Monday, March 31, 2008

Long Term Investments Are Not Risk Free: The Fallacy of Large Numbers and the Past Decade in Us Stock Markets

The S&P500 closed yesterday at 1,315.22 points. The first time the S&P500 stood at this level was April 1999. This past decade in the US stock markets has been a long-term investor’s nightmare. I’m referring mostly to retirement savings and households of course. The following chart is of the S&P500 index since 1999:

The rule of thumb in long-term saving is that stocks, over time, are the best investment option available as volatility gets averaged out and all that is left is to enjoy the average returns over the years.

Another rule is that the younger you are the riskier your investments should be since you have enough time to average out poor performance.

While financial advisors work according to these rules the academic world has had problems substantiating them on a solid academic basis.

Noble winning economist Paul Samuelson published an article on the subject in 1963 which is still referred to by almost any article ever since. The article was titled “Risk and Uncertainty: A Fallacy of Large Numbers”. In this article Samuelson describes a conversation between himself and his colleagues in which he offers a bet comprised of a better than 50%/50% chance of losing 100$ and winning 200$. A colleague soon replied he won’t accept a single bet but would accept a series of 100 bets. Samuelson argues his colleague is irrationally applying the law of averages to a sum and that accepting a string of bets when one identical bet is rejected is the “Fallacy of large numbers”. What does that have to do with the S&P500?

Essentially, in finance, we often consider stock investments as bets with some chance of losing x and winning (1+percent) of x. There is some chance a company will default and usually a better chance it will continue growing and with it our investments. As a life of a company much like a series of bets we can consider investment in such a way. Investing in an index is essentially diversifying our risk on many companies (usually within the same geography but no always). Thus we have access to such a series of promising bets.

The problem, however, can be understood intuitively. How is it that stock markets offer a premium on long-term investments (higher returns in the long run)? Where there are returns there must be risk. It seems Samuelson was on to something. Investing in stocks, even for the long-term, is accompanied by risk.

If you’re 20 and saving for 60 there is a good chance such a series of bets, or investments, will yield high returns. However, there is also a chance the last bets will result in heavy losses.

Financial advisors offer life-cycle investing to counter that effect. Invest up to 60% (just an example) in stocks when until 40, 30% until 50 and 10% until 60. By reducing your exposure you’re reducing risk. But isn’t the series of bets supposed to average at the end? Won’t I be losing return on investment? And most dangerous of all, what happens if by 40 I haven’t been able to generate high returns on investment simply because the economy in those years exactly was in a recession? It seems we can’t have it all.

The point I wanted to convey in this post is that there is always risk when investing in stocks. Investing for the long-term has proven so far but don’t assume you will generate 12% on average, each year, by investing in the S&P500 just because it did so from the 1950’s.

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About The Personal Financier

The Personal Financier is about sharing knowledge and experience relevant to our personal finances and our financial development:

  • Investing wisely
  • Understanding economic trends
  • Managing our real estate
  • Saving time and money
  • Introducing business and management concepts
  • Promoting self development
  • more…

The Personal Financier started out as an experiment. I enjoy writing and I set it up in order to house all the articles I wrote for freelance writing content sites. As my writing evolved and as The Personal Financier grew I found out writing for my own blog is a much better experience and definitely a more enjoyable one (even if the monetary compensation is negligible).

I’ve often asked myself what it is about writing that most appeals to me. To be perfectly honest I simply enjoy the fact people are reading me. I believe it’s a sort of recognition that I have something to contribute which keeps me going.

My name is Dorian Wales. I’m 30, married and I have no children, yet. I have an MBA with a specialization in finance and a BA in accounting and economics. I am currently employed as an economist for a large firm.

Blogging is a hobby of mine and I’m not eager to turn it into a profession. As a result most of time I devote to The Personal Financier goes to content and very little on promotion and everything else that goes with blogging (although I try).

The Personal Financier gets a facelift

I've spent some time this weekend upgrading the design of The Personal Financier. Blogger is not very clever and requires and a lot of manual adjustments (I am not webmaster, I simply write).

As a result the three following posts will include: an About section, a Contact section and a Top posts section which may not be so interesting to read but I must post them in order to link to them from my new menu bar.

Your patience is appreciated.



Saturday, March 29, 2008

Colleagues and Resources: Weekly Round-Up

I usually don't like round-up's very much since I think a blogger should contribute his own content and not leverage other peoples' content. However, round-ups are required to spread some link love and to show gratitude and appreciation to your colleagues.

