Investing Strategies

Investing strategies and corresponding model portfolios are dime a dozen. A quick look at websites like gurufocus.com shows at least five different ways one could model their portfolio. Some of the more prominent ones include - "Buffett-Munger portfolio", "Undervalued Predictable", "Low P/S" and "Low P/B" among few others. Similar look at another website validea.com, reveals more than a dozen such portfolios. Gurufocus and Validea are just two example I happened to pick out of plethora of websites offering similar services. The question is, are such offerings worth a closer look? Are they earning their keep?

Unfortunately, most of them would not give away the proven secret to getting rich and opportunity to join the likes of Buffett for free. Fortunately though, they are generous enough to share the secret for a few dollars a month (yes, I am being sarcastic). 

These strategies are godsend since almost all them seem to have beaten the benchmark index hands down by a wide margin. If this sounds too good to be true, it is. Or as yankees put it - there ain't no such thing as a free lunch. There exists several caveats. While they reveal the performance figures, they obscure the methodology behind the calculation of performance figures. Most likely, the performance figures also do not take into consideration the trading cost, re-balancing cost  or the monthly subscription fees. But the issues don't end here. Let's put aside the possibility of quantitative skewing and shadowing for now and move on to the qualitative and logical issues.

On a closer inspection, we find that there is one thread which is common across all of these portfolios. They are all modeled after the investing strategies of highly successful investors like Warren Buffet/Charlie Munger (Buffett-Munger portfolio, Morningstar wide moat portfolio), Ben Graham (Net-Net portfolio), Kenneth Fisher (Low P/S), David Dreman (Low PER) or Peter Lynch (Growth or PEG) investor. 

In other words, the sophisticated investing strategies of these legendary investors have been reduced to a few lines of computer code and, in some cases, even worse to a set of simple spreadsheet formula. If this is indeed the case, why are the likes of Warren Buffet/Charlie Munger not out of business yet? Or shouldn't Warren Buffet invest in acquiring code monkeys instead of  wasting  8-10 hours of his day reading & learning about businesses?

Surely, one cannot expect the computer model to identify stocks that fit the criteria of legendary investors with 100% accuracy. Would a rather large margin of error, say, 10% be suffice for our purposes of achieving alpha? Would it be fair to expect at a minimum 90% overlap in the holdings? These are question that every investor needs to ask before accepting such strategies at face value. 

Other times some of the strategies happen to outperform the market in a given period purely due to chance. Academics call the mistaken impression that a random streak is due to extraordinary performance the hot-land fallacy. I encourage anyone interested in exploring this further to read more about hedge fund manager Bill Miller and his CAN SLIM investing strategy.  

Investing strategies, like fashion trends,  seem to go in and out of style. What differentiates a well thought investment strategy is the philosophy and logical reasoning  behind it. I have listed below the investment strategies that I believe are based on logical reasoning and sound investment principles.

My aim is to track the long term annual performance of these strategies after transaction cost and taxes (@ a rate of 35%).


Magic formula aims to systematically apply a formula to seek out good business when they are available at bargain price. See wiki or the book 'The Little Book That Still Beats the market' for additional information.

As of 21st March 2014, the following is the list of 30 companies with a minimum market cap of 50 million recommended by the magic formula.



TickerPrice (Buy)
ACHI$5.90
ANIK$40.84
AGX$33.95
AVID$15.02
HRB$32.90
DEPO$24.12
ENTA$34.35
FLR$57.29
GME$40.92
GILD$102.29
GORO$2.95
IQNT$16.49
IDCC$53.29
KING$15.10
LFVN$0.80
LQDT$9.62
MTEX$18.95
MSB$16.18
MNDO$3.21
NHTC$17.36
NSR$21.90
PDLI$7.29
PFMT$3.59
PSDV$4.30
RPXC$15.01
TZOO$9.87
VEC$24.98
VIAB$69.76
WSTG$17.60
WILN$2.46

Dividend growth investing
This investment strategy aims of buy shares in companies that have raised dividends for at least ten years in a row. I will be tracking this using VIG ETF. If you want to read more or have greater control at dividend growth stocks, I suggest you visit Dividend Mantra or Dividend Growth investor.


