Saturday, September 20, 2008

"Mind" -> Allais Paradox And My Investment Strategy

As we often do on this blog, we have a special guest for today.

I am happy to say that we are going to be spending a little time talking about the psychology of risk with Maurice Allais. Unfortunately, this Nobel Prize winner is dead, but we can honor him by kicking around one of the more famous of his concepts, then we'll use this idea to examine the stock market today.

The Allais Paradox is a hallmark of the way that we are wired, and the best way to look at this is by having you immediately take a quiz. To be effective on this, you are going to have to actually take the quiz, and not just read ahead. Okay? Here we go.

I am a very generous blog writer, and I find a comment that you have posted on my website. I like your comment so very, very much that I write you an email, with the following being written:

"Dear XXXX,

You insight and comments on my blog posting are so very, very good, that I want to reward you somehow. However, I have been taking a look at risk lately, so I am going to reward you with a decision. I am going to give you 2 choices:

Choice A: I will give you a 100% chance of giving you 1 million dollars.


Choice B: I will give you a 25% chance of winning 5 million dollars.

Thanks Again For Your Comments,

Now what choice would you take? Come on. Be honest.

Why or why not? Just stop and think about this for a while. You may even want to write down your answer. You'll see later what most people pick. (Because this is "illogical," this is referred to as the Allais paradox, after our good friend Maurice. You have just participated in the Allais Paradox.)

Let's do another quiz. This is a follow-on to the Maurice Paradox.

Let's say that you are pulled up in front of a judge. He is very mad at you for speeding. So, he says the following:

"Hey look, I have a 6 sided dice," he says. "I'll roll the dice. If it comes up as a 1, you'll pay us zero. If it comes up any thing else, you'll owe $6000. However, to make it interesting, I'll give you another choice. No dice roll, but you'll pay me $5000 right now. So what will it be?"

So, would you take the 1/6 chance of paying no fine, or would you simply pay the $5000. What would your answer be? Again, why don't you write down the reason for your second choice. Also, note if you changed your mind after thinking about it for a while.

The first example involves upside. This was the original Allais Paradox. The second example involves downside. This was a variation on the Allais Paradox. This was done by Daniel Kahneman and Amos Tversky in 1979.

Here is a picture of Kahneman. Unfortunately, Amos Tversky died of skin cancer. However, Kahneman went on to win a Nobel prize for the work he did with his long time collaborator. Too bad Tversky was not there to see it.

What is the answer to above questions?

Well on the letter from me, most people would pick the "sure fire" $1M dollars over the 25% chance of winning $5M dollars. As for the speeding ticket? Most people would pick the "roll of the dice" over handing over $5000.

If we only played the odds, we would have always picked the $5M upside opportunity. After all, getting a 25% chance at $5M dollars is $1.25M on average. As for the roll of the dice, there should have been no preference. Both come out to be $10.

However, people are not wired that way. On "upsides" most people want to lock in the "sure fire" thing. On downsides, they believe "well, it won't happen to me. I won't be picked."

What is interesting is that researchers have looked at this trend in all types of cultures and all types of languages. You would think that the response to this issue would be driven a lot by culture, however, whatever culture you are in, the reaction is basically the same.

Once you start testing this on large groups of people, you can start to plot out the "value vs the risk" on a scale. Kahneman and Tversky did just this. The eventual curve that they built is now known as the "Prospective Curve."

The "Prospect Curve," which I've stolen from Wikipedia, is shown to the side of this text.

If you examine this curve, you will see that it has two axis. The curve plots out the value of gains and losses.

You can see, that minor gains are appreciated, but quickly they level off. So, in this case, you may feel good if I gave you a million dollars. However, you won't feel "five times as good" if I give you five million dollars. This is why most people chose the "sure thing" over the $5M dollar gamble. You have almost four times the risk on $5M, but you won't get twice the pleasure.

On the other side, you can see that losing $1M is more painful than gaining $1M dollars! The curve goes down further for losses than it goes up for gains. Once you have something, it is hard to give it up.

