Wednesday, October 29, 2008

Making Investment Decisions Together Helps Avoid Common Investment Mistakes

Two heads are better than one

Most common investment mistakes are deeply rooted in psychology. Many of these mistakes can be avoided by allowing another person to take part in the process and by giving this person’s opinions and believes an equal weight in decisions taken.

This person could be anyone from an investment broker, a financial planner or a trusted friend. However, who is more appropriate and worthy to take part in such sensitive and significant decisions than your life partner.

At first, some might flinch at the thought of an inexperienced or unprofessional person suddenly participating in a process that clearly requires a certain level of understanding and proficiency. Others might claim a spouse has a natural and given right to affect the financial decisions of the household.

I believe both arguments hold certain truths. However, I intend to show how allowing another to take part in the financial decision process, more specifically when it comes to investments, common mistakes can be significantly lowered or avoided at all.

Furthermore, a deeper and more intimate relationship has a better chance at avoiding these mistakes due to the mutual respect and understanding between the two partners. This mutual respect will assure both opinions are heard and a decision will be made together.

As I’ve already stated most common investment mistakes are deeply rooted in psychology. Some mistakes are a result of over-optimism and of success oriented planning. Others are a result of our innate inability to recognize our own mistakes (or success at times).

The following are three general common investment mistakes and how they can be significantly reduced or avoided by allowing your significant other in the decision process:

#1 Planning for the wrong investment term

Many investors get their investment terms wrong, planning for either shorter or longer periods of investment. Getting the investment term wrong usually ends in loss either as a result of not taking enough risk or taking too much risk accordingly.

Deciding on your investment term with your partner may produce surprising results. You thought you had at least 5 years before having your first child; I assure you your future wife has other plans. You may suddenly discover your husband isn’t as happy at work as you thought and he is contemplating a career change which will require higher levels of liquidity.

Communication is an essential part of living together and it is also, in turn, an essential part of your mutual financial planning.

#2 Acting on impulse

Be it investing on trends or on hot tips, selling too soon or too late or making all or nothing decisions every investor has been there and made his share of mistakes. I believe we all had wished someone could have whispered a word of warning in our ears or had calmed us down before we made those hasty and costly decisions.

Another person actively taking part in the decision process is another voice of reason. Simply taking the time to consult will often be enough to prevent yet another spontaneous and costly decision. On a more humoristic note image your wife after you’ve just told her about a great tip you got from a friend. One sour face and an “I don’t like him” just might have caused you to forget you’ve ever thought about buying that great bio-tech company you’ve just heard about.

#3 Lack of self discipline

It’s a known fact that two people have more discipline than just one. One individual constantly rationalizes reality to suit his wants and needs, convincing himself of certain scenarios and reasons and acting on them only to find reality backfiring on him.

Two people serve as anchors to one another. If you’ve ever trained with another person you must know how harder it is to quit or give up on yourself.

Your significant other can really help you stand fast against deviating from your goals and your earlier decisions. In investment this counts for a lot as constant switching is costly in commissions and lost returns.

Naturally, there are many particular investment mistakes which could be classified under these three groups or any other generic list of mistakes. The important message I’ve tried to relay is that your partner is invaluable in the decision process.

Another, less known fact is that women are better investors than men. If you need proof just think about your TV watching habits, constantly zapping between stations (stocks?) never really making the most of a single show.

Consulting with your partner has real added value, even if it’s psychological and not professional. Who knows? they might like it and make it into a profession or a serious hobby.

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Friday, October 24, 2008

Senior Regulators to Senate: Surprised at the failure of Voluntary Regulation. Where They Really That Naïve?

".. for the imagination of man's heart is evil from his youth" (genesis 8:21)

Three senior regulators were apparently very surprised by the behavior of financial institutions and especially investment banks and the part they played in the current crisis. Where they really that naïve? I find it a bit hard to believe.

What the regulators had to say

Chris Cox, chairman of the Securities and Exchange Commission, said in congressional testimony Thursday that he and other regulators have learned many lessons, chiefly that "voluntary regulation does not work." Apparently Cox urged Congress to fill "regulatory gaps" that are still putting the economy at risk. "The lessons of the credit crisis all point to the need for strong and effective regulation, but without major holes or gaps." Cox said Congress should appoint a select committee to address the challenges of regulation on a comprehensive basis.