First, a couple of articles from two of my favorite resources online:
1. Sharpening Your Skills: Disaster! @ Harvard Business School, Working Knowledge
A very relevant article on handling and managing crisis and how to develop the right skills to do so.
2. Business this week @ The Economist
A good summary of what happened in the business world this week.

I've particularly enjoyed the following posts by fellow bloggers and would like to share them:

The Consumer Focused Carnival of Real Estate is small but promising. Hosted by Searchlight Crusade who found a very innovative solution to handling over enthusiastic bloggers which mass submit carnival posts even if they aren't related to the subject matter. I especially liked Dax Desai's post on Buying a Foreclosure Property.

The Carnival of Personal Finance #145 hosted a few very interesting posts:
1. Is the perfect financial storm brewing? @ Millionaire Mommy Next Door
2. The fallacy of return on investment @Quest For Four Pillars

The Money Hacks carnival is new to me. I've enjoyed the following posts:
1. Critical Thinking and the Media - Awareness Brings a New Eye @ I've Paid for This Twice Already ...
2. Stock Market Technical Analysis Versus Fundamental Analysis, In Pictures @ The Digerati Life

Last, but not lease, The Festival of Frugality featured this interesting post on How to Spend Less for Organic Foods @ Jinxy Knows Best

Thursday, March 27, 2008

Tel Aviv Joins Earth Hour Project: The Green Trend in the Eyes of Future Studies

The city of Tel Aviv joined the “Earth Hour” project today with a one hour ‘lights off’ between 8:00-9:00 pm. The municipal building and towers around the city coordinated a live TV broadcasted ‘lights off’ which has definitely left an impression.

At first I adopted a very cynical attitude towards this initiative (which was even sponsored by corporations branding themselves ‘green’ but in reality have a long way to go). However, I quickly changed my mind as I witnessed the effect it had on awareness.

Rationally speaking one hour of darkness has no real affect what so ever. Furthermore, it may also be used as a distraction from the real environmental issues at hand which require an attention span of more than one hour and a lot more money. Marketing, however, is a whole different story. Going green has definitely become a major trend.

Trends have their life spans. The green trend will soon finish its hype phase and will hopefully lead to the next step which is usually comprised of hundreds of various companies and researchers making it more economically feasible.

Future studies or futurology, according to Wikipedia, is “the practice and art of postulating possible, probable, and preferable futures. Futures studies seek to understand what is likely to continue, what is likely to change, and what is novel. Part of the discipline thus seeks a systematic and pattern-based understanding of past and present, and to determine the likelihood of future events and trends.

According to a future studies model of technology evolvment each technology follows these steps:
1. Initial research often accompanied by a public revelation (taking approx. 5 years)
2. A media hype on the new technology ending in general disappointment (taking approx. 1-5 years)
3. Companies and researchers developing new, improved applications which introduce the technology back to the market stronger and better (takes approx. 20 years).
4. Technology slowly dies out

Green tech has many forms: Geo-thermal, solar, hydro and more. One of the greatest shortfalls of green techs is the lack of a strong economic incentive. Hopefully, by the time the hype dies down, and oil prices continue rising, more economically feasible technologies will find their way to the markets.

In the mean time, we have the responsibility to continue educating the next generation even if it’s just turning off the lights for one hour.

Image by Megiddo

Monday, March 24, 2008

How to Make Sure this is your Dream Home: 7 Practical Tips

As promised I’ll be writing a bit more on real estate. In this post I’ll discuss some practical tips on how to properly research a property before buying it. Since I’m writing for you, my readers, and I usually focus more on investments, I’ll be very happy to hear your thoughts and your level of interest in the subject in it, if any. As always if you would like me to focus more on one of the other topics I write about please let me know at:

I consider myself a diligent person. Before I buy I usually read consumer reviews, compare prices, ask for a trial periods, consult with experts, consider recommendations and more.

Surprisingly, I wasn’t as diligent when I bought my apartment. I did my research, and very thoroughly so, but I didn’t get a trial period (yes, there is a way) or a house inspection, for example.

Buying a home, as we always say, is probably going to be a major financial deal for most of us. Therefore, we must demand it from ourselves be as diligent as is humanely possible.

How can make sure the property we’re about to buy is the home of our dreams (for the next decade, at least):

#1 Rent before you buy

It might sound odd at first but this tip has a lot of sense. It doesn’t have to be the exact same property but it would be more helpful if it is. When buying a property you have to get a very intimate knowledge of its surroundings starting from morning and afternoon traffic to public services, parks and entertainment. Get to know the neighborhood, the schools, the business areas and everything that might make a difference.

If you have the option to rent a property and buy it later on take it. Get to know the property’s quirks, advantages and disadvantages. You would have asked for a 14 day money back guarantee if it was a stereo, wouldn’t you?

