Friday, December 26, 2008

Is the Stock Market a Big Ponzi (Madoff) Scheme?

Looking into the notion of the western financial markets as a big pyramid scheme


I'm sure many of you are familiar with the tale of monkeys and villagers that cleverly demonstrates certain aspects of the stock market. Here's a short version for those of you who aren't.


Of moneys and pyramids


Once upon a time in a village, a man appeared and announced to the villagers that he would buy monkeys for $10 each. The villagers, seeing that there were many monkeys around, went out to the forest and started catching them. The man bought thousands at $10 and as supply started to diminish, the villagers stopped their effort. He further announced that he would now buy at $20. This renewed the efforts of the villagers and they started catching monkeys again. Soon the supply diminished even further and people started going back to their farms. The offer increased to $25 each and the supply of monkeys became so little that it was an effort to even see a monkey, let alone catch it! The man now announced that he would buy monkeys at $50! However, since he had to go to the city on some business, his assistant would now buy on behalf of him. In the absence of the man, the assistant told the villagers; “Look at all these monkeys in the big cage that the man has collected. I will sell them to you at $35 and when the man returns from the city, you can sell them to him for $50 each.” The villagers rounded up with all their savings and bought all the monkeys. Then they never saw the man nor his assistant, only monkeys everywhere!


At times such as the one we are experiencing now it is very tempting to claim the stock market and western market economics are all one big Ponzi scheme as Nassim Nicholas Taleb , the author of the black swan theory, recently did.


The western financial systems as Ponzi schemes


Mr. Taleb is a philosopher and a former derivatives trader, whose black swan theory deals, in a very insightful manner, with the affect powerful yet random occurrences may have in any field (a black swan as a large-impact, hard-to-predict, and rare event beyond the realm of normal expectations).

The sub-prime crisis and the following credit crisis are huge black swans for that matter. Nassim Taleb enjoys the reputation of one of the few who foresaw the crisis.

According to Mr. Taleb, as was stated in a recent interview, the western financial society is based on a pyramid scheme, much like the Ponzi or Madoff schemes. We needn't take this statement to the letter but rather regard it as a notion to consider.

As many philosophers before him, I believe Mr. Taleb is offering a fresh perspective on an existing notion, in this case financial markets, which we should use to review our set ways of thinking.

In the headline I chose I asked whether the stock market is just a Ponzi scheme, a headline that wrongs Mr. Taleb's argument. The stock market is a means to an end: a tool to raise capital. Mr. Taleb "goes after" the western financial system that failed us.

The main argument is that investment banks and brokers usually risk other people's money and benefit on the upside only. This is a powerful argument with the results of which we can't really argue.

The tools of the trade are often complicated models which justify what they were built to justify while ignoring other important parameters. The already known end is usually a bubble busting, one size or the other. Models are simplifications of reality, that is their strength and weakness. Every model must be taken with a pile of salt.

By increasing the level of risk taken with other people's money bubbles are cyclical and are destined to explode eventually. Since the human mind is not very adept at dealing with risks objectively and is apparently very good displaying herd behavior the markets simply follow this cyclical pattern with investment bankers making a fortune every other 6 years or so.
The pyramid element is very strong. If you can either time the trend, or better yet create it, then you're one of the lucky few who put their money first. Chances are that like many other household investors, we'd be too late to really enjoy the party. What can we do? Simply be there, reserved yet present, through the good times and the rough.


Being aware is already a good starting point


There's no need to adopt a fatalistic approach to financial markets and keep all our money in ultra solid investments. Being aware of market dynamics and the structure of our "western" markets is important for financial survival and to taking advantage of the benefits they do offer.
We all enjoy the possibilities our financial markets offer. Our pensions, for example, are dependent on the market's performance. Even with bubbles bursting and crisis manifesting markets have displayed positive returns in the long term.

There is a solid basis and economic justification for the western financial markets and obviously claiming they are all a big pyramid scheme is too extreme. There is truth to the argument as I've discussed but there obviously so much more.