Alan Greenspan, former Fed chief, admitted he made a mistake in trusting the free markets to regulate themselves. Alan Greenspan said: 'I was shocked, because I have been going for 40 years or more with very considerable evidence that it was working exceptionally well.'

Where they really that naïve?

Apparently voluntary regulation does not work. That's a big surprise there, isn't it? Voluntary regulation is very much like asking a tiger to consider the implications of his hunting habits on the deer population. It's simply against his nature. Without proper enforcement will never work. They might as well have sent an email to financial institutions reading: we know you can make a lot of money but please take the time to stop and consider the possible unpleasant implications you making money might have. Oh and by the way invest millions of dollars in risk management sophisticated enough to actually manage the risks you're taking.

It's never that simple though. Regulators basically expected financial institutions to be professional enough to care about their own survival and to invest proper capital and effort into adequate risk management which should ultimately lead to a better competitive position in the market.

A financial institution which has the ability to manage its risks better can also properly price credit given thus asking for a higher risk premium from more risky clients. These clients, in turn, will obviously shop around for cheaper rates naturally offered by banks that lack the ability to properly price risks. The latter banks, in theory, should be the first to crumble under crisis.
The problem is that no CEO of a financial institution can afford to get left behind while other are cleaning up on the securitization of subprime mortgages and other exotic derivatives which apparently no one really understood.

Surely senior regulators understand how things work

In short, they do. We can't and mustn't trifle with these outstanding individuals who have obviously shown considerable talent and ability to get to where they are. What happened then?
I believe that much like other painful surprises the current crisis is a result of a certain conception of reality proven wrong. I believe the reasons behind the failure of intelligence and law enforcement agencies at 9/11 are similar in many ways to the reasons behind this crisis. When a certain concept or conception have taken place and hold over a group of people, from a couple to a country and the world, it is very difficult to break away from it.

Voluntary regulation, as a concept, has a lot of reason behind it as I explained earlier. The human mind has a tendency to let sleeping dogs lie and mark a big v sign on things that don't really need to be discussed again.

This sort of groupthink is common to many aspects of human lives. That is also why I hailed the Socratic Method in my previous post on the Gone Fishin' Portfolio.

I hold a deterministic point of view on life. I don't really believe this crisis could have been avoided as many many different streams converged into the river that is the credit crunch. Many smaller and bigger failures has to happen for a massive boom like this to happen.
Now that it has happen we are all experts in what should have been done and what needs to be done but all we are doing is preparing for the previous war when the next one will surely surprise us as well.

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Monday, October 20, 2008

Review: The Gone Fishin' Portfolio by Alex Green

The Gone Fishin' Portfolio offers a framework for saving, sound investment wisdom and no less important a step by step approach to their practical application up to a detailed asset allocation.

When I read through the first couple of chapters of The Gone Fishin' Portfolio by Alex Green I was surprised to find a philosophical reference to Plato's Apology and the Socratic Method. One of the bases of western philosophy, the Socratic Method dictates the constant inquiry of premises and assumptions and encourages an oppositional discussion as a path to knowledge. The Socratic Method is therefore a double-edged sword the author may end up facing himself. That was not the case.

Skepticism and the Socratic Method are a promising start to every book

As the story goes the Oracle of Delphi pointed Socrates out as the wisest of men (and women). Socrates, thinking it a paradox, set out to prove the Oracle wrong and turned to the wisest of Athenians who surely held knowledge that surpassed his own. Using his famous Socratic Method Socrates revealed none of these wise persons really held true knowledge as all failed to explain their concepts of truth, justice, good, beauty and happiness. Socrates found the oracle to be right as he was the only one aware of his ignorance, paradoxically making him the wisest of Athenians (He simply knew he didn't know). The author makes an equally strong argument when it comes to investing and managing our money.

The lesson Socrates had taught the world is a powerful and important one and when it comes to investing it seems we sometimes need a reminder. An author that advocates skepticism at the start of his book has already earned considerable credit in my eyes.

What is The Gone Fishin' Portfolio about exactly?

As aforementioned, much like Socrates, the author lays no claim to knowledge that is not available or is out of reach for all of us. The author quickly lays bare the claims of Wall-Street to "professional knowledge" which we, household investors lack. The case against professional money management is a bit strong, even demagogic at points but is essential for the author's main point. Managing our money isn't as complicated as other may want us to think.