#2 Have a chat with the neighbors

From my experience this is an excellent tip. It is a bit embarrassing at first but your neighbors a vast resource of information, especially when you’re buying with no previous knowledge of the area. Your neighbors will be able to tell you almost everything I listed before. How good the municipal and public services are, how bad is traffic, how are the other neighbors and the neighborhood. They may also tell you how price levels have progressed over the years and what are their thoughts on what future potential the area and property have.

#3 Get a house inspection

Though I myself have my reservations on this one it sure can’t hurt. The problem with house inspections is that they are very limited to what may be observed. They won’t go around drilling holes and cutting pipes. Still, a good, thorough inspection might save you from buying a property in a worse condition that you were bargaining for.

#4 Don’t bite off more than you can chew

Usually, as with every project, expanses outweigh the initial budget. However, this is no excuse to go spending over your abilities. The rule of thumb is not to spend over 30% of your income on housing and not borrow over 70% of the property’s value. Plan ahead and try your best to stick to your budget. Remember your current financial situation might change, for good or bad (plan conservatively).

#5 Consider future potential

Buying a property should also be regarded as an investment. You are paying too much good money to see it just stay at its present value with no return on investment (a huge alternative lose as you could have rented and invested the rest). How do you research potential? Consult with professional real estate agents; consider the future development possibilities, future growth of the area, location (location, location…) and much more.

#6 Make sure it suits your needs

Are you planning on getting married? Having a kid or two? More importantly, what’s your wife planning? It is important to buy a home which will also suit your future needs. I believe a newly bought home should last at least 10 years. Otherwise the deal costs are too significant to ignore and it is more economically sound to rent. Consider the future possibilities and keep them in mind when comparing properties.

#7 Make sure you can afford the maintenance

Many people have dream homes with huge lawns and gardens, maybe a fountain or two. Big homes with many rooms and outdoor space are also expansive on maintenance. Since you are probably able to afford the property, maintaining it should be relatively easier. However, are you willing to spend so much money on it? Are you aware of all the costs?

Taking the time to research a property properly can help make the difference between a successful investment which suits your need and a poor one which you will have to replace soon enough. More ideas and comments are always appreciated.

... Kristin, from The Financial Engineer, posted a very good comment on the need to take a trip to city hall and thoroughly research future development plans for the area. This advice is priceless. Simply imagine that beautiful garden you have across the street changing into a garage...

Friday, March 21, 2008

Another Edition of the Investment Basics Carnival

Welcome to another edition of the Investment Basics Carnival. I've picked the following articles because I believe they offer added value. I've added my own thoughts to each article. Hopefully you'll find them stimulating.


1. Trent presents Review: One Up On Wall Street posted at The Simple Dollar. An interesting book review of another book by Peter Lynch (former Fidelity fund manager and Wall Street guru).

2. Heather Johnson presents 10 Tips for Staying Positive in a Negative Market posted at Investing Blog. Psychology is as important as finance and economics in times of crisis.

3. ThePennySaved presents Learning about investing from Jim Cramer is like finding God through Jim Bakker posted at The Penny Saved. I agree hearitly. Furthermore, he needs to attract attention somehow, usually by being provocative. His last comment on the financial sector in the USA is no less than completely irresponsible.

4. Bobby Handzhiev presents The Sexy Art Of Losing Money posted at The Shark Investor. It's like falling of a bike or falling while skiing. No other way to learn.

5. vitalstarts presents Moving Average Mojo posted at Vital Starts Investing. Explaining the concept of a moving average. Important for novice investors.

6. Donovan Snelleman presents Why You Should Learn To Invest posted at Representing the "invest it yourself" school of thought. I believe it's very risky and requires deep understanding. As I always say professional exist for a reason

7. Jose DeJesus MD presents Improve Investment and Financial Results - Simplify and Conquer posted at Physician Entrepreneur- Keep it simple ...

8. mmhabits presents Let the Grass Grow: Seeding and Nurturing Wealth posted at Millionaire Money Habits. Watching investments compound is very similar to watching grass grow. I believe the trick is to avoid revisiting them often.

9. Mark Runta presents Strategies To Hedge Your Portfolio posted at Smart Investing & Money Management. Hedging is important for any portfolio. Just don't be temped to make money with derivatives and shorts since you just might lose everything.

10. Investing Angel presents How To Avoid A Stock Scam posted at Stock Tips. Tips on identifying stocks scams. Just remember there are no free lunches.

