Blame the Models? Take a Good Look in the Mirror

Is financial modeling to blame for the recent crisis? As always the fault does not lie with the tool but rather with the user. When was the last time you took a look at the validity of Net Present Value or Option Pricing?

The recent, or ongoing, financial crisis has been attributed, amongst other things, to over reliance on quantitative financial models which replaced good business judgment instead of supporting it.

The reason behind the failure of models wasn't simply poor modeling, for the most part. The main reason was poor business and risk management processes which placed blind faith in the models.

In this post I begin to explore the reasons why financial modeling increased the severity of the recent crisis and more importantly, what are the lessons we can implement to our personal finances?

The need for Financial Modeling

With the development of computing power advanced mathematical models enabled the creation of complex new financial instruments and professions such as financial engineering. Mathematicians and statisticians found their way to investment banks and hedge funds due to the increased demand and profitability of these endeavors.

These financial instruments included, for the most part, new underlying assets, that require complex financial models to model their pricing and behavior. Financial models which sadly broke during the recent crisis.

That is not to say that financial engineering and the use of models have been proven unsuitable for the financial markets. Much on the contrary, financial engineering and complex financial instruments help, in many cases, to increase the level of perfection in the market and ease the transfer of undesirable risks from one party to the other.

Models as a Representation of Reality

A Model, by its definition, is a representation of reality. Economics, for example, as any 1^st year student knows is based on very simple models of production, supply, demand and price. The strength and importance of these models is their ability to explain economic behavior even under very simplistic assumptions.

Think of the prisoner's dilemma in game theory or Nash's equilibrium which are very simple models that won their authors Noble Prizes. The beauty of the model is its ability to represent reality with a very limited framework.

As modeling advances assumptions are slowly removed creating more and more complex models which require a better understanding of the mathematic complexity. The reason is simple, the more "free" parameters the model needs to explain the higher the complexity.

Naturally, when dealing with financial instruments and their fair value pricing, models need to explain as much of the price as possible to adequately represent the fair value of the instrument. As such, models have grown quite complex as room for assumptions is very small.

What went wrong?

Before we get too judgmental let's consider the simple, commonly used model of Net Present Value. Net present value is a model used to determine how much a certain stream of cash flows is worth today – or, the present value of the cash flow.

Net Present Value is commonly used to determine the economic sense behind undertaking certain projects and investments. All those in the finance profession, as well as personal finance enthusiasts have probably tried to determine the net present value of a certain undertaking. The problem starts when you dig deeper into the model.

Most people are not aware Net Present Value assumes the following due to the very central role of the cost of capital in the model (further reading on NPV is available here):

• The existence of an efficient financial market – In order to price correctly an efficient financial market is required. NPV cannot be turned into value in the present if an IPO cannot be performed or valuated correctly.
  
  
• Access to financial markets– Without access to an efficient financial market the entrepreneur, again, cannot transform NPV to value in the present.
  
  
• The existence of diversified investors – Adequate pricing of the cost of capital can only be performed by ignoring the specific risk of the investment. A diversified investor, in finance, sees only the market risk when investing (the reason being a diversified portfolio will stay diversified even after investing in this particular project, for example).

When was the last time the Net Present Value calculation you had performed met these requirements? My guess is never.

The model is a helpful tool but the underlying assumptions and limitation cannot be ignored.

The reason behind why many of the financial models broke has to do with the assumption of liquidity and volume in the markets. Pricing models are built to price instruments under a normal market environment, as part of the normal course of business. When stressed scenarios occur the assumptions behind the models cease to exist and the model breaks.

• Black and Scholes model very commonly used for option pricing assumes normal distribution of returns (Not true, obviously).
  
  
• The CAPM Model (Capital asset pricing) which is a corner stone in asset allocation is based, again, on normal distribution of returns but also assumes, amongst others, the following highly debatable assumptions: Perfect availability of information, No taxes or transaction costs and a market portfolio which includes all types of assets (!).

With no liquidity in the markets strange phenomenon start to take place, phenomenon which cannot be analyzed through modeling but rather through good judgment and independent thinking.

The Importance of an Adequate Process

The role of an adequate risk management process cannot be overstated. Financial modeling is a tool, nothing more (and nothing less).

Like any tool the one who uses it needs to understand its capabilities and its limitations. Model limitations are inherent as they are, and only can be, a representation of reality.

Financial modeling will not go away. The need is too strong. What does need to happen is the implementation of robust risk management processes which will continue to remind what are the assumptions and limitation of the models and what the proposed mitigations against these limitations are.

The wisdom of the ancient Greek philosopher Socrates is a fitting quote: "I know that I know nothing" he said, not because he knew nothing because he didn't claim perfect knowledge. A humble state of mind is a very good start.

Related Posts:

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• What is the Recommended Investment Strategy for Household Investors?
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• The Big Mac Index – Applying Simple Economic Common Sense
• Would You Be Willing To Pay 60% Tax For a Higher Level of Social Equality?

Dow Hits 13 Month High on Decision to Keep Aid Flowing to the World Economy

My fundemental reasons for concern

As several of my last posts indicate I have whole heartedly adopted Dollar Cost Averaging as my investment strategy. The reasons have been discussed in length a few posts ago.

Today I thought about liquidating some of the investments I've made in the past 6 months due to the negative vibe in the market encouraged by leading economists and investment gurus such as Noriel Roubini, George Soros and Bill Gross who all attribute a certain bubbly taint in the markets.

Good thing I didn’t. I might, though, tomorrow.

The reason that kept me from selling today was my attempt at disciplined investing and self restraint. Still, my fear of a near drop in stock prices only grew today. The reasons for my fears are:

The low interest rate environment as a catalyst to bubbles – Low interest rate drives investors wild. Risk appetite is gradually growing seeking alternative means of generating returns slowly yet surely forgetting the risks involved. In a 0.25% interest rate environment an 8% return reflects a 7.75% (!) risk premium. We must not forget that.

Many stocks have regain past losses and some are close to 2007 levels than ever before – There is no sign the economic growth is stable enough for the long term to justify such a prices level.

The markets are running on the government expense fuel – Bank earnings and growth is generated mainly through increase government expense with no signs of private sector backing or growth. How long can governments keep this up?

