funds! Many thanks for that clear explanation.

There's nothing really to be suspicious of. All an index fund is is a group of stocks selected because they represent a particular market (S&P 500), industry (tech, energy, etc), size (small cap, medium cap), risk level ( income, growth ) or country.

Basically, if you say "hey...I want to invest in energy startups!" you can either go find a bunch of individual stocks for energy companies or you can find some Emerging Markets Small Cap Energy Fund.






But my point was that, with the advent of these very complex financial instruments nobody knows how to value them, because of their complexity,


My GF and her friends all work for investment banks and rating agencies. Part of the problem with the mortgage backed CDO (packages of mortages bundled together and sold like bonds) was that the risk for the initial home loans was never adequately assessed. People lying on their applications or brokers lying in order to push the deal through. Lenders lying on whatever info they give the underwriters. So the lender packages up all these loans and sells them while the rating agencies assign their ratings mostly based on bullshit. They aren't blameless either. Their customers are the investment banks that buy these instruments and they pressure the rating agencies to enhance their ratings so they can justify investing in them.




Do you have any evidence that people can actually beat the market predictably?



You don't need to beat the market all the time. Just most of the time. People who know what they are doing like Warrent Buffet invest long term in companies that are fundamentally sound and run well. He's not right all the time, but as long as he's right 60% of the time, he's making money.

My fraternity brother who's a Wall Street trader tells me people ask him for stock picks all the time. His reply is "if I knew what stocks were going to do, I wouldn't work. I'd just sit at home daytrading all day."


The problem is that as technology advances, the markets become more efficient. That means all the information about a particular stock or bond is already included in the price and it becomes harder to make money. So what happens is the Wall Street guys create these elaborate derivative instruments to try and capitalize on inefficiencies in the market. Except I'm convinced that none of these guys REALLY knows what they are doing. I think they create these elaborate 'systems' like a dude at the track in the hopes of getting rich quick and then getting out before the bubble they create bursts. IMHO of course.



I'm not heavily invested in the market, but I've done well with my two biggest positions:
-My previous employer, a management consulting firm specializing in distressed companies. I was in a Employee Stock Purchase Plan so I get a good deal regardless.
-Netflix. Because I figured about a year ago that there would be a lot of unemployed people and people with no job and not a lot of money tend to watch a lot of movies.

[Kiros]

Just want to chime in and say "Thanks" as well for the 3 part post, Scylla. I work in a position ancillary to the financial industry at the moment, and knew most of that already, and have (among other things) actually read an inch and a half thick CDO prospectus... and it was still an entertaining read. :)

I will say that I am kinda glad I took the job offer closer to home rather than the one at Lehman in NYC when I graduated from college . . .

[fruitbat]

I assume people are referring to the S&P 500 index when they say they're just going to buy an index fund.

That has to be one of the strangest assumptions I have ever heard. Especially with you giving bad advice based on you oddball misconception. As I am sure you know an index fund is a fund that . . . . wait for it . . . . tracks a given index. Which can be just about anything. Countless studies have shown portfolios of index funds outperforming managed funds in bull and bear markets. They have further shown that if it was as easy as 'buy low, sell high' the market would have corrected that inefficiency.

Lovely explanation of CMOs, but I would leave the personal financial advice alone.

[fruitbat]

I would also like to point out the fallacy of Scylla pointing out ABALX (American Balanced) as a fund that 'beats the market' without even defining what market he is talking about. Its composition is wildly different from the S&P 500, but I have a feeling that is what you were comparing it to. It may well beat its proper benchmark, but you also would have to pay a sales charge in most cases to make the purchase and take on the risk that the managements past performance will not carry forward into the future. See Bill Miller of Legg Mason for an example of that risk.

[Kimstu]

What we have to worry about is the next disaster which will be different and unexpected and only obvious in hindsight.

In what way was the current disaster "unexpected and only obvious in hindsight"? To whom?

AFAICT, the "nobody could have foreseen this catastrophe" angle is being touted primarily by media and financial experts who were in a position to foresee it, but preferred to think positive and assume it wouldn't happen. But there were plenty of other analysts out there who've been issuing warnings about potential dire consequences of recognizably dangerous strategies for quite a while now. Consider the points made in this 2006 article: (http://www.salon.com/tech/htww/2006/12/06/subprime/)


The Wall Street Journal led off a Monday story on trouble in the subprime housing loan industry with the following sentence: "Americans who have stretched themselves financially to buy a home or refinance a mortgage have been falling behind on their loan payments at an unexpectedly rapid pace."

Really? This was unexpected? [...]

Because it's exactly the same people who didn't expect quickly accelerating subprime loan trouble who are now telling us that they "don't expect any significant harm to the nation's economy or financial systems."

I guess if that does happen, the Journal will tell us it was unexpected. And it will be big news!

For a look back at someone who did predict, pretty closely, what would happen this year, we can go to Center for Economic Policy Research co-director Dean Baker's piece on the housing bubble published in January 2005 (http://www.demos.org/pub412.cfm), where he noted that "widespread declines in house prices will lead to a surge in mortgage foreclosures."

For an even gloomier update on Baker's views on the economy, take a look at his most recently published analysis (http://www.cepr.net/documents/publications/forecast_2006_11.pdf). What does he expect for 2007?


By the way, here's an excerpt from Baker's January 2005 piece:

For the economy as a whole, the collapse of the bubble will almost certainly mean a second recession. Home construction will fall sharply. Even more importantly, consumer borrowing, which was based on the $4 trillion in housing bubble wealth, will plunge. This could lead to a sharp downturn in consumption. In addition, widespread declines in house prices will lead to a surge in mortgage foreclosures, which in turn could lead to a collapse in the secondary market for home mortgages, requiring a government bailout of Fannie Mae and Freddie Mac.


[P.S. Excuse my interrupting myself to talk about me, but if I drop out for months at a time again after this post, it's not that I'm not interested, it's just that the teaching schedule is still really intense. Happy trails!]

[Scylla]

That has to be one of the strangest assumptions I have ever heard.

Based on my experience (which is extremely extensive,) when people talk about an index fund they mean the S&P 500 index fund about 95% of the time. In excess of half the time they are referring specifically to the Vanguard S&P 500 index fund. If they are talking about other indexes they usually specify them, such as the EAFE, or Russell 2000. If they are looking at sector indexes or partial indexes they will usually say they are using ETFs or Spiders or the Qs.

However, if you are saying "an index" you are referring to the SP500 in some form, or people who know what you are talking will at least assume you are.

So. If you are in the industry, as I am, and use the terms daily, as I do, and that's the way everybody, in your office firm and the whole investment community uses the terms, and has for the last 15 years or so.... than it's not really a strange assumption.

Especially with you giving bad advice based on you oddball misconception. As I am sure you know an index fund is a fund that . . . . wait for it . . . . tracks a given index.

Yeah, I've heard that's what they do. But if you say "index fund" and nothing else, convention is that you are referring by default to the SP500.

I know the appeal to authority is a logical fallacy. Nevertheless, that is a fact. I am an authority on this. I deal with it every day.

Similarly, if somebody asks you how the "market" is doing, they are referring to the DJIA, and not, say... the Hang Seng index or the farmer's market down the street.


Countless studies have shown portfolios of index funds outperforming managed funds in bull and bear markets.

That's a fact. 80% of funds underperform their respective indexes. Some of them do this by design. They seek to take less risk. Others simply aren't that good. Others have a poor representative index. Of the 20% that do outperform some of them do so by taking more risk. Some do it by style drift. Some do a very good job and simply consistently outperform their indexes with less volatility. That's why I gave an example of such a fund.


They have further shown that if it was as easy as 'buy low, sell high' the market would have corrected that inefficiency.

Really? It's funny that I am not aware of any such study. Doubtless this is because it doesn't exist. You have cite.

Lovely explanation of CMOs, but I would leave the personal financial advice alone.

I think it's wise that you do so.

[Scylla]

I would also like to point out the fallacy of Scylla pointing out ABALX (American Balanced) as a fund that 'beats the market' without even defining what market he is talking about. Its composition is wildly different from the S&P 500,

Yes it is. I would argue that since it's a balanced fund it is less risky than an all equity fund and would therefore have a lower expected return. The fact that it has significantly outperformed an all equity index over an extended period of time is a noteworthy achievement.



It may well beat its proper benchmark, but you also would have to pay a sales charge in most cases to make the purchase and take on the risk that the managements past performance will not carry forward into the future. See Bill Miller of Legg Mason for an example of that risk.