As the cycle continues regulation will be enforced more firmly, the fear will keep the markets at bay. Still, as the economy starts expanding again the perceived level of risk will decline again and the bubble will burst again.

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Monday, December 22, 2008

The Carnival of Money Stories Edition #90 – Happy Holidays Edition

The 90th Edition of the Carnival of Money Stories Hosted @ The Personal Financier


Merry Christmas


Welcome readers to this edition of the carnival of money stories hosted here, at the personal financier.

This December the three dominant monotheistic religions are celebrating their holidays and I thought it would be appropriate to use it as a theme for this carnival. Happy holidays to all.

If this is your first time here, at The Personal Financier, welcome! Please check out my Top Posts and consider subscribing to RSS Updates.

The carnival of money stories is about personal experience and stories shared by bloggers. Here are the selected posts:


Editor's Choice


Silicon Valley Blogger presents Got Laid Off? What To Do When You Lose Your Job posted at The Digerati Life, relays her stories and some tips on handling a layoff in this excellent post.


Frugality


KCLau shares Christmas On A Budget posted at KCLau's Money Tips, or how to be frugal this christmas season with the economy down.

Nora Dunn presents Taco Tuesday: The Inner Mechanics of Budgeting on Vacation posted at Wise Bread, sitting around a table with a bunch of travelers enjoying Taco Tuesday, Nora saw something interesting happen...

Miss M presents Pets are Priceless (and Pricey) posted at M is for Money, even tried a cost benefit analysis of pets?


Career


Jeff Rose presents Four Options With Your 401k When Changing Jobs posted at Jeff Rose, sharing his recent experience on the matter.

Richard Taylor presents How to Find the Perfect Job for Yourself posted at Fun With Living Blog, a version of a cute little tale I heard before...

Living almost large presents No Raise this year posted at LivingAlmostLarge, unfortunately no raises in our firm either. Hope 2009 proves to be better.


Happy Hanukah

Other


vh presents Privacy: It's none of their business posted at Funny about Money, a good post on the psychology of phone interactions between companies and their consumers.

Mr Credit Card presents Living Without Debt, An Extreme Example posted at Ask Mr Credit Card, a story of the Economides family... interesting.

Lazy Man and Money presents Lazy Man's Gift Guide 2008 posted at Lazy Man and Money, I guess this post qualifies as a story as it has some useful experience. Some very good gift ideas indeed.

Single Guy Money presents 2009 Financial Goals posted at Single Guy Money, sharing his financial goals for 2009.

The Dough Roller presents Starting a Business During a Recession–A Real Life Story posted at The Dough Roller, a story of his good friend who just started a business in the middle of one of the worst recessions in our country's history. Good reading.

Intelligent Speculator presents Recharging Batteries posted at The Financial Blogger, sharing how he always takes a moment to look at what has been done during the current year and what is coming next in 2009.

FMF presents Money Stereotypes: The Dutch, Indians, Jews, and More! posted at Free Money Finance, shares his experiences with money stereotypes. Not very PC and very untrue.

Dollar Frugal presents Save Time by Taking the Earliest Appointment Possible posted at Dollar Frugal, great tactic. Adopted it a while ago.

The Smarter Wallet presents Don't Pay Full Price! Where To Find Bargain Gift Cards posted at The Smarter Wallet, learned of bargain gift cards. Just make sure you don't get more than you bargained for.

Patrick @ Cash Money Life presents Rules for Regifting posted at Cash Money Life, asking whether regifting an acceptable practice? I wouldn't go there. Too much social politics...


Credit

J. Savings presents USAA just hollered - They're raising my credit card rates! posted at Budgets are Sexy., sharing the ever true moral of the story: Read the letters your bank sends ya!

Chris Holdheide presents Financial Money Traps: How Your Credit Cards Can Get The Best Of You And How To Fix It posted at stumbleforward.com, sharing some bad credit card experience.


