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Posted: 27 November 2009 - 0 comment(s) [ Comment ] - 0 trackback(s) [ Trackback ]
Category: Research






Revisiting The Capital Asset Pricing Model

by Jonathan Burton

Reprinted with permission from Dow Jones Asset Manager
May/June 1998, pp. 20-28

For pictures and captions, click here


Modern Portfolio Theory was not yet adolescent in 1960 when William F. Sharpe, a 26-year-old researcher at the RAND Corporation, a think tank in Los Angeles, introduced himself to a fellow economist named Harry Markowitz.. Neither of them knew it then, but that casual knock on Markowitz's office door would forever change how investors valued securities.

Sharpe, then a Ph.D. candidate at the University of California, Los Angeles, needed a doctoral dissertation topic. He had read "Portfolio Selection," Markowitz's seminal work on risk and return—first published in 1952 and updated in 1959—that presented a so-called efficient frontier of optimal investment. While advocating a diversified portfolio to reduce risk, Markowitz stopped short of developing a practical means to assess how various holdings operate together, or correlate, though the question had occurred to him.

Sharpe accepted Markowitz's suggestion that he investigate Portfolio Theory as a thesis project. By connecting a portfolio to a single risk factor, he greatly simplified Markowitz's work. Sharpe has committed himself ever since to making finance more accessible to both professionals and individuals.

From this research, Sharpe independently developed a heretical notion of investment risk and reward, a sophisticated reasoning that has become known as the Capital Asset Pricing Model, or the CAPM. The CAPM rattled investment professionals in the 1960s, and its commanding importance still reverberates today. In 1990, Sharpe's role in developing the CAPM was recognized by the Nobel Prize committee. Sharpe shared the Nobel Memorial Prize in Economic Sciences that year with Markowitz and Merton Miller, the University of Chicago economist.

Every investment carries two distinct risks, the CAPM explains. One is the risk of being in the market, which Sharpe called systematic risk. This risk, later dubbed "beta," cannot be diversified away. The other—unsystematic risk—is specific to a company's fortunes. Since this uncertainty can be mitigated through appropriate diversification, Sharpe figured that a portfolio's expected return hinges solely on its beta—its relationship to the overall market. The CAPM helps measure portfolio risk and the return an investor can expect for taking that risk.

More than three decades have passed since the CAPM's introduction, and Sharpe has not stood still. A professor of finance at the Stanford University Graduate School of Business since 1970, he has crafted several financial tools that portfolio managers and individuals use routinely to better comprehend investment risk, including returns-based style analysis, which assists investors in determining whether a portfolio manager is sticking to his stated investment objective. The Sharpe ratio evaluates the level of risk a fund accepts vs. the return it delivers.

Sharpe's latest project is characteristically ambitious, combining his desire to educate a mass audience about risk with his longtime love of computers. Technology is democratizing finance, and Sharpe is helping to push this powerful revolution forward. Through Financial Engines, Sharpe and his partners will bring professional investment advice and analysis to individuals over the Internet.


What do you think of the talk that beta is dead?

The CAPM is not dead. Anyone who believes markets are so screwy that expected returns are not related to the risk of having a bad time, which is what beta represents, must have a very harsh view of reality.

"Is beta dead?" is really focused on whether or not individual stocks have higher expected returns if they have higher betas relative to the market. It would be irresponsible to assume that is not true. That doesn't mean we can confirm the data. We don't see expected returns; we see realized returns. We don't see ex-ante measures of beta; we see realized beta. What makes investments interesting and exciting is that you have lots of noise in the data. So it's hard to definitively answer these questions.


Would you approach a study of market risk differently today than you did back in the early 1960s?

It's funny how people tend to misunderstand the CAPM's academic, theoretical and scientific process. The CAPM was a very simple, very strong set of assumptions that got a nice, clean, pretty result. And then almost immediately, we all said, let's bring more complexity into it to try to get closer to the real world. People went on—myself and others—to what I call "extended" capital asset pricing models, in which expected return is a function of beta, taxes, liquidity, dividend yield, and other things people might care about.

Did the CAPM evolve? Of course. Are the results more complicated shall just expected return is a linear function of beta relative to the Standard & Poor's 500-Stock Index? Of course. But the fundamental idea remains that there's no reason to expect reward just for bearing risk. Otherwise, you'd make a lot of money in Las Vegas. If there's reward for risk, it's got to be special. There's got to be some economics behind it or else the world is a very crazy place. I don't think differently about those basic ideas at all.


What about Harry Markowitz's contribution to all of this?

Markowitz came along, and there was light. Markowitz said a portfolio has expected return and risk. Expected return is related to the expected return of the securities, but risk is more complicated. Risk is related to the risks of the individual components as well as the correlations.

That makes risk a complicated feature, and one that human beings have trouble processing. You can put estimates of risk/return correlation into a computer and find efficient portfolios. In this way, you can get more return for a given risk and less risk for a given return, and that's efficiency a la Markowitz.


What stands out in your mind when you think about Markowitz's contribution?

I liked the parsimony, the beauty, of it. I was and am a computer nut. I loved the mathematics. It was simple but elegant. It had all of the aesthetic qualities that a model builder likes. Investment texts in the pre- Markowitz era were simplistic: Don't put all your eggs in one basket, or put them in a basket and watch it closely. There was little quantification.

To this day, people recommend a compartmentalized approach. You have one pot for your college fund, another for your retirement fund, another for your unemployment fund. People's tendencies when they deal with these issues often lead to suboptimal solutions because they don't take covariance into account. Correlation is important. You want to think about how things move together.


Tell us about your relationship with Markowitz.

Harry was my unofficial dissertation advisor. In 1960, he and I were both at the RAND Corporation. My official advisor at the University of California at Los Angeles suggested I work with Harry, but Harry wasn't on the UCLA faculty. I introduced myself to him and said I was a great fan of his work.


With Markowitz's encouragement, you delved into market correlation, streamlining Portfolio Theory with the use of a single-factor model. This became part of your dissertation, published in 1963 as "A Simplified Model of Portfolio Analysis."

I did my dissertation under a strongly simplified assumption that only one factor caused correlation. The result I got was in that setting, prices would adjust until expected returns were higher for securities that had higher betas, where beta was the coefficient with "the factor."

Portfolio Theory focused on the actions of a single investor with an optimal portfolio. You wondered what would happen to risk and return if everyone followed Markowitz and built efficient portfolios.

I said what if everyone was optimizing? They've all got their copies of Markowitz and they're doing what he says. Then some people decide they want to hold more IBM, but there aren't enough shares to satisfy demand. So they put price pressure on IBM and up it goes, at which point they have to change their estimates of risk and return, because now they're paying more for the stock. That process of upward and downward pressure on prices continues until prices reach an equilibrium and everyone collectively wants to hold what's available. At that point, what can you say about the relationship between risk and return? The answer is that expected return is proportionate to beta relative to the market portfolio.

In a paper I finished in 1962 that was published in 1964, I found you didn't have to assume only one factor. That basic result comes through in a much more general setting. There could be five factors, or 20 factors, or as many factors as there are securities. In a Markowitz framework, where people care about the expected return of their portfolios and the risk as measured by standard deviation the results held. That paper was called "Capital Asset Prices: A Theory of Market Equilibrium Under Conditions Of Risk." Eugene Fama called it the Capital Asset Pricing Model. That's where the name came from.

The CAPM was and is a theory of equilibrium. Why should anyone expect to earn more by investing in one security as opposed to another? You need to be compensated for doing badly when times are bad. The security that is going to do badly just when you need money when times are bad is a security you have to hate, and there had better be some redeeming virtue or else who will hold it? That redeeming virtue has to be that in normal times you expect to do better. The key insight of the Capital Asset Pricing Model is that higher expected returns go with the greater risk of doing badly in bad times. Beta is a measure of that. Securities or asset classes with high betas tend to do worse in bad times than those with low betas.


Perhaps you never imagined that the CAPM would become a linchpin of investment theory, but did you believe it was something big?

I did. I didn't know how important it would be, but I figured it was probably more important than anything else I was likely to do. I had presented it at the University of Chicago in January 1962, and it had a good reaction there. They offered me a job. That was a good sign. I submitted the article to The Journal of Finance in 1962. It was rejected. Then I asked for another referee, and the journal changed editors. It was published in 1964. It came out and I figured OK, this is it. I'm waiting. I sat by the phone. The phone didn't ring. Weeks passed and months passed, and I thought, rats, this is almost certainly the best paper I'm ever going to write, and nobody cares. It was kind of disappointing. I just didn't realize how long it took people to read journals, so it was a while before reaction started coming in.


What does the CAPM owe to finance research that came immediately before?

The CAPM comes out of two things: Markowitz, who showed how to create an efficient frontier, and James Tobin, who in a 1958 paper said if you hold risky securities and are able to borrow—buying stocks on margin—or lend—buying risk-free assets— and you do so at the same rate, then the efficient frontier is a single portfolio of risky securities plus borrowing and lending, and that dominates any other combination.

Tobin's Separation Theorem says you can separate the problem into first finding that optimal combination of risky securities and then deciding whether to lend or borrow, depending on your attitude toward risk. It then showed that if there's only one portfolio plus borrowing and lending, it's got to be the market.