True and true. Not sure why the sales charge is such an objection. "Free" management is often fairly priced. In some cases funds with low expenses and management fees may profit through trading. American Funds discloses it trading costs and has been actively seeking to make mandatory such disclosure to reveal what it considers deceptive sales practices by other firms. Similarly, American Funds uses a team approach to management to avoid the Bill Miller all-star melt down syndrome, so far successfully.

[Scylla]

In what way was the current disaster "unexpected and only obvious in hindsight"? To whom?

To me. 20 years ago.

AFAICT, the "nobody could have foreseen this catastrophe" angle is being touted primarily by media and financial experts who were in a position to foresee it, but preferred to think positive and assume it wouldn't happen. But there were plenty of other analysts out there who've been issuing warnings about potential dire consequences of recognizably dangerous strategies for quite a while now. Consider the points made in this 2006 article: (http://www.salon.com/tech/htww/2006/12/06/subprime/)



By the way, here's an excerpt from Baker's January 2005 piece:


[P.S. Excuse my interrupting myself to talk about me, but if I drop out for months at a time again after this post, it's not that I'm not interested, it's just that the teaching schedule is still really intense. Happy trails!]

I concede your point and apologize. I have not stated my position clearly. I was referring to the long term. I don't think anybody predicted this particular meltdown 20 years ago when its seeds were planted.

Right now, the seeds are being planted for future meltdowns of different varieties than today's. They may occur 10 or 20 years from now. Some we will dodge and may not even notice, having dodged them. Others will hit us head on. Exactly what they will be is not predictable, only that they will occur.

[fruitbat]

Based on my experience (which is extremely extensive,) when people talk about an index fund they mean the S&P 500 index fund about 95% of the time. In excess of half the time they are referring specifically to the Vanguard S&P 500 index fund. If they are talking about other indexes they usually specify them, such as the EAFE, or Russell 2000. If they are looking at sector indexes or partial indexes they will usually say they are using ETFs or Spiders or the Qs.

However, if you are saying "an index" you are referring to the SP500 in some form, or people who know what you are talking will at least assume you are.

So. If you are in the industry, as I am, and use the terms daily, as I do, and that's the way everybody, in your office firm and the whole investment community uses the terms, and has for the last 15 years or so.... than it's not really a strange assumption.



Yeah, I've heard that's what they do. But if you say "index fund" and nothing else, convention is that you are referring by default to the SP500.

I know the appeal to authority is a logical fallacy. Nevertheless, that is a fact. I am an authority on this. I deal with it every day.

Similarly, if somebody asks you how the "market" is doing, they are referring to the DJIA, and not, say... the Hang Seng index or the farmer's market down the street.




That's a fact. 80% of funds underperform their respective indexes. Some of them do this by design. They seek to take less risk. Others simply aren't that good. Others have a poor representative index. Of the 20% that do outperform some of them do so by taking more risk. Some do it by style drift. Some do a very good job and simply consistently outperform their indexes with less volatility. That's why I gave an example of such a fund.




Really? It's funny that I am not aware of any such study. Doubtless this is because it doesn't exist. You have cite.



I think it's wise that you do so.

Ok, lets back up for a minute. You seem to be saying that if you want a fund that will outperform its benchmark you just look for ones that have done so in the past. You invest in that 20% subset that has outperformed in the past and avoid those dogs that failed in their performance mission. That is one method that has been rather extensively shown not to work very well. Even the most favorable studies find your odds of future outperformance to be questionable at best.

So then what is the methodology people should be using to select the funds that have outperformed in the past and will likely outperform in the future? It has to be more than 'look at its record'.

I apologize if I came across as an ass, but misbenchmarking is a chronic problem and results in grossly inappropriate sales techniques. Funds are sold as 'beating the market', meaning having a return better than the S&P 500, when they are a balanced fund with 50% stocks, a quarter of which are outside the US. If one is going to compare performance with an index fund it needs to be the appropriate blended benchmark.

I prefer a diversified portfolio of index funds because of the low cost, low turnover, lack of manager risk, tax efficiency and style purity of the allocation. I prefer not to wonder if my fund manager achieved his past outperformance by luck or virtue and the track record of manger outperformance turning to underperformance leads me to my decision.

The good folks at Altruist advisors and Bogleheads.org have kindly accumulated some links that support that philosophy. See here, note that though this goes to a forum it is not a collection of message board posts:

http://www.bogleheads.org/forum/viewtopic.php?t=173

http://www.altruistfa.com/readingroomarticles.htm#PassiveActive


I would be curious to have a cite of a tested methodology that a layman could follow that would allow one to find funds that would consistently exhibit the future outperformance we would all like to have.

You seem to argue from a positoin of authority because you use these terms every day, but without evidence to support the postion it doesn't mean much. Most investments are sold be screening for the ones that have done well and implying that you have culled the dogs and are left with the cream (to badly mix a metaphor). I would argue that just doesn't work.

[Tabby_Cat]

I'd just like to add a word of thanks to Scylla for the very helpful analysis of how exactly these mortgages turned into such a meltdown.

I'm really rather interested in this fund versus index argument, however. Is it true that market cap determines the composition of the index?

I suppose it is almost axiomatic that investing in an index during a bear market would be pointless, but then again, as a low-risk investor seeking to start a nest egg, the scheme of "buy a fixed dollar amount every month, it automatically slows down your exposure as the market goes up, and vice versa (a.k.a buy low, don't buy high)" seemed to me a sensible proposition.

I hear you that a well managed fund would outperform an index, but where would I start looking to see if such a fund would actually do so, and continue to do so? The internet is full of financial crackpots pushing their personal pet theory, and investment banks full of financial conmen pushing their personal bank balance.

Sometimes, I start thinking that maybe "under the mattress" is a good investment policy.

[fruitbat]

I'd just like to add a word of thanks to Scylla for the very helpful analysis of how exactly these mortgages turned into such a meltdown.

I'm really rather interested in this fund versus index argument, however. Is it true that market cap determines the composition of the index?

I suppose it is almost axiomatic that investing in an index during a bear market would be pointless, but then again, as a low-risk investor seeking to start a nest egg, the scheme of "buy a fixed dollar amount every month, it automatically slows down your exposure as the market goes up, and vice versa (a.k.a buy low, don't buy high)" seemed to me a sensible proposition.

I hear you that a well managed fund would outperform an index, but where would I start looking to see if such a fund would actually do so, and continue to do so? The internet is full of financial crackpots pushing their personal pet theory, and investment banks full of financial conmen pushing their personal bank balance.

Sometimes, I start thinking that maybe "under the mattress" is a good investment policy.

I sympathise, but index investing makes this easier. The problem I see with the idea of spurning index funds in down markets is that it presumes that your entire allocation is in stocks and that managed funds know when to sell and avoid the downturn. There simply is not evidence this is the case.

An investor would first decide how to allocate the money. So you might decide, for example, to have 40% Domestic Stocks, 20% International, 30% Bonds and 10% Real Estate (I made this up off the top of my head, this is not actual advice). You then either choose a fund that combines those elements or own four funds covering those bases. Your bond allocation is the risk control. You aren't counting on someone to know when to move out of stocks, you control how much stock exposure you have.

A good company like Vanguard has asset allocation models that can help you develop your own plan and decide what level of risk is appropriate for you.

[Scylla]

Ok, lets back up for a minute. You seem to be saying that if you want a fund that will outperform its benchmark you just look for ones that have done so in the past. You invest in that 20% subset that has outperformed in the past and avoid those dogs that failed in their performance mission. That is one method that has been rather extensively shown not to work very well. Even the most favorable studies find your odds of future outperformance to be questionable at best.

You have to look pretty carefully at what the criteria are. In one way, you are correct. In another, not.

If, for example, you look at three year trading periods and simply invest in that proportion of funds that beat their index than, indeed, you are correct. Those funds typically fail to outperform going forward. You have picked yesterday's winners. The conditions that allowed those funds to outperform no longer exist.

So then what is the methodology people should be using to select the funds that have outperformed in the past and will likely outperform in the future? It has to be more than 'look at its record'.


Why? I think it depends on how you look at its record. If you're focussed on current five star funds, or 3 year performance figures than I indeed think you are being foolish.

If, on the other hand, you are looking at consecutive rolling 10 year performance figures and upside downside capture ratios than I think you are not so foolish, and perhaps.... wise.

I apologize if I came across as an ass, but misbenchmarking is a chronic problem and results in grossly inappropriate sales techniques.

Apology accepted and I agree with your latter statement.


Funds are sold as 'beating the market', meaning having a return better than the S&P 500, when they are a balanced fund with 50% stocks, a quarter of which are outside the US. If one is going to compare performance with an index fund it needs to be the appropriate blended benchmark.