Happy Eid ul Adha

Investing


Tristan presents I Found Financial Freedom - And It Was Really Easy! posted at Find Financial Freedom, shares his plan for financial freedom - delayed gratification.

Curt presents Rebalancing My 401k posted at PennyJobs.com, catching a lucy break like this isn't easy. If you can't time the market (which is probable since we care about our 401k) lowering risk levels will hurt long term returns. The stock market is really the only option for long term savers to meet an adequate pension.

Michael Cohen presents Are TheStreet.com Ratings Great Contrarian Indicators? posted at Stock Investing Tips, asking whether snapshot ratings on sites like thestreet.com good indicators of what NOT to do. I think in such volatile times one cannot really judge any analyst (although I'm usually not very fond of them in general).

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Saturday, December 20, 2008

The Madoff scheme – 4 Valuable Lessons

As always scandals present valuable lessons for us household investors


When I heard for the first time about the alleged $50 Billion "Ponzi scheme" by Bernard Madoff I was not surprised. Not to say I had anticipated such a scheme or would have known it to be one had I invested my money. It's just that some things don't change.

There are valuable lessons to be learned here, as always. Greed, lack of regulation and oversight, groupthink and more make up this sad story. The next outrageous financial scandal will probably consist of these key elements as well.

Short term memory is one of humanity's banes. In this post I'll explore my view on the lessons we can all learn from the current Wall-Street affair in the hope of implementing these, or at least some, the next time around.

If you haven't had the chance to read how Madoff pulled this off there's a good slideshow on cnbc.com.

This $50 Billion scam raises many questions. One of the most interesting questions in my opinion is raised in light of the fact Madoff accepted only the rich and able to his small circle of investors. These investors have the duty and all the means at their disposal to properly examine the investments they make. If the most professional can't tell good investment from a scam how can we ever hope to?


#1 Groupthink, herd behavior or both

Groupthink is usually a phenomenon observed in groups in which group members try to minimize conflict and reach consensus without properly analyzing and evaluating ideas. The many investors in Madoff's fund may not constitute a group for this purpose but they have without a doubt displayed characteristics of groupthink.

Much like a herd they all followed willingly without asking too many questions and without due diligence on their investment. This human behavior pattern, which is apparently deeply rooted in us does not serve well when it comes to good investing.

Time is a limited resource and our mind simply happily accepts the opportunity to conveniently rely on the work of others. The large French banking group, Societe-general, for example, held a due diligence of their own on Madoff's fund deciding something doesn’t look right. All it took was a short analysis which apparently quickly revealed irregularities.

Such a due diligence would have quickly surfaced the fact the funds CPA firm consisted of 3 people operating from a one room office, according to some reports.


#2 Voluntary regulation takes one more boot to the head

What's left of the concept of voluntary regulation is going through more abuse. Institutional investors have proven their inability and incompetence yet another time. Apparently we've been paying many fund managers to simply follow the trends and simple let themselves get carried away by the tide.

We can't look to the credit rating agencies or to CPA firms for help as well. Credit rating agencies have too complicated models and interests and the CPA's often refer to themselves as watchdogs rather than hound dogs meaning if they'll see something they'll report it but other than don't get your hopes up.

Furthermore, private investment companies don't fall under SEC regulation meaning they can do whatever they want.

#3 Obvisouly, if it's too good to be true it probably is

Good deals scare me. Everything has a price and one should always understand the benefit for the other side. Only when I understand how the deal benefits the counterparty, either as a promotion, smaller yet positive margins etc., I calm down and go through with it.

We all get that sensation before we go though a really good deal or investment when we're already counting our profits in our head. Our thinking is usually success oriented or otherwise we wouldn't have accomplished anything but letting your head cool for a day or two before you go through the deal can't hurt. If there's value to the counterparty as well it can wait.