Both the CAPM and index funds come from that. You can't beat the average; net of costs, the returns for the average active manager are going to be worse. You don't have to do that efficient frontier stuff. If markets were perfectly efficient, you'd buy the market and then use borrowing and lending to the extent you can. Once you get into different investment horizons, there are many complications. This is a very simple setting. You get a nice, clean result. The basic philosophical results carry through in the more complex settings, although the results aren't quite as simple.


The University of Chicago's Gene Fama and Yale University's Ken French came up with the Three- Factor Model, which states that beta matters less than either market capitalization or book-to-market value. Do Fama and French exaggerate?

All empiricists, myself included when I do empirical work, tend to exaggerate the importance of their particular empirical study. There are different time periods, different markets, different countries. You don't always get the same thing. Fama and French are looking at the question: Using historical manifestations of these ex-ante constructs, can we confirm that expected returns are related to beta and/or related to book-to-price and/or related to size? Given what they did and how they did it—using realized average returns, which are not expected returns—they found a stronger empirical correlation with book-to-price and with size than to their measure of historic beta.

The size effect and the value/growth effect had been written about before, so neither of these phenomena were new What was new was that Fama and French got that very strong result at least for the period they looked at—which, by the way, included the mid-1970s, a very good period for value stocks, which really drove up those results.


Fama and French's results were a product of the time period they examined?

There's a whole industry of turning out papers showing things "wrong" and "partially wrong" with the Fama- French study. I have not been part of that industry. I would only point out that during that period in the United States, value stocks did much better than growth. In the bear market of 1973 and 1974, people thought the world was coming to an end. It didn't come to an end. Surprise. The stocks that had been beaten down came back, and they came back a lot more than some of the growth stocks.

Maybe in an efficient market, small stocks would do better because they're illiquid, and people demand a premium for illiquidity That gets to be less compelling if you start thinking about mutual funds that package a bunch of small stocks and therefore make the illiquid liquid. As people figured that out, they'd put money into those funds, which would drive up the price of small stocks, and there goes the premium. For the value/growth effect, there's the behaviorist story that people overextrapolate. I have quite a bit of sympathy with that. I'm a bit of a fan of behavioral finance—the psychology of markets—so I don't dismiss that argument out of hand.

Since the studies about the size effect were published, small stocks have not done better than large stocks on average. Since the publicity about the value effect, value stocks haven't done as well as before around the world. So there's always the possibility that whatever these things were may have gone away, and that the publication of these studies may have helped them go away. It's too early to tell. It's a short data period. One would not want to infer too much, except that rushing to embrace those strategies has not turned out to be a very good idea, recently, certainly in the United States.


Empiricism is integral to investment theory. Do you discount such methodology?

I wouldn't discount it. I do it, and we all look carefully at the results. But it's been my experience that if you don't like the result of an empirical study, just wait until somebody uses a different period or a different country or a different part of the market. In the data it's hard to find a strong, statistically significant relationship between measured betas and average returns of individual stocks in a given market. On the other hand it's easy to build a model of a perfectly efficient market in which you could have just that trouble in any period. The noise could hide it.

The optimal situation involves theory that proceeds from sensible assumptions, is carefully and logically constructed, and is broadly consistent with the data. You want to avoid empirical results that have no basis in theory and blindly say, "It seemed to have worked in the past, so it will work in the future." That's especially true of anything that involves a way to get something for nothing. You're not likely to get something for nothing as long as you've got investors looking to get something for nothing.


Fama and French claim the Three Factor Model is an extension of the CAPM. Would you agree?

To the extent that the Fama-French study is a richer way of measuring the probability of doing badly in bad times, then there's nothing inconsistent with the Capital Asset Pricing Model. But there's a lot of confusion and inconsistency in how some people take the Fama-French results to market and advocate a big value tilt and a big small tilt in your portfolio. If those are just measures of an unrealized but future-looking beta, then you shouldn't have those tilts unless you happen to be one of those people who doesn't care how badly you do when times are bad. We do care when times are bad. Otherwise, there shouldn't be a risk premium for anything.


What about the Arbitrage Pricing Theory, which was originally proposed by Steve Ross at Yale? Is the APT stronger than the CAPM?

Yes and No. The APT assumes that relatively few factors generate correlation, and says the expected return on a security or an asset class ought to be a function of its exposure to those relatively few factors. That's perfectly consistent with the Capital Asset Pricing Model. But the APT stops there and says the expected return you get for exposure to factor three could be anything. The CAPM says no if factor three does badly in bad times, the expected return for exposure to that factor ought to be high. If that factor is a random event that doesn't correlate with whether or not times are bad, then the expected return should be zero.

The APT is stronger in that it makes some very strong assumptions about the return-generating process, and it's weaker because it doesn't tell you very much about the expected return on those factors. The CAPM and its extended versions offer some notion of how people with preferences determine prices in the market. The CAPM tells you more. The CAPM does not require that there be three factors or five factors. There could be a million. Whatever number of factors there may be, the expected return of a security will be related to its exposure to those factors.


Ross has said the APT came from dissatisfaction with the CAPM's assumptions.

You can't actually build a portfolio if you stop at the APT. You've got to figure out the factors and what the returns are for exposure to each factor. Some advocates of the APT have said one should just estimate expected returns empirically. I have argued that's very dangerous because historic average returns can differ monumentally from expected returns. You need a factor model to reduce the dimensions, whether it's a three- factor model or a five-factor model or a 14 asset-class factor model, which is what I tend to use. The APT says if in fact, returns are generated by a factor model, then without making any strong assumptions in addition to the model—which is strong to begin with—you can't assign numeric values to the expected returns associated with the factors. The CAPM goes further, putting some discipline and consistency into the process of assigning those expected returns.


So the great factor debate rages on.

I'd be the last to argue that only one factor drives market correlation. There are not as many factors as some people think, but there's certainly more than one. To measure the state of the debate, look at textbooks. Textbooks still have the Capital Asset Pricing Model because that's a very fundamental economic argument.


You've devoted much of your career to the study and understanding of market risk. Are today's investors focused enough on the downside?

Investment decisions are moving to individuals who are ill-prepared to make them. These are complicated issues. To say, here are 8,000 mutual funds, or even here are 10, do what's right, is not very helpful. The software versions and some of the human versions of the advice that people are getting often seem to ignore risk. They're bookkeeping schemes in which you earn 9% every year like clockwork. You die right on schedule. There's no uncertainty at all. Making a decision as to stocks vs. bonds vs. cash and about how much to save, without even acknowledging uncertainty—let alone trying to estimate it—seems to me the height of folly.


You've acknowledged your fascination with computers. What about your latest venture, Financial Engines, which will be available over the Internet?

We're working to help people understand the downside possibilities of different strategies, as well as the upside. There are two dangers that arise when people are ill-informed. One is that they won't realize what they've done. So when times are bad, they'll be very disappointed.

If you just take somebody's current investments and project return without any notion of risk, you give them a wildly distorted view of what their future might hold. It may be the best point estimate if you've done it carefully, but they have no notion of how good it can get or how bad it can get. So when and if it gets bad, they're not only likely to be desperately disappointed if they're already retired, they're also likely to do the wrong thing if they haven't retired.

In classrooms for decades, we've presented investments as a risk/return tradeoff.. Now, people are being presented investments as a return/return trade-off. There ought to be a law against that. Instead, we can help people understand the range of outcomes associated with different investments and help them find combinations of investments that are optimal.


How will the Internet impact the financial advisory business?

I don't think the Internet is the death knell for financial planning, but it certainly will affect it. There may be a migration to higher-net-worth individuals, or advisors will charge less and service more clients be cause they have better tools. At Financial Engines, we are focusing on investors who don't get any good advice. They get tips from their supervisor or relatives. These people really can't afford a financial advisor. The Internet is going to be potent and powerful for them. But that's not displacing advisors; it's bringing good advice to those who don't have it.

An upper level will always have human financial planners because, as a percentage of their assets, planners aren't very expensive. Even at that level, software is going to be increasingly important. The real issue is what happens in the middle. Almost everyone will get more computer and Internet input. There's going to be more of that and less of human beings in the mix. You can't afford to pay 3% of your money every year for advice, no matter how good it is.

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Posted: 6 December 2009 - 0 comment(s) [ Comment ] - 0 trackback(s) [ Trackback ]
Category: Research

The Arithmetic of Active Management

William F. Sharpe


Reprinted with permission from The Financial Analysts' Journal Vol. 47, No. 1, January/February 1991. pp. 7-9
Copyright, 1991, Association for Investment Management and Research Charlottesville, VA


"Today's fad is index funds that track the Standard and Poor's 500. True, the average soundly beat most stock funds over the past decade. But is this an eternal truth or a transitory one?"

"In small stocks, especially, you're probably better off with an active manager than buying the market."

"The case for passive management rests only on complex and unrealistic theories of equilibrium in capital markets."

"Any graduate of the ___ Business School should be able to beat an index fund over the course of a market cycle."

Statements such as these are made with alarming frequency by investment professionals1. In some cases, subtle and sophisticated reasoning may be involved. More often (alas), the conclusions can only be justified by assuming that the laws of arithmetic have been suspended for the convenience of those who choose to pursue careers as active managers.

If "active" and "passive" management styles are defined in sensible ways, it must be the case that

(1) before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar and

(2) after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar

These assertions will hold for any time period. Moreover, they depend only on the laws of addition, subtraction, multiplication and division. Nothing else is required.