Not necessarily. While misbenchmarking is a problem, there is not an appropriate benchmark for every fund. I happen to think that a team managed, disciplined investment strategy that has demonstrated less volatility and risk as measured by beta (and the implied consistency of returns that suggests) with a higher return than the S&P 500 consistently when measured both absolutely and by consecutive rolling 10 year periods, demonstrates that there can be better alternatives than simply buying an index. It doesn't prove anything for the future, but you can't do that with antything. I find it compellingly indicative.

I prefer a diversified portfolio of index funds because of the low cost, low turnover, lack of manager risk, tax efficiency and style purity of the allocation. I prefer not to wonder if my fund manager achieved his past outperformance by luck or virtue and the track record of manger outperformance turning to underperformance leads me to my decision.

The good folks at Altruist advisors and Bogleheads.org have kindly accumulated some links that support that philosophy. See here, note that though this goes to a forum it is not a collection of message board posts:

http://www.bogleheads.org/forum/viewtopic.php?t=173

http://www.altruistfa.com/readingroomarticles.htm#PassiveActive

Taking a quick glance at your cites, I'll trust you to correct me if I'm wrong, but it doesn't seem to me that they are truly arguing against managed money. A pretty compelling argument that can be made these days (and one that's attracting a lot of money) is that you can passively manage indexes and partial indexes, and have the benefits of management without the drawbacks of style drift, potential underperformance, etc.

The way to do this is to create a tailored portfolio out of index funds (or ETFs these days) to properly diversify yourself according to your risk tolerance and investment goals. You then rebalance periodically or as market conditions dictate or your goals change or according to whatever specific discipline you are following.

Is that the essential nut?

If it is, than I am very familiar. It's a good strategy. I approve. I think it has strong merits. I am a follower of several such ETF strategies myself.

Passive management is still a form of management. You are not simply blindly buying an index. You are tailoring and managing indexes. Agreed?

***

I still maintain and stand by my original argument that one is foolish if they simply "buy an index fund." That does not seem to be what you are advocating.

I repeat. Tailoring a portfolio of indexes to your specific needs is a form of management. It's a good form, IMO.


I would be curious to have a cite of a tested methodology that a layman could follow that would allow one to find funds that would consistently exhibit the future outperformance we would all like to have.

These are as easy to produce as they are valueless. Typically they are called hypotheticals. They show you what would have happened had you followed a given investment strategy in the past. It's easy to find or produce a strategy through backtesting that looks great on paper. How it goes in the future is a different story. That applies equally well to any strategy.

That sounds like a dodge, but it's not. In the whole world, there's about 25 funds that I like. They are all very unique.

You seem to argue from a positoin of authority because you use these terms every day, but without evidence to support the postion it doesn't mean much. Most investments are sold be screening for the ones that have done well and implying that you have culled the dogs and are left with the cream (to badly mix a metaphor). I would argue that just doesn't work.

I would agree. You're methodology while valid doesn't do much different. If we are talking about an investment discipline than I will share mine. I would argue that you should not seek performance. You cannot buy performance as it is nobody's to sell. Anybody that is trying to sell you performance is lying whether they are aware of it or not. You can't control it, and you don't know what it will be. Ergo, you can't manage it.

What you can do though, is manage risk.... partially. What you need to do is make sure that you are potentially being paid appropriately for every risk that you are taking. You need to make sure that you are not taking risks for which you have no possibility of getting paid. You need to seek to manage risk, not performance. You need to make sure that the risk level is appropriate for your goals and tolerance.

If you do that extremely well, you should, over time tend to receive a return appropriate to the level of risk you have taken.

After 20 years, that's my opinion of managing money and that's my investment discipline.

[Scylla]

I'd just like to add a word of thanks to Scylla for the very helpful analysis of how exactly these mortgages turned into such a meltdown.

Thank you.

I'm really rather interested in this fund versus index argument, however. Is it true that market cap determines the composition of the index?

Many. Even most. The S&P 500, yes.

I suppose it is almost axiomatic that investing in an index during a bear market would be pointless, but then again, as a low-risk investor seeking to start a nest egg, the scheme of "buy a fixed dollar amount every month, it automatically slows down your exposure as the market goes up, and vice versa (a.k.a buy low, don't buy high)" seemed to me a sensible proposition.

It's called "dollar cost averaging." It's an exceptionally good way to build wealth. I would argue that after you build it, a different strategy is called for to manage it, but I think dollar cost averaging is a great idea.

I hear you that a well managed fund would outperform an index, but where would I start looking to see if such a fund would actually do so, and continue to do so? The internet is full of financial crackpots pushing their personal pet theory, and investment banks full of financial conmen pushing their personal bank balance.

There are excellent advisors out there, and bad ones. Same goes for Doctors, lawyers and handymen. I answered your second question first because it's the easy one. For the first question I would say this: There is nobody that can tell you that any given fund is going to outperform in the future regardless of how well it has done in the past, or how consistently it has performed.

By that same token, nobody can tell you that any given index is going to provide a desirable or acceptable return in the future, either.

I happen to believe that a fund with superior long term performance (ten plus years, 40-50 is even better,) with low volatility, high consistency and a strong historic upside/downside capture ratio is a better candidate for investment than a market-cap weighted index fund for a variety of reasons.

I've already mentioned some. Another is that index funds are gamed. For example, AIG is likely to drop out of the SP500. For some reason I want to say Cisco will replace it, but that's just a guess, and I think it's wrong. Anyway, if CSCO is added into the SP500 it will happen on a specific day. In anticipation of this, the stock price is likely to move up significantly. Investors and fund managers will know that the stock is going to get added. They know that at a given point in time, every SP500 fund will have to buy CSCO. They buy it first and drive it up. Then the funds buy it and drive it up further. Once all that buying stops the stock typically drops a bit. You end up with bad execution on the buy in an index fund because of this. The same thing happens on the downside.

Sometimes, I start thinking that maybe "under the mattress" is a good investment policy.

That's a strong and aggressive investment in dollars versus other currencies and against inflation, so that carries its own risks as well.

[fruitbat]

Scylla, actually I think we mostly agree.

What I think is at the heart of my questioning comes down to this:

Take an average joe. Someone who does not know what a rolling ten year period, or upside capture is. How do you advise them to invest? A complicated strategy may or may not work, but it is not easy to understand or execute. If you walk down that path you are likely to leave Joe more confused and paralyzed by indecision. So the next step would be to hire an advisor who can execute a strategy for you. The problem there is that the vast majorty of those advisors are picking funds based on performance and taking a hefty fee for making the same mistake you would have made on your own.

The question of whether it is possible to outperform is ultimately less interesting to me than the question of what path a reasonably prudent layman should follow. To me, controlling the things you can control: cost, taxes, asset allocation - is the first step. I would then eliminate the risk that you don't have to take, which is manager risk. A good asset allocation using index or low cost, low turnover active funds (I am thinking of Vanguard funds here, but some others qualify) seems to offer the best combination of ease, risk control and long term success. By rebalancing you stay on track and are automatically selling high and buying low.

If one had, or wanted to acquire, specialized knowledge you may be able to outperform that portfolio, but that is beyond most investors desire to learn.

[DSeid]

Sticking to index fund vs managed fund investing ....

So accepted that most managed funds underperform their appropriate indices in both bull and bear markets you argue that some smaller universe of managed funds have over a fairly long time period outperformed the indices, by enough perhaps to offset their management fees.

Your argument then rests on the belief that past performance of these funds predicts future results if one looks at "consecutive rolling 10 year performance figures and upside downside capture ratios" ... now of course I'd love to see a study that actually showed that such was true, not a fund or so for which it has been true so far, lest you want to be disproved with counterexamples that did well for one ten year span and lousy over the next ten, but short of that I will argue why it seems unlikely that it would be true-

The performance of these exceptional historically outperforming funds rest not on some magic formula or on some corporate philosophy, but on the skill of a few exceptional stockpickers managing the funds. How long do these stockpickers last? A decade? Sure. For the next two decades after that? Less likely. Pick the fund that did well for ten years and you may be choosing it just as the critical stockpickers leave, or will be leaving.

Seems like a poor way to choose where to park your money for the next twenty years.

Again, I think a reasonably intelligent person can pick their own and do, on average, at least as well as the indices. If I can, any one can. But it requires a tolerance of risk, a bit of backbone, enough to diversify with, and a willingness to research out your ideas. Short of that the average Joe needs a fund or two. The average managed funds will underperform over time compared to a mix of index funds that reflect the broad market including small caps, mid caps and large caps (I here specify not just a S&P500 tracker). Picking managed funds that have outperformed is easy but picking ones that will outperform is hard, your proposed method notwithstanding.