TickerPrice (Buy)
VIG$82.22

Harry Brown portfolio
This portfolio is based on the behaviour of stocks, cash, gold and bonds during the times of economic prosperity, recession, inflation and deflation. Harry Brown advocated 25% allocation in each of the asset classes and rebalancing once a year. The logic behind it is as follows:
  • Stocks - VTI (25%):  During times of economic prosperity, stocks tend to perform better. 
  • Gold - GLD (25%): During times of inflation, gold tends to perform better.
  • Bonds - TLT (25%): During times of deflation, bonds tend to perform better.
  • Cash - SHY (25%): Cash performs well during the times of recession.
To learn more I recommend the books - 'Fail Safe Investing' and 'The Permanent Portfolio'. In addition, crawlingroad.com is an excellent resource for historical performance figures.

TickerPrice (Buy)
VTI$109.76
GLD$113.57
TLT$131.51
SHY$84.77

Plain old vanilla total market index funds
I have written about the reasoning behind this strategy several times (part-1, part-2 and part-3). Almost, all of my savings including superannuation are invested in VTI ETF.


TickerPrice (Buy)
VTI$109.76

Harry brown portfolio on steroids
This portfolio is exactly what it sounds like, Harry Brown portfolio but using call LEAP options with the following asset allocation.
  • Stocks - LEAP SPY (16.67%)
  • Gold - LEAP GLD (16.67%)
  • Bond - LEAP TLT (16.67%)
  • Cash - SHY (50%)
TickerStrike pricePrice (Buy)Expiry
SPY$210.00$17.2720/01/2017
GLD$113.00$12.5020/01/2017
TLT$131.00$8.5020/01/2017

Warning: Please bear in mind though, this is a speculative portfolio. I came up with this strategy and do not have any historical performance figures either to prove or disprove it. I have invested a very small portion of my saving into this portfolio. 

Next year, I will update the performance of these portfolios. 


Would love to hear from all of my readers.


Full Disclaimer: I am not a financial planner. The views expressed in this post are all mine and they may or may not suit your needs. Please do you own due diligence. I do not make money on any of the products suggested in this post.

Books

Outside of a dog, a book is a man's best friend. Inside of a dog it's too dark to read. - Groucho Marx 
Nowadays, I rarely, if ever, read fiction or novels. It is odd since my love affair with reading began with novels. I was never much of a reader, so much so, I hadn't read many books (outside my study curriculum) until I finished school. To say that I was preoccupied with course material would be a lie. Truth is, I didn't like reading at all. I don't know how or when, but gradually I started appreciating books. Now, I can't live without them. Okay, may be I have taken it a bit too far with my last sentence, but you get the point.

This brings us to Hunger Games tri-series. I enjoyed reading the first book of the tri-series. I found the second book readable and enjoyable in parts but the third book in the series was a let down. 


During my engineering days in Bangalore, I somehow managed to not succumb to ragging by the seniors in the hostel or on campus. If you did your engineering in India (and lived in hostel), you will agree that getting away without succumbing to ragging is a fairly rare event. Was it due to the fact that I was extra-ordinarily strong? Or was it due to the fact that my seniors were extra-ordinarily weak? Or was it just luck? I like to think that this was due to me being persistent in the face of adversity, but I doubt it and will be first to admit that I will never know for sure.

My seniors tried several measures to subject me to ragging ranging from threat to physical force. When everything else failed, they issued a memo abstaining hostelities from talking to me at all times regardless of whether they were in hostel or outside. Although I did not know this at the time, this turned out to be a blessing in disguise. Typically, the non-local hostelites tend to remain within the closed group of hostelites. Ousted from the so called 'hostel fraternity' I had no choice but to spend time and mingle with the locals. To date, I cherish the close friendship I developed with my Bangalorean friends during my first year in university.


It was during this time, someone (ashamed at not being able to recall the person’s name) recommended 'The Fountainhead' to me. I bought it from majestic for a mere INR 20, thanks to piracy. With no one to talk to in the hostel, no internet and TV, I buried myself in the book. And what a book it was.


The book drives home the idea of 'individualism versus collectivism, not in politics but within a man's soul'. 'The Fountainhead' had a profound effect on me. I made friends with 'Howard Roark' and 'Gail Wynand', my favourite characters. This book was and remains an indefinite source of strength for me. I highly recommend this book.


