Bernstein also gives an unfair example -- unfair because, to make a rational argument, he uses an extreme and emotional example.
In 1974 Consolidated Edison voted to suspend paying dividends, because they were faced with a financial crisis. Many investors were upset, and Bernstein quotes a woman as saying that since her husband died Con Ed had to be her husband and support her.
Now, Bernstein is correct that in this extreme situation the board of Con Ed did the correct thing. A bankrupt company can't pay dividends. I'm not saying that a company should pay dividends that it needs to survive.
But that's not the normal situation. The textbook argument is not that a company pay dividends and go bankrupt or stay in business . . . it's that a company should not pay dividends to expand the business or invest in other, more productive businesses.
Shareholders are co-owners of the business. They should see some return (and I mean REAL, spendable return -- not the kind of "returns" that most financial writers refer to when they call capital gains a 'return' even though NOTHING has been returned to the shareholder by the rise in stock price) on their investment -- or else they'd be better off in bonds.
Let's say you bought a McDonald's franchise. When it's new you'd have to buy equipment, the building, and so on. Once it's established, it should reinvest some profits in maintaining or replacing needed equipment, interior decorating, advertising, and so on -- if the current number of fryers and grills and satisfying the customer demand, it doesn't need to buy new ones in the hope that if it does, more customers will walk into the restaurant.
Given that reality, who would blame the franchise owner for taking some of the profits out of the business? Nobody, except Bernstein.
Given these many issues, I think it's quite rational for investors to think that $1 in their pocket is worth $2 in the retained earnings of a company whose stock they own.
stock dividends
stock dividends
Wednesday, June 27, 2007
Dividends versus Capital Gains Part 3
And what about investors? Bernstein argues that if they need money, they'd be just as well off selling their shares of the company, which in theory are worth that much more, because the company didn't pay dividends.
He writes that it's irrational for an investor to spend $600 in dividends to buy a TV but not to be willing to sell $600 worth of stock (that didn't pay out dividends) to buy the same TV.
But as I've argued above, the share price in the long run is only a little influenced by retained earnings.
If stock prices always reflected a rational evaluation of the company's balance sheet, and balance sheet improvement (or decline) were always 100% reflected in the stock's price rise (or fall), then this would make sense.
But in the real world, stock prices rise and fall every day purely on the give and take of supply and demand, between the bulls and the bears, mostly due to factors beyond the individual companies.
Today's $600 capital gain could easily become tomorrow's $600 -- or more -- loss.
Stock price rises are not permanent.
A dividend check cannot be taken back. The shareholder may waste it, but at least it was theirs to spend, reinvest or lose.
A capital gain is here today, gone next year.
Maybe for a lot of years.
As Bernstein well knows, dividends were the only reason to own stock from the October 1929 crash to 1954, and from 1966 to 1981. Is he saying that if companies had only refused to pay dividends that their stock prices would have gone up despite the Great Depression and World War 2. Despite the social turmoil of the 1960s, the Vietnam War, Watergate, the 1973 oil embargo and the tremendous rise in commodity prices during the 1970s, and the tremendous spike in interest rates?
Does he really want to say that companies could have raised their stock prices during all those problem periods, if only they'd refused to pay out dividends but reinvested the dividends instead?
Given the uncertain and fluctuating nature of capital gains, it's hardly a surprise that investors want to hang on to the shares of stock they own and collect the dividends. When they keep the shares, they can continue to collect the dividends, or even collect capital gains in the future if they so choose.
stock dividends
stock dividends
He writes that it's irrational for an investor to spend $600 in dividends to buy a TV but not to be willing to sell $600 worth of stock (that didn't pay out dividends) to buy the same TV.
But as I've argued above, the share price in the long run is only a little influenced by retained earnings.
If stock prices always reflected a rational evaluation of the company's balance sheet, and balance sheet improvement (or decline) were always 100% reflected in the stock's price rise (or fall), then this would make sense.
But in the real world, stock prices rise and fall every day purely on the give and take of supply and demand, between the bulls and the bears, mostly due to factors beyond the individual companies.
Today's $600 capital gain could easily become tomorrow's $600 -- or more -- loss.
Stock price rises are not permanent.
A dividend check cannot be taken back. The shareholder may waste it, but at least it was theirs to spend, reinvest or lose.
A capital gain is here today, gone next year.
Maybe for a lot of years.
As Bernstein well knows, dividends were the only reason to own stock from the October 1929 crash to 1954, and from 1966 to 1981. Is he saying that if companies had only refused to pay dividends that their stock prices would have gone up despite the Great Depression and World War 2. Despite the social turmoil of the 1960s, the Vietnam War, Watergate, the 1973 oil embargo and the tremendous rise in commodity prices during the 1970s, and the tremendous spike in interest rates?
Does he really want to say that companies could have raised their stock prices during all those problem periods, if only they'd refused to pay out dividends but reinvested the dividends instead?
Given the uncertain and fluctuating nature of capital gains, it's hardly a surprise that investors want to hang on to the shares of stock they own and collect the dividends. When they keep the shares, they can continue to collect the dividends, or even collect capital gains in the future if they so choose.
stock dividends
stock dividends
Dividends versus Capital Gains Part 2
Granted, many companies just can't afford to pay dividends. New companies that still must make a lot of investments to secure their businesses. Capital intensive companies that have to spend a lot just to keep up with the competition, and so on. Still, I would advocate that most investors stay away from such companies.