11. CheapCanuck presents Low Income Earners - It might be time to get those dividends rolling in posted at CHEAP CANUCK. Tips for maximizing after tax returns on investment.

12. Joe Hitchem presents Stamps - A Sticky Investment posted at Start Stamp Collecting. Investing in stamps is usually best avoided since returns are very low. This might change your mind.

13. Oscar DaGrouch presents An argument against reinvesting dividends posted at Make me money- I'm wondering why keep the stock at all if you're not ready to re-invest dividends?


A bit extreme for my taste, I believe excess frugality leads to unhappiness. Still these are interesting reads.

1. KCLau presents Top 5 Regular Monthly Expenses We Don’t Need posted at KCLau's Money Tips

2. Hank presents The 29 most frugal things I have ever done - do yours compare to my past levels of cheap? posted at My Investing Blog- .

Financial Planning

1. An interesting trade-off to consider. Praveen presents The 62/70 Solution for Claiming Social Security Benefits posted at My Simple Trading System.

2. chica with issues presents Which IRA is right for you: Traditional IRA vs Roth IRA posted at One Snarky Chica with Issues- A basic discussion and comparison.

I'd like to take the opportunity and acknowledge the following for featuring my posts on their carnivals: marketprognosticator, life lessons of a military wife and beingfrugal.

Wednesday, March 19, 2008

Lehman Brothers’ Yo-Yo: There are Lessons to be Learned

When I first saw the following chart of Lehman Brothers' stock, and what it went through these last couple of days, I instantly thought of a person being springed back to life using a crash cart ... charge to 200, clear! ....

I don't remember seeing anything like this for a long time now. Still, I think there are some important lessons to learn here.

It seems 80% Economy made room for 80% psychology. Panic rules the markets. After Bear Sterns collapsed and sold for under its fixed assets' value there is definitely room for panic. But even that should be controlled. A hint of rumors on Lehman Brothers' liquidity problems caused its stock to crash by almost 40%. That is definitely mass hysteria. It wasn't over then, however, as the next day the stock soared back to previous levels with nothing changing but the wind and whispers.

In times like these economics and finance make room for psychology. Understanding there isn't any rational behavior (or very little of it) behind what's going on is very important.

It also seems like no one really knows what's going on. We always give credit to the mysterious "market" and its key players which price and factor everything from expectations to the weather. Sadly it seems no one really knows what's going on.

What happened to the stock shows there's no room for sentiments. Some people must have thought the price was way over valued to sell it so low. The point here is they didn't think about what they just lost but they thought about what's left to lose. That's a very important lesson for us novice investors. Holding on to losing stocks isn't recommended (even if they sometimes gain everything back the next day ....).

The most important lesson we've learned is that it is better to keep cool and hold on during times of crisis then acting hastily. In times of crisis it's best to stick with our initial strategy and analyze what changed in the assumptions that lead us to it other than acting hastily and making bad decisions and bad moves based on unjustifiable gut instincts (it takes time to develop the right instincts to make these decisions during the heat of the moment). Stocks, like many other economic parameters, display a phenomenon called "overshooting" which often corrects itself quite rapidly.

If what you've lost during this recent slowdown caused you to lose sleep then your investment portfolio isn't suited to your risk preferences or term of investment. Keep this lesson in mind the next time you decide on a certain asset allocation.

Tuesday, March 18, 2008

How to Avoid Crippling Your Retirement Funds

Rainy days such as these are important reminders that what goes up can also come crashing down. The recent hacks and slashes in stock prices stress the importance of good financial planning, especially when it comes to retirement funds or a household’s nest egg.

Self directed IRAs (or Individual Retirement Accounts) offer great opportunities but also great risks. Managing your retirement portfolio by yourself enables flexibility, reduced commissions and completely matching your portfolio to your needs and estimations. However, professional portfolio managers exist for a reason. It is quite difficult to be emotionally detached from your own equity and decision making. Furthermore, acting unprofessionally can cost you very heavily.

How can we avoid suffering a heavy loss to our retirement funds?