[Gozu]

Damn, that was some good shit, Scylla.

Much love goes to you for explaining this mess.

[mangeorge]

I think I should have said "The stock market as we know it is over". ;) This "adjustment" does look like a bad one if one believes the experts on the tube. There have been some pretty shady goings on. Brokers taking advantage of none-too-sophisticated home buyers, for example.
Anyway, thanks to all for the education. I've learned quite a bit. Problem is, my retention is pretty low and I'm naive about investment. So I'll stick with Vanguard, who check-out pretty good. I retire in a couple years so the timing should be alright.
Not to worry, Paul Kangas and partner would never lead me astray.
Peace,
mangeorge

[Scylla]

Sticking to index fund vs managed fund investing ....

So accepted that most managed funds underperform their appropriate indices in both bull and bear markets you argue that some smaller universe of managed funds have over a fairly long time period outperformed the indices, by enough perhaps to offset their management fees.

That first part (both bull and bear markets) is not an accurate representation of what I said. I do not argue the second part. I state is a fact. You want I should provide more symbols? AIVSX has outperformed by 170 basis points over 75 years after all sales charges and expenses.

Your argument then rests on the belief that past performance of these funds predicts future results if one looks at "consecutive rolling 10 year performance figures and upside downside capture ratios" ...


This is a silly argument, and frankly a waste of my time as I've already addressed it. Past performance does not determine future results. It is a potential indicator. By the same token you cannot determine that a given index will produce acceptable or desirable results in the future.

now of course I'd love to see a study that actually showed that such was true, not a fund or so for which it has been true so far, lest you want to be disproved with counterexamples that did well for one ten year span and lousy over the next ten, but short of that I will argue why it seems unlikely that it would be true-

Again, future performance cannot be proven before the fact, so, of course, no such study attempting to do so exists. FYI, rolling 10 year periods does not mean 1940-1950, 1950-1960.... It means 1940-1950, 1941-1951, 1942-1952, etc.


The performance of these exceptional historically outperforming funds rest not on some magic formula or on some corporate philosophy, but on the skill of a few exceptional stockpickers managing the funds.

Really? Where'd you come up with that idea? I haven't argued it, nor do I believe it to be true.

How long do these stockpickers last? A decade? Sure. For the next two decades after that? Less likely. Pick the fund that did well for ten years and you may be choosing it just as the critical stockpickers leave, or will be leaving.

Well, if we're going to take a look at AIVSX than of the 6 portfolio managers of that fund, the one with the longest tenure has 43 years, and the one with the shortest has 16 years. The fund itself has over 75 years of returns consistently and significantly outperforming its benchmark. Those 75 years have involved innumerable manager changes, yet I would challenge you to detect an effect on the portfolion from any of them.

That should pretty much dismiss that argument of yours.

Seems like a poor way to choose where to park your money for the next twenty years.

It only seems that way because you are arguing from a standpoint of ignorance combined with poor assumptions. Had you actually known what you are talking about, it would doubtless seem otherwise.

Again, I think a reasonably intelligent person can pick their own and do, on average, at least as well as the indices. If I can, any one can.

I suppose its possible. Your story though is a familiar one. In my experience it will tend to follow pretty classic lines. You may not be aware of it, but you are likely outperforming because of a combination of factors. Most people who choose their own individual securities tend to outperform for a period of time before suffering a catastrophic failure. These same factors that are responsible for their outperformance entail added risk disproportionate to the outperformance. One may have 12 years of mild to decent outperformance and then in the 13th year suffer a catastrophic setback that leaves them far behind any benchmark... or wiped out.

We could talk about these factors, if you like.

But it requires a tolerance of risk, a bit of backbone, enough to diversify with, and a willingness to research out your ideas.

I don't think that a high risk tolerance is at all a benefit. Indeed, the most successful investors and managers that I know are ruthlessly intolerant of risk. Backbone also is a poor trait. A successful investor is willing to doubt himself, posesses a flexible mind and tends to be cautious.

Short of that the average Joe needs a fund or two. The average managed funds will underperform over time compared to a mix of index funds that reflect the broad market including small caps, mid caps and large caps (I here specify not just a S&P500 tracker). Picking managed funds that have outperformed is easy but picking ones that will outperform is hard, your proposed method notwithstanding.

This is a very poor series of assertion on a number of levels. If you are mixing up index funds, you are managing. I don't know what you mean by "average managed funds." I suspect there is no such thing. There is more to diversification than small cap, midcap, and large cap. You're going to need bonds, cash, and noncorrelated assets as well. What proportion will change depending on a variety of factors. You will want an international component, and ensure Growth/Value/GARP/Relative Value are represented. You will need to devise a core satellite strategy. If you are purchasing individual securities in a portfolio that is less than a couple of million dollars than the chances are that you are poorly diversified. Many of these things will tend to hold you back and retard performance in most years. A portfolio lopsided in these regards will tend to outperform for a period of time.

There is tons of research to support this. Most of it is proprietary. One can view the proof of the pudding through the extreme outperformance of managed money versus indexing.

A strong example of this would be the Harvard endowment:

http://vpf-web.harvard.edu/budget/factbook/02-03/endow_growth_39.html

http://www.nytimes.com/2008/09/13/business/13harvard.html


You claim that picking funds and managed vehicles that have a likelihood of outperforming is difficult. It's not. It's easier than a building a portfolio of your own (responsibly) I've provided several clear examples of long term outperformance.

What sort of audited figures do you offer as evidence of superior returns according to your methods?

[DSeid]

Scylla, you say that I misrepresent your position when I say that you accept "that most managed funds underperform their appropriate indices in both bull and bear markets" - yet in response to "Countless studies have shown portfolios of index funds outperforming managed funds in bull and bear markets." you replied "That's a fact. 80% of funds underperform their respective indexes."

I fail to see how I did anything other than accurately portray what you said.

A minority of managed funds do better than average and a minority of that minority have consistently done better than average. Yes you could, out of the universe of funds, find me some examples of individual funds that have over the years outperformed. By definition those examples would have one good ten year period followed by another one. And if you save up enough of those anecdotes you may be able to buy a bit of data ... or not. I can also point to Janus Fund which had a great rolling ten return, until it didn't, and then took quite a while to regain its stride. If say you were investing in 2000, as I was, and you used the rolling ten year return as a major criteria, as I did, you would have seriously considered putting a chunk into Janus, as I did. And if you did you would have done significantly worse than the index in the major dip that followed, as my Janus money did.

But that's just another anecdote and even ten of them won't buy either of us a single bit of data.

The data is not so impossible to collect, even if it would be cumbersome to do. How often over, say the past 40 years, have companies in a top quartile for each rolling ten year period been in the top quartile for the ten year period that began when the first ten year period stopped. And compare the performance in each case to appropriate index benchmarks. If historically rolling ten averages have failed to predict continued superior performance, either by staying in the top quartile or by beating appropriate index benchmarks, then your hypothesis is falsified.

Short of that sort of analysis, you are making it up, authority or not. And no, again, a dozen anecdotes does still not make for data. There have been thousands upon thousands of managed funds of various sorts. You can find a few dozen that have consistently done well and you offer that as proof that managed funds that have done well will likely continue to do well? Excuse me for being unimpressed, but again, I can also find examples of funds that did well for ten years or fifteen years or twenty that did lousy for the next ten or twenty. An example or so either way doesn't make the case; it doesn't "dismiss the argument". I can see that even from my "standpoint of ignorance." And oh yes, name calling also fails to make the case.

I can understand why you fail to understand what I mean by "backbone" and by "tolerance for risk" ... my fault I am sure for not stating it more clearly. By "backbone" I merely mean having the confidence to go against the herd mentality if your analysis and reanalysis leads you to conclude that the herd is wrong. Not being contrarian merely for the sake of being contrarian, but not being afraid to be contrarian either. Many investors behave like little kids in a soccer game - chasing where the ball is but almost always finding that the ball is no longer there by the time they arrive. As players mature they understand that they can't just go with a crowd trying to catch up to the ball - they need to position themselves where they deduce the ball is going to be. Sometimes their deductions will be wrong and sometimes right. You win or lose in investment based both on how often you are right compared to how often you are wrong and how the big the pay-off is when you are right compared to the cost when you are wrong. Without question picking your own at least feels riskier because every choice has the potential to under or out perform. Whether or not it is in reality is another story. Of course, I only have a dozen or so years of self-managing a portion of my portfolio. My rolling ten year returns may be good, but it may be, as you assume it will be, poorly predictive of my next decade. In fact I assume that the portion I self-manage is riskier despite my rolling average outperforming my funds. (Those funds being in my retirement portfolio and in the kids' 529s. As an aside, the benefits of tax protection in those vehicles cannot be overstated. IMHO anyone failing to fully fund those vehicles as early as possible is investing foolishly indeed.)