The companies that do traditionally pay dividends tend to be older and more established. They can afford to pay them.
One good example is Coca-Cola. It's paid only probably billions and billions of dollars in dividends to shareholders over the course of its long history. If it'd kept all that money, would it be even more successful? Would it have smashed all competition from Pepsi to Vess? Would Coke be sold in every single country in the world, even North Korea? Would every person in the world be buying a 6 pack or more a day? Or that the executives who introduced New Coke would have figured out they were making a mistake?
I don't think so. I could be wrong, but I think Coke has obtained as much brand saturation up to this point as it could have. It will keep expanding in the future, of course, and branching out into different kinds of drinks, but I don't think that there'd be a Coca-Cola bottling plant on every corner of the world if only Coca-Cola had refused to pay its shareholders dividends. I think many people in the world had to wait for various political and technical barriers that had nothing to do with Coke itself to fall. Plus, there're cultural and financial reasons why many people don't buy a drink they're not used to and can't afford. And of course Coke can't buy entry into North Korea or Iran.
I doubt its stock price would be so much higher that its investors would be glad it didn't pay any dividends.
It's Bernstein himself in an earlier section of this book that stresses the action of "return to the mean," or that trees don't grow to the sky, and businesses don't take over entire stock exchanges. At some point, the useful of that cash to the business would have to diminish. Some businesses have a natural limit to their growth, bounded on consumer tastes and other demand for their goods and services.
stock dividends
stock dividends
The companies that do traditionally pay dividends tend to be older and more established. They can afford to pay them.
One good example is Coca-Cola. It's paid only probably billions and billions of dollars in dividends to shareholders over the course of its long history. If it'd kept all that money, would it be even more successful? Would it have smashed all competition from Pepsi to Vess? Would Coke be sold in every single country in the world, even North Korea? Would every person in the world be buying a 6 pack or more a day? Or that the executives who introduced New Coke would have figured out they were making a mistake?
I don't think so. I could be wrong, but I think Coke has obtained as much brand saturation up to this point as it could have. It will keep expanding in the future, of course, and branching out into different kinds of drinks, but I don't think that there'd be a Coca-Cola bottling plant on every corner of the world if only Coca-Cola had refused to pay its shareholders dividends. I think many people in the world had to wait for various political and technical barriers that had nothing to do with Coke itself to fall. Plus, there're cultural and financial reasons why many people don't buy a drink they're not used to and can't afford. And of course Coke can't buy entry into North Korea or Iran.
I doubt its stock price would be so much higher that its investors would be glad it didn't pay any dividends.
It's Bernstein himself in an earlier section of this book that stresses the action of "return to the mean," or that trees don't grow to the sky, and businesses don't take over entire stock exchanges. At some point, the useful of that cash to the business would have to diminish. Some businesses have a natural limit to their growth, bounded on consumer tastes and other demand for their goods and services.
stock dividends
stock dividends
Dividends versus Capital Gains Part 1
I was reading Against the Gods by Peter Bernstein again last night, and near the end there's a section about the misperceptions and departures from pure rationality that investors make. I was shocked when I started reading a section that began by saying that there's no rational reason for corporations to pay dividends, or for shareholders to want them to.
As much as I've enjoyed his books up until then, I now have to think that when he wrote that he purely had his head up his rear end. That's a rational academic argument, but it's got no relation to the real world.
The academic argument is that when a corporation pays out dividends, it is losing cash that could be better spent in other ways, such as paying down debt or being invested in some way to make a better return. By being used to improve the company's balance sheet or to make a better business investment, the company's financial position is improved.
This means that the company's stock in theory will be worth more, because the company will be in a better financial situation.
At the time this book was written, capital gains got preferential tax treatment, so an investor receiving dividends paid full tax on them but an investor raising the same money by selling stock paid less in taxes. That's been changed in recent years, but the Democrats plan to go back to socking it to the owners of dividend-paying stocks (anybody who owns dividend-paying stock is obviously rich and evil and needs to have their money taken away from them ((according to class-warfare Democrats)) . . . by I digress.)
(Bernstein didn't mention transaction charges, which favor the dividend receiver over the stock seller who must pay brokerage commissions, but I admit that's minor compared to the tax difference.)
That's a great theory, and a company's stock price does get adjusted for payout of dividends, but that's hardly a major factor in a company's stock price determination. As Bernstein has written about himself, per modern financial theories a company's stock price is mostly determined by the overall market.
How many investors say to themselves, I liked company X at $50 a share but since it just paid out a dividend of 50 cents per share I'm not going to pay over $49.50? Stock buyers that really like that company will buy at market.
Furthermore, it's not real world to say that all cash a company keeps in retained earnings is invested well. Companies can and do waste it. It may just go to give company officers more stock options, which is not a benefit to shareholders. It may go to acquire another company which is a waste of time and effort. Many things can happen to that cash, many of them of no value to shareholders.
The 50 stocks in this Mergent index are not doing poorly in the market place even though they pay dividends.
Not to mention, Enron, Global Crossing and obvious frauds. Most companies and executives are not frauds, but that doesn't mean they're building shareholder value the best way with retained earnings.
stock dividends
stock dividends
As much as I've enjoyed his books up until then, I now have to think that when he wrote that he purely had his head up his rear end. That's a rational academic argument, but it's got no relation to the real world.