Fear of stagflation is real – Stagflation, the situation in which both inflation and economic stagnation are present is more and more a reality with each passing day. Price levels are bound to rise eventually due the huge amount of money being dumped on the markets by the government. Eventually the weak dollar may get weaker while the economy hasn't regained in full (again, very dependent on government expense).

Technical analysis points to diminishing volume of trade in recent stock price increase – The trade volume does not support the trend. This is cause for concern from a technical analysis perspective. Just look at the trade volume today.

The markets rejoice as government aid continues. This is a risky game. Any market position, whether short or long is a risky wager. I'm seriously thinking of adapting my strategy for the short term. Tomorrow I plan on restarting my dollar cost averaging after realizing some of the gains I had made during the past 6 months.

Related Posts:

• Dollar Cost Averaging – Practical Lessons From Recent Experience
• What is the Recommended Investment Strategy for Household Investors?
• How Should Households Invest? Sharing My Asset Allocation
• Stock Surges Are Usually Unexpected – How To Make Sure You Won't Miss Out

Dollar Cost Averaging – Practical Lessons From Recent Experience

My recent experience with Dollar Cost Averaging and the lessons I learned

Several posts ago I discussed my considerations on Dollar Cost Averaging and why I had selected it as my long term investment strategy.

I've been at it for 4 months and have shown the necessary self restraint, avoiding any impulse buying and selling and sticking to my original investment plan which includes investing a fixed, identical sum at the start of every month into a well diversified ETF portfolio.

It hasn't been as easy as it may seem. This is a good indication on my part. "Easy" usually doesn't lead to good results.

After short 4 months I've already learned several lessons I'd like to share in case some of you have decided to try Dollar Cost Averaging as well.

Lesson #1 - Speaking about self discipline and exercising it are two different matters

The idea is simple. Invest a fixed sum of money at each given period and average out sharp movements in asset prices. Drops in prices will be smoothed out by investments made during times of low prices (and the other way around as well, of course). Dollar Cost Averaging exposes an investor to less risk and therefore less return.

The challenge begins when we decide to implement Dollar Cost Averaging. When we save for retirement we usually take the money invested each period as a given and constant sum which we don't really have to think consider since this is a life term investment.

When investing our monthly savings things change. The level of commitment required from us is higher as we are in control of the funds invested. Suddenly we have to make the investment ourselves; committing to the asset of our choice and accepting the fact we are locking money for the long term.

Keeping to Dollar Cost Averaging when markets are peaking is challenging as well. Investing when you are sure the market faces a breather and a period of earning realizations is not an easy feat.

It is important to keep in mind our initial investment strategy and stray as little as possible. Remember why you adopted it at the first place. So far I've been able to keep to decision making but it was not as easy as I had though it to be.

Lesson #2 - Timing the markets is inherent in our psychology and is difficult to root out

I simply can't avoid timing the markets. Dollar Cost Averaging is probably one of the investment strategies which offer the most temptation to time the market as investments are made periodically.

Think of a scenario in which the market has rallied for 3 months (Like the past 3 months). Would invest, yet again, knowing full well the market is scheduled to take a breather? The same goes for bearish markets during which the temptation to buy more increases significantly.

Again self discipline is crucial for succeeding. Deciding to utilize Dollar Cost Averaging means abandoning the effort to time the market and recognizing them to be futile.

Lesson #3 - The long term is an obscure concept which is counter-intuitive to the human psychology

Again, my experience has taught me the long-term is one of the most obscure concepts in investing. Often mentioned but only rarely understood.

I believe long term investment actually contradicts human psychology and is very hard to maintain. When managing your own portfolio the urge to keep tabs is enormous. I haven't met anyone who can resist the temptation to monitor the portfolio daily or at best weekly or monthly.

In all sincerity, we may say long term but hope for short term. Again, self discipline and restraint are key traits for success.

In the meantime, and due to my rather lucky starting point I've managed to generate just over 10% in returns over the past 4 months which have been exceptionally well. I hope for a long term average of a yearly return of 6%.

Related Posts:

• What is the Recommended Investment Strategy for Household Investors?
• How Should Households Invest? Sharing My Asset Allocation
• Stock Surges Are Usually Unexpected – How To Make Sure You Won't Miss Out
• Know your Portfolio - Three Simple Charts Can Make a World of Difference
• Diversifying your risk in the stock market
• Key psychological factors in stock market success
  
  

Buy on the Rumor – Sell on the News: Our Psychology at Work

A counter intuitive rule of thumb explained

Rumors of new products, earnings, takeovers and mergers immediately raise share prices. This is understandable as the value of the company is expected to rise as a result and so investors who believe the rumor to be true (or true enough) can buy on the rumor with the hope of generate significant returns in a short time.

Sell on the news is more intriguing. Usually this tested rule of thumb works. Many times after the news the share’s price shows signs of uncertainty and fear of the recent height it had attained. The reasons why can shed some light on how our psychologies play yet another trick on us.

Shouldn’t buying on the news be more appealing?

Solid investors should not buy on the rumor. Rumors have a tendency to turn out to be false and the share’s price soon follows to previous or lower levels. Still, buying on the news is more often than not too late for any short-term profit. Shouldn’t buying on the news be more appealing?

It seems rumors excite the imagination of investors so that by the time the news gets out it’s often disappointing by the mere fact it is grounded to a certain reality. I think something deeper, rooted in our psychology is at work, and I will expand on it shortly.

For the value investor buying on the news is the sound path for the long term. It is understandable how buying on the rumor may generate higher short-term returns as the associated risk is much higher since rumors may turn out to be false. Still, if you are not a speculator look for the hidden value in the news.

It is important to remember that many times the thought or idea of a certain takeover or merger is more exciting than the actual results. As we know everything is personal and merging two companies, two boards and two managements is hardly an easy task. An idea of a merger may be brilliant at first but if the operational and practical side is weak the merger is doomed.

Buy on the rumor sell on the news – the psychology at work

The more interesting aspect of buy on the rumor – sell on the news is the psychological aspect at play. This rule gives us another good example of how fragile our minds are and why the market is a place for the more rational.

Over and under corrections and the confidence bias – Think of the first think that comes to your mind when you hear a rumor regarding a company. We all believe the share prices will sky rocket and are sorry for missing the opportunity. A rumor of an opportunity has a very strong effect on us. Our psychology usually leads us to see the up side of such an event ignoring the limits and limitations that exist. Our optimistic view is quickly generated into a peak in the share’s price only to later face reality and correct the price back downwards to reflect reality and overshooting.