#1 Monitor your asset allocation on a regular basis

Asset allocation is critical. A right mix of financial assets can make the difference. You should constantly be aware and monitor the following in your portfolio:

a. The mix of stocks and fixed income – Your primary risk generator is probably the share of stock you own. As value increases so does the share stocks take in your portfolio. Fixed income assets are crucial to balance risk levels and lower total portfolio risk.

b. Exposure to sectors and investment terms – Naturally stocks and fixed income assets should also be diversified to sectors and terms of investment. Again, as sectors evolve we might find ourselves with a strong financial sector bias which could prove to be costly should the sector crash and burn (hypothetically speaking).

c. Exposure to foreign currency – As most of us earn and spend in dollars our investments should be made in dollars as well. However, as currencies fluctuate and sometimes suffer periods of relative weakness it is important to have a small share of exposure to foreign currency in our portfolio. We should pay careful attention to the fact foreign stocks and ETFs are also considered investment in foreign currency (as their dollar value is also influenced by the exchange rate) and be careful not to increase our exposure without intention.

d. Geographical diversification – As globalization evolves we see a growing global flow of funds and accordingly a growing share of investment in other geographies. However, we are still home biased. I think keeping a home bias in a portfolio is still correct but we should also gradually increase our exposure to foreign markets. As the world evolves so should our portfolio.

#2 Adjust your portfolio to your age and risk preferences

Saving for retirement is usually long term. But your investment term obviously changes with your age. There is a debate in academic papers whether life cycle investing, or adjusting the risk to your age, is correct academically (the popular claim is that long term investment in stocks is still dangerous even though the deviations are evened out or otherwise there wouldn’t be any premium on long term investment) . While that is an interesting debate financial planners practice life cycle investing and usually swear by it. It is also intuitively appealing. A 60 year old person should by no means invest 50% of his portfolio in stocks as his retirement in on the line. A 20 year old still has the time to correct market crashes and can take short term (even 10 years) loss.
Be aware of your portfolio’s risk and adjust it to your age and risk preferences. If you are not sure about how much you dislike risk or what should your portfolio be made of I strongly suggest turning to a financial planner for help.

#3 Don’t be tempted to time the market and avoid trying to spot what may appear to be short-term investment opportunities

Its times like these that make your fingers itch. Such a drop in values will surely be followed by a strong bullish period since the weak companies are weeded out and the strong remain… etc… Why shouldn’t I increase the share of stocks in my portfolio?
Don’t be so sure. This slowdown and financial crisis might turn out to be caused by a fundamental economic change (for the sake of the example) and you just might never see your investment again. If you need an example just take a look at the Nasdaq at 2000’s and the Nikkei since 1990’s. Both have yet to regain their losses. Do you have the luxury of waiting 20 years for a decent return on investment?

Investing is all about discipline. You may and probably should take more risks with access savings. However, your retirement funds should not be experimented upon. I, personally, recommend turning to a financial planner who can apply the correct analytics tools and models and make sure your money for old age is safe and secure.

Image by scottwills

Sunday, March 16, 2008

How Much is Your Blog Worth? A Valuation Approach

You must have stumbled upon that cute application which tells you how much you blog is worth by multiplying a link to dollar ratio. I’ll risk it and say anyone of us bloggers would gladly sell his blog for half that amount. That multiplier has obviously been proven as un-economic at the least. However, the question remains. How much is a blog worth?

The financial foundation

If a blog is about making money it is very much like any other profitable endeavor or project and as such should be valuated using the same principles (with the correct adjustments). Finance theory teaches us a very simple lesson. If you want to know how much a certain project (or a company) is worth you have to examine the expected future cash flow this project or company will yield and adjust it to time and risk. Now, since we don’t always have the time to study each company thoroughly we often take shortcuts to the end. These shortcuts are the multipliers we use in order to get a “quick and dirty” rough valuation or ballpark (sometimes very rough and most of the times incorrect). Using multipliers is essentially inducing from other cases on our case and hoping it’s the same (clearly AOL isn’t going to buy our blog using the same link to dollar ratio it used to buy Weblogs). More on discounting cash flow and using multipliers can be found here.

That was semi-interesting, now what about my blog?

It seems we have two choices. Either go the long way and use DCF (discounted cash flows) or take shortcuts and use multipliers (is it safe?).

Let’s have a look at an example to make things a bit more clear. Let’s assume our small yet aspiring blog has the following statistics:

1. 250 unique incoming links.
2. 200 average unique visits a day with 300 page views.
3. 300 posts of at least 400 word each.
4. 25$ a month average adsense revenues.
5. 100$ a month average advertising revenues.

That little applet I mentioned would probably tell you this blog is worth around 120,000$. How much would you be willing to pay for it?

Option #1 – Discounting cash flows

Very simply put when valuating using discounted cash flows we need three important parameters:
1. Future growth
2. Risk (or discount rate)
3. Cash flows

These three parameters basically embody all the major assumptions and data available on the project. Growth represents how cash flows will behave in the long term. Usually long term growth is stabilized and it is very hard to achieve more than 3-6% long term growth (natural growth is around 2%). Short term growth can be and is much higher as the project evolves and market share increases. As everything in life the improvement curve is exponential leaving very little at the end.

