Managing Risk


The accepted wisdom is risk is volatility

That is one way to think about it, but volatility by itself is not risky.  What is risky is how much will the investment be worth on the day in the future when you want to sell it.

While volatility can be calculated to many decimal places, when and why you need the money is mostly unknown. So, maybe volatility is not as crucial as we think.

If you trade a lot, volatility matters

Volatility is the annualized standard deviation of returns. It makes sense if returns are distributed normally, bell curve, but they are not quite.  Market returns tend to be taller and skinnier than a bell curve, are not quite perfectly symmetrical, and they have bumps at the extremes where bell curves are near zero. We can assume that that doesn’t matte, but assumptions come with risk.

We know that the longer term volatility is quite small compared to very short term results. There is a formula to approximate how it changes. Take the time of the short duration and the time of the long duration.  Let say daily versus one year.  There are roughly 250 trading days in the year so the annual and the standard deviation is roughly the daily times the square root of 250.

Suppose daily volatility is 1.1%, then annual will be 1.1% times 15.81 equals 17.4%. In terms of volatility we are not much the wiser. The key element is the ratio of volatility to yield.

The daily return space roughly. 04% plus or minus 1%. It is about 50 times as wide as the daily yield. Mostly noise.

Annually the ratio 10.5% yield and 17.4% volatility.  Much more capable signal. If the market results were normally distributed we would expect this year to fall in the space yield plus or minus volatility roughly two thirds of the time. So -7% to plus 27%. A space roughly three times bigger than yield.

Volatility is a drag on yield if you turn the portfolio over too quickly.

That’s why we care about the holding period.  For long term investors the ratio of the yield to the space gets lower as you hold securities longer. More predictable in simple terms.

When you trade frequently, you get taken in by the volatility and on average your yield will fall by about half of the square of the annual standard deviation.  In the stock market that could cost about 1% annually so yield 9.5% instead of 10.5%

Trading daily is anti-statistical

With a yield of .04% and standard deviation of 1% you should expect on average to be around -.45%.  Yikes.

There is another cost.

Emotionally losses hurt us more than gains of the same size bring us joy. Trading frequently increases the exposure to negative results and so we felt worse than we should. The market needs to be up twice as many days as it is down to feel good. Historically, the 10%+ yield happens with only a tiny bias towards the plus side.

You could earn reasonable yields and be upset all the time.

Keep it simple.

Sound sleep is inversely proportional to perceived risk. The thing you know without the math – sell until you sleep. 

Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario. 

In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.

Please be in touch if I can help you. don@moneyfyi.com  866-285-7772

 

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Practical Fuzzy Approaches


Answers can be good enough

In homage to fuzzy logic, answers are not necessarily good and bad. There are many, maybe all, that are between.  The good enough space.

The good enough space is the perfection avoiding space.

Perfection is debilitating.

There is a syndrome called “perfection, procrastination, paralysis.”  PPP not only prevents perfect answers, it prevents any answer. The problem is the one that says how close to perfect do we need to get. 80% is a pretty good answer in situations affecting the future. You may recall the future is unknowable and therefore no 100% answers exist.

You waste your time trying to perfect such an answer.

You do not waste your time knowing how you come to decide and revisiting it once in a while to see if your perceptions have changed.  They probably will and that should not surprise you.

Good enough answers save a lot of time and that time can be used to make other decisions you would have had to avoid. Learn the idea of rules of thumb. Perhaps rather than call them something trivialized like that, you should treat as them as ideas that support reasonable expectations.

Things we can expect

  • The stock market will fluctuate.
  • The economy will produce a recession once or twice a decade.
  • Your children will grow up.
  • Your money needs in retirement will be different than they are now.
  • Income taxes will become more complicated
  • Advice is cheaper than do-it-yourself, because of unintended consequences of the do-it-yourself practitioners.
  • Everyone dies

Details don’t help much.