By the way, to my credit (yes, I can be self-righteous at times), I held up my end of the bargain by never ragging any of my juniors.

Nobody ever gets anywhere (Zenos paradox)

Zeno’s paradox goes like this: Suppose a student wishes to step to the door, which is 1 meter away. (We choose a meter here for convenience, but the argument holds for a mile or any other measure.) Before she arrives there, she first must arrive at the halfway point. But in order to reach the halfway point, she must first arrive halfway to the halfway point—that is, at the one-quarter-way point. And so on, ad infinitum.

In other words, in order to reach her destination, she must travel this sequence of distances: 1/2 meter, 1/4 meter, 1/8 meter, 1/16 meter, and so on. Zeno argued that because the sequence goes on forever, she has to traverse an infinite number of finite distances. That, Zeno said, must take an infinite amount of time. Zeno’s conclusion: you can never get anywhere.


Diogenes the Cynic took the empirical approach: he simply walked a few steps, then pointed out that things in fact do move. To those of us who aren’t students of philosophy, that probably sounds like a pretty good answer. But it wouldn’t have impressed Zeno. Zeno was aware of the clash between his logical proof and the evidence of his senses; it’s just that, unlike Diogenes, what Zeno trusted was logic. And Zeno wasn’t just spinning his wheels. 


Even Diogenes would have had to admit that his response leaves us facing a puzzling question: if our sensory evidence is correct, then what is wrong with Zeno’s logic? Consider the sequence of distances in Zeno’s paradox: 1/2 meter, 1/4 meter, 1/8 meter, 1/16 meter, and so on (the increments growing ever smaller). This sequence has an infinite number of terms, so we cannot compute its sum by simply adding them all up. But we can notice that although the number of terms is infinite, those terms get successively smaller. 


Might there be a finite balance between the endless stream of terms and their endlessly diminishing size? That is precisely the kind of question we can address by employing the logic of sequence, series, and limit. To see how it works, instead of trying to calculate how far the student went after the entire infinity of Zeno’s intervals, let’s take one interval at a time. Here are the student’s distances after the first few intervals: After the first interval: 1/2 meter After the second interval: 1/2 meter + 1/4 meter = 3/4 meter After the third interval: 1/2 meter + 1/4 meter + 1/8 meter = 7/8 meter After the fourth interval: 1/2 meter + 1/4 meter + 1/8 meter + 1/16, meter =15/16 meter There is a pattern in these numbers: 1/2 meter, 3/4 meter, 7/8 meter, 15/16 meter… The denominator is a power of two, and the numerator is one less than the denominator. We might guess from this pattern that after 10 intervals the student would have traveled 1,023/1,024 meter; after 20 intervals, 1,048,575/1,048,576 meter; and so on. The pattern makes it clear that Zeno is correct that the more intervals we include, the greater the sum of distances we obtain. But Zeno is not correct when he says that the sum is headed for infinity. Instead, the numbers seem to be approaching 1; or as a mathematician would say, 1 meter is the limit of this sequence of distances. 

That makes sense, because although Zeno chopped her trip into an infinite number of intervals, she had, after all, set out to travel just 1 meter.


Full Disclaimer: I am not a financial planner. The views expressed in this post are all mine and they may or may not suit your needs. Please do you own due diligence. I do not make money on any of the products suggested in this post. 

References:

What is the fairest way to divide the pot?

Suppose you and another player are playing a game in which you both have equal chances and the first player to earn a certain number of points wins. The game is interrupted with one player in the lead. 

In 1996 the Atlanta Braves beat the New York Yankees in the first 2 games of the baseball World Series, in which the first team to win 4 games is crowned champion. The fact that the Braves won the first 2 games didn’t necessarily mean they were the superior team. Still, it could be taken as a sign that they were indeed better. Nevertheless, for our current purposes we will stick to the assumption that either team was equally likely to win each game and that the first 2 games just happened to go to the Braves. Given that assumption, what would have been fair odds for a bet on the Yankees—that is, what was the chance of a Yankee comeback? To calculate it, we count all the ways in which the Yankees could have won and compare that to the number of ways in which they could have lost. Two games of the series had been played, so there were 5 possible games yet to play. And since each of those games had 2 possible outcomes—a Yankee win (Y) or a Braves win (B) –there were 25, or 32, possible outcomes. For instance, the Yankees could have won 3, then lost 2: YYYBB; or they could have alternated victories: YBYBY.The probability that the Yankees would come back to win the series was equal to the number of sequences in which they would win at least 4 games divided by the total number of sequences, 32; the chance that the Braves would win was equal to the number of sequences in which they would win at least 2 more games also divided by 32.