The Gone Fishin' Portfolio is a book aimed at the household investor surrounded by never ending piles of knowledge leaving him (or her) even more confused and baffled. The book offers a simple and robust investment strategy that has proved itself over the long haul.

Much like Socrates and his paradox the author does not claim to hold knowledge of any special investment strategy which will enable us all to generate phantasmal abnormal returns. You will find no secrets to timing the market as there are none and you will be disappointed if you're looking for a safe riskless investment strategy that will generate return out of thin air (again, there is none).

The author simply turns to old investment wisdom that relies on the basics of finance. Long term investing, diversification, varying levels of correlation and wise asset allocation are fundamental to the approach offered by the author. That is also possibly the book's main shortfall. The book lacks in innovation but most certainly makes up for it in sound investment advice.

The book offers a specific portfolio and is aimed at the majority of household investors who wish to wisely invest their savings and spend as little time as possible maintaining them (which is, by the way, great advice for long term investors). The portfolio offered by the author is a sound one and is allocated very much accordingly to the text book.

The book offers more than just a portfolio. It offers a framework for those of us who seek a comfortable retirement and wish to balance the risk of a financial shortfall with the risk inherent to financial investments. It points out the conflicting interests many money managers face when dealing with out savings and sheds light on various financial truths with historical evidence.

I believe The Gone Fishin' Portfolio serves as a good financial education book and I would recommend it to those of us who are less proficient in finance and investments and are taking their first or second step in the saving world. For the more proficient of us who understand good asset allocation, the CAPM model, the importance of long term investing and discipline and the crucial difference between investing and trading this book might serve as a good reminder of the basics.

The book is well written even if a bit simplistic at some places. The author effectively repeats and stresses the main points brought forth and conveniently sums the essence of every chapter at the end.

What would Socrates ask after reading The Gone Fishin' Portfolio?

As the Socratic Method dictates I'd question two main issues. The first one is the level of risk offered in the portfolio. The author suggests a very detailed portfolio which comfortably enough leaves only with the buy command and yearly maintenance, which is really a breeze. The asset allocation offered is relatively aggressive with 70% stocks in the portfolio. That is very important for long term savers. Arguably, as the term of investment shortens it is important to consider the level of risk taken (read Long Term Investments Are Not Risk Free for more on the subject).

The second thing I'd question is the array of Vanguard mutual funds recommended. The author recommends, very wisely and objectively, to invest in index funds which are less costly in commissions when compared with managed mutual funds which have not proved to outperform the markets (on average, it's actually the other way around). The author recommends Vanguard funds in terms of cost effectiveness. I'd test this premise before investing but the concept of the portfolio is true enough.

The Gone Fishin' Portfolio apparently outperformed the S&P for the last 5 years but that is not something to take for granted (that is do not assume it will continue to do so in the future, as the author points out). Naturally the author does not promise the portfolio will outperform the S&P every year and he very well shouldn't. The strength of the Gone Fishin' Portfolio is in its utilization of basic investment wisdom of long term asset allocation and rebalancing which has proved itself in the past (read Know your Portfolio - Three Simple Charts Can Make a World of Difference for more on the subject).

Disclosure: Book reviews on The Personal Financier are entirely objective and are not paid for or sponsored in any way by the author, publisher or any other third party. The Personal Financier receives a 4% share of books sales referred by us which help support the efforts on this blog.

Friday, October 17, 2008

How I Saved $2,000 by Being Creative and What Else Did I Discover

The before and after pictures of my latest experiment are attached but there was so much more to the process.

The straw that broke this camel's back was a cream "oven painted" M.D.F bed and dresser priced at a whopping $2,400. We've been looking for a new bedroom for quite some time now but haven't really been able to find anything that suited our taste and was reasonably priced.

We've been looking for a relatively specific design and color which apparently are quite hard to find. Upon returning, yet again, to a couple of pricy "designer" furniture stores we finally stumbled on something minimal and acceptable in our eyes. Naturally it was priced like it was the last bedroom on earth.