Expectations and reward pursuit – Strangely enough we seem to value some thing more when we wait for it to come true than we do when it finally does. This psychological bias has been demonstrated in research and is rather intuitive once you consider it.

When you plan a trip and consider all the wonderful activities you will enjoy your perceived utility is much higher than it actually is when participating in these activities. When expecting a raise, for example, its perceived value is higher than when you’ve already received it. The mechanism seems to be intuitive as well. Evolution has programmed us to constantly seek new rewards and never settle for what we already achieved.

Therefore, the perceived value of a certain rumor is more often higher than the actually value once it turns out to be true.

Psychology and investing go hand in hand. I find this connection fascinating and I’ve written quite a few posts about it exploring the different aspects and tricks our minds play on us. We can’t always control our psychologies but we can try to offset some of the bias and use it for our benefit.

Related posts:

• Challenging Happiness – Exploring the Irony of Human Nature


• Behavioral Finance in Everyday Life – The Lottery as a Case Study


• Is Rationalization the Key to Happiness?


• How Can they Possibly Afford That? Or Is Money in the Eye of the Beholder?


• Coming To Terms with Never Getting Rich – A Look at the Pre-Requirements
  

Diversification is Dead. Long live Diversification

Don’t give up on diversification through asset allocation just yet

A short introduction to asset allocation and diversification

Assets allocation is said to be the optimal investment method for household investors. As household investors we lack both the time and knowledge to handpick assets and build and maintain a long term investment portfolio on our own. Unless you have a significant enough portfolio brokers and financial consultants will also professionally manage your portfolio through one asset allocation or another.

Asset allocation relies on diversification and the benefits it presents. If finance diversification is aimed to lower the specific risks of an investment and capture only the market risk, which cannot be eliminated. Specific risks are the risks associated with a single investment and include the risk the company we invested in will lose a major client, for example, or lose their successful CEO.

Diversifying is aimed to maximize the return with a given level of risk. The math behind this model is based on the correlation between the assets we invest in and this is one of the ways portfolios are built.

The bad news

If you’ve managed such a diversified and allocated portfolio over the past couple of years you must have noticed diversification didn’t quite work, to say the least. Each and every portfolio crashed and burned, regardless of the asset allocation (unless you went short on the market).

All major stock indices, commodities, oil and almost every asset that comes to mind plummeted. Diversification over assets, geographies and currencies hasn’t saved our portfolios from significant losses.

Some hoped that the emerging markets will be strong enough and independent enough to balance out the devastating impact of the recent crisis. Another economic motor would have created two semi-correlated financial drivers which might have offset some of the damages. It appears that it is too early to nominate China (and the European Union) as the next economic powers that be.

The reasons may be abundant but it seems that with globalization came increased correlation between assets and swept our precious diversification away. What are we to do now? How can household investors invest in such a turbulent market atmosphere?

Well, aside from increasing the risk free asset portion of the portfolio (such as deposits and government bonds) I believe there are also good news to be had.

The good news

First and foremost what crashed and burned together would probably rise back together. As such, anything we’ll put our hands and money on will probably generate decent returns on the upcoming investment horizon.

Some of us remember the good times back at 2005-2007 where all the assets generated decent returns and stock picking was never as needless.

Moreover, on the geo-political side of things, the increased co-dependence between our countries’ economies will hopefully lead to increased cooperation and mutual consideration of our impacts on one another.

How should households invest?

I’ve tried answering this question in my previous posts. I’m still a big supporter of good asset allocation. As I’ve written before good asset allocation includes allocation of investments over time not just over assets. Time allocation or dollar cost averaging helps us smooth the behavior of our portfolio by constantly averaging the buying price of shares and bonds.

I believe that other markets will emerge as economic engines of growth and will hopefully serve the world economy alongside the USA.

Related Posts:

• What is the Recommended Investment Strategy for Household Investors?
• How Should Households Invest? Sharing My Asset Allocation
• Stock Surges Are Usually Unexpected – How To Make Sure You Won't Miss Out
• Know your Portfolio - Three Simple Charts Can Make a World of Difference
• Diversifying your risk in the stock market
• Key psychological factors in stock market success
• Tips for young investors
• Comparing Bonds Vs. Stock as an investment

How Should Households Invest? Sharing My Asset Allocation

Investing without an asset allocation in mind is more likely gambling than actual investing

A sound asset allocation is a key component in any investment portfolio. To put it bluntly investing without an asset allocation in mind is more likely gambling than actual investing.

Two weeks ago I wrote about my decision to gradually increase my exposure to the stock market as the low interest rate levels make it impossible to generate any real return on investment. Some may say low interest rates are a poor advisor. Still, I am quite confident in my decision to increase exposure to stocks in the long term using dollar cost averaging.

Having made up my mind on the question of when I turned to the question of what should I invest in or in other words: what would be a good asset allocation for me?

Asset allocation actually answers the very basic question of investing: What is the return I expect on my investment and, hand in hand, what is the risk I am willing to take?

A short introduction to asset allocation

I feel a short introduction is in order for those less familiar with the concept of asset allocation. I will avoid a deeper methodological discussion at this time.

Asset allocation is the strategy chosen by an investor to distribute his or her investment portfolio among various financial assets to achieve the investment goals. Asset allocation is the corner stone to investing.

Asset allocation has several goals the most important of which is to express the risk appetite of the investor in terms of allocation of funds to different financial assets through which the investment will achieve its goal taking into account the risk involved.

In finance theory, asset allocation is a means of minimizing the specific risk a certain financial asset has. Since various financial assets are not perfectly correlated diversification of the portfolio to several financial assets may (and perhaps should) result in a portfolio which is complete diversified with as little specific risk as possible (specific risk is the risk a certain stock has such as the death of a successful CEO). The diversified portfolio remains with the market risk only – the risk that characterizes the entire market.

Assets may and should be allocated according to several parameters for adequate diversification:

• The level of risk of the financial asset – From derivatives to government bonds financial assets holds varying levels of risk. Through asset allocation one risky instrument may offset another.
  
  

• Specific characteristics of the financial asset (usually associated with risk) – Stocks of different types vary immensely in risk and return. Large-caps are usually considered more conservative while small-cap or emerging markets are traditionally considered riskier. Risk levels in bonds vary as well with government bonds on the safer side (depends on government of course) and high-yield junk bonds are sometimes riskier than stocks.
  
