Are You Listening To The Signal Or The Static?

When I was in high school, I listened to baseball on the radio.  Joe Chrysdale and Hal Kelly on AM 580, CKEY told the story of the Toronto Maple Leafs baseball team.  Sparky Anderson played there in the early ‘60’s.  Who could forget Rocky Nelson?  He was a very good hitter, but the story was that he kept his glove in oil lest it get rusty.  Clang!

If there was no Leaf game, you could catch Harry Caray with the Cardinals on KMOX.  You could hear Gibson versus Koufax or Drysdale or Marichal, and follow Stan Musial at the end of his brilliant career.  You had to pay attention though, because listening to KMOX required that you ignore the static.

AM radio stations send a strong clear signal and the vagaries of the atmosphere and the receiver’s location interferes with it.  That is what static is.

Sort of like the stock market.

In the stock market there is a clear underlying value driver (the signal).  Obscured by short term variability (static)

The signal that results for a given security or even an index is a combination of things.  The economy, the business and its management, products, population growth, demographics, competitors, technology, brand.

If you track values of the S&P 500 since the early 1920’s, you will find the signal is almost exactly 10%.  The values tend to run in a trough between 9.8% and 10.2%.  It is moderately clear.  Values don’t stay far away for very long.  Year over year variations are seldom more than 3 times the size of the signal.  Most years lie between minus 20% and plus 40%

For 250 trading days a year, 10% annually is a bit less than .04% daily.  Looking at daily returns however, you find that you cannot see the .04% signal at all.  Static dominates.

There are days when the change has been more than 100 times the expected .04%.  There is one day when it was more than 500 times.  Yet, at the end of several years, the static all cancels and the underlying signal remains.

What does that mean?

  1. Most of the intense traders are trading noise not signal.  Day trading does not use investment rules for success even though it sometimes looks like they are.  It is hard to imagine how the static contributes information but I suppose, for a trader, it must.
  2. If you are an investor, as opposed to a trader, the static will be confusing.  Ignore it
  3. You will usually be upset with the stock market if you follow it too closely.  How so?  I should have less risk if I pay attention.

True if you are a robot.  Not so much for humans.

According to Nobel Prize winner Daniel Kahneman, people are about twice as upset over a given loss as they are happy for an equal sized gain.  To give yourself a chance of happiness, you should look at intervals where you are about twice as likely to see a gain as a win.  If you look at the market every day, the odds are about equal that you will see a loss or a gain.  Emotionally though, that is plus one and minus two.

I am sorry to say that I am not as fluent with math as I once was, and my awareness of the Central Limit Theorem is vague at best, but I think if you look at the stock market about once every 42 months you should expect to see positive results twice as often as negative results.

This will not and probably should not change your behavior, but at least you can console yourself that the market is working, just not today or this month, or however often you look.

Here’s the real defense to static.

Think about buying a small part of a business instead of buying a share.  They are exactly the same thing, but when you think about buying part of a business, the day-to-day variances are in context.  If instead, you buy a stock it is easy to fall into the volatility trap.  If the share price is the only thing you relate to, then the variability will be more apparent and thus more disturbing.

Warren Buffet buys businesses not stocks.  The difference from you is that he buys the whole or most of the business rather than a minute fraction of it.  He has said however, that he would not care if they closed the stock exchange for 10 years after he buys.  He seeks management, market position, products, techniques and people.  Day to day differences do not change those.

You might want to do the same or find a manager who does.

Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.

Follow on Twitter @DonShaughnessy

Good Managers Are Right More Often Than Bad Managers. Yes???

Many years ago, one of my cousins attended the Advanced Management Program at Harvard.  This is a program for seasoned executives and most find it quite fulfilling.  One of the things they do when they are there is work as a team and carry out a research project.

Their Project was:

Discover how strong managers make better decisions than weak managers.

That is a very interesting topic and one that would have a huge payback if you could discover the underlying principles.

They investigated information accumulation, assessment skills, personality, delegation skills, strategic insight, tactical awareness, implementation skills, and more.

They found that weak managers made decisions that were wrong about two thirds of the time.  On the other hand, strong managers made wrong decisions about two thirds of the time.  Not a vast difference there.

But, there were still weak and strong managers.  How Come?