The academic argument is that when a corporation pays out dividends, it is losing cash that could be better spent in other ways, such as paying down debt or being invested in some way to make a better return. By being used to improve the company's balance sheet or to make a better business investment, the company's financial position is improved.
This means that the company's stock in theory will be worth more, because the company will be in a better financial situation.
At the time this book was written, capital gains got preferential tax treatment, so an investor receiving dividends paid full tax on them but an investor raising the same money by selling stock paid less in taxes. That's been changed in recent years, but the Democrats plan to go back to socking it to the owners of dividend-paying stocks (anybody who owns dividend-paying stock is obviously rich and evil and needs to have their money taken away from them ((according to class-warfare Democrats)) . . . by I digress.)
(Bernstein didn't mention transaction charges, which favor the dividend receiver over the stock seller who must pay brokerage commissions, but I admit that's minor compared to the tax difference.)
That's a great theory, and a company's stock price does get adjusted for payout of dividends, but that's hardly a major factor in a company's stock price determination. As Bernstein has written about himself, per modern financial theories a company's stock price is mostly determined by the overall market.
How many investors say to themselves, I liked company X at $50 a share but since it just paid out a dividend of 50 cents per share I'm not going to pay over $49.50? Stock buyers that really like that company will buy at market.
Furthermore, it's not real world to say that all cash a company keeps in retained earnings is invested well. Companies can and do waste it. It may just go to give company officers more stock options, which is not a benefit to shareholders. It may go to acquire another company which is a waste of time and effort. Many things can happen to that cash, many of them of no value to shareholders.
The 50 stocks in this Mergent index are not doing poorly in the market place even though they pay dividends.
Not to mention, Enron, Global Crossing and obvious frauds. Most companies and executives are not frauds, but that doesn't mean they're building shareholder value the best way with retained earnings.
stock dividends
stock dividends
Sunday, June 24, 2007
Don't sell stock and you don't have to worry about volatility
Later in Against the Gods, Peter Bernstein comes close to what I'll be writing about in my own book on income investing.
He points out that the volatility Harry Markowitz posits as equal to stock market risk does not matter to "For true long-term investors -- that small group of people like Warren Buffett who can shut their eyes to short-term fluctuations and who have no doubt that what goes down will come back up -- volatility represents opportunity rather than risk, at least to the extent that volatile securitites tend to provide higher returns than more placid securities."
In that sentence he cannot get away from a concern with market price. But he does mention his wife's late aunt who used to boast that she was his only in-law who never asked him what he thought the market was going to do.
"I didn't buy in order to sell," Bernstein quotes his aunt-in-law.
Most people don't understand this attitude -- but it's perfectly logical if you are buying to receive dividends for the rest of your life.
Then you don't need to care about the market price, as long as you continue to receive ever-incresing dividend checks every quarter.
Your only risk is the danger that the company will decrease, suspend or end its quarterly dividend payments.
dividends overcome volatility
dividends overcome volatility
He points out that the volatility Harry Markowitz posits as equal to stock market risk does not matter to "For true long-term investors -- that small group of people like Warren Buffett who can shut their eyes to short-term fluctuations and who have no doubt that what goes down will come back up -- volatility represents opportunity rather than risk, at least to the extent that volatile securitites tend to provide higher returns than more placid securities."
In that sentence he cannot get away from a concern with market price. But he does mention his wife's late aunt who used to boast that she was his only in-law who never asked him what he thought the market was going to do.
"I didn't buy in order to sell," Bernstein quotes his aunt-in-law.
Most people don't understand this attitude -- but it's perfectly logical if you are buying to receive dividends for the rest of your life.
Then you don't need to care about the market price, as long as you continue to receive ever-incresing dividend checks every quarter.
Your only risk is the danger that the company will decrease, suspend or end its quarterly dividend payments.
dividends overcome volatility
dividends overcome volatility
Volatility is a good proxy for risk only if you are a short-term investor
Against the Gods by Peter Bernstein is subtitled "The Remarkable Story of Risk" though this is somewhat clipped. Obviously, risk as danger is not something that has a story. The book is about the attitudes and techniques people take in facing risk.
We have always faced danger. But we couldn't always buy insurance.
When it comes to stock market investing, Bernstein does finally discuss the nature of risk, when writing about Harry Markowitz's famous paper Portfolio Selection.
Because Markowitz uses volatility as a "proxy" for risk, Bernstein writes. The vast majority of financial writing do not even realize that volatility is not risk per se.
So he does discuss whether or not volatility is a good proxy for risk, or whether there's a better way to deal with it. If you don't look upon volatility as itself dangerous to your money, then stock market investing is less risky than putting your money into
a certificate of deposite that is risky because of its low yield.
volatility does not equal risk
volatility does not equal risk
We have always faced danger. But we couldn't always buy insurance.
When it comes to stock market investing, Bernstein does finally discuss the nature of risk, when writing about Harry Markowitz's famous paper Portfolio Selection.
Because Markowitz uses volatility as a "proxy" for risk, Bernstein writes. The vast majority of financial writing do not even realize that volatility is not risk per se.
So he does discuss whether or not volatility is a good proxy for risk, or whether there's a better way to deal with it. If you don't look upon volatility as itself dangerous to your money, then stock market investing is less risky than putting your money into
a certificate of deposite that is risky because of its low yield.
volatility does not equal risk
volatility does not equal risk
Value investors exhibit Gambler's Fallacy
Peter Bernstein continues to raise interesting points in Against the Gods.