My apologies as well for the shorthand reference to diversification. Your full fleshed articulation of broader diversification is of course correct. I however again hear you making assertions that short of evidence (not anecdotes) to back them up are just being pulled out of your ass: "Most people who choose their own individual securities tend to outperform for a period of time before suffering a catastrophic failure."? Do you actually have data that supports that claim or is just something to be believed based on your appeal to your authority? It may be true, or not, and I am sure you believe it is, but you merely saying it is so fails to make the case.

No I am not attempting to convince individuals to invest all on their own. In truth the first priority really must be to take advantage of tax protected vehicles to save for both retirement and kids' colleges (if applicable). A selection of index instruments and/or selected managed funds that results in an appropriately diversified for stage of life portfolio (yeah, bond funds, international exposure, etc.) which is added into consistently over the years is most suitable for those purposes.

After that some us will have some fun picking some on our own. Again, many of us would likely do as well (on average maybe better even) just putting more into an index fund or managing a collection of them. But it's nowhere near as much fun.

[fruitbat]

Scylla, with so much money at stake and so much data to study are you seriously saying that there is no evidence for the outperformance of managed funds because the data is proprietary. Pointing to the Harvard endowment is not a cite. They invest in ways that would be impossible for ordinary Americans with resources they don't have. Still it amounts to 'look, I have found something else that has outperformed indexes'.

If you believe you have a system that works for outperforming an index based portfolio consistently and over a long period of time then I find it just about impossible to believe that there is no academic evidence to support that method. Thus far you have shown that you are adept at pointing to investments that have outperformed in the past, but that does not consitute evidence of future outperformance. The references to how long you have been in the business and how much you know don't much help either. You may be arguing with people who have equivalent experience, but choose to let their argument and the evidence speak for itself.

[DSeid]

OH Scylla just one more illustration of what I meant by "backbone" and "tolerance for risk" - I have a good friend who also was choosing some of his own stocks for a portion of his portfolio. And he loved it in a bull market and he beat the indices by a small margin ... but then there was a big drop in the market. He lost less, significantly less, than the indices. But of course he still lost in that short term. He still couldn't take it. He sold off and put it all with a professional manager.

One other comment on your claim as to the amount that is needed in order to diversify a portfolio - diversification is nice, is important, but diversify too much and all you've dome is roughly created an equivalent of an index fund. The consensus seems to be that a mere 20 stocks can be diversified enough. Many (http://www.investopedia.com/articles/01/051601.asp), including Warren Buffet believe that too much diversification can even be hurtful to a portfolio.Diversification is like ice cream: most people would agree that both diversification and ice cream are "good" things. This doesn't mean you can't have too much of a good thing. Eat too much ice cream and you'll end up with a stomach ache.

The common consensus is that a well-balanced portfolio with approximately 20 stocks diversifies away the maximum amount of market risk. Owning additional stocks takes away the potential of big gainers significantly impacting your bottom line, as is the case with large mutual funds investing in hundreds of stocks. We leave you with the sage words of the "Oracle of Omaha", Warren Buffett: "wide diversification is only required when investors do not understand what they are doing".A couple of million dollars is not required for diversification although clearly using an intelligently selected variety of funds or index instruments as part of a core holding is an easy way to accomplish it.

A question for you: how easy/difficult is it today to find asset classes that really are noncorrelated? My outsider's eye view is that those classes that have been touted as non-correlated have not been behaving so. Lock-step, no. But still quite well correlated. Everything seems tied together today. That is however just an impression. What has been your experience?

[Voyager]

There's nothing really to be suspicious of. All an index fund is is a group of stocks selected because they represent a particular market (S&P 500), industry (tech, energy, etc), size (small cap, medium cap), risk level ( income, growth ) or country.

Basically, if you say "hey...I want to invest in energy startups!" you can either go find a bunch of individual stocks for energy companies or you can find some Emerging Markets Small Cap Energy Fund.

By index funds I meant S&P or the Dow. Investing in the funds you mentioned is betting on a market segment, which is fine. The opposite of index funds is not buying individual stocks. I can't watch the market closely enough to even try to do that. Funds with very specific investment objectives is the way I go most of the time - except for a few cases like buying Google at $160. :)


You don't need to beat the market all the time. Just most of the time. People who know what they are doing like Warrent Buffet invest long term in companies that are fundamentally sound and run well. He's not right all the time, but as long as he's right 60% of the time, he's making money.

My fraternity brother who's a Wall Street trader tells me people ask him for stock picks all the time. His reply is "if I knew what stocks were going to do, I wouldn't work. I'd just sit at home daytrading all day."


The problem is that as technology advances, the markets become more efficient. That means all the information about a particular stock or bond is already included in the price and it becomes harder to make money. So what happens is the Wall Street guys create these elaborate derivative instruments to try and capitalize on inefficiencies in the market. Except I'm convinced that none of these guys REALLY knows what they are doing. I think they create these elaborate 'systems' like a dude at the track in the hopes of getting rich quick and then getting out before the bubble they create bursts. IMHO of course.
.

Of course you wouldn't win all the time, you would just do enough better than the averages. Almost all stories I've seen of "smart" investment managers get done when their particular bias is working. Follow up after the next shift and they get screwed. It is kind of like the Tom Peters curse. Just about any company profiled by him, in "in Search of Excellence" or the follow up books, crashed, because he was profiling them at their peaks.

[Scylla]

Scylla, you say that I misrepresent your position when I say that you accept "that most managed funds underperform their appropriate indices in both bull and bear markets" - yet in response to "Countless studies have shown portfolios of index funds outperforming managed funds in bull and bear markets." you replied "That's a fact. 80% of funds underperform their respective indexes."

I fail to see how I did anything other than accurately portray what you said.

Not deliberately, and I apologize for being Picayune. That 80% of mutual funds fail to outperform their index over time is a fact that's been demonstrated and that I agree with. If you say in "both" bull and bear markets that indicates you are comparing the performance of mutual funds in bull markets against their index with their performance in bear markets against their index. There is an analyst whose work suggests otherwise. His criteria was "managed money" not mutual funds, but managed money includes the class of mutual funds. What he found was that managed money underperformed in bull markets with statistical significance and outperformed in bear markets with statistical significance. If you then corrected for beta and style drift this trend was shown to be even more pronounced. We spend a lot more time in bull markets than in bear markets historically, and therefore indexes tend to outperform managed money over time.

The problem this analyst was working on was the sequence of returns problems. Stated simply, if you removed a fixed income off two pools of money both of which averaged say, 7% over a period of time, than you might have one pool that ran out of money and another pool that had doubled even after the withdrawals even though both averaged exactly 7%

This is due to the sequence of returns. If your pool of money has significant negative years early on on top of the withdrawals it is unable to recover and sustain those withdrawals. If it has strong performance early on than it is able to do so without difficulty. I.E. Start with 100k. First year's performance is down 30%. You now have 70K. You with withdraw 5k. You know have 65k. The next year's performance is down 25%. You know have 49k. You withdraw 5k. You now have 44k.

Even if other the next several years you're performance reverts to the mean 7% your portfolio will run out of money because you are withdrawing more than your earning because of the poor performance in the initial years. Losses hurt you much more than gains help you. For example. If you start with a 100k and lose 50% in the first year you have to make 100% in your second year to return to your starting principle.

This analyst was proposing a methodology for achieving index level returns in bull markets yet managed money returns in bear markets.

Hence, my picayune bristling over a seemingly minor point.

Yes you could, out of the universe of funds, find me some examples of individual funds that have over the years outperformed. By definition those examples would have one good ten year period followed by another one.

No. You're describing consecutive ten year periods. I am describing rolling ten year periods. I described the distinction earlier, and it's an important one as the latter measures consistency of returns rather than absolute returns, the importance of which I've described above.

And if you save up enough of those anecdotes you may be able to buy a bit of data ... or not. I can also point to Janus Fund which had a great rolling ten return, until it didn't, and then took quite a while to regain its stride. If say you were investing in 2000, as I was, and you used the rolling ten year return as a major criteria, as I did, you would have seriously considered putting a chunk into Janus, as I did. And if you did you would have done significantly worse than the index in the major dip that followed, as my Janus money did.

No. Not really. Janus' relative outperformance was a function of both position and sector concentration. Stochastic analysis suggested a meltdown was inevitable.

They did not have "great rolling ten year return periods" It was not team managed, nor did it have a defined discipline, and in 1999 the manager had only been there for 5 years. With only a five year track record, it's not subject to this type of analysis.