Eight weeks later, they knew the answer.

Strong managers quit doing stupid things sooner.  Addition by subtraction.

That is crucial.  Let the good decisions run and kill the bad ones.  That is least wasteful of resources, least demanding for service, least error prone, and least depressing.  Everything you are involved with is either working or new and that sounds like fun.

Why doesn’t everyone do that?  Insecurity, pride, psychopathic persistence, irrational optimism, nurturing personality.  Who knows?

Understand and operate under the law of symmetry of ownership.

At a given price, the decision to invest in a project and the decision to keep that project at the price it would sell for if you already own it are identical.  Each offers the choice between having a given amount of money or the project.

Assuming you have given it a fair shot and if you would not buy the project for the price it would sell for, you should not keep it either.  That is true even if the price to sell is zero dollars.  Some gifts are liabilities.

It is like golf.  There is not a lot of point spending time and thought deciding how to make a downhill 20-foot putt with two turns in it.  Get it close and move on.

Quit Quick!

How Many Hours Will You Work In Your Career?

If you own your own business or are a professional like a doctor, lawyer or engineer, the number likely is greater than 100,000.  If you are an employee, it is likely to be more than 70,000.

Together with your skills, and risk, and sacrifice of other things that would have been nice, those hours represent the economic value of “You.”  We can agree that the value is quite large.  Enough to pay for your living, and fund your retirement and leave something for the children.

Write 100,000 on a piece of paper.

Now stroke off zeroes until you come to the number of hours that you will spend, in your lifetime, planning what to do with that very large number with the dollar sign in front of it.  Be honest.

I presented this idea in a seminar once and after I stroked off a couple of zeroes someone in the back said, “Get real.  Stroke off the one.”  It is not far from reality for most people.

Most give the financial planning task to people who ask too few questions to find out what you want, do not ask enough about priorities or policies, and do not supply enough options.  Typically, they are quite interested in your current and near future resources.

Reality – most people don’t do financial planning because they don’t know how.

You might want to give some thought to learning a little more about it.  Your part is actually straightforward and knowing that part, you immunize yourself against weak methods from the others.

Answer To The Howard Hughes Rate of Return Test

People are not intuitive about compound interest problems so  you need to learn a way to approximate rates of return.

On Friday I presented this problem.

Howard Hughes inherited $400,000 and died 53 years later worth $2,000,000,000.  What was his average rate of return?

There are several ways to solve this with a calculator or a computer.  And, there is at least one way to solve it without those tools.  All start with the realization that he ended with 5,000 times more.

My financial calculator using PV=1, FV=5000, PMT= 0, N=53 computes i to be 17.433468%

Using Excel Create A = LN(5000)/53;  Interest rate = EXP(A)-1 = 17.433468%

Or we can get a good guess this way. Use the handy Rule of 72

First, find out how many doubles there are.  5,000 lies between 2 to the power 12 (4096) and 2 to the power 13 (8192).  Around 12.3 doubles. So each double took about 4.31 years.

We also know that if you divide the number of years it took to double into 72 you get an approximate interest rate.  In this case 16.7%.  It also works the other way.  If you know the interest rate, it will tell you how long to double.

Was your guess close to 17%?

If not, be sure to do the arithmetic in future.  Your intuition may fail you.

You Can Overdo The Tool Thing

No one wants an electric drill.

They want holes.  The drill is how they get them.

Financial products are like that.  No one wants to own life insurance or an RRSP.  They want what life insurance or an RRSP can do.

Many financial plans fail because some people like their tools too much.  Tax shelters, limited partnerships, trusts, pension plans, corporate mutual funds, segregated funds, Alberta trusts, some kinds of life insurance, and hundreds more.  Design matters and is exciting in some way.  You might be the only one who has one of these tools.  Pretty cool.

It is not that these are bad tools.  It is just that they don’t work the same way for everyone and some of them don’t work at all for you.

You can tell if you should have one.  Focus entirely on what the tool does, not what the tool is.  If you cannot see the “How I get whatever it is that I want” part, (like the drill gets holes) then probably the tool is not for you.  Strategy first.  Tactics next.

If you are a financial adviser, you should not show a client any tactic or tool that is not in the context of solving a problem or exploiting an opportunity that the client knows about and values.