Don’t over think the problems or the answers.

It is like the EU specifying browness of French fries because of acrylamide issues. Trace elements don’t matter enough to change the outcome. The fundamental parts of French fries will hurt you unless you are moderate.  If you are moderate, the trace elements wouldn’t matter at all.

If trace elements matter we could sprinkle a milligram of cinnamon on our food and live forever.

Merely common sense

Deal with the big obvious questions and the simple answers before adding complexity.

Dealing with complexity too early is almost always a way to procrastinate

Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario. 

In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.

Please be in touch if I can help you. don@moneyfyi.com  866-285-7772

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Indirect Participation In BitCoins


Two decision problems.

All investments require a decision to buy and some have a requirement that you know when to sell. BitCoin is presently an example of a two-decision problem.

The more volatile the investment the greater the requirements to know both ends. A value investor needs only a way to assess intrinsic value and when markets vary greatly from that assessment, they buy or they sell. As Buffett has said, markets are bipolar. Value investors make money by trading against emotional blemishes in the market prices.

The decision is then only one dimensional. Is the price in the market so far enough away from its intrinsic value that it makes sense to either buy or sell?

Two decisions are more error prone.

If I assume being right is a 50-50 proposition, I will be right half the time. But, if the decision requires that I both buy right and sell right, at 50-50 on each, I will be right only once in four times. In the long run 3 errors in 4 is not the way to financial success.

One decision problems

If we look at the value investor approach, the decision could be either buy, sell, sell short, or do nothing. Doing nothing is by far the most common. They look like different decisions, but they are not.

All of them are relational. If I know intrinsic value and I see the market behaving in ways that are irrational in respect to that, I do whatever is required to optimize my position. All I am required to do is maintain a clear and updated idea about intrinsic value. Hard, but at least rational.

One decision stocks

In the late ’60s the market was quite bubbly and there was a group of stocks that were in great demand because of their growth prospects. National Student Marketing Corp was one of the more famous. NSMC and others were touted as one decision stocks. The buy decision was the only one that mattered. How well did that turn out?

As you might expect, not well at all.

When you expect a stock to rise, but cannot identify the values that must change to make it happen, you are gambling. Traditional measures like profit margin, market size, market share, innovation, rate of change in sales, competitors actions, and cost containment, lead to value changes. You can identify these and assess value because improvement in these leads to improvement in net free cash flow and that is what drives business valuations.

Price attaches to value – Eventually.

Believing a security will go up because it has been going up is like believing in magic. Outcomes with no connection to fundamental inputs. Eventually, fundamentals win.

FOMO

If you have a high fear of missing out, you will be tempted to play in markets that are essentially driven by magic. You can play the game if you wish, but you should realize it is magical thinking.

A rational way to participate in magic markets

In the gold rushes of the late 19th century, prospecting and mining provided poor results.  A few made a lot of money, most lost all their money. Their was, however, one group who made reasonable returns.  The people who supplied the materials miners and prospectors needed.

Think suppliers of food, tools, clothing, tents and the like. How could you go wrong? People had to buy your goods. Banks and assayers did well too.

Who supplies materials in the bitcoin marketplace. Nvidia supplies the boards bitcoin miners like in their computers. Maybe a bitcoin exchange would be a good investment. While they might be hurt by a change in mania for BitCoins, they will be less volatile than the coins themselves.

Think it through. Your goals involve money far in the future. Risking money you might need for money that is based on magic seems wrong.

Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario. 

In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.

Please be in touch if I can help you. don@moneyfyi.com  866-285-7772

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Understand The Price – Cost – Value Relationship


A subtle difference

How much does it cost and what is the price are not the same question.

Price

Primary definition:

“the amount of money expected, required, or given in payment for something.” Google dictionary

Secondary definition

“an unwelcome experience, event, or action involved as a condition of achieving a desired end.”

The secondary definition hints at the difference between price and cost.

