Author Archives: Patrick Crook

Morningstar Sees The Light

Really interesting paper from Morningstar ETFInvestor. If you are not a subscriber, Meb Faber has made it available here. The author of the paper, Samuel Lee, applies a simple moving average crossover approach to six separate strategies. The conclusions were powerful:

In virtually every equity, currency, and commodity index we tested, moving-average-based timing schemes reduced drawdowns without sacrificing return (in many cases improving it). The improved risk-adjusted returns can’t be explained by the increased average exposure to cash or to a few anomalous periods.

A moving average crossover signal is not a predictor of anything, it is a risk management device. One of the most effective ways to improve performance, as demonstrated by this paper (and many others), is to avoid ghastly drawdowns. This isn’t about trying to time tops and bottoms, it’s about avoiding most of a downtrend and capturing most of an uptrend. Definitely worth a read.


It’s Kind Of Like Trying To Push A Rope

A lot of people have an aversion to holding cash in an investment portfolio. For the last four or five months, we have been holding a much larger than normal amount of cash and this has inspired an uptick in questions from newer and prospective clients. Polite questions, but with an undertone of frustration. I wouldn’t think much of it, but some of the meetings I’ve had lately with people that are considering firing their current adviser and coming over here have been eye-opening.

When people are in the process of firing their current guy, they usually strip away undertones and are more explicit in describing their frustration. When cash balances are large, the frustrated client sometimes attributes this to incompetence, fear or laziness on the part of the adviser. Often they’re right. Sometimes the frustration stems from not understanding the decision making process. But other times the problem stems from unrealistic assumptions. An assumption that if you just look hard enough, the vast universe of tradable securities has to reveal at least some opportunities that are better than cash.

Objectively, it’s true – there are always opportunities somewhere. From a practical standpoint though, the odds of successfully exploiting those opportunities can change dramatically depending on the broader market environment. I’m not willing to put money at risk in places where the odds are stacked against us. In an environment where the probability of success is low, holding cash is the logically better choice. The urge to try to make something happen can be strong, but it’s dangerous. The market doesn’t care what you need or want and doesn’t reward you for trying really, really hard. There are no participation medals.

Poker players, military historians, football coaches and tacticians of all stripes understand that folding, retreating and punting can be valuable tactics in the face of long odds. We accumulate cash to preserve our ability to act when the winds of probability eventually turn in our favor.

Investing Is Not a Magical Pretend Business

It’s funny how a lot of the conventional thinking with regard to investing is focused on being deliberately ignorant and purposely conformist. The conventional mindset among both individuals and advisers is that we should just focus on asset allocation, periodic rebalancing and patience. That’s all. Just do that and watch the money come in, eventually.

In every other type of business venture, we prize creativity and innovation. A unique product or service can be a tremendous competitive advantage. Had Steve Jobs decided that his business plan was to do exactly what Michael Dell does, the story of Apple would have been much different. If Ford, Honda, Mercedes and Bugatti all built the same car at the same price, there would be no reason for more than one of them to exist.

Beyond being innovative, successful business owners tend to be proactive about protecting themselves against hazards that could have devastating consequences. They put locks on the doors, buy fire insurance and avoid extending credit to hobos. If water is pouring through a gaping hole in the roof of the warehouse, they fix it rather than blithely assuming that these kinds of events are normal and will eventually go away.

The standard approach to investing entails replicating a generic asset allocation plan then populating that plan with low cost index funds. Sometimes you rebalance the investments to stay in perfect conformation with the generic plan. If risks present themselves you must ignore them because the plan is a good one that has the approval of a guy that won a Nobel prize! You don’t know him, but trust me, he is very smart. In return for patient allegiance to the generic plan that everyone should copy, we expect a lifetime of returns that beat inflation.

Of course, many people want to take a more active role. Investments are selected by doing research. [Sarcasm Alert] They will do the hard work of uncovering gems by looking in Value Line for stocks with a low p/e. An adviser will make sure to stay on top of things by reading the reports written by the firm’s investment strategist – you don’t know him, but he is very smart. We will pick talented fund managers by reading information compiled by Morningstar. This is a good strategy because a lot of people aren’t willing to go all the way to the library to conduct research. [End Sarcasm]

The assumption that we deserve good returns by doing exactly what everyone else does, with information that everyone else already has, flies in the face of common sense. Doing this while purposely ignoring risk is lunacy. An adviser that is not willing to work hard enough or smart enough to create an innovative approach is a dead man walking. The traditional, generic approach isn’t worth paying for and will not last.

How To Sniff Out BS Research

Interesting article from Scientific American on how to evaluate whether or not an article or report is scientifically sound or just an attempt to justify a preconceived conclusion.

In other words, even if I can’t evaluate someone else’s raw data to tell you directly what it means, I can evaluate the way that data is used to support or refute claims. I can recognize logical fallacies and distinguish them from instances of valid reasoning. Moreover, this is the kind of thing that a non-scientist who is good at critical thinking (whether a journalist or a member of the public consuming a news story) could evaluate as well.

The ability to read and judge research critically is one of the most important skills an investor, or anyone for that matter, can have. Read it all here.

“It’s a Mathematical Inevitability”

It gets tiresome reading day after day on the ever deeper hole states, cities and other municipalities are digging themselves into. Tiresome, until Michael Lewis writes about it. In this case he covers California and a couple of cities that are already beginning to collapse.

The problem was going to grow worse until, as he put it, “you get to one.” A single employee to service the entire city, presumably with a focus on paying pensions. “I don’t know how far out you have to go until you get to one,” said Reed, “but it isn’t all that far.” At that point, if not before, the city would be nothing more than a vehicle to pay the retirement costs of its former workers.

Read the whole thing here: California and Bust