  

• Foreign currencies – Allocation across currencies is important as well to reduce exposure to a single currency and increase exposure to other powerful or promising currencies.
  
  

• Other parameters such as industries, geographies, commodities, real estate and more.
  Asset allocation holds infinite possibilities. The guideline, as I mentioned, should be the risk appetite of the investor.

My asset allocation

If you've read my previous post on my decision to return to stocks you are aware of my choice to invest through ETF's and index funds. I believe that household investors with as little time on their hands to manage investments should not try to identify value investments in stocks simply because we don't have the time.

Chances of beating the market are slim to none so my recommendation to household investors, such as myself is to join the market (other than try and beat it).

Thus the allocation I will present will be achieved through investing in ETF's and index funds which track a certain index which suits my desired allocation.

It is important to remember that the following allocation is one I built for my own risk appetite and financial situation. Is may serve as an example but should be adapted for anyone else. The purpose of this post is to share my investment management with my readers.

The following is the asset allocation I have chosen for my investment portfolio:

I plan on reaching this asset allocation within 6 months of gradually increasing my exposure to ETF's and index funds in each category.

My considerations for choosing this asset allocation

My considerations for allocating my assets as such are comprised of the following:

I believe the US will emerge first from the current crisis with Europe lagging behind. I believe that the US economy is much more flexible and open to allow for rapid return to growth. The European economy is heavier and less flexible and will suffer more through the coming period. The level of money printed by the US government and the low interest rate environment are frightening as inflation my quickly be upon us. Still, I believe the US economy is resilient enough to withstand such impacts. Hopefully the situation would allow for rapid correction of interest rates to combat inflation after growth has been achieved.

Emerging markets present a long term opportunity which I would hate to miss. This is quite a risky investment but for the longer term (over 15 years) emerging markets such as China, India and others look very promising.

The financial sectors should rebound first if it survives. Banks are usually the first to capitalize on return to growth through credit issued and investments made.

As I mentioned I don't believe in beating the markets so I've decided to join them by investing the rest in ETF's and index funds which track country leading indices such as the S&P500, FTSE, DAX and others.

Monitoring my asset allocation

Setting up an asset allocation is not enough. As values of assets change the allocation shifts. Imagine a strong bullish period in stock markets. The percentage of investment in stock increases as stocks rise thus slowly shifting your asset allocation towards this instrument.
I've written a post in the past on how to monitor a portfolio which I strongly recommend as a supplement to this post.

Related Posts:

• What is the Recommended Investment Strategy for Household Investors?
• Stock Surges Are Usually Unexpected – How To Make Sure You Won't Miss Out
• Know your Portfolio - Three Simple Charts Can Make a World of Difference
• Diversifying your risk in the stock market
• Key psychological factors in stock market success
• Tips for young investors
• Comparing Bonds Vs. Stock as an investment

What is the Recommended Investment Strategy for Household Investors?

I've promised to update you, my readers, on my investment decisions. I've decided.

After months of deliberation I've finally decided on getting my feet wet again and bought some stocks on Monday. As readers of The Personal Financier know I am a big fan of investment vehicles that track certain indices such as index funds or ETF's so I've decided on gradually increasing my exposure to the markets via these financial instruments.

Needless to say I have a gift for timing the market, the other way around. Since my recent purchase leading indicators, such as the S&P500 had shed over 5%. That was rather expected as the markets rallied these past couple of months.

In this post I'll share my personal considerations behind my recent decision to increase exposure to stocks. If I breakdown my decision into three main lines of consideration they would be:

• My considerations regarding my desired investment style.
  
  
• My considerations regarding the market environment.
  
  
• My decision to use index funds and ETF's and invest gradually using dollar cost averaging (Investing a certain sum each period).
  

My considerations regarding my desired investment style

So why did I decide to reinvest in stocks again? The reasons behind my newly discovered enthusiasm about the markets and why I decided on gradually increasing my exposure to stocks has a lot to do with what I consider a desired or suitable investment style for me and many other household investors (in my opinion, of course).

During the past couple of years I've been fortunate enough (ironically) to not have to worry about my savings and investments as I had none. I'd bought an apartment and literally invested my funds there releasing me of my need to consider alternative investments. Luckily enough the apartment I had bought has yet to suffer the impact of the housing crisis.

Now, two years later I've managed to save up a sum which necessitates more serious consideration regarding where to invest it and how to both preserve it and grow it, if possible.
Naturally, the state of the markets was enough cause of concern for me to seriously consider my investment plans. Losing my hard earned money is not an option.

The more I thought of it I understood I was failing to obey my view on investments, a view that I had learned after paying "tuition" in investment losses in my early investment years.

#1 I decided sitting on the fence won't get me far
I find out I was literally sitting on the fence. Avoiding decision allowed me to remain unscathed during the recent plummet but I did not earn anything either. I've written a post titled "Who Dares Wins" but failed to follow it.

There is no need to take huge risks for huge profits, just thought out risk for a better chance of meeting my personal financial goals.
Sitting on the fence is not a solution to anything. It's a very easy way out. Usually when I avoid deciding I know something is wrong. So I decided to slowly climb down from the fence.

It does feel much better to have decided and to have the feeling of taking a path and having a purpose. My savings were idling in a short term deposit which barely covers the bank's fees with the low interest rate environment. I had to do something and feel like I'm doing something.

#2 I was guilty of timing the market
I just can't help it. I don't think many can. I always try and time the market. Since one does not usually keep objective score of one's efforts of timing the market we never know whether we are any good at it. I most certainly am not.

No one thought the market would rally 50% after Citi's March earning release. Missing out on such a rally is very costly in terms of investment. And now, having raced 50% up the more probable scenario is a downward technical correction in prices… and then? Timing the market almost never works so I've decide to stop and just invest a portion at a time thus averaging these corrections out and enjoying the long trend in prices which will hopefully be a bullish one.

#3 I finally remembered I am a long term investor
It took some time but I've finally remembered I'm actually a long term investor. I think it's hard on humans to invest for the long term. We are programmed to be impatient and impatience is a bane for investors.

I think the birth of my baby boy had something to do with it. I've decided on treating my investments as his. An 18 year investment term should be enough to be considered long term (some may argue).