On the down side, if if the odds look "about even," and the pain is pretty painful, most people will pick the result where maybe they'll get lucky and pay nothing. This is section of the down curve where it is less than a 45 degree angle.

"Well, once I lose $5,000, it is only a little more painful to lose $6,000," you might say. "Besides, maybe I can lose nothing and really feel good."

One of my co-workers says, "I'm numb" once he gets beyond a certain point in a quarter. I believe him. However, he is willing to take a little bit of a gamble, and get all the way back up the curve.

This is exactly what happens on the stock market, and this is why I am adjusting my portfolio.

The market is down 15% for the year. The financial sector has many skeletons in their closet. The government is taking over all the major financial institutions. And what is the hope of most of the people on Wall Street? They are rolling the dice, hoping to get lucky and cause their portfolio to regain the loses that they have had for the year.

However, I think that all the cards are pointing to a difficult 18-24 months. I hope that I'm wrong, but I'm in the part of the curve where I haven't lost much, and I want to preserve what I have.

Let me take you though some high level trends.

What I am showing on the chart to the side is the S&P 500 index. This is the "average" value of the stock market over the last 10 years.

Why am I showing you the S&P 500?

You are probably familiar with some type of mutual fund because you have a 401K plan. What you are doing is handing money to "professional money managers" that are supposed to give you good returns.

However, the real secret is that 80-90% of "professional managers" don't beat the S&P500! The other 10% are simply lucky.

The only guy that seems to have a 30 year track record of beating the street is Warren Buffet. He has been preaching for years that having a professional manage your money means that you will suffer. Finally, somebody showed up from New York, and challenged Buffet on this. Very simply, they wagered $1M on the following:

“Over a ten-year period commencing on January 1, 2008, and ending on December 31, 2017, the S&P 500 will outperform a portfolio of funds of hedge funds, when performance is measured on a basis net of fees, costs and expenses.”

Buffet will pay $1M to a charity if he loses. However, he won't lose. The bet can be found here.

So, now we are looking at a graph of what a "good" return should be. If you look at the S&P 500 index, you will see that it had a tremendous run-up going into calendar year 2000. If you remember back in time, the run up was due to the "tech bubble." At that time, the best way for Investment Banks to make money was to get any tech company that looked even half making a lot of money was to found a company and take it public.

Once you did your IPO (Initial Public Offering) everybody in the market would jump in and make money. Tremendous money was flowing into the technology sector, and stock price was going absolutely crazy. The real winners were the investment banks that made a ton off of every public offering.

However, technology wasn't backed by anything that could give returns. When it was found out that many of these companies couldn't make a buck, the tech market collapsed. Unfortunately, many investors lost a ton of money.

I think that I am "unique" in recognizing that our problems today go back to the problems in the technology sector. There was a massive machine all tuned up and ready to make money. This was the investment banks. Now, I hate and love these guys. They are greed personified. They do all types of stupid stuff to make money. However, they serve a very good purpose. This is how people get their companies started. Without them we'd be in trouble also.

With a lot of people losing a lot of money, Alan Greenspan, who may go down as a worse Fed Reserve chairman than George Bush was a president, lowered the Federal Reserve rate down to 1%. Now, considering that Greespan had given extremely cheap money to anybody that wanted it, all that the banks needed to do was find somebody to borrow it.

The idea that you could borrow money cheap, then lend it out to house owners was beyond anything that Wall Street could turn down.

So when there wasn't a technology industry to make money, the commercial and investment banks started doing stupid loans off of the "new bubble." The new bubble was this real estate.

Now, this is bad enough. However, to make this plausible, they need some type of insurance in case things went bad. However, insurance needs a reserve "just in case" somebody needs to actually use the insurance. However, there wasn't enough money to actually insure all the lending that was going on.

Therefore, Phil Gramm (former McCann man that was helping him with how to handle the economy in his election campaign for the presidency, pictured here with McCann) sponsored credit default swaps in our senate, with a little help from Phil Lugar.