I usually don’t mind paying a bit extra for quality and design. I have shared my view of frugality (or the extreme version of it) here at TPF (The Personal Financier) more than once and am usually far from being frugal (for good and bad). However, this time I was really upset by the obvious lack of value for money. A good design merits higher prices but proportionality is also very important. $2,400 for an M.D.F bed and dresser was a tad too much.

After a very short negotiation the sales person was willing to lower the price by $300. Needless to say that wasn't enough. On the way back the muse hit me on the head with a hammer. We had some time off this past week. Why not put it to good use with some old fashioned manual labor? There's nothing really wrong with the bed we have. Why not try and suit it to our needs?

If you've been reading TPF for a while now you must have read my post on Doing It Yourself Doesn't Always Pay - A Short Lesson Learned Yet Again. Well, apparently I had forgotten the lesson yet again and had set out on a quest to paint our bed myself.

I boldly marched into a hardware store and spent $70 on paint and supplies. If this works, I thought to myself, I just saved close to $2,000.

And much to my surprise it actually worked. I couldn't believe my eyes; the bed we've been looking for has been under our nose this entire time. It's potential waiting to be revealed. All it took was one coat of primer, a 15 hour wait, two coats of paint and one night spent sleeping on the floor. An adventure if you will.

There's something deeper to this whole experience aside to saving money, which is always great. It appears I've missed manual labor (a bit). There's something about creating, transforming and building that is important to the human soul. Papers and computers don't simply fail to fill that gap.

It's really amazing how our consciousness if molded by what we do. Being able to perform a very simple thing like painting a bed really altered the way I look at things. Maybe I don't need a new dining table after all?

As for the argument on the cost of lost or spent time for this effort see my post on Outsourcing Our Chores - Do We Overvalue Our Spare Time? There's isn't really a price for every spare hour we have. Even if there is I still think $2,000 is a pretty good price for two days work.

Wednesday, October 15, 2008

Dow Crashes and Burns, a Reckoning and more @ The Roundup

The customary weekly roundup

I really thought it would take more time to crash and burn again (How to Recognize a Bull Trap). The Dow had shed another 733 points in what I can only describe as indescribable. I didn’t expect wall-street to get all fidgety this fast. Some of the financial reports published by leading companies were not that bad at all and exceeded expectations. I guess sentiment on wall-street is just too bearish.

To start this roundup I’ve chosen to point out these articles from the NY Times and The Economist:

On to the past week’s carnivals:

The Carnival of Personal Finance #174 - The Columbus Day Edition was hosted by Greener Pastures, a young and promising blog on Frugality, Personal Finance, and Sustainability. My post The Credit Crisis Presents a Rare Opportunity for Learning and Experience was chosen as an Editor’s Pick! I enjoyed the following posts:

The 34th Money Hacks Carnival - Fall Into Savings was hosted by Where You
Are Now
featuring beautiful pictures of autumn and great posts:

More from fellow personal finance bloggers:

Monday, October 13, 2008

How to Recognize a Bull Trap

Listen carefully. Can you hear the snap? The sharpest daily surge in the Dow since 1932 will hopefully prove me wrong, although I doubt it.

It usually happens eventually, a strong (very strong) green day after a stormy streak of bright red days that surprised even the most pessimistic individuals. It just couldn't get any lower than this, could it?

Headlines everywhere quickly take comfort in the stock market rebound praising government intervention, the ingenious true fundamental investors and everything else that comes to mind. We did say manic-depressive at least a couple of times, haven't we?

As my readers probably know by now I usually feel more comfortable outside the herd. As such, I feel I have the responsibility to share other points of view. In this post I will discuss the (probable) possibility anyone hoping to ride any short-term up-trend amidst a bloody ocean of butchered stocks may very well find himself in the firm grasp of the infamous bull trap. I've also found interesting contradicting evidence which I will point out.

According to Investopedia a bull trap is "a false signal indicating that a declining trend in a stock or index has reversed and is heading upwards when, in fact, the security will continue to decline."

What Do Bull Traps Feel Like?

#1 There's supposed to be a period of treading in place

When you apply common sense to it you quickly understand markets don't simply reverse the trend just like that. Fundamentals and expectations need time and reasons to change. No government plan can really impact the market in a matter of days.

The market naturally moves in trends and reflects the group thinking of investors. Since market players are human as well I tend to believe markets reflect human psychology and as such move in distinct trends.