My considerations regarding the market environment

In my recent posts I've written about a correction in prices which is probable to follow the recent rally. I had thought the stress tests will give enough reason for sophisticated investors to realize profits and change the trend. This hasn't happed, yet. Markets have shed 5% but this can be considered only profit taking on an uptrend.

I still believe a correction is in order but since I've decided on quitting my market timing efforts I've decided to ignore this belief. This is actually a great relief. No one seems to really know what's going on anyway.

It certainly wasn't short-term considerations regarding the economy which got me to reinvest. There seem to be fundamental reasons to believe the global economy will get better in the near future (2-3 years).

#1 Very low interest rate environment leaves little choice
There is money out there looking for reasonable returns. With interest rates this low this money has little choice of investment and will turn, eventually, to the stock market. Interest rates on deposits are so ridicules many investors will find it very hard to accept.

This low interest rate environment will hopefully serve to set the markets back in motion with cheaper credit more motivation to capitalize on this opportunity.

There are risks to such a low interest rate environment, together with increasing influx of money into the markets. Inflation will follow and will have to be controlled but hopefully we'll be on a correct course by then.

#2 Risk appetite seems to be returning to the markets
One of the effects of the recent crisis has been a dramatic impact on risk appetite. When risks seem to be that high no return is justifiable. Risk appetite is perhaps the most important thing for the stock market which is, in essence, a risk-return tradeoff.

Recently there seems to have been a shift in trend and the risk appetite is reappearing. The public's share in the stock markets is increasing through institutional investors and, hopefully, it won't be long before the mass market will find stocks appealing again.

#3 Cyclicality
As my market timing days are over I am better equipped to use one of the characteristics of financial markets in my advantage. Cyclicality is a common trait of financial markets. Though it never seems so in times of prosperity or times of depressions, the tide will turn and the markets will change.

Keeping a presence in the market is vital for long term success and profiting of cyclicality.

My decision to use index funds and dollar cost averaging

My considerations should be clear by now in light of my investment style and market beliefs.

#1 Beating the market is as hard as timing it
Chances are you or the institutional investor you've chosen though a fund or IRA cannot beat the market. For this reason buying the market is the way to go. Fees and commissions paid are often unjustified and hurt portfolio performance with no real abnormal returns over the market.

Index funds are cheap in fees, are simple to follow I believe serve best the needs of household investors.

#2 Dollar cost averaging is a good way to gradually increase exposure
Uncertainty rules the markets, especially today. I would be very nervous had I invested my entire savings in one period. The market is still very fickle and dangerous. Naturally the risk – return equations dictates that averaging investments over time will yield lower returns, and it does, but it is important for sleeping at night.

Dollar cost averaging enables me to remain content even when markets correct themselves downwards. I'll just buy more, cheaply. When markets are bullish again I'll profit on the average investment.

I believe the outlines I've described to be the optimal solution for independent household investors under the current market conditions. I am not recommending anything to anyone. I'm simply describing my strategy as I've promised to do in the past.

I would not like to expose the size of my investments but rather the portion. I've invested 10% of my portfolio in stocks (US Index) and will continue to do so on a monthly basis.

I will update my readers on how my portfolio progresses. By next week I will hopefully have finalized my planned asset allocation and will share it as well.

Related Posts:

• Stock Surges Are Usually Unexpected – How To Make Sure You Won't Miss Out
• Know your Portfolio - Three Simple Charts Can Make a World of Difference
• Stock recommendations from analysts or brokerage houses: How valuable are they?
• Diversifying your risk in the stock market
• Key psychological factors in stock market success
• Tips for young investors
• Comparing Bonds Vs. Stock as an investment
  

Image by: misw

The Recent Rally in Stock Prices is Nearly Over

Stock markets around the world have surged by over 25% during March and April. I believe market players are already looking for a good excuse to start selling again…

During the past month we've witnessed an amazing good old rally in stock prices. The S&P jumped from its recent new low of 676 points to 856 points in a month's time (that's 26%).
A rally like this is typical to a stock market that has taken such severe blows. Unfortunately there is no way of timing it.

Those of us with decent short term memory surely remember a similar rally that took place during December and January 2009 where the S&P rose from its second recent low of 752 to 931 only to crash back to 676, as we know now. That was 23% rally by the way.

Obviously these rallies are impossible to time. Still, I'm sensing something in the air. The financial papers and headlines are usually good proxies for a change in atmosphere. I believe I detected a change in what had recently been a surge in optimism to more sinister financial news.

Recent Developments

To start things off several "financial gurus" have expressed their opinion on the recent rally in stock prices and have characterized it as a "bear market rally". Do not be tempted to believe these guys really know what they're talking about. I believe they don't know where the markets are headed any better than the rest of us. What do they know?

First and foremost we must remember these individuals and institutions hold certain positions in the market and these positions speak for themselves. I am most certainly not accusing anyone of fraud or deliberate misguidance. We just need to keep in mind the facts.

Second, they are probably aware of the influence of their opinion and use it wisely. Third and maybe most important these "predictions" also serve as a method of communicating between the different institutions and market players. Ironically reality is created through these predictions.

Here are some examples of opinions recently published:

• The French Bank Societe General had defined the recent rally "a dash for trash" as the stocks that everyone was looking to sell only a month ago have shown price increases of over 60%.
  
  
• American Investor Marc Faber had expressed his opinion according to which the markets will suffer another 10% drop before rising again.
  
  
• Famous investor George Soros had stated the recent rally is a bear market rally as the American economy is still struggling with a difficult recession. Furthermore the American banking industry is literally in a state of bankruptcy.
  
  
• Morgan Stanley analysts have predicted the market is still bearish as corporate profits, housing prices and bank balance sheets have yet to recover adequately.

Bad financial news plays a significant role in setting the course of the markets in either direction. Surprisingly, or not, financial news tends to side with the opinions of leading market players and financial institutions. The following is a collection of the news gathered over the weekend so far:

• Goldman Sachs is expected to issue $10 Billion in stocks next week in order to repay government aid funds. From a first glance this seems like good news. The problem is what happens with other financial institutions that are yet unable to repay the government? What does this say about their financial condition? Several articles have taken this tone in reporting about Goldman Sachs' intention.
  