But that's just another anecdote and even ten of them won't buy either of us a single bit of data.

Actually it does show us something. It shows us that you need to be careful in analyzing investments.

The data is not so impossible to collect, even if it would be cumbersome to do. How often over, say the past 40 years, have companies in a top quartile for each rolling ten year period been in the top quartile for the ten year period that began when the first ten year period stopped. And compare the performance in each case to appropriate index benchmarks.

I don't know. I think it's a meaningless analysis. I try not to look at those results, as they are deceptive. Again, You seem to be not clear on the difference between consecutive ten year periods and rolling ten year periods. Please let me clarify again. Here's an example of consecutive ten year periods: 1910-1919,1920-1929,1930-1939,1940-1949. The time period 1910-1949 gives you four consecutive 10 year periods.

Rolling ten year periods look like this: 1910-1919,1911-1920,1912-1922..... ....1939-1949. That period gives you 40 rolling 10 year returns.


If historically rolling ten averages have failed to predict continued superior performance, either by staying in the top quartile or by beating appropriate index benchmarks, then your hypothesis is falsified.

Since 1929, I beleive there were something like 3 rolling ten year periods in which ICA did not outperform its index (I'll have to check Monday, it may be 5, but it's very small) There was a total of about 75 rolling ten year periods to analyze. Assuming that we need inception plus 15 to bring us a minimum of 5 rolling time periods to analyze, than for the last 60 consecutive years this method would have succesfully predicted future outperformance.

There are many, many funds on which you can perform this analysis. To make it valid you need 15 years of tenure of management (or defined investment discipline.)

Short of that sort of analysis, you are making it up, authority or not. And no, again, a dozen anecdotes does still not make for data. There have been thousands upon thousands of managed funds of various sorts. You can find a few dozen that have consistently done well and you offer that as proof that managed funds that have done well will likely continue to do well?

I have made no such claim. Several times I have said you cannot prove future performance. All you can do is give yourself a statistically significant likelihood of outperformance, adjusted for risk as measured by beta and standard deviation.

That you can do.



Excuse me for being unimpressed, but again, I can also find examples of funds that did well for ten years or fifteen years or twenty that did lousy for the next ten or twenty.

Again, you're confusing consecutive versus rolling, and again I am not suggesting I can promise future outperformance any more than you can promise the future acceptability of an index return. What I can do is make it statistically likely that I will outperform, and that I will do so with a lower standard deviation, thus mitigating the sequence of returns risk should I need to remove funds from the portfolio.



An example or so either way doesn't make the case; it doesn't "dismiss the argument". I can see that even from my "standpoint of ignorance." And oh yes, name calling also fails to make the case.

I'm not name calling. I have 20 years of industry experience that directly bears on this topic. Comparatively speaking, you are ignorant, just as I would be comparatively ignorant talking to a Dr.


Of course, I only have a dozen or so years of self-managing a portion of my portfolio. My rolling ten year returns may be good, but it may be, as you assume it will be, poorly predictive of my next decade.

You only have 3, and only then if you've been adhering to a consistent discipline throughout.

My apologies as well for the shorthand reference to diversification. Your full fleshed articulation of broader diversification is of course correct. I however again hear you making assertions that short of evidence (not anecdotes) to back them up are just being pulled out of your ass: "Most people who choose their own individual securities tend to outperform for a period of time before suffering a catastrophic failure."? Do you actually have data that supports that claim or is just something to be believed based on your appeal to your authority? It may be true, or not, and I am sure you believe it is, but you merely saying it is so fails to make the case.

I understand. Your skepticism is well-founded. I'm only a guy on the internet as far as can be demonstrated. I am claiming special expertise and access to data that I cannot share. This is not, generally speaking, a recipe that should provoke total acceptance in a reasonable person.

On the other side of the coin, if you are talking to somebody who says they are an auto mechanic, and you know a thing or two about automobiles, you might be in a position to judge whether the person you are talking to is credible and knows his stuff enough to be what he portrays himself as. Apply such judgement to me and act accordingly.

[gravitycrash]

If you want to stick to the gambling analogy, when you buy into the market you're buying into the house. Over the long run the house always wins, but there are times when there are people that cause the house to lose. When that happens all you can do is shrug and wait for the house to start coming up big again.

If you look at the market's performance over the last century, if you got in and you stayed in you're a rich man. It's the people that bet the farm on a single pull of the handle that inevitably get hammered.

Exactly. I have probably lost whatever equity in my home that I had. I'm confident that it will come back. I still have 20 years to retirement.
People will soon be buying homes because of the great bargains to be found. The market and housing industry needed a huge wake up call.
And yes, I am for more regulation for home loans. The quasi-private market fucked up, I admit it.
If the government gives them a free pass on the loans to them I'll be more than pissed.

[Scylla]

Scylla, with so much money at stake and so much data to study are you seriously saying that there is no evidence for the outperformance of managed funds because the data is proprietary.

That I don't know. The data that I use is propietary. Most, if not all of the good research you have to pay to access or be in the industry (Ibbotson, Lipper Analytics, Jaywalk, Bloomberg, Morningstar, as well as the access to firm specific analysts or their output.) The terms of access specifically prohibit you from reproducing it for, or making it available to unauthorized third parties. You are double specifically warned that if you put any of it on the internet they will hunt you down and kill you (all right, I'm exagerating)

This is the norm in the industry as such product is difficult and expensive to produce and valuable for its exclusivity.

There are public sources available, and some of these that I've named do provide limited information for public consumption. Generally, I don't find that stuff to helpful.

Pointing to the Harvard endowment is not a cite. They invest in ways that would be impossible for ordinary Americans with resources they don't have. Still it amounts to 'look, I have found something else that has outperformed indexes'.

Isn't that a good thing. You want to outperform without taking on excess risk, right? Therefore, you would think those that have done it consistently over a long time period might be pertinent or of interest, right?

I don't understand what you're getting at. You seem to be arguing that outperformance is unuttainalbe, or unlikely, and ask for proof otherwise. I give you examples of groups and methodologies that have consistently done so over extremely long periods of time, and you say "That's not proof. Show me proof." Clearly since future performance does not yet exist, I can't produce it for you. What I can demonstrate is that based on history there is a statistically significant likelihood for future outperformance in certain cases, and strategies. How many more do you want?

Indexes are a form of management or an investment discipline. Their entire value is that they produce a statistically significant history of returns from which one may intuit a reasonable expectation of future performance. It seems disingenuous to accept the statistical significance of indexes but not that of management, especially when the distinction is nothing more than a matter of degree.

Here, You want to beat the S&P 500 in a statistically significant manner dating back to inception in 1860 something? Rebalance it to equal sector weightings, use a dogs of the dow type model, push it through an alpha surprise model, a dividend discount model, or use any other of dozens of defined criteria to improve it.

Basically any of these would have produced statistically significant outperformance over long time periods in the past.

If you believe you have a system that works for outperforming an index based portfolio consistently and over a long period of time then I find it just about impossible to believe that there is no academic evidence to support that method.

There is tons. The dogs of the dow has significantly outperformed the dow for just about any statistically significant time period you care to look at it. There are thousands more, some simple, some complex. Some publically defined, some not.

The couple of funds I showed you are more than happy to show you how well they did. In fact it's hard to avoid.


Thus far you have shown that you are adept at pointing to investments that have outperformed in the past, but that does not consitute evidence of future outperformance.

Yes it does.

You are misunderstanding the conventional legal disclaimer. "Past performance is no guaranty of future returns."

If I show you a spot in Alaska where Salmon have come to spawn every year for millions of years, that is no guaranty that they will come there and spawn next year.

Most would concede that such is statistically significant evidence that it is very likely that they will in the future.

It is dismaying that you are unwilling to accept such evidence or even consider it as such since it is the only evidence that is available without a time machine.


The references to how long you have been in the business and how much you know don't much help either. You may be arguing with people who have equivalent experience, but choose to let their argument and the evidence speak for itself.

I'm not arguing with such people. If you are a heart surgeon for example, and you're talking with somebody else about heart surgery, you're going to know pretty quickly whether the person you are talking to is a heart surgeon.

You don't talk like a broker, fund manager, research analyst, hedge fund, principle, trader, or other folk in the industry. You talk like the customer of a discount firm who listens to radio programs, and reads material from planners who use discount firms as custodians or otherwise produce material for the consumption of discount firm clients.

I am not putting them down (well actually I am. I think they fucking suck. I think they are self-righteous lying pricks who only survive by preying on gullibility and impugning their betters and are only where they are because they failed miserably on the other side of the business.)