Value is what you get. Cost is what you give up.

The real question you must ask yourself is what, in total, must I give up to get some value that someone else is willing to exchange with me.

Cost is a bundle

Price is a unit of cost but not the only unit. If the value is a given bundle of pieces, to get the part of it represented by price to be lower, you typically must give up something else in the bundle.

Typical things in the value bundle

  1. Price
  2. Predictability
  3. Durability
  4. Warranty
  5. Ease of Use
  6. Customer Service
  7. Functionality
  8. Prestige
  9. Tax characteristics

For example, I can buy certain things directly from a Chinese vendor for a lower price than a local vendor.  Is that a good deal?

It is if I don’t care about predictability of delivery, or having the good match the description, or the warranty, or customer service, maybe the price is fair. If I care about any of those, then taking the lowest offered price seems illogical.

People have known this for a long time and there is wisdom on the point.

John Ruskin English, 1819-1900

“A thing is worth what it can do for you, not what you choose to pay for it.”

“Its unwise to pay too much, but its also unwise to pay too little. When you pay too much, you lose a little money ….. that is all. When you pay too little, you sometimes lose everything because the thing you bought was incapable of doing the thing it was bought to do. The Common Law of business balance prohibits paying a little and getting a lot … it can’t be done. If you deal with the lowest bidder, it is well to add something for the risk you run, and if you do that, you will have enough to pay for something better.”

My friend Moe Margles

“I can’t afford anything that cheap”

“Cheap is expensive”

Life should be about optimizing the cost to value relationship. Comparing price alone will provide little guidance.

Quality is like buying oats -if you want nice, clean oats, you must pay a fair price; however – if you’re satisfied with oats that have already been through the horse – such oats can be had a little cheaper!!

Author unknown to me.

Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario. 

In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.

Please be in touch if I can help you. don@moneyfyi.com  866-285-7772

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Mathematics Applies To Financial Planning In Odd Ways


Financial Planning is, by necessity, a fuzzy thing.

Even the great mathematician/philosopher Bertrand Russell had problems with it.

“Everything is vague to a degree you do not realize till you have tried to make it precise”

Markets are vague. Efficient markets or behavioural finance come to mind as being vague. Perhaps both can work together to make sense of the world.

It would behoove us all to have an understanding of formal fuzziness.

The ideas of fuzzy logic are nearly 100 years old now and the more complete parts are more than 50. Time to catch up.

Quick overview.

Our traditional Aristotle derived logic relies on something being true or not true. For computational purposes, the statement has value 1 or 0. True or false. That leads to “The Law of the Excluded Middle” In Aristotle logic there is no truth value in respect to things that are neither true nor untrue.

For example a 3-foot long log has value 1 for the statement, “That is a 3-foot long log.” Band value 0 for the statement that is a bench. But, if I position it beside a campfire it then has a certain benchness about it. What value should I assign to the statement “That is a bench.” The statement is not true with precision 1, nor is it clearly untrue and so with value zero. Benchness is not a concept that our western logic deals with.

Fuzzy logic does. It might assign truth value .5 to the statement. At the same time if I put the log beside my driveway, the value as a bench might fall to near zero and value as a curb rise to a number close to 1.

In fuzzy logic, context matters. Just like in life.

The relationship to financial planning

All financial planning has outcomes that occur in the future. The future is unknown, so no statement about it has truth value 1, certainly true. But neither do statements have truth value zero, certainly untrue. Almost all statements fall between.

You see the problem.  We understand Aristotle logic intuitively and it forms most of our philosophical views. We assess truth and falsity without consideration of nuance.

That works pretty well for things like, “That is a coin” but less well for things like your return on investment will be 7% over the next 40 years. When we take fuzzy statements as being Aristotle-like statements about truth, we become confused. Confusion never adds to the probability of success.

We need better ways to find what has meaning, (not quite the same thing as truth) because we can only assess the future using meaning.