As a matter of fact, this former McCann staffer may be the single reason for the melt down in the market today. Again, credit default swaps is just another name for "insurance." Only, Gramm was able to drive a bill that made it illegal for credit default swaps to be called insurance. Unlike insurance, which is tightly regulated, these vehicles require NO BACKING IN CASE OF DEFAULT.

In other words, the insurer is not required to be able to deliver the insurnace.

When Buffet heard about this, he said that credit default swaps were "time bombs." How right he was. The bombs are starting to go off. Interesting, Buffet is voting for Obama. While Buffet has talked about tax rates, I think one of the main issue is that McCann seemed to embrace Gramm (until Gramm put his foot in his mouth once too many times by saying that the economy was just doing fine, and anybody that said different was a whiner).

Buffet has picked the lessor of two evils by picking Obama in his mind.

However, things run in cycles. We are not in the great depression, no matter what some headlines are saying. We don't have a run on the bank. We have crippled outselves with large debt loads as a nation, but the core of the USA is fine. It is just an extended house remodeling that we need to do.

The interesting thing about the "general problems" with the last bubble in the economy was that it took two years to hit bottom. In our new situation, I think that we will also take about two years to hit bottom. Clearly, we have launched into an unknown space. The government has made the most massive investment (or bail out) in our history. The impacts of this will not wind its way through our economy for 2-3 years from now.

So, what is my suggestion?

Well, if you like risk, you can start to short the market. This is what I've been doing all this year through a moderate "covered calls" strategy. Because of my strategy, my portfolio is down 5% for the year instead of the 15% for the S&P 500. I was actually up 5% just a couple of months ago, but made some slip ups in my investment strategy, which was completely foreseeable. (Basically, you can't run a personal portfolio AND do a stressful job. You will slip up on something.) However, I'm pretty proud of outperforming the market.

However, this last week gave me quite a scare. There was a point where the market was down over 20% year to date. If not for a phenomenal intervention by the government, and a crazy rally on Friday, I would have been down 15% for the year.

When the market popped back on Friday morning, I immediately liquidated part of my assets. I now have 20% of my liquid net worth in cash. In 27 days, once the next option expiry date, I will convert another 20% of my portfolio into cash. So exiting October, I will have at least 40% of my money in hard cold cash. By December, exiting the year, I will have 80-85% of my portfolio in cash.

So, once you have all your assets in cash, what do you do?

1. Put them in a safe place.
2. Wait for the market to turn around

Where is a safe place? Well the BEST place is T-Bills or government back bonds. However, they both have a problem in that they are are not liquid. The best thing about have cash is if the market does take a massive nose dive, you may want to actually buy something along the way. A house. A car. Even an investment. If you are a Wall Street firm, this is no problem. If you are an individual, there is nothing like a savings or checking account.

Now, lets say that you've been saving for a number of years, and you have at least $150K saved up. My suggestion is to have your money in at least four FDIC banks, spread evenly with no more than $100K at each bank (or $200K if you have a joint account with your spouse). The key is a minimum of four banks, regardless if you have a $800K or $80K. FDIC banks will cover any bankruptcy up to $100K for single people, and $200K for married couples.

If you are just starting out with $1K for savings, my advice is getting saving more. Cash is king in an uncertain time. However, you can probably get away with just one bank.

The reason for multiple banks is to be able to get you your cash at anytime regardless of bankruptcy. A local bank IndyMac, went bankrupt because of the market. While the invest is secured, it takes an extended time to get your money out of the bank. Spread risk by having your bank accounts spread out.

Some of my ideas for banks?

Ing Direct (if you ask me for a referral, they'll pay me $10!) They pay around 3% on savings accounts.

E*Trade Bank. While there are cheaper stock trades, E*Trade blends them all together seamlessly. They also pay around 3% on savings.

HSBC Direct. Another online bank with a 3% interest.

Finally, I have an account at Bank of America. They pay lousy, lousy. But their cash machines are all over the place.

Just hang onto cash for the next 18-24 months.

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