Before a choice of reversal is made a period of treading in place, hesitantly, often takes place. Some market players believe the recent change in trend maybe a good opportunity to buy while others think it's a good time to get rid of more stocks.

I find it very hard to believe the stock market suddenly reverses a trend in the way schools of fish or flocks of birds do.

#2 Corrections are to be expected

Corrections are to be expected when the market shifts violently in either direction. When we look at stock market charts these are quite visible and very common as market players test the environment and realize both profits and losses.

These corrections are comprised of various effects which ultimately add up to form either a bull or bear trap in a certain general trend. For example:

  • Short players are probably realizing the profits and taking a breather before plunging back in.
  • Fundamental investors are taking advantage of low stock prices and are buying another share of their favorite companies.

#3 After the manic the depressive will reappear

Even in times of crisis, good news find may their way to the financial headlines. In the current crisis we've had massive government interventions, $700 billion bailout plans, banking industry bailout, liquidity poured on markets like water, joint worldwide interest rate cuts and so far nothing.

Someone decided, that if the stock market is painted green something must be working and their choosing a headline accordingly: "government pledges bank aid; Dow jumps more than 900 points". A +11% move is awesome indeed.

What happened? Where'd all the depression go? Suddenly central banks have enough money and tools to solve the crisis in a day? One might say the crisis was uncalled for, and reason is back in the markets. I do hope that is the case but somehow I doubt it.

The less probable scenario

It just might be that our problems are solved. If central banks provide a solid foundation of liquidity and guarantees banks may feel comfortable to lend again and the wheels of the market will grind back to work.

Perhaps this was (rather than is) a financial markets crisis which the real economy suffered little from. I lack the experience to tell. Somehow I believe the previous scenario I painted is much more probable.

I promised contradicting evidence. In a post titled 10 Bullish Charts, Signals, Indicators @ The Big Picture very interesting evidence is brought forth to substantiate the claim the market has hit its low. One word of caution is in place, there are always some indicators which indicate exactly what you're looking for. It's very important to judge them for yourself.

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Saturday, October 11, 2008

From a Financial Crisis to a Real Crisis: The Makings of a Greek Tragedy?

Anyone else have that strange feeling a tsunami heading our way while we're idling on the beach? A discussion on the relation between the financial markets and the real economy.

The image seems fitting. The earthquake caused by the stock markets in the heart of the financial ocean will most likely unleash a tsunami that will rage all over the real economy. We've all witnesses the impact the credit crunch has on the financial markets. What's in store for us as far as the real economy goes?

Stock prices are supposed to reflect the values of companies. The value of companies is derived by their cash flow producing ability and the risk involved. If the value of a stock is greatly depreciated than we must assume either the risk of doing business is much higher or the cash flows to be generated are much lower (or both).

Lower cash flows and higher risk assume, in turn, that the economic environment is less supportive of the company's activities either in lower demand for the company's products or a higher cost of doing business (finance and credit) due to risk.

Higher Risks

This crisis is a bit different but it will eventually portray the same symptoms of any other recessions. The combined effects of a "credit crunch" and a huge liquidity shortage will eventually take their toll on companies. Credit is the oil in the market's motors. Without credit there really can't be any market activity.

Some of the very essence of business is the magic of using debt to generate value. Hardly any company has enough equity to do business. All companies borrow, simply because their business enables them to generate value over the cost of the money borrowed.
In the current crisis the cost of credit has risen dramatically for two main reasons:

  • The loss of trust in the markets - No one feels able enough to estimate the risk inherent in a certain company and as such cannot properly estimate and price the credit given. Financial institutions seem to prefer not to lend at all.

  • The lack of liquidity – These go hand in hand as the lack of liquidity forces each company to carefully consider who they conduct business with and who gets they cash leaving them with credit lines.

As a result the risk of doing business is dramatically enhanced thus effecting stock prices. Some companies may be very vulnerable to this phenomenon as they've leveraged themselves greatly with debt or operate under very low margin making their lives much harder.

Lower Demand

When people have less money they tend to spend less. This is a general rule the US has been able to side-step so far but it seems those days are gone, for now. We have less money when:

  • We have less money – a tautology indeed. When people lose capital they have less money.

  • We think they have less money – Even more important is how people perceive their financial situation.