  
• The Fed and Federal government have asked banks to avoid publishing stress test results and wait for the formal report to be submitted by the government. Such news could be considered ordinary as well but have been speculated upon fearing that several banks may not have enough capital to withstand their stress tests.
  
  
• The budget deficit of the US has soared in the last six months to unfathomable highs amounting to $956.8 Billion. Apparently this deficit has only been equaled by that of the Second World War.
  
  
• Two more banks in the US have collapsed. This brings the total of collapsed banks to 23 in 2009 vs. 25 in 2008.

What does this have to do with the long term?

All of these circumstantial evidence points, in my humble opinion only, to the upcoming end of the current rally in favor of a cooler period. Hopefully we won't witness any further sharp declines in stock prices and this might be a good time for me to re-enter the markets after a long period of waiting. I'm guilty of timing the markets, I know. It's simply irresistible.

We must remember that every period of one way movement in the markets is often corrected by an opposing period, however short, which represents capitalization of profits and "taking air" before conquering new highs.

These are only a handful of opinions regarding the state of the markets. We must keep in mind that the stock market, in theory, doesn't care much about the balance sheets of the upcoming quarter but rather what these represent in the long term.

Soon enough the tide will turn and someone will decide we've had enough. Stock prices will rise expecting the economy to recover and the economy will recover because stock prices are rising in a beautiful, ironic circle of forged reality. The markets are all about expectations. That is why they are unexpected and unforeseeable.

Stock Surges Are Usually Unexpected – How To Make Sure You Won't Miss Out

Historical market data explains why many investors, including myself, missed on the recent surge in stock prices

Since my last post the markets have astonishingly recovered over 20%. A couple of press releases by Citi and Bank of America were enough to send the financial sector sky rocketing with these two banking giants doubling their stock prices.

After witnessing such extreme movements up in stock prices I often try to review my thought and decision making process, or to put it in simpler terms, try to figure out why on earth I wasn't a part of the party?

Two weeks ago it seemed like the biggest retail banks in the US may well be on their way to nationalization. The state of the economy seemed poorer than ever and no hope was in sight. The S&P500 stood at 676 and there were no indications something is about to change.
Still, it is the nature of the markets to be cyclical and what goes down usually comes up. Even in these difficult days we've seen the markets go up by as much as 10% a day only to come crushing down again.

It can be quite frustrating to have your predictions and instincts be proved right on the market while you didn't actually have enough confidence to carry them out. Still, short term trading, whether it is performed on an hourly, daily, monthly or even longer time periods is very risky.
Catching the market at its very low is an impossible mission. No one is able to constantly identify the turning point in the markets while strangely enough many think they can. The legendary Warren Buffet had recently reinvested significantly into the market saying he is almost certain we've got a way to go before the markets turn but he is experienced enough to know that he can't time the market.

A look at the data

As readers of The Personal Financier are surely aware by know psychology plays many tricks on investors.

The human mind is not very good in handling large amounts of data over a historical period. We cannot conclude with success from market data we've heard or read through over a period of time.

Just imagine how many times you've heard of price shifts of a certain stock over a week's period, for example. Most of the time you'll be more than certain that stock's price has risen considerably while it actually didn't gain as much as you'd expect. The reason is we more attuned to positive news on stock than negative and we naturally remember and cling to up movements in prices rather than down movements.

The same phenomenon exists in long term trading. Raw data proves there are only a handful of days in which stocks actually gain or lose significantly. These, therefore, cannot be timed and identified in advance.

There were approximately 4,559 trading days between January 1st 1990 and February 2nd 2008. Only 51 of these days yielded a price change of over 5% in the Nasdaq, and a mere 8 days in the S&P. Maybe 5% is too much to ask for? If we suffice with 3% the numbers change to 238 days for the Nasdaq's and 59 days for the S&P.

What are our chances of catching such days? Very basic statistics quickly determines we have a 1.1% chance of catching a 5% price shift and 5.2% chance of catching a 3% price shift in the Nasdaq. The S&P's statistics are even "worse" 0.2% chance of a 5% price shift and 1.3% chance of a 3% price shift.

The long tail or 80/20 principle work here as well. The numbers are a little different but the principle remains. The majority of days will end in price shifts of fewer than 1% or 1%-3%. That is the long tail of trading days or the "80%".

Smart investing

In order to really capitalize on short term market gains, as the one we had only recently witnessed one must be constantly present in the market. Adjusting portfolio exposure to stock and other financial instruments slowly and gradually is the right way to work.
Sure, you'll experience the short term losses as well but the working assumption is that on average the gain is higher than the loss.

frequent flyer miles

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The Japanese Banking Crisis of the 1990's: Are We Facing a Similar Stagnation?

What can we learn from the 1990's Japanese banking crisis and the long slump in the Japanese stock market? Are we facing a similar scenario?

Price levels in stock markets worldwide are increasingly becoming attractive with each day brining yet another slump. The time of the long term investors has come. Still, a relentless doubt lingers on – Does this crisis represent an unorthodox change in the economy? Have the markets set into a recession which might take more than the usual 1-3 years to recover from?

The readers of The Personal Financier are familiar with my favorite example I often use when demonstrating why long term investing in stock is not risk free, as the odds suggest. That example is of the Japanese market which hasn't really recovered from the banking crisis it had experienced in the end of the 80's and early 90's.

The Japanese stock market, represented by the NIKKEI225 index has slumped from a level of almost 40,000 points in 1990 to 7,000 in 2003, a level which the Japanese market is currently revisiting in this crisis. The market hasn't shown any real recovery and has touched the 18,000 points level briefly in 2007.

The Japanese stock market is the stuff of nightmares for all long term investors and demonstrates the significance of geographical diversification.

The big question is: are we witnessing the Japanese banking crisis all over again in the US and western economies? Will the market slump for decades before showing signs of recovery?

The intuitive answer would be: no. No crisis is like another. Still, as I'm constantly considering buying into these levels of stock prices I thought a comparison of the two will prove interesting.

The Japanese Banking Crisis of the 1990's: Sources and Lessons

In January 2000 the IMF (International Monetary Fund) published a paper titled "The Japanese Banking Crisis of the 1990's: Sources and Lessons" which examined the characteristics of the crisis. Hopefully this paper would be able to shed some light onto our current situation.

The paper traces the roots of the crisis to accelerated deregulation and deepening of capital markets without an appropriate adjustment in the regulatory framework as well as to weak corporate governance and regulatory forbearance. Sound very familiar doesn't it?