Anyway, the whole side of the business that tears down management and claims that indexing is the way to go has a huge vested interest in doing so.

It's a logical fallacy, but I think it's a valid argument nonetheless. The truly enormous sums of money, the foundations and endowments, the insurance companies and the banks, the extremely wealthy.... these are the group that we might consider "smart money." They have the largest vested interest in getting the highest possible return for the least risk.

Overwhelmingly these enitities use managed money.

Chuck and the index funds are going after your less-sophisticated investors.


There's a reason for this.

[DragonAsh]

FWIW, I do quite a bit of day trading, and no way do you need to be right more than 50% of the time. Some of my best weeks were when I was 'right' (made money) on only 40% or less of my trades - but each winning trade was much bigger on average than my average losing trade.

I personally had become increasingly skeptical of 'diversification' - seemed to me like a good way to dilute any positive returns. Sure, the reduced risk is nice - but I figured, if I can handle the risk management portion myself, why diversify away potential gains?

It's why I stopped having pros manage my funds, and started doing it myself. If I feel confident in a particular trade, I can take a slightly larger position on it, knowing that if I'm wrong, I can and will bail in a hurry. I can be wrong five times in a row and make it all up and more on the one trade I get right. For the average investor, it's the other way around. They have four or five winning 'trades' (or years) and then one really bad trade (year) that sets them back.

I think it's partially in our mindset - we're conditioned to always having to be right most of the time. Bailing on a trade feels like 'we were wrong' - which would be true if there was actually a rhyme or reason to the stock market. There isn't. No one knows which way the next tick will go. There may be mass consensus agreement on a particular item - what a company's sales will be, for example - but no one - I repeat, no one - knows what the market's reaction will be.

[gonzomax]

You need to feel sorry for Hank Greenberg, He ran AIG for many years. He retires with 1.5 billion in stock. It now is worth 100 mill. It may be even less after the last couple days. Poor old guy had it made. He bitched at management for months offering to help them out. They did not need him. They had it under control.

[mangeorge]

You need to feel sorry for Hank Greenberg, He ran AIG for many years. He retires with 1.5 billion in stock. It now is worth 100 mill. It may be even less after the last couple days. Poor old guy had it made. He bitched at management for months offering to help them out. They did not need him. They had it under control.
Now here's my disconnect. He could lose 90% of what's left and still be rich. A lot of people surviving on $40k/yr now have nothing. I feel for them, not Greenburg.
He's going to suffer? Cry me a fucking river.
mangeorge
BTW, I've lost nothing so far, and probably won't. I'm doing fine, and I ain't whining.

[Mr. Svinlesha]

Scylla:

Well, I'll grant you this: when you know your shit, you really know your shit.

I noticed in your explanation on page 1 you failed to mention anything about lack of governmental oversight. McCain and Obama both seem to think that the current "market adjustment" was the result of a deregulated financial market. What's your take on that? Should the government have stepped in and regulated these CMOs thingies? Would other regulations have helped? Or do you see the problem as something basically beyond the scope of regulation?

There seems to be a growing consensus among the economists I read that we haven't reached bottom yet, and that this problem is even more severe than anything we've seen -- maybe as bad as the Great Depression. Here's the assessment (http://www.pbs.org/moyers/journal/09192008/transcript4.html) of Kevin Phillips:
Well, the greatest story never told in several senses. The first sense and when I do bad money, it's bad capitalism and bad money in the sense of the dollar and bad money in the sense of bad dog, bad Wall Street. But what's here that doesn't get the attention is the United States in the last 20 years undertook an enormous transformation of itself with no attention paid. And what it means is and what makes all this so frightening is the country is at risk because of the size of the financial sector that has never been graded on its competence and behavior in any serious way. They are the economy at this point. And we are now seeing what happens when a 20 to 21 percent of GDP financial sector starts to come unglued....

Well, just to give you an example of how many there are, Alan Greenspan has finally decided to admit, you know, this may be one of those once-a-century biggies. Well, what makes it fascinating is that I sometimes use the description "seven sharks." There are seven sharks in the tank with the economy.

And the first is financialization because we're so dependent on this industry that's sort of half lost its marbles. The second is that you have this huge buildup of debt, absolutely unprecedented anywhere in the world. The third is you've now got home prices collapsing. The fourth is you've got global commodity inflation building up.

The fifth is you've got flawed and deceptive government economics statistics. The sixth is that you've got what they call peak oil where the world is, to some extent, running out of oil. So it's not just commodity inflation, it's a shortage of oil. And then the last thing is the collapsing dollar. Now, whenever you get this sort of package in one decade, you got a big one. And when Greenspan says it's a once a century, I think it's another variation but on a par with the Thirties.
What do you think?

[Scylla]

Scylla:

Well, I'll grant you this: when you know your shit, you really know your shit.

Thanks.

I noticed in your explanation on page 1 you failed to mention anything about lack of governmental oversight. McCain and Obama both seem to think that the current "market adjustment" was the result of a deregulated financial market. What's your take on that?

I think it's a pretty expedient thing to say. IMO, this current meltdown required a chain of circumstances to occur. Starting with the mortgage backed securities, I think it's pretty noncontroversial to say that a lot of people ran through a lot of red lights in the origination of mortgages that should not have been issued, and these were securitized without regard for the risks that were being taken, and that this was done because there was a lot of money to be made. I don't think anybody thought they were being evil. After all, you're getting rich while helping people live the American dream by owning their own houses. You're helping the economy with the housing boom, and those people with those low interest rate mortgages make money as the housing market increases. It's a big win all around. So what if things are getting a little extreme and frayed around the edges? Things have been that way for a long while but it still keeps working.

One may know logically (if one thinks about it) that this can't continue, but just like in 90s with the tech boom, bubbles are compelling. They make you believers. People think "sure it has to crash sometime, but not now"

Naturally there is a boom and bust phase with different industries as a part of the market cycle. As long as it doesn't get too extreme it's not a bad thing. This got pretty extreme.

Probably though, things would have worked themselves out. Some big financial companies would lose a lot of money (but they'd made a lot and that's the nature of risk) some of them like countrywide would go under, housing would slow down. Some people who were unlucky or foolish would lose their homes to foreclosure. Most people and businesses would be ok. The wise man knows that when people start talking about mortgages as a "sale" rather than a "loan" a credit crunch isn't far behind.

It was and would have been pretty severe. Strong oversight and regulation would have mitigated it to a degree. The problem with regulation is this: Good regulation is absolutely necessary. Bad regulation, or regulation for the sake of doing something is terrible, maybe worse than nothing.

There should have been some brakes applied to the predatory lending practices, maybe credit should have been tightened, but that's hard to do when the economy is otherwise slow and having problems, and this is one of the few things powering it on. You put the brakes on origination and securitization and you may end up hurting things in other areas more. It's a tightwalk, and I'm not sure there was a solution that let you walk the line in terms of credit tightening. If there was, I don't know that it would be possible for anybody to walk that line. The predatory origination was too much though. That should have been stopped. I would have preferred to see it happen at the state level, as I think the various markets were different, and the demographics were different. This way there's a better chance that the rules you put in place for the rich suburbs of New Jersey don't end up meaning nobody in W. Virginia can get a mortgage. Then too, seperate rules for various states would have made it more difficult to for originators to go wild. They would have had to tailor there products more depending on the state, and it would also have slowed down the securitization since the mortgages would not all be standard from state to state. There was a little bit of this, a real little but not a lot.

The current meltdown of the last week or so should be viewed as a seperate issue. It's dependant or linked to the housing crises, and, it wouldn't exist without it, but you couldn't have regulated it away by doing anything with mortgages. I think it helps to look at the mortgage crisis as one issue and the financial meltdown of last week as another. It may be partially fallacious to do so, but bear with me, and I'll show you.

As I said, I think we probably gotten through the current mortgage situation without help. It was severe, but not absolutely terrible. Hurting hedge funds and short-sellers were able to exploit this weakness, and than, thanks to a change in methodology among the rating companies they were able to actually magnify or create weakness.

Regulating this problem is tough. The short sellers serve an important purpose. In most circumstances they serve to retard bubbles, and add efficiency to the pricing mechanism. They take incredible risks to make money, and nobody weeps for them when they lose. Theirs is a negative sum game with a potential for unlimited losses. You have to be sharp to be a successful short seller. There's that. Then too, it's tough to stop them. There are other ways they can bet on things going down, and other markets that we don't regulate that they can attack our securities from.

The best way is to rally and squeeze them and force them to cover. How you regulate a rally, I don't know (although we seemed to do it a couple of days ago.) Ultimately, I think there are going to need to be more regulation applied and the short sale rules are going to need altered.