Our current yearly cash flow stands at: (100$+25$)*12 which are 1,500$. If we assume growth we need to adjust the numbers. Let’s assume away that the cash flows from our blog will evolve as following:

Year 200X – 2,500$
Year 200X+1 – 5,000$ (100% growth in revenues)
Year 200X+2 – 8,000$ (60% growth in revenues)
Year 200X+3 – 10,000$ (25% growth in revenues)
Year 200X+4 and forever – 4% growth in revenues annually

On to the discount rate: In order to value a projected sum of money we need to transform it into “today’s” money. 100$ today are worth 100$(1+ interest rate) a year from now. If the interest rate is 5% then 100$ today are worth 105$ a year from now (and vice versa 105$ a year from now are worth 100$ today). In finance the discount rate represents risk or: "what is the return I expect on my investment?". Since blogging is a risky industry a proper discount rate should be much higher than the FED’s interest rate for example. Let’s assume our discount rate should be 12%. How much is our blog worth?

2,500$/(1+12%)^1 (discounting for 1 year) + 5,000$/(1+12%)^2 (two years from now) + 8,000$/(1+12%)^3 + 10,000$/(1+12%)^4 + 10,000$/(12%-4%) discounted by 1.12^5 (long term cash flow – cashflow/ discount rate – growth rate).

If we add everything up our blog is worth: 89,196$.

What happens if our blog has, more realistically, reached 2,500$ annually and will only grow at 2% yearly? Then our blog would be worth: 25,000$ = 2,500$/(12%-2%).

Growth and discount rate assumptions have a very significant impact on the final result. Have a look at the sensitivity analysis for a blog with annual revenues of 1,000$ and changing risk and growth assumptions (the value is the result):

Naturally many other assumptions have been made in these very simplified calculations. Sometimes value should be added for synergies that might be created for example (a blog’s content completes another’s content to create a classic case of 1+1>2).

I hope you get the general idea.

Option #2 – Using multipliers

Easy and fund multipliers give us instant results. Sadly there are hardly any two companies, project and even blogs which are similar to each other. Each has its own circumstances and characteristics which will guarantee the result of using multipliers will be swayed at best.
However, as I’ve written, we don’t always have the time to go through the process DCF requires. Let’s have a look at multipliers then.

Multipliers are essentially indicators of a certain project or company’s value which use its main revenue generators to conclude the total value. In case of blogs these revenue generators might be incoming links or page views, subscribers, unique visits and more. Here are some examples

1. Unique link multipliers (used by that application) – Take the number of unique link you have and multiply it. By what? AOL and Weblogs are said to have used a 490$ a link multiplier. It doesn’t really matter though. A 490$ link multiplier means our blog is worth around 122,500$! Wow. Take a quick look up the post and see which cash flows might justify this value.

2. Unique visits – let’s assume that in my blog each unique visit generates 0.01$. We can combine DCF and this multiplier now since my annual revenues are 720$ a year (200*0.01*360). All that is left is to use the proper growth and risk parameters.

3. Number of posts – Since we have some knowledge of how much each post might be worth (around 7.5$-20$ using helium, associated content, constant content and other content buyers and publishers, depending on quality of course) we can take the number of posts and multiply them: 300*(7.5$-20$) = 2,250$ - 6,000$ (value increases as the number of posts increases).

I think the general idea here as clear as well.

So, how much is your blog worth? I hope you have the tools now to experiment some more with your own statistics and estimates on growth and risk. As always I’d love to hear your thoughts and your results.

Saturday, March 15, 2008

The ECB and the FED: A Difference of Approaches

I find it very interesting to observe the different approaches of the two most influential central banks in the world to the current slowdown or recession (choose whatever you think is appropriate). Both the US and Europe are showing an increasing number of negative economic indicators which point to an economic slowdown. The two banks are currently struggling with the same two generic problems:
1. An economic slowdown and fear of recession
2. Rising inflation and rising commodity prices

The FED has taken quick action so far and reacted in a resolute manner to the situation in the markets by both reducing interest rates sharply and increasing the flow of funds dramatically. Just this past week the FED announced plans to inject $200 billion into ailing credit markets by offering to swap high-quality Treasuries to banks and investment houses for beaten-down mortgage-backed securities. The Fed is also expected to lower interest rates by an additional 0.75%-1.5% (estimates vary). It seems the FED is determined to fight the slowdown and credit crisis first and deal with the price levels next.

The FED’s quick actions stand in sharp contrast to the European Central Bank’s (ECB) decisions so far. This past couples of months have shown the ECB, headed by Jean-Claude Trichet, is in no hurry to reduce interest rates and is more concerned with rising price levels. The ECB was expected to reduce interest rates by at least 0.25%-0.5% during the last two meetings and has chosen so far to leave the interest rates untouched.