Of course, certain definitions of the key terms are necessary. First a market must be selected -- the stocks in the S&P 500, for example, or a set of "small" stocks. Then each investor who holds securities from the market must be classified as either active or passive.

  • A passive investor always holds every security from the market, with each represented in the same manner as in the market. Thus if security X represents 3 per cent of the value of the securities in the market, a passive investor's portfolio will have 3 per cent of its value invested in X. Equivalently, a passive manager will hold the same percentage of the total outstanding amount of each security in the market2.

  • An active investor is one who is not passive. His or her portfolio will differ from that of the passive managers at some or all times. Because active managers usually act on perceptions of mispricing, and because such misperceptions change relatively frequently, such managers tend to trade fairly frequently -- hence the term "active."

Over any specified time period, the market return will be a weighted average of the returns on the securities within the market, using beginning market values as weights3. Each passive manager will obtain precisely the market return, before costs4. From this, it follows (as the night from the day) that the return on the average actively managed dollar must equal the market return. Why? Because the market return must equal a weighted average of the returns on the passive and active segments of the market. If the first two returns are the same, the third must be also.

This proves assertion number 1. Note that only simple principles of arithmetic were used in the process. To be sure, we have seriously belabored the obvious, but the ubiquity of statements such as those quoted earlier suggests that such labor is not in vain.

To prove assertion number 2, we need only rely on the fact that the costs of actively managing a given number of dollars will exceed those of passive management. Active managers must pay for more research and must pay more for trading. Security analysis (e.g. the graduates of prestigious business schools) must eat, and so must brokers, traders, specialists and other market-makers.

Because active and passive returns are equal before cost, and because active managers bear greater costs, it follows that the after-cost return from active management must be lower than that from passive management.

This proves assertion number 2. Once again, the proof is embarrassingly simple and uses only the most rudimentary notions of simple arithmetic.

Enough (lower) mathematics. Let's turn to the practical issues.

Why do sensible investment professionals continue to make statements that seemingly fly in the face of the simple and obvious relations we have described? How can presented evidence show active managers beating "the market" or "the index" or "passive managers"? Three reasons stand out5.

  • First, the passive managers in question may not be truly passive (i.e., conform to our definition of the term). Some index fund managers "sample" the market of choice, rather than hold all the securities in market proportions. Some may even charge high enough fees to bring their total costs to equal or exceed those of active managers.

  • Second, active managers may not fully represent the "non-passive" component of the market in question. For example, the set of active managers may exclude some active holders of securities within the market (e.g., individual investors). Many empirical analyses consider only "professional" or "institutional" active managers. It is, of course, possible for the average professionally or institutionally actively managed dollar to outperform the average passively managed dollar, after cost. For this to take place, however, the non-institutional, individual investors must be foolish enough to pay the added costs of the institutions' active management via inferior performance. Another example arises when the active managers hold securities from outside the market in question. For example, returns on equity mutual funds with cash holdings are often compared with returns on an all-equity index or index fund. In such comparisons, the funds are generally beaten badly by the index in up markets, but sometimes exceed index performance in down markets. Yet another example arises when the set of active mangers excludes those who have gone out of business during the period in question. Because such managers are likely to have experienced especially poor returns, the resulting "survivorship bias" will tend to produce results that are better than those obtained by the average actively managed dollar.

  • Third, and possibly most important in practice, the summary statistics for active managers may not truly represent the performance of the average actively managed dollar. To compute the latter, each manager's return should be weighted by the dollars he or she has under management at the beginning of the period. Some comparisons use a simple average of the performance of all managers (large and small); others use the performance of the median active manager. While the results of this kind of comparison are, in principle, unpredictable, certain empirical regularities persist. Perhaps most important, equity fund managers with smaller amounts of money tend to favor stocks with smaller outstanding values. Thus, de facto, an equally weighted average of active manager returns has a bias toward smaller-capitalization stocks vis-a-vis the market as a whole. As a result, the "average active manager" tends to be beaten badly in periods when small-capitalization stocks underperform large-capitalization stocks, but may exceed the market's performance in periods when small-capitalization stocks do well. In both cases, of course, the average actively managed dollar will underperform the market, net of costs.

To repeat: Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.

This need not be taken as a counsel of despair. It is perfectly possible for some active managers to beat their passive brethren, even after costs. Such managers must, of course, manage a minority share of the actively managed dollars within the market in question. It is also possible for an investor (such as a pension fund) to choose a set of active managers that, collectively, provides a total return better than that of a passive alternative, even after costs. Not all the managers in the set have to beat their passive counterparts, only those managing a majority of the investor's actively managed funds.

An important corollary is the importance of appropriate performance measurement. "Peer group" comparisons are dangerous. Because the capitalization-weighted average performance of active managers will be inferior to that of a passive alternative, the former constitutes a poor measure for decision-making purposes. And because most peer-group averages are not capitalization-weighted, they are subject to additional biases. Moreover, investing equal amounts with many managers is not a practical alternative. Nor, a fortiori, is investing with the "median" manager (whose identity is not even known in advance).

The best way to measure a manager's performance is to compare his or her return with that of a comparable passive alternative. The latter -- often termed a "benchmark" or "normal portfolio" -- should be a feasible alternative identified in advance of the period over which performance is measured. Only when this type of measurement is in place can an active manager (or one who hires active managers) know whether he or she is in the minority of those who have beaten viable passive alternatives.



1. The first two quotations can be found in the September 3, 1990 issue of Forbes.

2. When computing such amounts, "cross-holdings" within the market should be netted out.

3. Events such as mergers, new listings and reinvestment of dividends that take place during the period require more complex calculations but do not affect the basic principles stated here. To keep things simple, we ignore them.

4. We assume here that passive managers purchase their securities before the beginning of the period in question and do not sell them until after the period ends. When passive managers do buy or sell, they may have to trade with active managers, because of the active managers' willingness to provide desired liquidity (at a price).

5. There are others, such as differential treatment of dividend reinvestment, mergers and acquisitions, but they are typically of less importance.

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Posted: 6 December 2009 - 0 comment(s) [ Comment ] - 0 trackback(s) [ Trackback ]
Category: Market news




Published: October 13, 2009

“IF you really want to know why the financial system nearly collapsed in the fall of 2008, I can tell you in one simple sentence.”

 The statement came from a man sitting three or four stools away from me in a sparsely populated Midtown bar, where I was waiting for a friend. “But I have to buy you a drink to hear it?” I asked.

“Absolutely not,” he said. “I can buy my own drinks. My 401(k) is intact. I got out of the market 8 or 10 years ago, when I saw what was happening.”

He did indeed look capable of buying his own drinks — one of which, a dry martini, straight up, was on the bar in front of him. He was a well-preserved, gray-haired man of about retirement age, dressed in the same sort of clothes he must have worn on some Ivy League campus in the late ’50s or early ’60s — a tweed jacket, gray pants, a blue button-down shirt and a club tie that, seen from a distance, seemed adorned with tiny brussels sprouts.

“O.K.,” I said. “Let’s hear it.”

“The financial system nearly collapsed,” he said, “because smart guys had started working on Wall Street.” He took a sip of his martini, and stared straight at the row of bottles behind the bar, as if the conversation was now over.

“But weren’t there smart guys on Wall Street in the first place?” I asked.

He looked at me the way a mathematics teacher might look at a child who, despite heroic efforts by the teacher, seemed incapable of learning the most rudimentary principles of long division. “You are either a lot younger than you look or you don’t have much of a memory,” he said. “One of the speakers at my 25th reunion said that, according to a survey he had done of those attending, income was now precisely in inverse proportion to academic standing in the class, and that was partly because everyone in the lower third of the class had become a Wall Street millionaire.”

I reflected on my own college class, of roughly the same era. The top student had been appointed a federal appeals court judge — earning, by Wall Street standards, tip money. A lot of the people with similarly impressive academic records became professors. I could picture the future titans of Wall Street dozing in the back rows of some gut course like Geology 101, popularly known as Rocks for Jocks.

“That actually sounds more or less accurate,” I said.

“Of course it’s accurate,” he said. “Don’t get me wrong: the guys from the lower third of the class who went to Wall Street had a lot of nice qualities. Most of them were pleasant enough. They made a good impression. And now we realize that by the standards that came later, they weren’t really greedy. They just wanted a nice house in Greenwich and maybe a sailboat. A lot of them were from families that had always been on Wall Street, so they were accustomed to nice houses in Greenwich. They didn’t feel the need to leverage the entire business so they could make the sort of money that easily supports the second oceangoing yacht.”

“So what happened?”

“I told you what happened. Smart guys started going to Wall Street.”


“I thought you’d never ask,” he said, making a practiced gesture with his eyebrows that caused the bartender to get started mixing another martini.

“Two things happened. One is that the amount of money that could be made on Wall Street with hedge fund and private equity operations became just mind-blowing. At the same time, college was getting so expensive that people from reasonably prosperous families were graduating with huge debts. So even the smart guys went to Wall Street, maybe telling themselves that in a few years they’d have so much money they could then become professors or legal-services lawyers or whatever they’d wanted to be in the first place. That’s when you started reading stories about the percentage of the graduating class of Harvard College who planned to go into the financial industry or go to business school so they could then go into the financial industry. That’s when you started reading about these geniuses from M.I.T. and Caltech who instead of going to graduate school in physics went to Wall Street to calculate arbitrage odds.”