Today all of us have less money and we also think we have less, both on a current and future basis. Most of us will probably tighten up our belts and closely monitor out outgoing cash flows. What economists call private consumption will take a hit and with it many companies who thrive on our shopping.

This will naturally have an impact on financial results of many companies further fueling the stock market crash.

From a Financial Crisis to a Real Crisis

The beauty of it is we've only just begun. The stock market, being what it is, supposedly already factors in all I've talked about and assumes both cash flows and risks have taken a turn for the worse assuming what I've written above will most probably happen.

All that is left is for us, and the economy, to play our small parts in the game. It's rather troubling when you think about it this way. Fate is already determined. Much like the tragedy of Oedipus who was prophesized to kill his father the king so are we marching on the path to recession.

Take a look at the following graph which details the lagged relation of unemployment and the stock market for a good example:

(I've found this chart in an interesting post @ Disciplined Approach to Investing)

Related Posts:

Image by: Roby Saltori

Monday, October 6, 2008

The Credit Crisis Presents a Rare Opportunity for Learning and Experience

For those of us who weren’t here to witness a crisis up close the current credit crunch offers a rare opportunity to learn

Experience is what separates the men from the boys and in the stock market experience is one of the most important success factors for investors.

In the past five years, stock markets around the world blossomed. The US markets showed solid returns, emerging markets throughout the world climbed to new highs the likes of which were not imagined. The High-tech industry returned with a bang and peace and happiness reigned in the land.

The old and battle hardened market players kept repeating one painful truth. The novices have yet to experience a real stock market crash. Young fund managers and investment brokers have been living a euphoric life in a loss free environment for too long. I remember reading many articles about the problematic atmosphere in trading rooms and brokerage firms living under the illusion, or hope more likely, that this market environment is here to stay.

There have been some people who even went the extra mile and claimed that the markets have become so efficient everything is already priced and factored into stock prices. If understanding the financial asset we bought was so complicated I guess we should never speak of this notion of efficiency ever again.

What’s the upside then?

Much like any other crisis there is value to be had. I’m not referring to the obvious (and very uncertain) potential for fabulous returns. I’m talking about experience. The experience this crisis offers us, as investors, is priceless.

Every day give us new insight and understanding into market mechanics and human psychology. The next time around we won’t be that surprised anymore.

What have we learned so far?

We learned to be more skeptics. Even the most advanced banks with the best personnel available were blinded by greed and indifference to risks. Their vast knowledge, capabilities and IT systems didn’t save them. Their controls faded like the wind and they all fell prey.

We learned not to worship those “know it all” brokers, analysts and consultants. The trend was their friend and when it suddenly changed they all stood baffled, staring blankly into the darkness.

We learned the media is really all about hypes. We learned that instead of encouraging debate and investigative reporting all we get are huge flashing red arrows and words like plummeted, catastrophe and crisis. The media lives and feeds of fear and so encourage it.

We learned that regulators will never have enough resources, manpower and abilities to really regulate. The industry will forever be one step ahead of the regulator while the latter fights to catch its breath. We learned governments act slowly or not at all (truth be told the US government worked surprisingly fast in this crisis).

We learned to regard rating agencies and financial reports with due care. We learned conflicts of interests are everywhere and that AAA doesn’t really stand for anything once market conditions change. We learned to lower our expectations when it comes to objective reviews which the company pays for.

We learned the market can turn on us in days and we’ll never see it coming. We learned we won’t notice we’re jumping with no parachute until it’s too late.

We learned no one really knows what’s going on in the markets. We learned fear and volatility are everywhere and how quickly the markets stop being about finance and economy and become totally dependent on psychology.

I’m very curious as to what we have yet to learn. Especially how the uptrend will return, sooner than we expect and as always, we won’t notice it until it’s too late.

Related posts:

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Sunday, October 5, 2008

New initiative, technical analysis & world on an edge @ The Roundup

The customary weekly roundup

It’s been a while since my last roundup. I’ve been trying my best to devote what free time I have to keep posting to the Personal Financier. I hope you find my posts to be at an adequate level. I’ve told you all about my new job (which takes about 65 hours of my time each week) and so I’ve reduced my posting frequency to twice a week.

As always I appreciate your comments and enjoy your emails. Please feel free to continue sending in your thoughts and questions.