FWIW, I didn't hear anybody predicting the meltdown that occured in the last week or so. Nobody that I'm aware of guessed that the combination of circumstances would lead to the murder of relatively healthy companies by shorticide.



I think there are too many variables and unknowns to say with any responsible degree of confidence. I don't think it's all over either. Based on the way the LIBOR swung last week, I'm deeply concerned that credit tightening aimed at new origination is going to push a lot of current mortgages into default, and may start another more severe round of housing related woes. I think the consumer is going to suffer a lot more as he gets hit with round two of a credit crunch.




[quote]Here's the assessment (http://www.pbs.org/moyers/journal/09192008/transcript4.html) of Kevin Phillips:

What do you think?

I'm not worried about financialization, again cyclicality is fixing this as we speak. I'm not overly worried about the government debt as it's carrying costs are very low and the government pays back in deflated dollars. Consumer debt may very well be a problem, the question is one of severity. Three and four I'm not worried about. I'm not sure what he means by the fifth. The sixth is a real problem, but not just now (I'm not really worried about oil because everybody else is. The problems that really kill you aren't usually the ones your paying attention to.) The dollar needs killing. When the dollar's strong everybody bitches about jobs going overseas and how we can't sell our products abroad. The dollar has been too strong for a long time. It's weakness is relative to this, cyclical, and in my opinion a very good thing for us long term.

[gonzomax]

Part of the consumer debt problem is due to the credit card companies writing the regulation for their own business. They charge usurious rates, can jack the rates up practically at will and pushed bankruptcy reform that only helped them. They have to find a way to make that fairer. People who have been running their lives on credit cards are in financial trouble too. Many had little choice.
We have to rein in the looters.

[mangeorge]

Part of the consumer debt problem is due to the credit card companies writing the regulation for their own business. They charge usurious rates, can jack the rates up practically at will and pushed bankruptcy reform that only helped them. They have to find a way to make that fairer. People who have been running their lives on credit cards are in financial trouble too. Many had little choice.
We have to rein in the looters.
There is talk, finally. We'll see.

[ajfrod]

The stock market has its pros and cons. Money which has to be safe must be safe.

[Trom]

Scylla -

Thanks for the write-up on the mortgage/CDO mess. Very interesting to hear an "insider's" perspective.

Perhaps I'm getting the wrong vibe from you, and if so I apologize. But, you seem to be coming down harder on regular short-sellers of financial stocks than I would expect. I assume you agree with the recent push to correct the Failures to Deliver/naked shorting in financials is a good move. Though, I would argue far too late, and forcing people to make delivery on contractual obligations isn't my idea of tough, hard-nosed work by a regulator. I don't believe it's something for which the SEC deserves to be patted on the back.

What is your opinion of the recent ban on legitimate shorting of financial stocks? The equity market open following that announcement was the wildest thing I've seen (though my experience in the industry is not nearly as extensive as yours). Stocks that usually have 30-50 cent spreads were trading with 3-5 dollar spreads. Zions Bancorp is one example of the crazy trading going on (ticker: ZION). The closing imbalances were similar in volatility. Do you think taking away liquidity, as they've done, was the right move? I'm glad I'm not an options market maker...

Also, if the shorts have driven these banks down to levels far below their "real" value? Why is no one buying?

[Scylla]

Scylla -

Thanks for the write-up on the mortgage/CDO mess. Very interesting to hear an "insider's" perspective.

Perhaps I'm getting the wrong vibe from you, and if so I apologize. But, you seem to be coming down harder on regular short-sellers of financial stocks than I would expect. I assume you agree with the recent push to correct the Failures to Deliver/naked shorting in financials is a good move. Though, I would argue far too late, and forcing people to make delivery on contractual obligations isn't my idea of tough, hard-nosed work by a regulator. I don't believe it's something for which the SEC deserves to be patted on the back.

In some of my earlier posts here, I tried to make it clear that I thought the real bad guys were the ratings companies, not the short sellers.

What is your opinion of the recent ban on legitimate shorting of financial stocks? The equity market open following that announcement was the wildest thing I've seen (though my experience in the industry is not nearly as extensive as yours). Stocks that usually have 30-50 cent spreads were trading with 3-5 dollar spreads. Zions Bancorp is one example of the crazy trading going on (ticker: ZION). The closing imbalances were similar in volatility. Do you think taking away liquidity, as they've done, was the right move? I'm glad I'm not an options market maker...

I didn't notice unusual spreads except at the open. Are you sure you were looking while the market was open and not the premarket or after hours trading?

Also, if the shorts have driven these banks down to levels far below their "real" value? Why is no one buying?

At 1:00 on Thursday Morgan Stanley was around 10. It closed right around 22. We were up around 400 points Friday. I consider that buying.

[Trom]

In some of my earlier posts here, I tried to make it clear that I thought the real bad guys were the ratings companies, not the short sellers.

Ahh. I misjudged your post then. The following paragraph is what confused me:

Hedge funds were already having a bad year and looking to recap losses. Short sellers were in a feeding frenzy. This was like ringing the dinner bell.

If you shorted a stock and drove its price down, it's rating would drop. Most credit covenants require additional collateral when a rating drops which means the company has to put up more money. Of course they can't get it easily because their rating just dropped. This makes the stock go down. The short sellers go nuts, and maybe the rating gets cut again. They need more liquidity, can't get it, and the whole thing becomes a self-fulfilling prophecy. The act of shorting the company kills it. It becomes almost a true one way bet.

The time period you're referring to above is what I was referring to in my question on why buyers weren't supporting these companies while they were being hit by the shorts. (Bolding mine.)


I didn't notice unusual spreads except at the open. Are you sure you were looking while the market was open and not the premarket or after hours trading?

Yes. Premarket and after hours spreads are usually meaningless.



At 1:00 on Thursday Morgan Stanley was around 10. It closed right around 22. We were up around 400 points Friday. I consider that buying.

I'd consider that an artificial, panic move up due to a malfunctioning market brought about by government intervention. :)

[mangeorge]

Well hell!
Looks like it happened after all.
What's-his-name, which I just forgot, says the stock market as we know it is gone.
I'm paraphrasing here. Maybe he said Wall Street.
One thing for sure, we are living history.

[mangeorge]

I just want to sure nobody took The Leap. ;)
I hope you are all surviving. What a rush, eh!
Peace,
mangeorge

[gravitycrash]

Naw, anybody who is seriously invested in the stock market knows that you will take your lumps. Anybody who feels like jumping off a tall building after this just doesn't understand how the market works.

Warren Buffet just said last week that this is an ideal time to jump back in. I think he qualifies as an expert.

[mangeorge]

Naw, anybody who is seriously invested in the stock market knows that you will take your lumps. Anybody who feels like jumping off a tall building after this just doesn't understand how the market works.

Warren Buffet just said last week that this is an ideal time to jump back in. I think he qualifies as an expert.
Your username is just a coincidence to this post, right? ;)
Anyway, I went back and re-read the OP, and my concers and seem valid for what's going on right now, including agencies (FBI, etc) looking for signs of wrongdoing.
And it does seem pretty obvious that the whole system will be going through some pretty profound changes. It looks like gonernment oversight will be the answer.
I know little about the markets and such. All I know is what I get from watching The McLaughlin Group. ;)

[msmith537]

You need to feel sorry for Hank Greenberg, He ran AIG for many years. He retires with 1.5 billion in stock. It now is worth 100 mill. It may be even less after the last couple days. Poor old guy had it made. He bitched at management for months offering to help them out. They did not need him. They had it under control.

And yet somehow I think he'll manage to make ends meet.




Well hell!
Looks like it happened after all.
What's-his-name, which I just forgot, says the stock market as we know it is gone.
I'm paraphrasing here. Maybe he said Wall Street.



Probably "Wall Street". When times are good, people don't care about where the money goes, they just say "yaaaaay". When everyone's investments drop 25%, people are like "who the fuck is paying some 28 year old douchebag enough money to drive around in a Ferarri and sip Crystal at some club in the Meatpacking District and why?"




Naw, anybody who is seriously invested in the stock market knows that you will take your lumps. Anybody who feels like jumping off a tall building after this just doesn't understand how the market works.

Warren Buffet just said last week that this is an ideal time to jump back in. I think he qualifies as an expert.


People who are "seriously invested" in the markets tend to be investing someone elses money.


It probably is a good time to jump back in. Well, not that good since I jumped in last week and am down about 5%. But it should be fine in a few months.

Except the DOW is down close to 40%. If you lost 25% of your investment, it sort of feels like you just shit money away. Second, how long will it take for the market to recover 40%!?