“But you still haven’t told me how that brought on the financial crisis.”

“Did you ever hear the word ‘derivatives’?” he said. “Do you think our guys could have invented, say, credit default swaps? Give me a break! They couldn’t have done the math.”

“Why do I get the feeling that there’s one more step in this scenario?” I said.

“Because there is,” he said. “When the smart guys started this business of securitizing things that didn’t even exist in the first place, who was running the firms they worked for? Our guys! The lower third of the class! Guys who didn’t have the foggiest notion of what a credit default swap was. All our guys knew was that they were getting disgustingly rich, and they had gotten to like that. All of that easy money had eaten away at their sense of enoughness.”

“So having smart guys there almost caused Wall Street to collapse.”

“You got it,” he said. “It took you awhile, but you got it.”

The theory sounded too simple to be true, but right offhand I couldn’t find any flaws in it. I found myself contemplating the sort of havoc a horde of smart guys could wreak in other industries. I saw those industries falling one by one, done in by superior intelligence. “I think I need a drink,” I said.

He nodded at my glass and made another one of those eyebrow gestures to the bartender. “Please,” he said. “Allow me.”

Calvin Trillin is the author, most recently, of “Deciding the Next Decider: The 2008 Presidential Race in Rhyme.”

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The Investment Club Advantage

Making profits is one of the main motivators for setting up an investment club and most investment clubs do make a good profit. But there is much more to an investment club than just making money. Do not imagine a group of people with their heads buried deep in the Business Day newspaper. Meetings tend to be lively, informal affairs normally held in the private room of a pub or at members' homes. Everyone gets a chance to have their say before the latest investment suggestion is voted on. Although some clubs make staggering profits, for most investment clubs it is a case of getting rich steadily. Consider starting or joining an investment club if:


  • You are new to investing and are looking for a good way to get your feet wet.
  • You would feel more comfortable learning about investing with others than on your own.
  • You have roughly R200 to R500 available that you can invest through the investment club each month.
  • You have been putting off learning about investing and sense that having a responsibility to the group would provide some much-needed discipline.
  • You think it would be fun to have a group of people with whom to share company research and to discuss investment topics.
  • Friends have gently suggested that it would be good for you to get out of the house once in a while.

Furthermore, investment club members derive a number of other benefits:


  • Profit opportunities - Surveys show that collective investment decisions based on discussion and democratic choice are more likely to produce sustained profits. The pooling of investment money allows investors to own a wider range of shares than otherwise possible.
  • Spread the load - Carrying out research into potential investments can be structured and spread amongst the membership. There is safety in numbers. Several people evaluating a share purchase are less likely to make that big wrong decision that decimates the portfolio.
  • Informed investments - The collective brain power and experience of people who each have knowledge and experience of different market sectors will produce opinions and information that will guide you to sensible decisions. Sharing investment knowledge and research with others covers a lot more ground than an individual can.
  • Low risk - Pooling a relatively small amount of money with others every month will be an ideal way to gain hands-on experience of how the share market works. The low monthly cash outlay is affordable by just about anybody, enabling one to build up an investment portfolio in small, easy pieces.

Investment clubs are not just good for newcomers to investing, though. Also consider forming an investment club if:


  • You are an experienced investor, but do not have the time to study as many companies as you would like. (A dozen people studying and presenting one company per month result in 144 company reviews!)
  • You are confident in your investing decision-making, but you think it would help to be able to bounce thoughts off others and get some additional perspectives.
  • You would welcome the chance to learn from other seasoned investors who have expertise in areas you do not know that much about.

Investment clubs serve as a terrific way for those new to investing to learn more about it in a friendly group setting. Many people are terrified of taking their first investing steps and investment clubs make this relatively painless, as members cough up modest sums and invest carefully together after deliberating over the pros and cons of any action. Many members eventually find that the investment clubs guide their own personal investing. After a while, their equity in the pooled investment club account may be relatively small compared with their separate personal accounts. Investment club meetings will offer many good ideas of attractive shares in which to invest and while the investment club may buy a few shares, members often go home and buy more shares for their own trading accounts. You may not have the time to research several shares each month on your own, but by participating in an investment club, you will share in the research of others and have the extra bonus of a group setting in which to discuss investing ideas and issues.

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Category: Research

Spreadsheet Programs

Hi! With time, the number of spreadsheets on this page have also increased. To help you in finding the spreadsheet that you might want, I have categorized the spreadsheets into the following groups:
1. Corporate finance spreadsheets: These spreadsheets are most useful if you are interested in conventional corporate financial analysis. It includes spreadsheets to analyze a project's cashflows and viability, a company's risk profile, its optimal capital structure and debt type, andwhether it is paying out what it can afford to in dividends.
2. Valuation Inputs Spreadsheets: In this section, you will find spreadsheets that allow you to
a. Estimate the right discount rate to use for your firm, starting with the risk premium in your cost of equity and concluding with the cost of capital for your firm.
b. Convert R&D and operating leases into capitalized assets
c. estimate the right capital expenditures and diagnose the terminal value assumptions to see if they are reasonable.
3. Valuation Model Reconciliation: In this section, you will find spreadsheets that reconcile different DCF approaches - FCFE versus Dividend Discount Model, FCFE versus FCFF model, EVA versus Cost of capital and Net Debt versus Gross Debt Approaches.
4 . Big-picture valuation spreadsheets: If you are looking for one spreadsheet to help you in valuing a company, I would recommend one of these 'ginzu' spreadsheets. While they require a large number of inputs, they are flexible enough to allow you to value just about any company. You do have to decide whether you want to use a dividend, FCFE or FCFF model spreadsheet. If you have no idea which one will work for you, I would suggest that you try the "right model" spreadsheet first.
5 . Focused valuation spreadsheets: If you have a clear choice in terms of models - stable growth dividend discount, 2-stage FCFE etc. - you can download a spreadsheet for the specific model in this section.
6. Valuation of specific types of companies: Valuation is all about exceptions, and these spreadsheets are designed to help value specific types of companies including:
a. Financial Service firms: While dividend discount models tend to be the weapon of choice for many, you will find an excess equity return model here.
b. Troubled firms: You will find an earnings normalizer spreadsheet, a generic valuation model for valuing a firm as a going concern and a spreadsheet that allows you to estimate the probability that a troubled firm will not survive.
c. Private companies: You will find spreadsheets for adjusting discount rates and estimating illiquidity discounts for private companies.
d. Young and high-growth firms: You will find a revenue growth estimator as well as a generic valuation model for high growth firms in this section.
7 . Multiples: You can estimate equity as well as firm value multiples, based upon fundamentals.
8 . Valuation in Acquisitions: You can value synergy in an acquiisition and analyze a leveraged buyout.
9 . Valuation of other assets: In this section, you will find a model for valuing income-generating real estate.
10 . Value Enhancement Spreadsheets: In this section, you will find a spreadsheet that reconciles EVA and DCF valuation, a model for estimating CFROI and a DCF version of a value enhancement spreadsheet.
11. Basic option pricing models: In this seciton, you will find Black-Scholes models for valuing short term options, long term options and options that result in dilution of stock (such as warrants). In addition, you will find spreadsheets that convert Black-Scholes inputs into Binomial model inputs and use the binomial model to value options.
12. Real option models in corporate finance: In this section, you will find three basic real option models - the option to delay, the option to expand and the option to abandon. In addition, the value of financial flexibility is considered as an option.
13. Real option models in valuation: In this section, you will find models to value both a patent (and a firm owning a patent) as an option, natural resource firms and equity in deeply troubled firms.
These spreadsheet programs are written in Excel and are not copy protected. Download them and feel free to modify them to your own specifications. I do have video guides available for some of the most accessed spreadsheets. I hope they are useful.



Video guide Description

Corporate Finance

  This program allows you to do a basic capital budgeting analysis for a project, and compute NPV, IRR and ROI.

  This program allows you to use past returns on a stock and a market index to analyse its price performance (Jensen's Alpha), its sensitivity to market movements (Beta) and the proportion of its risk that can be attributed to the market. riskchecker.xls   This spreadsheet allows you to check your computations of Jensen's alpha, range on beta and expected return, given the output from a return regression (risk.xls above).

  This program allows you to enter the current beta, tax rate and the debt equity ratio for your stock, and obtain a table of betas at different debt ratios.

  This program allows you to estimate a rating and a cost of debt for your company from the firm's interext coverage ratio.

  This program allows you to estimate an "Optimal" Capital Structure for a company using the Adjusted Present Value Approach.



This program allows you to estimate an "Optimal" Capital structure for a company using the cost of capital approach.

  This is a variant that allows you to estimate an "Optimal" capital structure for a company whose operating income might vary with its debt rating - for instance, financial service firms.

  This program allows you to estimate the duration of a firm's assets and its sensitivity to other macro economic variables. It may be useful in the design of debt.

  This program compares the dividends paid to what a firm could have paid, by estimating the free cash flow to equity (the cash flow left over after net debt payments, net capital expenditures and working capital investments.

  This program computes the value of equity in a firm using a two-stage dividend discount and FCFE model. (For more extensive choices on valuation, look at the programs under the valuation section below.)


  This file describes the programs in this section and provides some insights into their usage. impliedROC&ROE.xls   This spreadsheet allows you to compute the ROC or ROE implied in your terminal value calculation. wacccalc.xls   This spreadsheet allows you to estimate the cost of capital for your firm.