He writes about the concept of regression to the mean, and how this has worked as a system of investing for people such as Warren Buffett and other value investors. Although he doesn't mention it, it also explain the Dogs of the Dow technique (before it became well known.)
Not to mention the "magazine cover" effect. This is where people who make the covers of magazines in their fields for their accomplishments often go downhill afterward. SPORTS ILLUSTRATED has actually studied it, because there're numerous examples of players and teams who have never been so good as they were before making the cover of that magazine. One options guru I know of (you likely get mail order advertisements from him) uses magazine covers as a contrary indicator in his system. If a company or CEO makes the cover of a business magazine, it's time to dump the stock!
It also explain the Growth Trap as explained by Jeremy Siegel in his latest book The Future for Investors. When you pay a premium for a stock with great growth prospects, you don't do as well as you do when you put the same money into an investment that is not comparatively overpriced. He compares long term investments in IBM and Standard Oil, and in China and Brazil. (Yes, in the past Brazil has been the better long term investment despite all its political and economic problems and despite China's phenomenal growth -- keep that in mind the next time you get sales letters in the mail telling you that you're going to be poor if you don't invest in China and India.
However, keep in mind Bernstein's caution that it's not always easy to know where the mean is and when the regression will occur. People who invested in the stock market in 1930 because they thought the crash was over lost a lot of money.
In gambling circles, the belief that random results will soon revert to normal because they've been abnormal, is known as the Gambler's Fallacy.
A lot of people have lost a lot of money to casinos because they were sure the roulette's wheel long streak of red "had" to end on the next spin, or 7 had to come up, or the slot machine had to pay off . . .
regression to the mean
regression to the mean
He writes about the concept of regression to the mean, and how this has worked as a system of investing for people such as Warren Buffett and other value investors. Although he doesn't mention it, it also explain the Dogs of the Dow technique (before it became well known.)
Not to mention the "magazine cover" effect. This is where people who make the covers of magazines in their fields for their accomplishments often go downhill afterward. SPORTS ILLUSTRATED has actually studied it, because there're numerous examples of players and teams who have never been so good as they were before making the cover of that magazine. One options guru I know of (you likely get mail order advertisements from him) uses magazine covers as a contrary indicator in his system. If a company or CEO makes the cover of a business magazine, it's time to dump the stock!
It also explain the Growth Trap as explained by Jeremy Siegel in his latest book The Future for Investors. When you pay a premium for a stock with great growth prospects, you don't do as well as you do when you put the same money into an investment that is not comparatively overpriced. He compares long term investments in IBM and Standard Oil, and in China and Brazil. (Yes, in the past Brazil has been the better long term investment despite all its political and economic problems and despite China's phenomenal growth -- keep that in mind the next time you get sales letters in the mail telling you that you're going to be poor if you don't invest in China and India.
However, keep in mind Bernstein's caution that it's not always easy to know where the mean is and when the regression will occur. People who invested in the stock market in 1930 because they thought the crash was over lost a lot of money.
In gambling circles, the belief that random results will soon revert to normal because they've been abnormal, is known as the Gambler's Fallacy.
A lot of people have lost a lot of money to casinos because they were sure the roulette's wheel long streak of red "had" to end on the next spin, or 7 had to come up, or the slot machine had to pay off . . .
regression to the mean
regression to the mean
Stock prices are a random walk toward greater wealth
In another section of Against the Gods by Peter Bernstein, he discusses whether or not the stock market truly moves in a "random walk" -- if it does, the graph of the market should resemble a normal distribution, or bell curve.
He graphed the moves of the markets for every month for 70 years, and found that they did indeed resemble a normal distribution bell curve -- with two differences.
First, there is an upward bias. That is, the long run the stock market does go up. We know that. And it proves that capitalism works. Our free market economic system is, on the whole, creating wealth, and this is reflected in the stock market.
Second, the "long tail" at the left is much bigger than a strict normal distribution would call for. This means, paradoxically, that extreme market moves to the downside happen more frequent than is statistically probable. His graph would have included the 1973-1974 downturn and the October 1987 crash.
Short term market results are not predictable. Stock prices change as a result of new events and information, but these events are unpredictable. Therefore, they add up to a random walk that as Burton Malkiel has described moves upward in the long run, thanks to the wind of economic growth.
If you want steady Eddy market prices you have to go with something like Treasury Inflation Protection Securities that increase in value on a regular basis and also have the benefit of going up at the inflation rate.
random walk
random walk
He graphed the moves of the markets for every month for 70 years, and found that they did indeed resemble a normal distribution bell curve -- with two differences.
First, there is an upward bias. That is, the long run the stock market does go up. We know that. And it proves that capitalism works. Our free market economic system is, on the whole, creating wealth, and this is reflected in the stock market.
Second, the "long tail" at the left is much bigger than a strict normal distribution would call for. This means, paradoxically, that extreme market moves to the downside happen more frequent than is statistically probable. His graph would have included the 1973-1974 downturn and the October 1987 crash.
Short term market results are not predictable. Stock prices change as a result of new events and information, but these events are unpredictable. Therefore, they add up to a random walk that as Burton Malkiel has described moves upward in the long run, thanks to the wind of economic growth.