The favoring economic conditions of the late 1980's Japan which included above-trend economic growth and near-zero inflation resulted in a considerably lower risk premium for the country and a marked upward adjustment to growth expectations which in turn boosted asset prices and fueled rapid credit expansion during the period. Still familiar…

Those who forget history are bound to repeat it. The exponential growth in the derivatives market along with a weak, passive and partial regulatory framework played a major part in the current crisis as well. Weak corporate governance as demonstrated in weak risk management and lack of internal controls proved fatal again.

The foresight of the IMF paper is rather remarkable: "The Japanese banking crisis serves as a warning that such a crisis can befall a seemingly robust and relatively sophisticated financial system".

The question regarding the unusual length of the crisis is answered to some extent
According to the IMF's paper weak corporate governance and regulatory forbearance stifled any incentive for meaningful restructuring of banks as well as their corporate borrowers.

Forbearance and restricting of bad loans – The structure of the banking system in Japan is different an important to understand as it contributed to the length of the crisis. Main banks in Japan act as quasi-insider monitor of the borrowing firm and as a mediator when borrowers fall into stress. This is advantageous as the monitoring costs are lower due to scale advantages of information on borrowers. Unfortunately, these main banks were reluctant to admit they had failed in identifying bad loans and began restructuring them, including the unpaid interest in yet another credit given.

By restricting non-viable loans banks actually increased the amount of problematic credit issued in the market. The end is obvious.

Capital Base - To salvage their deteriorating capital base banks issue more subordinated debt in higher returns to institutional investors thus further increasing the exposure to bad loans throughout the market (always suspect high returns). Furthermore, banks looked to tap unrealized capital gains to increase capital base, thus selling their stock and bond holdings and real-estate.

Weak corporate governance – The ownership structure and the board of directors' composition created little in the way of motivation for sound corporate governance. Owners had been dependent on the credit issued by banks and the boards of directors were comprised of former employees which were expected to hand over the board sit to other employees at the end of every term as a sort of bonus for the years worked at the bank.

Bank management was not under pressure to maximize profitability and returns and the absence of the necessary checks and balances meant no incentive for proper restricting or dealing with problems.

Regulatory weakness and forbearance – It is argued that the strategy of the government, postponing in dealing with the problems, actually raised the fiscal cost of the final resolution of the banks.

The authorities did very little in the way of arresting the decline in the conditions of the banking systems up to 1995. Regulators feared public panic in light of the strong measures needed to salvage the banks which grew in light of the lack of insurance on deposits.

Again, the IMF paper is amazingly insightful: "By giving rise to moral hazard problems, regulatory forbearance and "too big to fail" doctrines can lead to "gamble for resurrection" which often weakens financial institutions further".

Interest rates in Japan have been very low over the past decade and the economy is stagnant. Are we facing the same market conditions?

Conclusions for the current crisis

I felt calmer after reading the IMF paper and writing the aforementioned. It seems both crises have similar characteristics from a quick glance but a deeper examination proves the two are also different.

Regulators world-wide, I'd dare say under the leadership of Bernanke, seem of have learned and implemented the lessons in full. Lehman brothers was a mistake but no one could have foresaw it at the time (it was important to let Lehman fall from the moral hazard perspective on things). Government interventions are enormous and central banks are very attentive to the markets.
Furthermore, corporate governance may have played a part in this crisis but it was lack of adequate risk management and greed that were at the root of the current fall, not forbearance, which is somewhat comforting. Greed can be associated with economic cycles and will give way to prudential management every other cycle.

As far as restructuring and bad loans are concerned banks did delay some write-offs but we are also witnessing the biggest losses in the history of the world which surprisingly serve as a comfort.

The big questions of how much more financial waste is buried deep in balance sheets of financial institutions will remain unanswered but hopefully this crisis will be resolved in less than a decade.

Nationalization of banks, including the biggest two, may be very unpopular but it seems there isn't much choice in the matter and in that case earlier is better as the Japanese example illustrates.

The US market has defiantly had a lost decade as all major stock indices are revisiting levels they hadn't seen for 13 years. Still, perhaps this is an opportunity of a life-time. I, myself, am becoming more and more agitated and I do believe I will buy my way back in the markets in the near future. As I promised before I will update on my decision on this blog as it may be an interesting test case for the long-term.

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Behavioral Finance in Everyday Life – The Lottery as a Case Study

Is lottery a tax on stupidity or are our flawed psychologies playing another trick on us?

My wife and I usually enjoy strolls around our neighborhood on weekends, especially on sunny winter days. We live in the city and in our last stroll I kept noticing lottery advertisements everywhere as if they were beckoning to me.

Lottery has been deemed a tax on stupidity for a good reason. Every smart and aware consumer knows better than to throw money away on odds smaller than those of getting hit by lightning 3 times in a row.

Still, I couldn't help but buy a ticket. I felt I'd be I'd ignoring all the signals I had received that day calling out to me: buy and ye shall win. After having bought the ticket, for some reason, I'm full of hope and a very strong sensation of confidence in my chances of winning something.

I'm sure many of you have experienced that feeling before as well. Somehow, even though I am aware of the slim odds an unjustifiable feeling of optimism surges and the thoughts of all the things I'm going to do with my soon to be acquired financial independence overwhelm me.

There's a certain bias at work here and as my readers know I love psychological biases. This feeling of elation and of profits to come reminded me something. I usually get the same feeling when I make a stock investment. I simply can't be more certain this particular stock will drive my portfolio to new highs. Where does this conviction come from?

Behavioral finance and hedonic psychology - Daniel Kahneman and Amos Tversky's work

Daniel Kahneman is an Israeli psychologist and Nobel laureate, notable for his work on behavioral finance and hedonic psychology. With Amos Tversky and others, Kahneman established a cognitive basis for common human errors using heuristics and biases, and developed Prospect theory.

Kahneman and Tversky's work on behavioral finance is one of the most interesting and important to anyone who wishes to learn of the limitations of human rationality and the psychological biases that play a key part in our "rational" thinking. Their work is very relevant for investors everywhere as it ties in very tightly to stock market success and failure due to the affects of psychology on us, as investors or traders.

The Representativeness Heuristic – A wrong perception of chance

Would you choose consecutive numbers like 1,2,3,4,5 for the lottery? I'm guessing that you won't. But why not choose these numbers?