So in order to calculate the Yankees’ and the Braves’ chances of victory, we simply make an accounting of the possible 5-game sequences for the remainder of the series. First, the Yankees have been victorious if they had won 4 of the 5 possible remaining games. That could have happened in 1 of 5 ways: BYYYY, YBYYY, YYBYY, YYYBY, or YYYYB. Alternatively, the Yankees would have triumphed if they had won all 5 of the remaining games, which could have happened in only 1 way: YYYYY. Now for the Braves: they would have become champions if the Yankees had won only 3 games, which could have happened in 10 ways (BBYYY, BYBYY, and so on), or if the Yankees had won only 2 games (which again could have happened in 10 ways), or if the Yankees had won only 1 game (which could have happened in 5 ways), or if they had won none (which could happened in only 1 way). Adding these possible outcomes together, we find that the chance of a Yankees victory was 6 in 32, or about 19 percent, versus 26 in 32, or about 81 percent for the Braves. According to Pascal and Fermat, if the series had abruptly been terminated, that’s how they should have split the bonus pot, and those are the odds that should have been set if a bet was to be made after the first 2 games.


If the two teams have equal chances of winning each game, we will find, of course, that they have an equal chance of winning the series. But similar reasoning works if they don’t have an equal chance, except that the simple accounting we just employed would have to be altered slightly: each outcome would have to be weighted by a factor describing its relative probability. If we do that and analyze the situation at the start of the series, we will discover that in a 7-game series there is a sizable chance that the inferior team will be crowned champion.


Full Disclaimer: I am not a financial planner. The views expressed in this post are all mine and they may or may not suit your needs. Please do you own due diligence. I do not make money on any of the products suggested in this post. 

References:

How certain can we be that they were telling the truth?

At Duke University, two students had received A’s in chemistry all semester. But on the night before the final exam, they were partying in another state and didn’t get back to Duke until it was over. Their excuse to the professor was that they had a flat tire, and they asked if they could take a make-up test. The professor agreed, wrote out a test, and sent the two to separate rooms to take it. The first question (on one side of the paper) was worth five points. Then they flipped the paper over and found the second question, worth 95 points: “which tire was it?” What was the probability that both students would say the same thing?

If the students were lying, the correct probability of their choosing the same answer is 1 in 4. That is, there is a whopping 25% probability that we would get away with chance alone. 


Full Disclaimer: I am not a financial planner. The views expressed in this post are all mine and they may or may not suit your needs. Please do you own due diligence. I do not make money on any of the products suggested in this post. 

References:


Availability bias

In reconstructing the past, we give unwarranted importance to memories that are most vivid and hence most available for retrieval. The nasty thing about the availability bias is that it insidiously distorts our view of the world by distorting our perception of past events and our environment.

Full Disclaimer: I am not a financial planner. The views expressed in this post are all mine and they may or may not suit your needs. Please do you own due diligence. I do not make money on any of the products suggested in this post. 

References:


The law of large numbers vs the law of small numbers

Toss a (balanced) coin 10 times and you might observe 7 heads, but toss it 1 zillion times and you’ll most likely get very near 50 percent, which is closer to the underlying probability.


The phrase law of large numbers is employed because, it concerns the way results reflect underlying probabilities when we make a large number of observations.

In real-life situations we often make the opposite error: we assume that a sample or a series of trials is representative of the underlying situation when it is actually far too small to be reliable.


The misconception—or the mistaken intuition—that a small sample accurately reflects underlying probabilities is so widespread that Kahneman and Tversky gave it a name: the law of small numbers.  The law of small numbers is not really a law. It is a sarcastic name describing the misguided attempt to apply the law of large numbers when the numbers aren’t large.


When people observe the handful of more successful or less successful years achieved by the Sherry Lansings and Mark Cantons of the world, they assume that their past performance accurately predicts their future performance.