If you want steady Eddy market prices you have to go with something like Treasury Inflation Protection Securities that increase in value on a regular basis and also have the benefit of going up at the inflation rate.
random walk
random walk
Nifty Fifty means you can overpay for growth stocks
Against the Gods by Peter Bernstein continues to contain a lot of concepts that are enlightening me in my research on investing for income.
He discusses Daniel Bernoulli and the Petersburg Paradox, where Peter tosses a coin until it turns up heads. For every toss of tails, Paul must pay Peter a number of ducats doubled from the previous toss. That is, 1,2,4, and so on into infinity. The expected value of being Peter is infinite, but nobody would pay that.
Then he transitions into the late 1960s and early 1970s when it seemed like the Nifty Fifty stocks were going to go up to infinity, and investors bought their shares as though they were worth any amount up to infinity. As though the real risk was in not owning shares in these stocks rather than in owning them, no matter how expensive.
If you know any stock market history, you know what happened. The market crashed in 1973 and hit terrible lows in 1974. The Nifty Fifty fell even farther than other stocks, since they had farther to fall. They did not surpass their December 1972 peaks again until July 1980.
Yet he also points out that they were good stocks and if you'd bought them at reasonable prices and just held on for the long run, you'd have made good money. They didn't grow into infinity, but they did have good growth prospects.
Bernstein doesn't mention this, but I suspect that their dividends made them worth holding on to. The real risks were in paying too high a price for the income stream and in selling those stocks when the prices were low.
Nifty Fifty
Nifty Fifty
He discusses Daniel Bernoulli and the Petersburg Paradox, where Peter tosses a coin until it turns up heads. For every toss of tails, Paul must pay Peter a number of ducats doubled from the previous toss. That is, 1,2,4, and so on into infinity. The expected value of being Peter is infinite, but nobody would pay that.
Then he transitions into the late 1960s and early 1970s when it seemed like the Nifty Fifty stocks were going to go up to infinity, and investors bought their shares as though they were worth any amount up to infinity. As though the real risk was in not owning shares in these stocks rather than in owning them, no matter how expensive.
If you know any stock market history, you know what happened. The market crashed in 1973 and hit terrible lows in 1974. The Nifty Fifty fell even farther than other stocks, since they had farther to fall. They did not surpass their December 1972 peaks again until July 1980.
Yet he also points out that they were good stocks and if you'd bought them at reasonable prices and just held on for the long run, you'd have made good money. They didn't grow into infinity, but they did have good growth prospects.
Bernstein doesn't mention this, but I suspect that their dividends made them worth holding on to. The real risks were in paying too high a price for the income stream and in selling those stocks when the prices were low.
Nifty Fifty
Nifty Fifty
Wednesday, June 20, 2007
Risk and the utility of wins and losses
I've been reading Against the Gods by Peter Bernstein, which is about risk and how people have learned about probability, how to measure risk, and to some extent control it or use insurance to relieve it.
According to him, it was a man named Bernoulli who first articulated the idea of utility -- that is, that individual people put different emotional values on outcomes. A previous ancient writer said that people should not be so afraid of being struck by lightning, since it happened so rarely. Bernoulli said that people just put a higher emotional importance on the risk of being struck by lightning than of other, more common, dangers.
And Bernstein points out that human life would be a lot less rich if there weren't people who put a lot more value on the reward of taking a risk than they did on the loss they'd suffer from failing. Those are entrepreneurs, explorers and other pioneers who set out to accomplishment something (often at great cost) that is unlikely but which could bring great wealth.
It also explains why I play the lottery. The purely numbers-oriented people say, "The odds are 75 million against you, it's a scam." But I put a greater value on the (admittedly, highly unlikely) wealth I could win than the $2 I lose by playing.
If I didn't play, that $2 would just be absorbed into my daily cash budget, so it has a low utility to me. But I wouldn't have the right to dream of what I'd do if I won.
And who knows? Maybe someday I win. I know the odds are against me, but somebody eventually wins all the money. As long as I have a ticket, it could be me.
If someone has to beg for change on a streetcorner, then they should spend that $2 on the food they need to survive.
If you're depending on the lottery to make you wealth, you need to get off your butt and learn how to make, save and invest more money. You need to perhaps buy some government TIPS bonds to help your savings keep up with inflation.
But don't blame the lottery because some people who play it actually should use that $2 for some other purpose, or because they're too lazy or unambitious to work for wealth in other, more certain ways.
utility and risk
utility and risk
According to him, it was a man named Bernoulli who first articulated the idea of utility -- that is, that individual people put different emotional values on outcomes. A previous ancient writer said that people should not be so afraid of being struck by lightning, since it happened so rarely. Bernoulli said that people just put a higher emotional importance on the risk of being struck by lightning than of other, more common, dangers.
And Bernstein points out that human life would be a lot less rich if there weren't people who put a lot more value on the reward of taking a risk than they did on the loss they'd suffer from failing. Those are entrepreneurs, explorers and other pioneers who set out to accomplishment something (often at great cost) that is unlikely but which could bring great wealth.
It also explains why I play the lottery. The purely numbers-oriented people say, "The odds are 75 million against you, it's a scam." But I put a greater value on the (admittedly, highly unlikely) wealth I could win than the $2 I lose by playing.
If I didn't play, that $2 would just be absorbed into my daily cash budget, so it has a low utility to me. But I wouldn't have the right to dream of what I'd do if I won.