We can do that in our planning if we accept vagueness as a fact and build it in to our decisions. Fuzzy logic will be behind robots and they will become more common, so let’s learn a little.

Fuzzy Logic is moving forward

Lofti A. Zadeh is the mathematician who formalized fuzzy logic.  He presented it as “Fuzzy Set Theory” in 1965. It was scorned and, as with most things outside the accepted view of the world, he paid a price in his career.

But some recognized its possibilities.

The process was taken up initially in Asian countries and applied to everything from Japan’s bullet trains to washing machines that monitor the dirtiness of the clothes within. Clean and dirty are Aristotle, while dirtiness is fuzzy. Decelerating is not quite Aristotelian.

It is not an accident that Asian countries picked it up first. “The Law of the Excluded Middle” is not part of their philosophical background. Many Asian people do not understand the idea “opposite of” as a meaningful statement. We may see black as the opposite of white.  They don’t quite understand that, although most adapt to our way of thinking, however bizarre they may see it.

The robots are coming!

Fuzzy logic is useful in artificial intelligence because, to be intelligent, a system must understand nuance and address meaning rather than the truth of specific statements. Meaning always includes context and that is not the case with the law of the excluded middle.

Some people treat fuzzy logic as probability, but it is subtly different. It is more about meaning. That is the problem.

We know how to assess meaning in a general way, but we don’t know how to describe it. We tend not to think of meaning as being a probability. Meaning is what matters and yet we can’t talk about it with values and almost not with words.

How odd.

A way to check yourself.

From Zadeh’s writings, we can test our assessments about the future with a simple thought.

“As complexity rises, precise statements lose meaning and meaningful statements lose precision”

The future is automatically complex, so you won’t find meaning in yields to 2 decimal places. Look for the direction of your plan, not the details. Look for meaning not accuracy.

“Precision is not truth.” – Henri Matisse

Use ideas of meaning, tendencies, and your own hopes, fears, and expectations to show you the way.  Common sense is fuzzy but useful. Think guides instead of maps for help.

Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario. 

In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.

Please be in touch if I can help you. don@moneyfyi.com  866-285-7772

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Do You Love Surprises?


The value of surprise.

Surprises can delight you. Surprises can make you stronger. Or not!

As Clouseau learned in “The Return of the Pink Panther,” vigilance and preparation cannot prevent all possible bad surprises.

Cato and Clouseau in The Pink Panther.

A financial advisor should help clients avoid surprises.

It is often not easy. Clients seem immune to the experience of others, and that is the one value they should be seeking. No one can make enough mistakes in their lifetime to learn the collective experience of humanity.

Education would help, but education coupled with first hand, live actors, is better. Other than advisors, who has that?

Predictability is the other side of surprise.

Everyone intuitively values predictability. Enough retirement income, a sufficient estate, a margin for error, education opportunities for the children, an emergency fund. You can insure some of it, but for a lot you must put a process in place that leads to achievement.

Advisors know and understand processes that work. Most of those we learned by observing processes that failed. Usually by impetuous choice or by carelessness in implementation.

Do-It Yourself is anti-logic.

Complex things are not easy to understand. Without understanding, solutions cannot be certain to be appropriate. No one does their own root canal, yet many believe themselves capable of doing their own will, their own financial plan,  and their own brake repairs. Sometimes it works, but sometimes is not good enough for things that matter.

Seek help.

At least seek someone who can take a look and help you see the contradictions and voids in your plan.

Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario. 

In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.

Please be in touch if I can help you. don@moneyfyi.com  866-285-7772

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Aren’t Bubbles The Most Fun


Reality is not like theory 

On Thursday past a client asked if they should buy Bitcoins at $15,000.  I replied, certainly not, it is a tulip bubble. He replied, “That’s what you said in July when it was $3,000.”

My, “So the bubble is bigger,” response was not persuasive.

What is happening here?