How could professionals really hope for 30 consecutive years of positive returns? One interesting view on this I read over the past week was that many investors knew something was fishy and hoped to gain on it as well. They hadn't dreamed they were on the receiving end of this mega-scam.


#4 Diversification – goes without saying

Even the most solid appearing, ever-gaining, investments can be quite risky due to specific risks. Specific risks are the risks inherent in any single investment and its business as well as fraud, bankruptcy and others.

The only way to avoid specific risks (and to remain with the systematic risk) is by diversifying. This message is repeated so often I can't really write about it anymore. Simply diversify.

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Saturday, December 13, 2008

Key psychological factors in stock market success

Psychology plays a key role in stock market success. Know these main key success factors. This is a repost of one of my favored posts.



Much has been written on the part of psychology in stock market success. We've all witnessed recently just how crazy the markets can get.

These lessons in psychology are probably the easiest to learn and hardest to implement since they actually go against how we are "programmed", as humans. There are reasons for our behavior, probably good ones but in the stock markets we need to adopt a whole other state of mind to succeed.

Psychology is everywhere in the stock market and effects all from the novice to the most professional (aside for computers). The two common most repeated advice in investing: making long term investments and diversifying the portfolio are good advice which have also stemmed from the need to guard against mistakes caused by our psychological biases.

Many investors make the same mistakes over and over again. Mistakes such as: selling profitable stocks too soon, holding on to losing stocks forever or lacking the discipline to stay in the market and avoid frequent buying and selling are all a result of poor understanding of key psychological factors required to succeed in the stock market.

Knowing the enemy is the first part in defeating it. So, with our further introductions, here are the common psychological factors at play in the stock market:

Anchoring

Anchoring is a psychological phenomenon in which one judges data (a stock price or exchange rate) by comparing it to a certain anchored similar data. Is 1 euro for 1.4 $ expansive? Since it has been cheaper we tend to think it is more expansive now, but is it? Just because market prices are high it does not mean they can't get any higher.

Biased risk avoidance

Kahneman and Tversky have shown people tend to avoid risk in potential profits and prefer risks in potential losses (preferring a raffle to a certain loss for example). One must always consider the investment at hand from a statistical point of view regardless of irrationality forced by our minds at times.

Over confidence

A common psychological factor in investment is over confidence. We're always sure we're going to beat the market. Our investments are always good ones. We often accredit more to known factors about a stock then to the unknown and take little of the unknown into consideration.


Lack of self discipline

Be disciplined in your investment or trading techniques. Be consistent in your decisions and do not be afraid to back them up. Do not allow yourself to be intimidated and weakened by every event in the market. If you in there for the long term: stay there. If you have a stoploss use it.

Lack of self confidence

Trust your experience and instincts (if they've proved to be right so far). Do not be afraid to follow what seems to be a promising investment and do not rush to sell when you've gained some return on investment. Believe in your analysis and in your decisions.

Lack of patience

Successful investing requires patience. Do not have a peek at your portfolio's performance every other minute. Investing for the long term requires years to generate those fabulous high returns we always hear about.

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Saturday, December 6, 2008

Is This the Opportunity of a Lifetime?

Does the current crisis pose the opportunity of a lifetime?


Lately I've noticed a change in attitude. It just might be my wishful thinking, and I certainly don't have any objective data to support this feeling but I think something is shifting.


Considerably more articles are concentrating on the opportunity part of the current crisis rather than the massive losses we've all experienced. Many columnists are carefully discussing the relative sanity of current stock prices and the high risk premium they're trading in.


Opportunities are everywhere


Diversification didn't help much during this crisis. It rained, and we all got wet. The economic environment that preceded this crisis had hypothesized emerging markets like China, Brazil, Russia and others are strong enough to keep world economic growth going even should the US economy weaken considerably.


It seems we can lay that hypothesis to rest, at least for the upcoming decade or two. Globalization, for good or bad, has created many co-dependencies, one of which is the innate inability to actually properly diversify ourselves.