And who knows? Maybe someday I win. I know the odds are against me, but somebody eventually wins all the money. As long as I have a ticket, it could be me.
If someone has to beg for change on a streetcorner, then they should spend that $2 on the food they need to survive.
If you're depending on the lottery to make you wealth, you need to get off your butt and learn how to make, save and invest more money. You need to perhaps buy some government TIPS bonds to help your savings keep up with inflation.
But don't blame the lottery because some people who play it actually should use that $2 for some other purpose, or because they're too lazy or unambitious to work for wealth in other, more certain ways.
utility and risk
utility and risk
Tuesday, June 19, 2007
Income Investing Today - new book
Income investing is becoming a more popular subject. I just found another hardcover book devoted to it in the bookstore today -- Income Investing Today by Richard Lehman. I've got it on order from Amazon and can't wait to read.
Obviously there are many people looking for an alternative place to put their money besides a passbook account in a bank or chasing "growth" stocks that often don't grow - or which soon pop like a balloon.
My only concern is that, from flipping through it, it's obvious that he comes from a fixed income background -- although he prefers to avoid that phrase -- and so focuses on various securities besides dividend-paying stocks. This puts your portfolio at risk from inflation.
Still, it takes dividend-paying stocks years to catch up and then surpass the higher fixed income securities, and money in the present and near-term is worth more than a money in later years.
Income Investing Today
Income Investing Today
Obviously there are many people looking for an alternative place to put their money besides a passbook account in a bank or chasing "growth" stocks that often don't grow - or which soon pop like a balloon.
My only concern is that, from flipping through it, it's obvious that he comes from a fixed income background -- although he prefers to avoid that phrase -- and so focuses on various securities besides dividend-paying stocks. This puts your portfolio at risk from inflation.
Still, it takes dividend-paying stocks years to catch up and then surpass the higher fixed income securities, and money in the present and near-term is worth more than a money in later years.
Income Investing Today
Income Investing Today
Sunday, June 17, 2007
Asset allocation period for rebalancing advice is poort
However, something about the how-to information on asset allocation in both books disturbed me even more than one writer wanting to see patterns in short-term random results.
The advice about rebalancing.
Both of them say that after a period of time you should rebalance your portfolio, selling the assets which have most risen in price and buying more of the assets which have risen the least (or fallen!).
There is no clear cut consensus on how often you should do this, nor even any guidelines. The books mention periods of one year, quarterly, monthly and even weekly -- but leave it up to the reader.
This seems to me an incredible weakness, for several reasons:
1. Using a short period means you have little opportunity to take advantage of long term trends. For example, if you'd started an asset allocation program in 1995 would it have made much sense to sell off all your stocks in 1996? That bull market ran through March 2000.
Also, bear markets can go on for a long time. Some asset allocation programs contain gold. If you'd started an asset allocation program in 1981, your portfolio would by now consist almost entirely of gold . . . how happy would you be about that?
2. If your accounts are not tax-sheltered, you're realizing taxable capital gains, so part of your portfolio's gains are going to the government.
Even tax-sheltered accounts will have increased transaction costs. Brokerages like to rebalance client accounts every quarter. I wonder why they do it so often?
Seems to me that a poor asset allocation program is little better than an HYIP con game.
asset allocation rebalancing flaws
asset allocation rebalancing flaws
The advice about rebalancing.
Both of them say that after a period of time you should rebalance your portfolio, selling the assets which have most risen in price and buying more of the assets which have risen the least (or fallen!).
There is no clear cut consensus on how often you should do this, nor even any guidelines. The books mention periods of one year, quarterly, monthly and even weekly -- but leave it up to the reader.
This seems to me an incredible weakness, for several reasons:
1. Using a short period means you have little opportunity to take advantage of long term trends. For example, if you'd started an asset allocation program in 1995 would it have made much sense to sell off all your stocks in 1996? That bull market ran through March 2000.
Also, bear markets can go on for a long time. Some asset allocation programs contain gold. If you'd started an asset allocation program in 1981, your portfolio would by now consist almost entirely of gold . . . how happy would you be about that?
2. If your accounts are not tax-sheltered, you're realizing taxable capital gains, so part of your portfolio's gains are going to the government.
Even tax-sheltered accounts will have increased transaction costs. Brokerages like to rebalance client accounts every quarter. I wonder why they do it so often?
Seems to me that a poor asset allocation program is little better than an HYIP con game.
asset allocation rebalancing flaws
asset allocation rebalancing flaws
Asset allocation assets exhibit random covariance
Recently I read several books on asset allocation. This is not a full review of them, but I did notice several disturbing points.
One of the books wrote a lot about the variance between difference types of assets, such as stock and bonds. This variance is a critical point for asset allocation, because the theory behind it, Modern Portfolio Theory, comes from Harry Markowitz's work showing that overall portfolio risk is reduced by holding assets that don't go up and down in tandem.
Anyway, the book went on at length about how tricky this is, because the variance of stocks and bonds changes over time, and came up with different variances over 3 year periods in the past.
I had one of those flashes -- and it goes like this.
The stock market moves in a random walk.
The bond market moves in a random walk.
Therefore, whether stocks and bond prices go in different directions through various 3 years periods is . . . ta! da! --
Random.
I mean, at any given moment either market go only be going up, down or sideways. Therefore, sometimes they'll go in the same direction, sometimes they won't.
Yet this book wants you to adjust your allocation periodically on the basis of these random moves.