I believe these fundamental differences in approach stem from the nature of the markets these central banks are responsible for. The US is characterized by a far less rigid employment market and regulations which enable corporations to act more swiftly to times of slowdown by cutting jobs and reducing the workforce. This, for good and bad, enables the US market to adapt more quickly to recessions and economic slowdowns which in turn enables the central bank to act as swiftly.

The European market, on the other hand, is characterized as having a more organized and rigid workforce (also due to the large number of employees in the government and public sectors). This rigidity forces the central bank to be extra careful when dealing with inflation since salaries and purchase power do not respond to economic slowdown as fast.

This ofcourse is simplifying the matter but it seems this fundamental difference has significant importance.

I’d like to take this opportunity to thank Mike from Four Pillars on including me in the #143 issue of the carnival of personal finance.

Tuesday, March 11, 2008

Is Present Value - Value in the Present? The Economic sense behind Net Present Value

Present value is a very common financial tool which is used to determine the current value of a future sum of money. 1,000$ a year from now, at 5% interest, are worth approx. 952$ (As you could deposit 952$ today, with 5% interest and receive 1,000$ in a year). Discounting is the process of translating future sums of money to present value.

Present value (or net present value in case of a series of timely cash flows) is also used to determine the economic feasibility of projects and entrepreneurships or in other words – Are they at all profitable? A project with a positive NPV is worth undertaking.

Net present value (or NPV) is widely used. However, seldom do we question the economic justification to use this financial tool and the economic source of an NPV. Does a positive net present value represent actual value in the present?

We should start at the very basic. What is the source of a positive NPV in a project? Where does it come from? For example, a construction company has decided to undertake a housing project in New York. Surely, the company has come to the conclusion this project has a positive NPV and as such is worth undertaking. Why is the discounted sum of cash flows positive?

The source of a positive NPV is a competitive advantage. This competitive advantage generates the positive sum of discounted cash flows for the company. Each competitive advantage is actually an economic market failure. Markets for labor, materials, technology and more are inefficient and entrepreneurs take advantage of this inefficiency.

This may sound extreme but is well demonstrated by the following example: Our construction company has gained hold over certain workers, contractors, land, instruments and more which enable it to undertake the housing project. The positive NPV is generated by the fact all those resources are unavailable to everyone.

Understanding where a positive NPV comes from is the first step. The more meaningful one is whether this positive NPV actually is value in the present? Can this competitive advantage be translated to value today?

When we come to think of it many firms generate value daily by a rise in stock prices. A company which has just received a new project, which is believed to be profitable, announces the news to the public to be rewarded, in return, with an increase in stock price. This is NPV at play. Believing the project would indeed be profitable the market assigns a higher value to the company today. This is transforming NPV to value in the present.

There are four distinct ways of transforming NPV to value in the present:

1. An IPO – A classic way of transforming NPV to value in the present. An IPO is selling a share in the entrepreneur’s initiative to potential investors. These investors understand or estimate a certain future profitability in the project and are willing to pay a certain sum today in order to benefit from future cash flows.

2. Selling the project – Selling the project as a whole to another company is another way of translating NPV to value in the present. Another company might be able to increase the project’s value even further due to some other market failure (such as scale advantages for example). This company would be willing to pay the entrepreneurs a certain sum of money today against a potentially higher NPV.

3. Selling the idea – Selling the idea is much the same as selling the project. Lacking the tools to actually make a project happen an entrepreneur might sell the idea to another company. Obviously, the other company has those tools, again, as a result of the aforementioned market failures. The value received by the entrepreneur today would of course be lower.

4. A loan – An entrepreneur can receive a loan based on future cash flow forecasts for his initiative. This loan is value received today against NPV.

A very important and overlooked conclusion should be noted here. Taking a second look at the way NPV is transformed to value in the present leads us to it. The conditions to transforming NPV to value in the present are:

1. An efficient financial market – In order to price company stocks and value information an efficient financial market is required. NPV can not be tuned into value in the present if an IPO can not be performed or valuated correctly.

2. Access to financial markets – With out access to an efficient financial market the entrepreneur, again, can not transform NPV to value in the present.

3. The existence of diversified investors – This condition is not intuitive. In order to correctly valuate a project using NPV a discount rate should be available. Discount rates are actually proxies for risk in a project. Diversified investors ignore specific risks and take into account systematic risks only. As a result the discount rate used by the diversified investors would be the lowest and as such would result in the highest value possible for the project. With out diversified investors a proper discount rate can not be agreed upon and the NPV can not be transformed to value in the present.