Consider a situation in which two companies compete head-to-head or two employees within a company compete. Think now of the CEOs of the Fortune 500 companies. Let’s assume that, based on their knowledge and abilities, each CEO has a certain probability of success each year (however his or her company may define that). And to make things simple, let’s assume that for these CEOs successful years occur with the same frequency as the white pebbles or the mayor’s supporters: 60 percent. (Whether the true number is a little higher or a little lower doesn’t affect the thrust of this argument.) Does that mean we should expect, in a given five-year period, that a CEO will have precisely three good years? 


No. Even if the CEOs all have a nice cut-and-dried 60 percent success rate, the chances that in a given five-year period a particular CEO’s performance will reflect that underlying rate are only 1 in 3! Translated to the Fortune 500, that means that over the past five years about 333 of the CEOs would have exhibited performance that did not reflect their true ability. Moreover, we should expect, by chance alone, about 1 in 10 of the CEOs to have five winning or losing years in a row. 


What does this tell us? It is more reliable to judge people by analyzing their abilities than by glancing at the Scoreboard. Or as Bernoulli put it, “One should not appraise human action on the basis of its results.


Going against the law of small numbers requires character. For while anyone can sit back and point to the bottom line as justification, assessing instead a person’s actual knowledge and actual ability takes confidence, thought, good judgment, and, well, guts.


Executives’ winning years are attributed to their brilliance, explained retroactively through incisive hindsight. And when people don’t succeed, we often assume the failure accurately reflects their talents and abilities. 


Full Disclaimer: I am not a financial planner. The views expressed in this post are all mine and they may or may not suit your needs. Please do you own due diligence. I do not make money on any of the products suggested in this post. 

References:


Gamblers fallacy



Another mistaken notion connected with the law of large numbers is the idea that an event is more or less likely to occur because it has or has not happened recently. The idea that the odds of an event with a fixed probability increase or decrease depending on recent occurrences of the event is called the gambler’s fallacy. For example, if Kerrich landed, say, 44 heads in the first 100 tosses, coin would not develop a bias toward tails in order to catch up! That’s what is at the root of such ideas as “her luck has run out” and “He is due.” That does not happen.

For what it’s worth, a good streak doesn’t jinx you, and a bad one, unfortunately, does not mean better luck is in store. Still, the gambler’s fallacy affects more people than you might think, if not on a conscious level then on an unconscious one. People expect good luck to follow bad luck, or they worry that bad will follow good.
 
Now, we know that a modern slot machine is computerized, its payoffs driven by a random-number generator, which by both law and regulation must truly generate, as advertised, random numbers, making each pull of the handle completely independent of the history of previous pulls. And yet… Well, let’s just say the gambler’s fallacy is a powerful illusion.


Full Disclaimer: I am not a financial planner. The views expressed in this post are all mine and they may or may not suit your needs. Please do you own due diligence. I do not make money on any of the products suggested in this post. 

References:

The truth behind the saying - 'If you can't measure it, you can't manage it'



Numbers always seem to carry the weight of authority.

As a kid, all of us have gone through the ordeal of submitted an essay and receiving a grade (by teacher) based on quality of the essay. But, we must recognize that a grade is not a description of an essay’s degree of quality but rather a measurement of it, and one of the most important ways randomness affects us is through its influence on measurement. In the case of the essay the measurement apparatus was the teacher, and a teacher’s assessment, like any measurement, is susceptible to random variance and error. 

Voting is also a kind of measurement. In that case we are measuring not simply how many people support each candidate on election day but how many care enough to take the trouble to vote. 

All measurements are imprecise.

It is one of those contradictions of life that although measurement always carries uncertainty, the uncertainty in measurement is rarely discussed when measurements are quoted. If a fastidious traffic cop tells the judge her radar gun clocked you going thirty-nine in a thirty-five-mile-per-hour zone, the ticket will usually stick despite the fact that readings from radar guns often vary by several miles per hour.

The uncertainty in measurement is even more problematic when the quantity being measured is subjective, like English-class essay.

Numerical ratings, though dubious, make people confident that they can pick the golden needle (or the silver one, depending on their budget) from the haystack of choices. The key is to understand the nature of the variation in data caused by random error

If you can't measure it precisely, you can't manage it precisely


Full Disclaimer: I am not a financial planner. The views expressed in this post are all mine and they may or may not suit your needs. Please do you own due diligence. I do not make money on any of the products suggested in this post. 

References:


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