Doing tactics first means the tool has value without the context of its purpose.  It would be  like Armani selling quarter-inch, designer drills for $800 each.

They don’t, do they?

You can never be sure any more.

Investing is Tough Stuff???

Posted on September 29, 2012 by Don Shaughnessy

What should form the basis for an investment decision?

People who buy investment funds learn about risk and volatility and return and so on. Alpha (value added by management), beta (match to the underlying index) and others are used as persuasive tools by advisers. As I discussed yesterday, the market stats may be misleading because they are dominated by trades that are not investment trades.

To invest wisely, we will need other methods.

Profit is a poor proxy for success and investors should not rely on the number without considering other facts. Traders need not care. They are driven by market anomalies not underlying business values.

Strangely, a business can become bankrupt while it is profitable. This profit ambiguity causes problems for business owners, managers, policy makers and investors. The problem is that profit doesn’t mean much by itself. Even earnings per share or the Price/earnings ratio may not tell you what you need.

The market value of a security may be more in the realm of a psychiatrist than an investment analyst. But over a long time, the strangeness of price will be replaced by the reality of fundamentals. You still need to pay attention though.

Profit is an opinion not a fact. Unlike people, IBM does not get a T4 for their annual income.

Suppose an incorporated business earns $1,000,000 using the tax rules and generally accepted accounting principles (GAAP.) In Ontario, the tax bill would be $220,000 leaving $780,000 to invest. Clearly profitable! BUT, only within the system of GAAP and taxation. In the real world, the result might well be very different.

Suppose the business must invest $1,500,000 to remain competitive in its industry, (same market share and same technology as the leaders in the industry.)

Did it really make a profit or did it really lose $720,000?

The “economic answer” is it lost $720,000, but even that is not simple.

By investing the profits and borrowing, the business continues to exist and possibly a weak entrant in the industry will become weaker still and succumb. So, the true long-term economic loss is actually somewhat smaller. Maybe a lot smaller and possibly not a loss at all. Some of the cash loss is an investment in future market share. How do you value that now?

Management faces the task of deciding if they will survive long enough to benefit from the investment. They might be wrong. Especially problematic if the government bails out the weak entrants.

For those looking at profit alone, other expenses matter too. Marketing, advertising, R&D, and employee training, pay off over long periods but have immediate cost. Good for tax expense but hard for the analysts Some other expenses, like pensions, have a visible price today but an unknowable future cost.

In both accounting and taxation, profit is not the result of facts but rather is the result of rules and opinions. Things like depreciation rate, inventory and product obsolescence, bad debts, investment rate to be earned on the pension fund, future technology effects and more.

As an investor, can you glean much from the financial statements?


In most cases, it makes sense to pay attention to the management letter. I know a high performance fund manager who looks for the words challenge or challenging in that letter. If he sees either, he throws the statement away. In his words, “I have only limited resources, so why would I invest with people who have challenges?”

When looking for an investment, use commons sense.

I like and use the product, I like management, I like the industry.

Then look at the numbers.

  • Cash is real, profit is opinion. Or at least, cash is more likely to be real because you go to jail if you fool with it. Not so much with profit.
  • Look for dividends.       They impose a discipline on management and the cash paid out reduces the homeless dollar problem. When management finds that problem, some pretty dodgy projects get funded.
  • Not much debt. You cannot go bankrupt if you don’t owe any money.
  • When things go wrong, quit quick. Holding losers and waiting for recovery is a losing tactic. The price of tulip bulbs peaked in Holland in February 1637 and has not returned to that high.
  • Apply the buy/keep symmetry rule. A decision to keep a stock at a given price is fundamentally the same as the decision to buy it at that price. Either way you are making a choice between having a given amount of money or having a given amount of stock. If you would not buy the stock at that price, you should not keep it at that price either. Your history with it is not relevant. You will live in a future that does not care how you get to it.

Sometimes investing is as easy as finding a good business and participating in it. That is especially true if you cannot understand the “other” market.

A Simple Way To Turn $1,000 Into $1,000,000

We are all looking for easy ways to accomplish useful things.  Well here is a way to be a millionaire without winning a lottery.

Take $1,000, invest it at 5% and wait 141 years and 7 months.  Only 73 years if you can get 10%.