  This program summarizes the three approaches that can be used to estimate the net capital expenditures for a firm, when it reaches stable growth.

  This program converts operating lease expenses into financing expenses and restates operating income and debt outstanding.

  This program converts R& D expenses from operating to capital expenses, estimates a value for the research asset and restates operating income.

  This spreadsheet calculates the implied risk premium in a market. This can be used in discounted cashflow valuation to do market neutral valuation.

Valuation Model Reconciliation fcfevsddm.xls   This spreadsheet allows you to reconcile the differences between the FCFE and the dividend discount models for estimating equity value. fcffvsfcfe.xls   This spreadsheet allows you to reconcile the differences between the FCFF and the FCFE approaches to valuation. fcffeva.xls   This spreadsheet reconciles a cost of capital DCF valuation with an EVA valuation of the same company GrossvsNet.xls   This spreadsheet allows you to reconcile the differences between the Gross debt and Net debt approaches to valuation.

All-in-one Valuation Models

  This program provides a rough guide to which discounted cash flow model may be best suited to your firm.

  This spreadsheet can be used to value tough-to-value firms, with negative earnings, high growth in revenues and few comparables. If you have a firm, this is your best choice.

  A complete dividend discount model that can do stable growth, 2-stage or 3-stage valuation. This is your best choice if you are analyzing financial service firms. fcfeginzu.xls   A complete FCFE valuation model that allows you to capital R&D and deal with options in the context of a valuation model.



This model tries to do it all, with all of the associated risks and rewards. I hate having to work with a dozen spreadsheets to value a firm, and I have tried to put them all into one spreadsheet - a ratings estimator, an earnings normalizer, an R&D converter, an operating lease converter, a bottom-up beta estimator and industry averages. Try it out and make your own additions. Loose Ends in Valuation

  This model analyzes the value of control in a firm.

  This program estimates the value of synergy in a merger.

  This spreadsheet provides different ways of estimating the value of a brand name, although each comes with some baggage.

  This spreadsheet allows you to measure the complexity in a company and give it a score. GrossvsNet.xls   This spreadsheet allows you to understand why the gross and net debt approaches give you different estimates of value for a firm. liqdisc.xls   Estimates the illiquidity discount that should be applied to a private firm as a function of the firm's size and financial health. Uses both restricted stock approach and bid-ask spread regression.

  This spreadsheet allows you to estimate the probability of distress from the bond price of a company.

Focused Valuation Models

  Stable growth, dividend discount model; best suited for firms growing at the same rate as the economy and paying residual cash as dividends.

Two-stage DDM; best suited for firms paying residual cash in dividends while having moderate growth.

Three-stage DDM; best suited for firms paying residual cash in dividends, while having high growth.

  Stable growth, FCFE discount model; best suited for firms in stable leverage and growing at the same rate as the economy.

Two-stage FCFE discount model; best suited for firms with stable leverage and having moderate growth.

Three-stage FCFE discount model; best suited for firms with stable leverage and having high growth.

  Stable growth FCFF discount model; best suited for firms growing at the same rate as the economy.

Two-stage FCFF discount model; best suited for firms with shifting leverage and growing at a moderate rate.

Three-stage FCFF discount model; best suited for firms with shifting leverage and high growth.

  Three-stage FCFF valuation model, also presented in terms of projected EVA.

  A generalised FCFF model, where the operating margins are allowed to change each year; best suited for firms in transition.

Financial Service firms eqexret.xls   Estimates the value of equity in a bank by discounting expected excess returns to equity investors over time and adding them to book value of equity.

Troubled firms normearn.xls   Normalizes the earnings for a troubled firm, uising historical or industry averages. distress.xls   Estimates the likelihood that a troubled firm will not survive, based upon bond ratings as well as bond prices. fcffneg.xls   Generalized FCFF model that allows you to value negative earnings firms as going concerns.

Private firms pvtdiscrate.xls   Adjusts the discount rate (cost of equity) for a private firm to reflect the lack of diversification on the part of the owner (or potential buyer) minoritydiscount.xls   Estimates the discount for a minority stake in a private business, based on the value of control. liqdisc.xls   Estimates the illiquidity discount that should be applied to a private firm as a function of the firm's size and financial health. Uses both restricted stock approach and bid-ask spread regression.

High Growth Firms revgrowth.xls   Estimates compounded revenue growth rate for a firm, based upon market share and market size assumptions. higrowth.xls   This spreadsheet can be used to value tough-to-value firms, with negative earnings, high growth in revenues and few comparables. If you have a young or start-up firm, this is your best choice.


  This is a model that uses a two-stage dividend discount model to estimate the appropriate equity multiples for your firm. It will give you identical answers (in terms of value) as the 2-stage DDM model.

  This model uses a 2-stage FCFF model to estimate the appropriate firm value multiples for your firm. It will give you identical answers (in terms of value) as the 2-stage FCFF model.


  This program analyzes the value of equity and the firm in a leveraged buyout.

  This model analyzes the value of control in a firm.

  This program estimates the value of synergy in a merger.

Other Assets reval.xls   This spreadsheet allows you to value an income-generating property as well as just the equity stake in the property.

Value Enhancement valenh.xls   This spreadsheet allows you to make a quick (and dirty) estimate of the effect of restructuring a firm in a discounted cashflow framework. fcffeva.xls   This spreadsheet shows the equivalence of the DCF and EVA approaches to valuation.

  This spreadsheet allows you to estimate the current CFROI for a firm.

Basic Option Pricing Models bstobin.xls   This spreadsheet converts the standard deviation input in the Black-Scholes model to up and down movemenents in the binomial tree.

  This is a dividend-adjusted model for valuing short-term options. It considers the present value of expected dividends during the option life.

  Tnis is a dividend-adjusted model for valuing long term options. It considers the expected dividend yield on the underlying asset.

  This is a model for valuing options that result in dilution of the underlying stock. Consequently, it is useful in valuing warrants and management options.

Real Option Models in Corporate Finance

  This model estimates the value of the option to expand in an investment project. Modified, it can also be used to assess the value of strategic options.

  This model estimates the value of the option to delay an investment project.

  This model estimates the value of financial flexibility, i.e, the maintenance of excess debt capacity or back-up financing.

  This model estimates the value of the option to abandon a project or investment.

Real Option Models in Valuation

  A model that uses option pricing to value the equity in a firm; best suited for highly levered firms in trouble.

  A model that uses option pricing to value a natural resource company; useful for valuing oil or mining companies.

  A model that uses option pricing to value a product patent or option; useful for valuing the patents that a company might hold.


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Category: Research

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Active Portfolio Management 

Is it possible to outperform the market?


This is one of the most important questions any investor should ask.


If your answer is no, if you believe the market is efficient, then passive investing or indexing - buying diversified portfolios of all the securities in an asset class - is probably the way to go. The arguments for such an approach include reduced costs, tax efficiency and the fact that, historically, passive funds have outperformed the majority of active funds (see MARKET EFFICIENCY and INDEXING).


But if your answer is yes, it is possible to beat the market, then you should pursue active portfolio management. Among the arguments for this approach are the possibility that there are a variety of anomalies in securities markets that can be exploited to outperform passive investments (see INVESTOR PSYCHOLOGY), the likelihood that some companies can be pressured by investors to improve their performance (see CORPORATE GOVERNANCE), and the fact that many investors and managers have outperformed passive investing for long periods of time.


But the active investor must still face the challenge of outperforming a passive strategy. Essentially, there are two sets of decisions. The first is asset allocation, where you carve up your portfolio into different proportions of equities, bonds and other instruments (see GLOBAL INVESTING and INVESTMENT POLICY). These decisions, often referred to as market timing as investors try to reallocate between equities and bonds (see FIXED INCOME) in response to their expectations of better relative returns in the two markets, tend to require macro forecasts of broad-based market movements (see ECONOMIC FORECASTING and POLITICS AND INVESTING). Then there is security selection - picking particular stocks or bonds. These decisions require micro forecasts of individual securities underpriced by the market and hence offering the opportunity for better than average returns.


Active investing involves being 'overweight' in securities and sectors that you believe to be undervalued and 'underweight' in assets you believe to be overvalued. Buying a stock, for example, is effectively an active investment that can be measured against the performance of the overall market (see PERFORMANCE MEASUREMENT). Compared to passive investing in a stock index, buying an individual stock combines an asset allocation to stocks and an active investment in that stock in the belief that it will outperform the stock index.


In both market timing and security selection decisions, investors may use either technical or fundamental analysis (see TECHNICAL ANALYSIS, VALUE INVESTING and GROWTH INVESTING). And you can be right in your asset allocation and wrong in your active security selection and vice versa. It is still possible that an investor who makes a mistake in asset allocation, perhaps by being light in equities in a bull market, can still do well by picking a few great stocks.


There are arguments for both active and passive investing though it is probably the case that a larger percentage of institutional investors invest passively than do individual investors. Of course, the active versus passive decision does not have to be a strictly either/or choice. One common investment strategy is to invest passively in markets you consider to be efficient and actively in markets you consider less efficient. Investors can also combine the two by investing part of a portfolio passively and another part actively.