1,2,3,4,5 have the same chances of appearing than 2,8,12,23,35 but the last seems much more probable to be the winning numbers due to their randomness. Our minds are programmed in such a way as to correlate order with intention, which is mostly true. Still, there are times when this is obviously false.

The same phenomenon exists in the roulette where the combination red-red-red-black-black-black is thought of as much less likely than black-red-red-black-red-black. We have a certain expectation of nature restoring order to it, offsetting the results.

The Overconfidence effect and Optimism bias

Very common in investors the overconfidence effect is a bias in which people are correct in their judgments far less often than they think they are. For example, for certain types of question, answers that people rate as "99% certain" turn out to be wrong 40% of the time. Overconfidence is one kind of what is called the miscalibration of subjective probabilities.

You really can't get any more optimistically biased than hoping to win the lottery against unbeatable odds.

Apparently the lethal combination of overconfidence and optimism bias is very common and very hard to resist. According to Kahneman and Tversky only seasoned stock market brokers, weatherpersons and dog track analyists have shown some resistance to the effects of these biases.

I'm still hoping to win something but somehow I'm a little less confident in my guesswork. Still, people do win.

If you find judgement under uncertainty and heuristics and biases as interesting as I do please let me know. In the near future I hope to write more on these issues. In the meantime, you may be interested in Kahneman and Tversky's Judgment under Uncertainty: Heuristics and Biases

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Valuation and Risk Measurement Models under Heavy Criticism – What Went Wrong?

Are valuation and risk measurement models as the root of all evil?

In this crisis we witnessed a broken market. Financial institutions relaying on complex financial models for both valuation and risk management suffered heavy losses and saw their methodologies break before their eyes.

Many valuation models and risk models literally stopped functioning and started spewing out numbers that seem to have no real connection with reality and stock market prices.

Many investors and financiers alike are losing faith in what was once held high as the hope of objective decision making based on mathematical calculations. Math and numbers provided a sense of security and scientific aura to many managers who only recently learned of their limitations, the hard way.

It is natural for us to assume complex equations and finance theory applied to the markets is much better than any subjective human judgment made. The model does over-estimate risk or influenced by market psychology. The model is no eager to sell on profit and is essentially not biased by any psychological human weakness.

So what went wrong?

Understanding models

Reality is far too complex to model. At least for us simple minded humans. As a result all models have to make assumptions which simplify reality and enable to model it while still providing powerful insights into the subject matter.

Many simple models are very powerful such as simple economic supply and demand, game-theory prisoner’s dilemma and many many others. The most important thing, then, is to be aware of the assumptions made in the model and draw the model’s limitations as a result.

In order to understand how far these limitations may go I’ll examine too very commonly used financial models: VaR, which is a commonly used risk measurement model and Black and Scholes which is a commonly used valuation model.

VAR and black swans

I’ve recently discussed the question of whether the western financial markets are just a huge Ponzi Scam. Nassim Taleb, author of the Black Swan theory suggests so (read more here: Is the Stock Market a Big Ponzi (Madoff) Scheme?).

So what do black swans have to do with value at risk? Let’s have a look at VaR and its purpose.

Value at Risk is a widely used measure of the risk of loss on a specific portfolio of financial assets. All the financial institutions in the world use VaR in their risk management efforts. For a given portfolio, probability and time horizon, VaR is defined as a threshold value such that the probability that the mark-to-market loss on the portfolio over the given time horizon exceeds this value (Wikipedia)

To put it simply VaR is the amount a certain portfolio might lose on a given probability and length of time.

For example, if a portfolio of stocks has a one-day 5% VaR of $1 million, there is a 5% probability that the portfolio will fall in value by more than $1 million over a one day period (Wikipedia).

When VaR is applied a probability has to be assumed. This is one of the main weaknesses of VaR and is crucial for understanding its limitations. When VaR is calculated a given timeframe and confidence level are assumed. For example I’d like to have a 95% confidence that in a 10 day period I will not lose over $1,000 on my portfolio.

What VaR does is take either historical or expected values for the assets and uses a statistical distribution to calculate the maximum loss on a 95% confidence level.

The problem lies with the remaining 5% which are not modeled and that’s where the black swans come into play. A black swan refers to a large-impact, hard-to-predict, and rare event beyond the realm of normal expectations. That is exactly what that remaining 5% (or 1%) represent. The chances are slim but the impact will be destructive (see sub-prime and credit crisis).

This limitation cannot be avoided. Had one modeled for 100% of occurrences than the Value at Risk would simply be the entire portfolio as there’s always a chance to lose everything.

Black and Scholes Model and non standard times

Another very commonly used model is the Black and Scholes model for option pricing. This model, sometimes under certain adjustments, is considered the gold standard for option pricing.

The model is quite complex and relays on relatively advanced mathematics but as always the model needs to make assumptions on reality which in turn limits it.

The Black and Scholes model is very powerful for option pricing and provides very interesting data on the impact of time, base asset price movements and standard deviation on the price of options.

However, the mighty Black and Scholes model assumes that the stock prices, which are the basic asset for the option, distribute normally (Normal Distribution) and that continues trading exists.

Obviously when the market is broken and trading is slim Black and Scholes simply doesn’t work. Option pricing according to Black and Scholes will usually be ridiculously high.

More complex financial instruments call for more complex valuation models along with more difficult to understand assumptions and limitations. No wonder we got lost in all the numbers.

It’s not that everyone wasn’t aware. There aren’t any better tools out there

I wouldn’t hurry to disparage financiers everywhere. Most of these individuals understand very well the limitations of models and modeling for financial assets. The problem is there aren’t any better tools out there.

Financial institutions have to quantify risk and valuate assets somehow. As such these models are the best solution available next to selling the assets altogether.

The problem stated when models weren’t accompanied with adequate skepticism, conservatism and a good infrastructure that calls for experience and judgment. It’s really not my intention to offer wisdom in hindsight. I’d make the same mistakes myself. That’s just human nature. Let’s make sure we implement these lessons in the future.

As always the industry will overshoot to access conservatism of valuations and extreme risk assessment. The ones that will make money are the ones that will be brave enough to remain calm and sound and apply the common sense we all know to be right but too afraid to apply.

Related Posts:

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

Image by: scottwills

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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