Look, the whole idea is that you're reducing risk because these two markets both are random, but can go in different directions. But it's obvious that sometimes they'll go in the same direction.
If you want uniformity, put your money in a passbook savings account in a bank.
asset allocation illusion
asset allocation illusion
One of the books wrote a lot about the variance between difference types of assets, such as stock and bonds. This variance is a critical point for asset allocation, because the theory behind it, Modern Portfolio Theory, comes from Harry Markowitz's work showing that overall portfolio risk is reduced by holding assets that don't go up and down in tandem.
Anyway, the book went on at length about how tricky this is, because the variance of stocks and bonds changes over time, and came up with different variances over 3 year periods in the past.
I had one of those flashes -- and it goes like this.
The stock market moves in a random walk.
The bond market moves in a random walk.
Therefore, whether stocks and bond prices go in different directions through various 3 years periods is . . . ta! da! --
Random.
I mean, at any given moment either market go only be going up, down or sideways. Therefore, sometimes they'll go in the same direction, sometimes they won't.
Yet this book wants you to adjust your allocation periodically on the basis of these random moves.
Look, the whole idea is that you're reducing risk because these two markets both are random, but can go in different directions. But it's obvious that sometimes they'll go in the same direction.
If you want uniformity, put your money in a passbook savings account in a bank.
asset allocation illusion
asset allocation illusion
Tuesday, June 12, 2007
No level playing field for individual investors aiming for capital gains
Last night I began re-reading CAPITAL IDEAS by Peter Bernstein and suddenly he gave away an important clue about why individual investors such as you and I are at a disadvantage when it comes to trying to beat the stock market.
He mentioned how much the market's volume has gone from being transactions by individual investors to transactions by funds - pension funds, mutual funds, endowment funds and charitable funds. And he casually mentioned how these were tax-free -- that is, free of all capital gains taxes. He repeated this again a page or two later.
The proverbial light bulb went off over my head. No capital gains taxes! Say what?
I don't know about you, but I never knew that before. To tell the truth, I'd never thought about these funds paying capital gains taxes. I just assumed they did.
I can understand why the government allows them to sell securities without paying capital gains taxes, but it still puts you and I at a significant disadvantage relative to these institutions, when you and I try to compete as stock pickers.
We have to pay capital gains taxes. That's a significant drag on the long term performance of any person buying and selling stock. It's why Warren Buffett's favorite holding period is "forever."
So by not having to pay it, these institutions are making decisions free of a major constraint that we face.
This is a major factor in the stock market -- and nobody's talking or writing about it.
So it's one more good reason why we should be investing for income, not capital gains. Because if we play the buy stocks now so they'll go up and we sell them at a profit game, we're competing against major institutions and fund managers who not only have tremendously more resources (including their time) than we have -- but they don't have to pay capital gains taxes, as we do.
Don't pay capital gains taxes, yet enjoy a cash return from your investments -- buy securities for income, and never sell them.
capital gains disadvantage
capital gains disadvantage
He mentioned how much the market's volume has gone from being transactions by individual investors to transactions by funds - pension funds, mutual funds, endowment funds and charitable funds. And he casually mentioned how these were tax-free -- that is, free of all capital gains taxes. He repeated this again a page or two later.
The proverbial light bulb went off over my head. No capital gains taxes! Say what?
I don't know about you, but I never knew that before. To tell the truth, I'd never thought about these funds paying capital gains taxes. I just assumed they did.
I can understand why the government allows them to sell securities without paying capital gains taxes, but it still puts you and I at a significant disadvantage relative to these institutions, when you and I try to compete as stock pickers.
We have to pay capital gains taxes. That's a significant drag on the long term performance of any person buying and selling stock. It's why Warren Buffett's favorite holding period is "forever."
So by not having to pay it, these institutions are making decisions free of a major constraint that we face.
This is a major factor in the stock market -- and nobody's talking or writing about it.
So it's one more good reason why we should be investing for income, not capital gains. Because if we play the buy stocks now so they'll go up and we sell them at a profit game, we're competing against major institutions and fund managers who not only have tremendously more resources (including their time) than we have -- but they don't have to pay capital gains taxes, as we do.
Don't pay capital gains taxes, yet enjoy a cash return from your investments -- buy securities for income, and never sell them.
capital gains disadvantage
capital gains disadvantage
Sunday, June 10, 2007
Stocking picking PQ randomly distributed?
Somewhere earlier in this blog or in an article, I speculated that the great investing success of Peter Lynch, Warren Buffett, John Templeton and a handful of others is not due to them being lucky stock pickers/coin flippers (as the Efficient Market Theory would have to claim), but neither does their success refute the Efficient Market Theory.
According to EMT, it's extremely difficult to beat the market on a long term basis -- but not necessarily.
I speculated that the ability to beat the market long term was made up of a number of personal qualities which were distributed randomly through the human population. So, quite by randomness, those individuals were born with and had the opportunity to develop the qualities that made them able to beat the market.
Therefore, the ability to beat the market still adheres among money managers, pension fund managers and mutual fund managers to a normal distribution, where only a small percentage do in fact beat the market long term.
Yet it's not due to luck in stock picking, but "luck" in the sense they were born with the ability (or, most likely, combination of abilities).
Anyway, in reading CAPITAL IDEAS by Peter Bernstein, he says something to the same effect, calling this beat the market long term ability "Performance Quotient" or PQ and speculates that only a tiny percentage of the population has the genius-level PQ.