Guru of active portfolio management: Bill Miller

It is hard to be the best performing manager for the past five years out of a field of more than five hundred. Not just that it is so difficult to be there - and it is - but also difficult to maintain one's mental balance. The temptation is to be too cocky and believe the publicity one receives. Or one could become too concerned with the inevitable stumble that lies ahead: old Bill has just lost it, some will say.

One way Bill Miller of Legg Mason's Value Trust keeps his head is to stress the intellectual side of investment. And he concentrates his investment attention so that extraneous contemporary PR does not distract him. His job is to outperform and every instinct he has is brought to bear on that objective. Over and over, he can repeat his lessons from profits and losses. His shareholders' glories and pains are his own. He takes the lessons, structures them into principles and keeps improving.

Miller is rather liberal in defining the details of his tactics when it suits him. He is not bothered by people who say that Czech bonds, for example, or go-go tech stocks trading at sky-high price-to-earnings ratios are not value investments: if they go up, they were and that is what counts. The definitional straitjackets of others are their problems, not his.

Miller is reaching out to complexity and the Santa Fe Institute, where he is a trustee and has a house, to teach him how to break today's investment bronco. Few others have the patience to deal with the ambiguities inherent in any emerging science. And it lets him contemplate the future of investment styles with a catholic perspective, a dogged determination to triumph and in the company of physicists ready to humble anyone wasting a good mind on one of the soft sciences, for money.



Nobel Laureate Bill Sharpe makes a simple yet powerful case against active management in his article 'The Arithmetic of Active Management': 'If active and passive management styles are defined in sensible ways, it must be the case that: (1) before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar; and (2) after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar These assertions will hold for any time period. Moreover, they depend only on the laws of addition, subtraction, multiplication and division. Nothing else is required.'


Sharpe continues: 'This need not be taken as a counsel of despair. It is perfectly possible for some active managers to beat their passive brethren, even after costs. Such managers must, of course, manage a minority share of the actively managed dollars within the market in question. It is also possible for an investor (such as a pension fund) to choose a set of active managers that, collectively, provides a total return better than that of a passive alternative, even after costs. Not all the managers in the set have to beat their passive counterparts, only those managing a majority of the investor's actively managed funds.'

Rex Sinquefield of Dimensional Fund Advisors is more brutal. He says there are three classes of people who do not believe that markets work: the Cubans, the North Koreans and active managers.


Yet investment managers are competing hard to manage institutional and individual investors' money and it is not surprising that they make claims about their market-beating potential - usually using active strategies - and, where possible, their market-beating performance records. And social norms of prudence, investor anxiety and anticipation of regret over flawed decisions contribute strongly to the demand for supposed financial expertise. Of course, if you believe in active investing, it is best not to judge a manager by their past performance indicators but rather by the plans by which they expect to add value through outperformance.


Ambitious investors and investment managers almost all want to beat the market, but it is worth asking why should they want to beat it for you. Why should precious insights into the nature of the market be available for sale to the general public, either directly through a fund or indirectly, perhaps through a book advocating a particular investment technique as the route to outperformance? If an investment technique is so good, it would seem to make more sense to keep its secrets to yourself.


It does seem to be the case that an investor who tries to predict short-term changes in share prices has to be right about 70% of the time to beat the market. Peter Jeffreys of S&P Fund Research, a London fund-rating company, has screened 4,800 funds since 1982 to see if past winners repeat their success in the future. He finds that the probability of that comes down to 'almost pure random chance': using three year rolling average performance as a measure, it turns out that of funds that beat the average six years running, only just over a half did so the next year.


[Guru response, if any]

I think the on-line market is like the discount business--it just further segments the market; it doesn't replace traditional trading or brokerage. Sort of like TV to the movies, then VCR's etc. On-line traders are most like traditional discount customers, which is why Schwab is so successful at it. The do-it-yourself market is big and growing in a lot of industries, but it rarely if ever totally displaces those who want to pay for service and advice. This is different from, say, book retailing, where the best customers of Borders are the best potential customers of Amazon. The best brokerage customers, equity oriented wealthy families who use margin are not the profile of the E-trade customer, whose demographics are entirely different. They may merge in a generation or so, but by then only the most dim witted brokers will not have been able to adapt.


Where next?

The latest research in financial economics seems to confirm that markets are not strictly efficient and that there are 'pockets of predictability'. This offers some hope to 'disciplined' active managers if they can come up with innovative techniques to achieve superior long-term returns (see FINANCIAL ENGINEERING).

But it is very important for any investor to watch closely for changing market drivers. For example, the market drivers until late 1998 were easy credit, moderating inflation, lower interest rates, rising earnings and the wide publicity of a sixteen year bull market in equities - by some counts, a fifty year bull market. The 1990s have seen a 16% compounded rate of growth for equities versus 6% historically, so it is not surprising that strong momentum keeps everyone in the game.

But we are beginning to face a different set of market drivers and it is hard to tell where they will drive us. The kind of financial concerns we face are rather novel in all of our lifetimes. There is illiquidity; wealth has been destroyed in many parts of the world; and inflation has turned to disinflation, to lower inflation and now to deflation. Deflation is destructive, especially for debt, which has led to a quality preference on debt where only the highest quality can pass muster and the ability to borrow is probably the only thing that counts in analyzing securities (see VALUE INVESTING).

What about the impact of news on portfolio management decisions? It is worth noting that precisely the same evidence may be used to support a good market tone or a bad market tone - a bull market or a bear market. For example, the absence of rising prices could be good for continued growth and low unemployment, or it could be bad because deflationary forces are building up and, as the experience of Japan indicates, they are extremely destabilizing. Interest rates are attractive for borrowing and money is plentiful, which is very good for business; but it may well be bad because it means that a great deal of money is flowing in from overseas to the United States as the last fortress of capital.

Similarly, the public continues to buy IPOs (see INITIAL PUBLIC OFFERINGS), almost every single one. Is that good because it means confidence or bad because it means that there is such a strong psychological undertone to the market that when it cracks, nothing will bring it back? What is more, we have got the quality stocks doing much better for the last several years than the broad market averages. Good because it suggests leadership? Or bad, meaning that there really is a low level of confidence, and this is just speculation in well-known names?

Also, we have continued concerns about what will happen in the year 2000 with our computer systems. Good - if nothing happens - or bad - because the year 2000 is only months away? Finally, earnings are good, but on the other hand, the majority of the surprises are on the downside: there appears to be a deterioration in terms of buildup of disappointments. So the same news can be seen as good or bad.


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Watch out: Those asset management fees add up


They say you get what you pay for, but consumers of asset management services sometimes get less. That can be especially true at times like these, when good returns are hard to find.

Chances are you don't know how much you are paying the fund managers you patronize, or what exactly you are paying them for. A fund's return - how much it gains or loses in a given period - encompasses deductions for several varieties of charges and other expenses, details of which are typically buried in fine print.

Fund providers take a management fee and, in some countries, a separate one for advertising and marketing. Among the miscellaneous other costs are brokerage commissions and outlays for safekeeping of assets and for administrative functions like accounting, sending out statements to shareholders and so on.

Apart from those running costs of ownership, there is often a charge that investors should consider a deal-breaker: the sales load. This is a percentage of the investment that is tacked on and split between the fund's distributor and the buyer's financial adviser - even if he doesn't use one.

Benjamin Tobias, a Florida financial planner and someone who stands to benefit from this sort of charge, advises investors to steer clear of any fund that imposes one. "I really do not think that a front-end load should ever be paid," he said. "I would go so far as to say that the front-end load should not be allowed."

What he finds so detestable is not the load per se but that advisers receive it up front. "Regular monitoring of the investment and circumstances are the single most important aspect" of financial advice, Tobias said. "When paying a front-end load, will the adviser be there in years to come when compensation is not going to be earned?"

What is certain to be there for all the years that an investor owns a fund are the fees and expenses. Investors may ignore them because they amount to just 1 percent or 2 percent or so of their stake in a fund each year, but as Jeff Tjornehoj, senior research analyst at Lipper, pointed out, they add up. "While those fees may not seem like much," he said, "if you compound the numbers over 10 to 20 years, you're talking about real money."

It can be even more real during periods of weakness. If an equity fund has total annual expenses of 2 percent - typical for Europe but on the high side for an American product - they will reduce the return by just one-tenth in a bull market year when the portfolio gains 20 percent. In a tough year, when the fund's share value increases by, say, 4 percent, the costs will cut that in half, and during a bear market the expenses will magnify the loss.

The severity of the impact of costs during a losing run may increase because of the way management fees are structured, Tjornehoj said. A fund may charge 1 percent on the first $1 billion of its asset base, then 0.8 percent on the next $1 billion and so on. That means that as a fund shrinks in a bear market from losses and shareholder withdrawals, the management fee is likely to account for a higher proportion of assets for the remaining investors.

All else being equal, a small fund will cost more to run than a big one because fixed costs must be spread over fewer assets. That helps to explain why European funds, which tend to be smaller than American funds, are more expensive.

But there is more to the higher fees than managers merely passing along higher costs. Christopher Traulsen, head of fund research for Morningstar U.K., points out that management fees tend to be twice as high for British funds as American ones, no matter how big they are.

The industry "offers a robust selection of funds from a wide array of providers, and yet the majority of them have hit on the exact same fee for their services: 1.5 percent per year," Traulsen said in a research report.