If you have only $100 you can get there in a little less than 189 years at 5% and 97 years at 10%

If you are in a high tax bracket, 5% is what is left over after taxes are paid on 10%

The important lessons here:

  1. By having ten times more capital, you reduce the time by less than 25%
  2. By doubling the yield you can about halve the time
  3. Yield and time matter more than the principal amount.
  4. Be very conscious of things that reduce the yield
    1. Investment fund MER
    2. Taxes can reduce yield by almost half.  Avoid taxes
    3. Tax-free growth is good.  TFSA, RRSP, RESP, Life Insurance
    4. Be risk averse.  The money you lose is important but the time lost is not recoverable.

People are not good at intuitively understanding compound interest.  Do the arithmetic when faced with anything involving yield and time.

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Don Shaughnessy is a retired partner in an international public accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.



Howard Hughes turned $400,000 into $2,000,000,000 in 53 years.
What is his average compound rate of return?

Has Investing Changed?

On 10 October 2008, 11.5 billion S&P 500 shares changed hands.

For context, from January 1951 to December 1969, there were fewer than 25 billion shares that moved.

In the decade of the 2000’s four times more shares traded than in the entire history of the index to that point.  Prior to 2000 stock prices and volume were correlated.  .82 R-Squared in the 90’s.  In the 2000’s not so much.  R-Squared of .01.

We have learned that knowing things is nice, but knowing what they mean is better.

Knowing that volume and price are no longer correlated could mean that the old ideas about how markets work and how one should design a portfolio, may be defective.  If that is true, then passive investing may not be a good tactic.

Have you heard of “Project Express?”

It is a $300 million Trans-Atlantic fiber-optic cable that will exchange data between London and New York 5.2 milliseconds faster than existing cables.  A few electronic trading firms will have exclusive access to it.  The 5 millisecond speed difference gives them a huge advantage over their competitors in electronically traded stocks.  Enough to pay off the $300 million investment at least.

That makes me wonder two things.

  1. Is an index that is created by trades where a 5 millisecond difference matters, the same as an index built on the activities of people who were buying and selling, as investors, over a period of years?
  2. And if it is not the same, does Modern Portfolio Theory and its derivatives really make sense?

All of the indicators like alpha, beta and the Sharpe ratio might be misleading.  Does anyone know what volatility and risk mean in the electronic trading world?  Not likely.  Most of those trades are not speculative.  They lock in a price anomaly and keep the difference.

I don’t know the answers to the questions.

I do know that if you are basing your investment decisions on what you read in last week’s Forbes or yesterday’s Financial Post, and then executing trades through an on-line brokerage, you are not playing the same game as the people who are trading the bulk of the stock.  According to Tabb Group LLC, a market research firm, 55% of current trading volume comes from firms using high frequency trading tactics.  You are a cave-dweller who is more than 5 milliseconds behind.

Over the years, I have decided that it is not smart to play games when you don’t know the rules, who is on the opposing team, and how they keep score.  So, it could be that a common sense approach to investing will make more sense.  Pay less attention to statistical material and more to the businesses you are acquiring.

More on Monday

Know Where You Are Going Before You Set Out

When you are hunting, a dog is a wonderful asset.  Companion, scout, court jester and retriever.  However, you do not let the dog decide what, when or where to hunt.  Most importantly, when it comes time to shoot, you do not give the gun to the dog.

And so it should be with financial planners.

Most financial planners are good company and have a lot to contribute.  Their defect is that if you do not know what you want to do, they will decide for you.  It will make sense for a little while.

The error is missing the distinction between strategy and tactics.

Strategy is yours and tactics belong to the planner(s).  If you do not have a strategy, you cannot understand fully what a tactic is for and you cannot tell what to do if anything changes.

In simplest terms, strategy is the answer to all the “W” questions.  What am I trying to do, what do I have to get it with, what changes can I anticipate, what level of uncertainty will I accept, when do I need it, who is involved, where will I be and so on.  A planner can help you be complete, but they cannot derive the strategy for you.

The planner can help prioritize the strategic parts and set up a time frame to accomplish the parts that are not completely solved in the beginning.  Most clients do not have the unlimited resource needed to do everything.  10-Year Term life insurance is a good example of this.  You will not want it at year 11 so the solution is a temporized one.  It works when you must allocate your scarce resources to currently pressing matters.