He brings up an idea I didn't think of -- that most people with PQ do not manage money for others. They prefer to keep their talent (which still has to be coupled with hard work, just as people with high I.Q.s still have to work hard to come up with genius level ideas) and their investing results to themselves.
I'm not so sure of that -- successful money managers can make a lot of money by managing other people's money. Yet it's also true that the most successful managers are probably just as good or better at selling themselves than at their long term results. And many people with a high PQ may not be good at selling themselves -- it's a separate talent, after all.
Yet Warren Buffett started out forming a limited partnership with friends and relatives.
So who knows -- it's one thing to have a high PQ. It's another thing to have enough money to invest with it so that you can get rich.
Stock Picking
Stock Picking
According to EMT, it's extremely difficult to beat the market on a long term basis -- but not necessarily.
I speculated that the ability to beat the market long term was made up of a number of personal qualities which were distributed randomly through the human population. So, quite by randomness, those individuals were born with and had the opportunity to develop the qualities that made them able to beat the market.
Therefore, the ability to beat the market still adheres among money managers, pension fund managers and mutual fund managers to a normal distribution, where only a small percentage do in fact beat the market long term.
Yet it's not due to luck in stock picking, but "luck" in the sense they were born with the ability (or, most likely, combination of abilities).
Anyway, in reading CAPITAL IDEAS by Peter Bernstein, he says something to the same effect, calling this beat the market long term ability "Performance Quotient" or PQ and speculates that only a tiny percentage of the population has the genius-level PQ.
He brings up an idea I didn't think of -- that most people with PQ do not manage money for others. They prefer to keep their talent (which still has to be coupled with hard work, just as people with high I.Q.s still have to work hard to come up with genius level ideas) and their investing results to themselves.
I'm not so sure of that -- successful money managers can make a lot of money by managing other people's money. Yet it's also true that the most successful managers are probably just as good or better at selling themselves than at their long term results. And many people with a high PQ may not be good at selling themselves -- it's a separate talent, after all.
Yet Warren Buffett started out forming a limited partnership with friends and relatives.
So who knows -- it's one thing to have a high PQ. It's another thing to have enough money to invest with it so that you can get rich.
Stock Picking
Stock Picking
Friday, June 8, 2007
Profit taking is dis-respecting capital gains - good!
According to the news, stock investors have spent the last few days "taking profits." Years ago I read a sour comment by a trader that they wished they were taking profits, but in reality was simply trying to get out at less of a loss.
Still, since the overall market did reach record highs early this week, I'm sure that many people did have profitable positions.
So if holding onto stocks for long-term capital gains the optimum procedure, why do the traders who know the market best always rush to convert their capital gains to cash? Could it be they value cash in their hands today more than the nebulous prospect of future capital gains -- capital gains which exist only on paper and which could go up in smoke tomorrow.
$7 trillion in capital gains vanished in March 2000. Today's Dow record could turn into the high water mark of a flood -- a record, but the water's receded. Capital gains come and go.
profit taking
profit taking
Still, since the overall market did reach record highs early this week, I'm sure that many people did have profitable positions.
So if holding onto stocks for long-term capital gains the optimum procedure, why do the traders who know the market best always rush to convert their capital gains to cash? Could it be they value cash in their hands today more than the nebulous prospect of future capital gains -- capital gains which exist only on paper and which could go up in smoke tomorrow.
$7 trillion in capital gains vanished in March 2000. Today's Dow record could turn into the high water mark of a flood -- a record, but the water's receded. Capital gains come and go.
profit taking
profit taking
Thursday, June 7, 2007
Harry Dent's latest bubble boom predictions
I just got through skimming the latest update from Harry Dent. Dent is the demographer/forecaster who uses demographic information to make stock market predictions, and has an enviable record of calling bulls and bears not based on company info, but on where in the lifestyle spending cycle the baby boom generation is.
In his most recent book, THE NEXT BUBBLE BOOM he predicts that the downturn from 2000-2002 would be followed by another bull market that would dwarf what we saw in the late 1990s -- with the Dow reaching 32,000 to 40,000 by 2010!
What's he saying now? I'll give you a hint - he's found another long-term cycle, the Geopolitical Cycle, which also affects results. And a look at today's headlines make it clear it's not boosting stock market results, although we're having a bull market despite the world's problems.
Dent still calls for a boom but has modifies its extent - and you better know when to get out. Because he's still calling for it to be followed by a long, extended bear market until 2022.
To check out the report, go to:
Harry Dent latest bubble boom report
Dent new forecasts
Dent new forecasts
In his most recent book, THE NEXT BUBBLE BOOM he predicts that the downturn from 2000-2002 would be followed by another bull market that would dwarf what we saw in the late 1990s -- with the Dow reaching 32,000 to 40,000 by 2010!
What's he saying now? I'll give you a hint - he's found another long-term cycle, the Geopolitical Cycle, which also affects results. And a look at today's headlines make it clear it's not boosting stock market results, although we're having a bull market despite the world's problems.
Dent still calls for a boom but has modifies its extent - and you better know when to get out. Because he's still calling for it to be followed by a long, extended bear market until 2022.
To check out the report, go to:
Harry Dent latest bubble boom report
Dent new forecasts
Dent new forecasts
Subscribe to:
Posts (Atom)