The more data assembled about fund expenses, the stronger the case for buying index funds seems to become. It gets even stronger when you consider that there is no clear evidence that funds with higher expenses produce returns that are strong enough to overcome the extra outlay. "Certainly there are some fund managers out there who have great reputations and slightly higher fees than their peers," Tjornehoj noted. "What's unknown is whether those managers will continue to outperform. The only thing you can be sure of is that their costs will be higher."

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Category: Research

Why guaranteed products are not the best product for your hard earned cash.

JOHANNESBURG -  Billions are invested annually in guaranteed products because some investors don't like investment risk. Inflows into these products increase dramatically after a stock market crash as investors don't want to suffer losses again. Unfortunately this is precisely the time when you don't need a guarantee because it is unlikely that the market will collapse again so soon after a crash. Many of these guaranteed products offer a stock market return with the benefit of capital protection. This seems to be a great deal as you invest in the stock market without the risks. The problem is that most of your stock market growth comes from dividends which you don't earn with guaranteed products.

How guaranteed products are structured
There are hundreds of different types of guaranteed products, so for this article I will focus on five-year products that offer a stock market investment with a capital guarantee. This type of product will usually offer you a 100% capital guarantee and link your investment growth to the performance of a stock market index or something similar. Your performance is calculated by the movement of the index over the five year period. As an example, if the All Share Index starts at 26 000 and grows to 35 000 after five years, the index performance is 34%. Most guaranteed products will not give you 100% of the index growth, they will usually limit your growth to 75% of the index performance. For the investment in this example your total return would be 25.5% over the five years. It is important to note that this is a total return and not an annual return.

Why not use these products?
If you are prepared to lock away your capital for five years, you really don't need a capital guarantee. If you are really risk averse, you could take 25% of your capital and invest it in the index yourself (via an ETF) and place the balance in a five year RSA retail savings bond. In the history of our stock market to date, you would not have lost money with this type of investment. If your retail bond only gives you 8% per year, you would get all your capital back plus 10% growth just from the bond. In addition you can get anything from 0% to 50% additional growth from the index ETF. This means you could have between 110% and 160% growth for a five-year investment with no lock ins. If you were to split the capital 50:50 between the bonds and the index, it is still unlikely that you would lose money over five years.

If you look at Graph A below, it shows what type of growth you would have had if you had started investing in the JSE on January 1 1960 and ended in April 2009. The three components of this growth were: inflation, dividends and capital growth. As you can see, dividends contribute more than 60% of your real growth from shares where real growth is the return above inflation. Most guaranteed products don't give you the dividend growth. This means you are sacrificing more than 60% of your potential equity returns. Dividends are such an important part of share price growth that you would be better off not investing in shares if you don't get the dividends because the compounding effect of dividends will protect you from capital losses over time.

Because a guaranteed product needs to run for a fixed term, you will be heavily penalised if you decide to draw your capital before the term expires. You will lose the benefit of your capital guarantee and you might end up losing some of your current market value as the product provider needs to trade a small illiquid investment which means big dealing costs.

My final concern is the value of the guarantee. You need to ensure that the company offering the actual guarantee is financially sound. As we saw in the financial crisis, you cannot simply rely on the fact that a large financial institution provides the guarantee, it could collapse and leave your investment worthless.

GRAPH A: FTSE/JSE All Share Index: Components of Total Nominal Return (Jan 1960 - Apr 2009)


Source: Data from McGregor BFA, method derived from Plexus Asset Management; analysis by Cannon Asset Managers

Are there any good guaranteed products?
As you may have gathered, I am not a fan of guaranteed products but there are special situations where they can be helpful. Firstly, the term of any guaranteed product should not be longer than three years. If you want to invest in shares you need to hold them for five years at least. If this is not possible then a guaranteed product makes perfect sense.

A guarantee also makes sense if you are investing in a high risk market (eg, Russian or Brazilian shares) and you are not in a position to monitor your investment properly. I would naturally argue that you should avoid an investment that you cannot monitor properly but if you are going to invest anyway then try to use a guarantee.

What else this graph tells us
The analysis and resulting graph was given to me by Cannon Asset Managers and provides some very interesting information that should prove useful to all equity investors. The analysis was done to argue the case for value investing and thus shows the impact of dividends on equity returns over time. It highlighted dividends because the shares that are targeted by value investors, such as Cannon usually have a good dividend yield. To me, the graph also shows the benefits of long-term equity investments. If you are an equity investor and you only buy the index and re-invest your dividends, it is unlikely that you will lose money in REAL terms if you invest for periods of eight years or longer. From the graph you can see that there was only eight year period since January 1960 where you would have lost money in real terms and that was if you invested at the market peak in the late 1960s and sold your shares in the late 1970s.

The graph also shows the real dangers of inflation, which I feel poses a far bigger threat to long-term savings than stock market risk. Because the effects of inflation are not dramatic, we don't really feel them over one or two year periods. It is only once you start seeing the compounded effects of inflation (the top section of the graph) that you realise that this is the aspect of your investments that should concern you the most.

*Warren Ingram, CFP®, has been advising people about their money management since 1996. He is a director of Galileo Capital,

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Category: Trading


Jonathan Spicer and Herbert Lash, Reuters|

03 December 2009 03:59


Who's afraid of high-frequency trading?

How money managers invest is changing.

NEW YORK (Reuters) - Inside the offices of Tradeworx, an emerging player in the secretive and controversial world of high-frequency trading, it's dead quiet as staffers pore over the "tape," financial industry speak for the record of the day's transactions.


Many of the firm's 30 employees are not yet 25. They were hired straight from college to ensure their thinking and work habits are untainted. Now they're making Wall Street's latest fortune, a fraction of a penny at a time.


The only clue that Tradeworx, a six-year-old hedge fund based in Red Bank, New Jersey, is a financial outfit at all are two giant screens that break up the monotony of white walls and grayish carpets. The physics and computer science graduates are crafting complex computer codes to exploit trading patterns revealed by the tape.


Tradeworx and other firms like it use such algorithms in the lightning-quick trading approach that is altering the landscape of U.S. markets, driving broker-dealers out of business and changing how money managers invest.


High-frequency trading now accounts for 60 percent of total U.S. equity volume, and is spreading overseas and into other markets. These traders stand ready to buy and sell shares at all times, providing the liquidity that keeps markets moving. As a result, trading is now cheaper and easier than ever.


Yet critics worry fast trading may undermine the integrity of the U.S. equity market, a bastion of capitalism and corporate America, and could even spark another financial crisis.


They also complain about the money high-frequency firms are making -- and how they are making it. During last year's plunge, when volatility rose, many high-frequency traders earned 10 times their usual profits, executives at several of the proprietary firms told Reuters.


For their part, the fast traders don't see what all the fuss is about.


"We live in a capitalist society," said Tradeworx Chief Executive Manoj Narang, 40, wearing jeans, runners and a Yankees baseball cap.


"People should expect and be willing to pay a price for the liquidity that they get. No one should expect that a provider of liquidity is just going to stand there while you bulldoze them into submission," Narang said.


Tradeworx started high-frequency trading in January and now accounts for about 3 percent of overall volume in the exchange-traded fund SPDR Trust, which tracks the Standard & Poor's 500 Index and is one of the most heavily traded securities.


High-frequency traders point to last year's steep sell-off as proof of their value in helping the market run smoothly. While over-the-counter and other markets seized up, exacerbating the worst financial crisis since the Great Depression, fast traders continued to buy and sell shares.


Proponents also laud computerized trading for eliminating the shady transactions that often occurred in the past when people were directly involved in trading.




Trading today seems less intimate, less human, married as it is to computer code. The revolution has caught some people off guard, and has led to deep concerns.


Many institutional money managers are uneasy about how the fast traders anticipate their transactions, and worry that there might be information leakage about their trading intentions -- a critical issue for asset managers.


"High-frequency trading, fundamentally, when you look at what their algorithms are finding, they're almost a structured way of trying to front-run," said Jim McCaughan, chief executive of the asset management arm of Principal Financial Group, where he oversees about $215 billion in assets.


"That just seems to me ultimately as doing it at the expense of other investors," he said.


McCaughan said he had no proof of wrongdoing, yet he suspected it is quite likely the leaking of information may have happened. "If it has, it would at best be unfair to other investors and perhaps criminal," he said.


A furor over the extent of computerized trading erupted this summer when news of the enormous profits being garnered rankled a public already apprehensive about a crisis rooted in Wall Street -- whose bailout the taxpayer is footing.


Critics fear an errant computer code, similar to the program trading behind the Black Monday crash of 1987, could engender another deep market plunge.


The U.S. Securities and Exchange Commission is taking months to investigate all this. With high-frequency trading spreading quickly from its U.S. equity base, the regulator's response will be crucial for capital markets around the world.


Key to any discussion of high-frequency trading is the tape, which records the price, time, size and order of trades. It's the day's financial narrative, and its availability is held up as a major reason why the U.S. equity markets are trusted for their transparency and fairness.


The tape is also highly prized by traders, who base their computer instructions, called algorithms, on this data. The Nasdaq Stock Market produces about 50 gigabytes of information every day, which is measured in nanoseconds -- or a billionth of a second.


Lotus Capital Management LP of New York earlier this year realized that a competitor was beating it to a trade it had programed by exactly 3 microseconds, day after day. The loss meant Lotus was forfeiting about $1,000 in daily revenue on that particular trading strategy.