The further circumstances are from meeting these conditions more caution should be taken in utilizing NPV as a financial tool.

Friday, March 7, 2008

10 Sure Ways to lose 50% of your investment

Before I start I want to thank the “baglady” for choosing my article on “practical reasons why you should learn a foreign language” to be first on this week’s carnival of personal finance. I apologize for the delay in posts. This week has been hectic. And now, without further delays my post on 10 sure ways to lose 50% of your investment.

#1 Have you heard of technical analysis? I’ve read this book and I’m really cashing in

Technical analysis is a method of using data on a financial asset’s past behavior to foresee future trends. Technical analysis has always been regarded suspiciously by academic scholars yet attracted a huge crowd of supporters amongst investors and traders.
In academic papers stocks are usually assumed to follow a pattern of “random walk”, meaning past price behavior can teach us nothing on the future. However, as markets are not perfect (read more on stock market efficiency) there is reason to believe technical analysis can present more information before reaching an investment decisions.
The important point here is that technical analysis, or any other investment or trading technique, can and should not be used alone as sole parameters for decisions. Regardless, technical analysis is very complicated and requires a deep understanding of statistics and sometimes finance.

#2 That analyst really knows his stuff. I’m going to act on his recommendations

Acting on analyst recommendations can cost you big time. Many analysts are amateurs. Others have conflicting interests and are selling what their investment bank just offered. Some are excellent. Can you tell who is who? As technical analysis analyst recommendations can be factored in a decision. They should not the only consideration to investing (more on analyst recommendations here)

#3 That stock can’t get any lower than that…

Buying a stock just because it has fallen sharply is a big mistake. The saying “don’t try to catch a falling knife” has turned out to be true many times. Sometimes, stock fall for no apparent good reason. However, we don’t have all the information which is often available to bigger investors who certainly know what they are doing when they’re selling that stock. Buying stocks which are traded at very low levels can prove profitable but this technique is often complimented by fundamental analysis and diversification.

#4 I think the (pick emerging market) stock exchange has a lot of potential

Emerging markets hold great potential. That is a fact. However, they hold great risk as well. And that’s another fact we don’t always pay attention to. A military coup, outrageous inflation, communist parties, lack of information, lack of transparency and what not are all very dangerous to investors. That’s why recommendations for investing in emerging market are usually at 8%-10% of your portfolio and diversified to at least 3-4 countries.

#5 If I hang on for just a bit more I’ll regain what I’ve lost

Holding on to losing stocks is a very human thing to do. We get attached to stocks and companies and refuse to let go even if contradicting facts get thrown in our faces. Set a limit. Sell. Don’t hang on desperately. There are many other opportunities just waiting for you to invest in them (wisely).

#6 I heard you can make 1,000% returns on investments in derivatives

The attraction of derivatives, mainly options and futures, are understandable. People enjoy a weekend in Vegas. If you’re gambling your money in derivatives instead of the roulette table everything’s good and you even save the plane ticket. However, if you consider yourself an investor use derivatives only to hedge and insure you portfolio. If you don’t know what that means you should be anywhere near these financial assets.

#7 I can’t make any serious money with diversification. I’m going to put all my eggs in one basket and watch it like a hawk

A common tip by investment gurus is to stock pick and avoid diversification if we want to get richer. Sadly, less than 0.000001% of the population has a proven ability to do that. If you like the odds go ahead. If you’re investing for retirement or college please diversify your portfolio (read more on diversification of risk in the stock market).

#8 Day trading is the life for me

I can just picture it know. Getting up late, staying in my pajamas, and slowly turning on the computer with a hot cup of coffee in my hand. That’s the life. Or is it? 90-95% of day traders lose (I believe the real numbers are much bigger).
Think about it. If it’s so easy (or even possible) why doesn’t everyone do it?
Do yourself a favor. Get a job.

#9 My friends are telling me clean-tech is the next hot sector

I don’t know if you’ve ever noticed but usually we follow trends not start them. If you could start a trend then you just might be able to can make a nice return on investment. Following one, however, insures everyone else will make a nice return on investment thanks to you.
There is a very good chance that if we hear of a trend market prices already reflect the information and there is not much to gain by investing in that particular trend.

#10 I’m a solid guy. I’m at ease only when my money is safely in my bank account

I had to finish with this one. Not investing your money (wisely) is one of the surest ways to lose in the long. You won’t lose your capital but you will lose potential return on investment. How do we invest wisely? A future post will try to answer this challenging question.