Aside from a good client thinking I am a moron, there is a window into the world of investment pricing. When you think about it, if you master that, you are nearly done.

Here is the point.

Everything has two prices

In any market, there are always two to discover. The prices are created in different ways and sometimes they coincide and sometimes they do not. In the Bitcoin market, they do not coincide just now.

Price discovery #1 – A thing is worth what it will earn.

Earning is a complex idea. It could be future income like rent from an apartment building, or dividends from a stock, or interest from a bond. The interesting one is the value of your career derived from the future stream of earnings you could expect. Just because there is no market for something to trade doesn’t mean it has no value. You exchange capital for earnings and a return of the capital over time

Another aspect of this is a thing is worth what it will save. Some assets reduce costs without creating income. Home appliances have replaced servants in most of our homes. Their value can be found in the same way – the present value of future cash flow that accrues because you have the asset.

Price Discovery #2 – A thing is worth what it will fetch.

The market value is not created in exactly the same way as the intrinsic value. It is just a number. Eventually the prices coincide, but the variation at a given time can be enormous on either side of the intrinsic value amount. The market price is created with reference to the underlying idea, but it is tempered by other factors which are less capable of analysis.

Real estate brokers and business M&A specialists know about the special buyer. Someone who has a value attachment greater than the underlying earning value. Selling the family home or the family business has more emotional content than economic. That’s why estate planning is so hard.

In market pricing there are unmeasurable factors:

  1. Fear. The price tends to be lower than the value.
  2. Fear of missing out. The price tends to rise as more participate.
  3. Greed. The price tends to go higher
  4. Euphoria. Higher still
  5. Crowd support.  Higher again

It becomes a self adjusting cycle. The news of a price increase becomes the reason to buy. A price increase has nothing whatever to do with the utility of the purchased item. Utility is the only durable value.

As you soon discover, the connection of market price and intrinsic value is not a required condition in an auction.

Humans are not rational most of the time

Humans are wired to gather information from their environment and to use it to improve their well being. Unfortunately, they are also conditioned to find external factors to support what they already believe. Confirmation bias. So, when they believe governments are corrupt or inept or both, they readily connect to the idea of a substitute for something as important as a way to settle money exchanges. Rising prices of thecsubdtitute just confirms their belief.

A bitcoin is a way to exchange value.  It is not value in itself. Bidding up its price is like bidding up the value of $20 bills to five $10 bills from its current two. Paralleling the change in Bitcoins over the last 3 years or so, a $20 bill would today be worth about 1,600 $10 bills. Do you see anything odd about that?

Bitcoins rise in value as the madness of the crowd, the human confirmation bias error, and promotion by those who win by stoking the flames, plays out. In many ways it is similar to the gold market. Gold may have a longer history but, the only obvious difference in the narrative supporting the market price of each is Bitcoin is digital and gold is analog.

It is possible that Bitcoin may go much higher.

Could it double again? Probably possible.

Physicist, Erwin Schrodinger, he of dead and alive cat fame, once observed that if a thing is not specifically prohibited, it will eventually happen. Bitcoin doubling its market price is not prohibited so therefore not impossible. Neither is dropping to a tenth of one percent of the current price prohibited.

No news here

Today would be a good day to reread the 1841 book, “Extraordinary Popular Delusions and the Madness of Crowds” That it is still in print is a key indicator of its utility. It deals with several of the early bubbles. You learn that smart won’t defend you. If anything it will cost you. Isaac Newton lost most of his fortune in a bubble.

Your mission

Determine what value must be added on the intrinsic side to make the market price of Bitcoin justifiable. And therefore sustainable. If intrinsic value is not being added there is no justification for a higher price.

I personally have noticed little value added to Bitcoins since $100. Maybe since $10. They are just the digital equivalent of paper currency.

Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario. 

In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.

Please be in touch if I can help you. don@moneyfyi.com  866-285-7772

 

 

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