Tactics all answer a different question.  “How?”

Do not get involved with tactics.  They exist in a complex and ever-changing world. Taxes, law, economic and investment background, politics, family law, various products that encapsulate several of the parts, and more.  You could not keep up to enough of the pieces to have a hope of getting it right over a long period.  Don’t try.  Buy help.

Tactics can fail in two ways .  One is that the product or technique does not work.  Markets fell for instance.  The second is that the tactic works but it is the solution to no known problem.  That happens when you have no strategy.

If you have a sound strategy you can easily say no to things that don’t fit.  If you know what you are looking for and have communicated it, it is likely that no one will ever recommend them to you.  An added time-saving bonus.

The world conspires against you.  You will see advertising that confuses rather than clarifies.  For example, I recently saw an ad that trumpeted “a unique RRSP strategy.”  There is no such thing as an RRSP strategy and anyone who uses the term does not get planning.  An RRSP is a Tactic.  The strategy is to have money to spend when you retire.  What and when, maybe who.  The RRSP is “HOW” you get it.

In the end, your job is to select among tactics presented by the planner.  You should not even look at one unless it is presented in the form, “Given what you are trying to accomplish with this decision, any of these three options can work for you.  Let me show you how they differ, the advantages and disadvantages of each, and how they may integrate with other parts of your plan.”

Your role is to decide and supply the resources.  The planner’s job is to help you cover all the strategic ground and discover tactical options to achieve your plan.  Eventually help you implement the options.  And even further down the time line, revisit the strategy and review and revise the methods.  It helps keep you on track if they are your conscience.

If you start with how, you will likely miss the reason you are doing it.  For all you know, the tactic does not apply to you.

If you do not know where you are going, any road is a good enough.

Distant Elephants

If humans are offered two similar rewards, they will usually choose the one that comes soonest.  If they have to wait, they will want a little more.

We know, or at least psychologists and economists know, how that happens.  Future events are “discounted” to the present and compared to the current value or cost.

There are several ways to do it.  Economists and psychologists assume “exponential discounting.”  Much like finding the value of a bond.  Use some constant rate to discount the future amount back to the present.  It is rational, easy and efficient.  In a 5% world, $100 today, should be worth $105 in a year or $127.63 in 5 years.  These are all the same.

Nevertheless, like many theoretical constructs, not everyone uses exponential discounting, and no one uses it all the time or in all situations.

People who study this subject find that oftentimes people use “hyperbolic discounting.”

In this method, the first delay attracts a very high rate and as the time gets longer, the discount rate gets lower.  Maybe 20% for the first year and 6% for the second and 3% after that.  It sounds complicated but we use it more than we think.  Essentially, it means we live in a short time envelope and things not in the envelope are rendered unimportant.

Saving pays off tomorrow, spending pays off today.

If we discount the tomorrow value at a very high rate then we will always spend today because the present value of the future benefit is too low.  At 20%, $105 a year from now is only worth $87.50.  Even the 5 year result is only worth about $92.

Similarly, the pain to do a tax return is high.  Everyone promises to organize in early March and have it done by 1 April.  They never do, even though they know that leaving it to the last minute will be harder.  Here the discounted value of future pain is much less than the pain of current effort.  Procrastination has an immediate payoff.

Hyperbolic discounting applies to more than saving, spending or avoiding procrastination.  It insidiously affects decision-making.  It allows us to commit, too easily, to projects that start far in the future.  It is the distant elephant problem.

An elephant that you can see 4 miles away looks pretty small.  Not a threat.  Not a problem.  When the same elephant charges you from 30 yards away, it is a very big problem.  Same elephant, different context.

Like agreeing to become the fund raising chairman for the United Way two years from now.  That is much easier to agree to than if it were one year away or, horror of horrors, starting tomorrow.  Same current pat on the back; different meaning for the commitment.

Under hyperbolic discounting our present self makes decisions that our future self would not.  That is true even though the same assumptions are used by both selves.  And therein lies the problem.

There is not a lot we can do about discounting per se.  It works and our brains are hard-wired.  We can still have the wit to recognize it and learn to minimize its adverse effects.

Until tomorrow (discounted at a high rate)

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