In this roundup I’ve chosen to present some of the posts I enjoyed from fellow personal finance bloggers which I frequent:

First, I’d like to point out a new initiative by a blogger I highly value. The author of Quest For Four Pillars has set-up a new blog titles ABCs of Investing. This is a promising initiative I recommend to anyone who feels a bit insecure about his basic investing knowledge. This blog will offer two short and simple posts each week on various aspects of investing basics.

Here are my recommendations for this week:

And here are a couple of articles that caught my eye:

Saturday, October 4, 2008

Roller Coaster Ride in a Manic Depressive Stock Market: Researching the Option to Make a Quick Profit

I’ve decided on objectively researching the possibility of making a quick profit off the recent ups and downs. Here are the results

In the past couple of weeks I’ve written quite a bit on the manic-depressive behavior of the stock market and the possibility of making a quick, yet risky, profit from it. As I’ve described in length I avoided gambling on this phenomenon for various reasons.

I attributed my “success” at guessing the market’s direction in the day to come to various biases and luck. Usually when I do decide to make a short term move I more often lose money than make a profit.

Numbers are usually reliable and I turned to them to take an objective look at the phenomenon. Markets with high volatility (or “fear”) often act in a manic-depressive pattern sinking to new lows daily usually followed by a short rapid daily incline. I decided to test this out to see if it’s based on more than my feelings.

I’ve analyzed the S&P500’s behavior in the last 20 years and tried to make sense of the manic-depressive market. What I searched for is short term market behavior which suits what I described. In short: I searched for days with unusual negative or positive returns to see what happens in the following day.

I think we’ve all noticed how September presented us with several examples of daily negative returns of -4% and up which were followed by days with significant positive returns (only to return to the negative a day later).

My findings were quite interesting

My findings were quite interesting. The total number of trading days I analyzed was 5,230 in the past 20 years. In order to substantiate my findings I had to fine-tune “unusual” return. Therefore, in my analysis I looked for days in which the negative returns were lower than -2%, -3% and -4%. Then I conducted the same analysis for positive days in which returns were higher than 2%, 3% and 4%.

My first finding was very interesting itself. The numbers of days on each side of the spectrum (positive and negative) were amazingly quite the same. Out of 5,230 days of trading in the past 20 years:

  • 144 days generated negative returns lower than -2% vs. 143 days generating returns higher than 2%.

  • 35 days generated negative returns lower than -3% vs. 39 days generating returns higher than 3%.

  • 11 days generated negative returns lower than -4% vs. 14 days generating returns higher than 4%.

I love symmetry and the symmetry revealed on each side of the return spectrum is pretty interesting.

My second finding shows days which generated negative returns are more likely to be followed by days with positive returns. Trading days that generated positive returns have an almost 50% chance of being followed by another positive trading days. Trading days that generated negative returns have a much higher chance of producing a positive return the next trading day.

My third and most important finding shows that in accordance to our intuition the higher the impact in a certain day the higher the chance the next day will produce an opposite result.

  • A trading day which followed a trading day which generated returns lower than 2% had a 63% chance of generating a positive return.

  • A trading day which followed a trading day which generated returns lower than 3% had a 71% chance of generating a positive return.

  • A trading day which followed a trading day which generated returns lower than 4% had a whopping 91% chance of generating a positive return.

As aforementioned days which generated positive returns display a more averaged behavior:

  • A trading day which followed a trading day which generated returns higher than 2% had a 45% chance of generating a negative return.

  • A trading day which followed a trading day which generated returns higher than 3% had a 51% chance of generating a negative return.

  • A trading day which followed a trading day which generated returns higher than 4% had a 64% chance of generating a negative return.

What can be said really?

It appears the results are in accordance with our initial intuition although some results were more surprising than others.

An annoying paradox or built in flaw of this sort of research is that the rare phenomenon we’re looking for are, in fact, rare. As such any statistical induction would be highly inaccurate. It seems the pattern is in accordance with out intuition but it is suffice to look at yesterday to throw us back into blunder.

Yesterday was a negative trading day (even though it stated higher than +2%) which followed a pretty nasty trading day in which the S&P500 took a -3% dive.

The problem is that we, as investors, never invest in the average but in a specific day, period, portfolio, etc. Still I think this was a rather interesting experiment.

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Image by: gwburke2001