As I've discussed in the past the goal of diversification is to lower specific risks in investment leaving only the systematic risk which cannot be diversified. It seems that due to the co-dependencies of economies worldwide the systematic risk has actually risen.


This will work the other way around as well. In times of economic growth investments everywhere will show growth. Whether in real-estate, stocks, commodities or others, eventually growth will get there as well.


It is more probable than not, in my opinion, that every dollar invested today will grow considerably in 5 years time. The economy is cyclical and what goes up eventually goes down, and vice versa.


The more pressing question is: Would better opportunities present themselves in two months time?


No one can really answer this question but I certainly feel the tide changing. If you remember previous discussion I've always thought that reduced volatility in trading will be one of the predicators to the first steps out of this crisis. We're not there yet.

The good news is the stock market is a lot more like a speeding bus and a lot less like a light bulb. It's not an on/off, 1 or 0 thing. If you see the bus begin to speed away you can still catch it. Losing the first 10% (or more likely 30%) of price shifts is a relatively small price to pay for more quiet and peace of mind.


The problem: Most of us don't have the privilege or investing the Warren Buffet way


Attempting to be fearful when others are greedy is relatively easy. Being greedy when others are fearful is the tricky part.

I believe any investment made today will very probably generate generous returns in 5 years time. The problem is I don't have enough money to commit myself for such an investment term.
Furthermore, and much more frustrating, had I had $100,000 more I still wouldn't feel secure enough to risk more than 30% of that sum. Being greedy when others are fearful is a privilege for individuals and companies with very deep pockets.

It kind of reminds me of that statistical "trick" played in casinos, for examples, where you simply double your previous bet to earn the initial sum you'd bet on. For example, you bet $1, lose it, then bet $2, lose those and then bet $4 to win another $4. You net gain is $1. The problem is that this geometric column advances in a scary pace (2 in the power of …). Try to deploy this strategy and you'll find yourself betting $256 in 8 turns or $1,024 in ten.


What can we hope for as household investors?


Household investors should stick to basic principles when it comes to stock investments (I guess you've read these before so I'll try and emphasize the more important aspects. If you'd like to explore more please browse my investing section or top posts):


#1 Stock investing is a long term commitment

Even though prices seem relatively inviting the market can quickly turn around again. For long term investors the economic environment is relatively enticing. Prices have reached a level which prices the risk far better than a year ago; some might say pricing too much risk.

Keep in mind you'll probably face more crisis along the way. The clean-tech bubble, the Chinese bubble, or what not (who knows). It takes quite a stomach to being a long term investor.


#2 Dollar cost averaging can really help off-set some of the risk

Although academic researchers and finance professors disagree on this somewhat it seems spreading your investments over a certain period helps off set the risks associated while also lowering potential return (this should be clear).

I've written a more detailed post on dollar cost averaging which shows how it helped even out returns for investors in the US and Japan (where the market has been performing poorly for 20 years).

The market environment is currently very interesting for those who seek to start investing slowly, a certain amount each time. Prices are relatively low and should they drop more you've got yourself a better price for you next investment.


#3 Diversification and asset allocation

As mentioned diversification can't help much when it comes to a crisis such as this. Still it's far better to lose the average market loss than lose 90% in any given stock. Diversification, together with asset allocation helps in building a more robust portfolio to better withstand shocks.


Avoiding risk altogether is not an option


Extreme risk aversion is not the answer. In Extreme Risk Aversion Paradoxically Leads to Another Huge Risk I discussed why avoiding stock investments altogether creates another significant risk, that of failing to meet our financial goals, especially our retirement goal.
Stock investments are the only tool which can really provide the added value much needed in long-term savings. A 2% difference in the average yearly return is most significant and practically dictates a whole other lifestyle in retirement.

I promised to keep you updated when I make my move back in the market. I'm usually a terrible proxy and would advise you to sell the moment I buy but it'll make for an interesting, and more importantly long term experiment.


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