Lotus, a quantitative trading firm that uses high-frequency strategies, invested and tinkered, eventually shaving five microseconds from the router and two microseconds from the execution server.


"By just reading the tape you can see a lot of what the other guys are doing. You can see who is successful. So eventually everyone is operating more or less the same strategy," said Louis Liu, the 37-year-old founder of Lotus.




Operators like Lotus have changed the nature of the business. Small start-ups can launch with less than $1 million, and are creating enormous cost pressures on established broker-dealers and others that can't keep up, Liu said.


"That's where a lot of the complaints are coming from. We're driving the spreads down and squeezing the profit margins," he said. Legacy operators know what needs to be done, "but they're not willing to cannibalize their existing business," he added.


Being nimble is key to success. Narang said he and his partners at Tradeworx realized a couple of years ago that high-frequency traders were "eating the lunch" of its hedge fund business. In response, Narang moved into fast trading and incorporated those techniques in the hedge fund.


The firm began targeting math whizzes very selectively. Last year, just six of 1,500 resumes led to jobs at Tradeworx, one of several firms setting up shop in up-and-coming Red Bank, a former manufacturing hub.


Others agree with Liu that the recent cries of foul play and other criticisms of electronic trading are coming from those who have been displaced in the lucrative brokerage business.


"The broker-dealer business model is dying, and you have massive over-capacity," said Harold Bradley, chief investment officer at the Ewing Marion Kauffman Foundation in Kansas City, where he oversees $1.7 billion in assets.


"You don't need a dealer to put you and me together through three other brokers in a Nasdaq stock. There should be fewer people in the business."


Several incidents this summer underscored the secrecy and money to be made from high-frequency trading. The FBI in July arrested a former Goldman Sachs Group Inc (GS.N) computer programer for allegedly stealing trade secrets. The bank later reported blowout second-quarter earnings, bolstered by $10.78 billion in trading income.


When TABB Group estimated $21.8 billion was earned annually in high-frequency trading, the media pounced on the issue. Yet few critics asked how the size of profit compared to the past. Rosenblatt Securities pointed out that as far back as 1997, overall trading on the Nasdaq alone may have generated $20 billion in annual brokerage revenue, suggesting that profits were already substantial more than a decade ago.




Proprietary trading powerhouses Getco and Tradebot, hedge fund Citadel Investment Group and trading desks at Goldman Sachs and Citigroup Inc (C.N) are some of the industry's prominent names.


Tradebot and Getco, seen as trailblazers in rapid trading, regularly account for a combined 20 percent of the overall U.S. stock market. Market sources suggest the firms each trade more than 1 billion shares a day. Tradeworx trades some 80 million shares per day.


With worries over systemic risk growing, the SEC has jumped into the fray. It has proposed a ban on so-called flash orders and wants to crack down on the scores of anonymous trading venues known as dark pools.


The regulator plans to issue a report early next year that officials said would focus on whether markets reliant on high-frequency trading are more or less efficient for long-term investors, including those trading small- and mid-cap stocks.


Most fears of a blow-up surround what is known as naked sponsored access, in which brokers allow traders use of their identification to directly trade on exchanges, saving the traders valuable time.


Critics also say the fast traders are less willing to take the other side of trades outside of large-cap stocks, reducing the amount of liquidity in smaller companies.


Politicians also are stirring the pot. Senator Ted Kaufman has warned high-frequency trading could lead to market chaos and systemic risk.


In October, SEC Chairman Mary Schapiro told Reuters the regulator "will not hesitate to propose regulatory approaches" if concerns are "significant.


The SEC recently hired Richard Bookstaber, a well-known former risk manager at Morgan Stanley (MS.N), Salomon Brothers and hedge fund Moore Capital Management, to work in a newly created division designed to identify risks in financial markets.


Bookstaber indicated on his blog in August that he is not particularly worried that high-frequency trading or the use of algorithms will lead to a blow-up. "I don't think the risk is as big as many are making it out to be," he wrote.


Institutional investors mostly complain about alleged unfair advantages and that their trades are being "gamed."


A high cancellation rate for orders has sparked suggestions that the algorithms are deployed to glean information from pending order flows, and then based on that knowledge, race ahead to scoop up trades.


More than 90 percent of orders submitted to the New York Stock Exchange by high-frequency firms are canceled, according to an NYSE Euronext (NYX.N) official. Overall, the average daily trade volume of NYSE-listed stocks has more than tripled in five years as of 2008.


The head trader of a European money manager with more than $100 billion in assets said high-frequency traders profit through pattern recognition software to anticipate a trade.


"It's a certain knowledge of what's coming. It's not like they're guessing what's going to happen, they're not speculating," said the trader, who spoke on the condition of anonymity. And he added emphatically: "They know."


Detractors also question the amount of money the high-speed traders make, especially after holding a stock for only a few seconds. They wonder what purpose such quick turnover serves.


The market "is not trading on fundamentals anymore. It makes no sense, it's very frustrating for traders," said Alan Valdes, director of floor trading at NYSE member Kabrik Trading. "It's all programs."




The criticism has frustrated high-frequency traders, who are increasingly going public to defend their business. Several said they expect little impact from any new regulation, and expressed confidence that their role in the marketplace would be preserved.


Fast traders are proud they make their money through a battle of wits, believe in the work ethic and do not rely on chummy business ties. There is talk of forming an association, presumably to quell complaints and educate the public about their business.


"If you were on Wall Street in the 1990s ... you would need to take guys out to dinner and build relationships, otherwise you couldn't get at the order flow. And now, if you're good ... there's no barrier to entry," said Cameron Smith, general counsel at Houston-based technology and trading firm Quantlab Financial LLC, which does high-frequency trading.


"That is a really incredible improvement to the Wall Street environment," he said. "That's how we want markets to work."


A sign of the critical role the fast traders have assumed came to the fore last year after the SEC briefly banned the short-selling of financial securities. Spreads widened and trading volume declined as high-frequency traders cut back on their presence to adjust algorithms.


After the ban was lifted, the high-frequency players came back. Spreads started collapsing and volume picked up, said Todd Mackedanz, head trader at Fisher Investments, the firm founded by billionaire investor Ken Fisher based in Woodside, California.


"With that said, they do in a sense play a fairly important role in the marketplace," Mackedanz said.


Fisher Investments, like other institutional investors, has set tight price limits and is careful about whom it trades with to try to ensure it gets the best execution possible.


Many investors fear that high-frequency trading may fall prey to bad habits. In 1994, for instance, an academic study found that a large number of Nasdaq stocks were traded with spreads that were double the minimum, raising the question of whether dealers colluded to maintain wide spreads.


Jean-Marie Eveillard, a legendary investor on Wall Street, said that high-frequency trading strikes him as suspect. But Eveillard said in an e-mail message that he had no particular insight other than this: "If in a good mood, I say Wall Street is nothing but a vast promotion machine. If not, it's a den of thieves. So there is always the possibility of front running, insider trading, market manipulation."




Any big market move creates ripples on which high-frequency traders feast.


Correlation strategies -- like selling the S&P 500 index exchange traded fund when a blue-chip company misses earnings expectations -- are left to high-frequency players with the most horsepower. Others are relegated to more complicated techniques, poring over historic trading records in various regions and asset classes.


Market making is the dominant technique, with the top-tier "ultra high-frequency" firms -- those trading more than 1 billion shares per day and holding positions for seconds -- relying heavily on gathering the rebates exchanges pay them for posting orders.


If a trader's bid of $15.80 for Bank of America (BAC.N) shares is matched, that person might immediately post an offer for the same price, hoping to capture two rebates while breaking even on the spread.


The result, according to several independent proprietary firms, is a flooding of the 50 some U.S. trading venues with orders, and near-immediate execution for investors -- even if the high-frequency trader on the other side of the trade walks away with one-tenth of a penny per share, on average.


A misunderstood dynamic of high-frequency trading is that it thrives off volatility, thereby reducing it. The clear winners in the revolution are small investors, who have seen their trading costs fall remarkably and markets price shares far more efficiently.


"Most of our clients really don't spend a lot of energy worrying about the last penny on a trade, or the last two pennies," Charles Schwab, founder of Charles Schwab Corp (SCHW.O), the largest U.S. discount brokerage, said last month during a Web cast business update.


"We think the liquidity components are perfectly satisfactory."




The 2000 decision to price quotes in decimals of a dollar was probably the most important in a series of U.S. rule changes in the last dozen years that sowed the seeds of high-frequency trading.


A spread of 25 cents for a Nasdaq stock was not uncommon 15 years ago, when market makers and floor specialists had fixed commissions and wooed clients to win business.


The late 1990s introduction of alternative trading venues was another regulatory turning point, as well as a 2005 "trade-through" rule that ensured investors get the best U.S. bid or offer, no matter where it was.


Transactions are dramatically faster, and the duration of time long-term investors own securities has been shortened. Eighteen months is now considered very long, compared with two or three years about half a decade ago.


Another complaint that haunts high-frequency trading is secrecy -- not just around their firms' strategies but even who they are. A number of firms declined to be interviewed by Reuters.


"People think that high-frequency trading firms ... are secretive because they're doing something untoward," Narang said. "Really the reason they're secretive is because as soon as they spill the beans other people can compete with what they're doing."


All Wall Street firms want to stay under the radar screen, said Robert Olman, president of Alpha Search Advisory Partners, an executive search firm for hedge funds and prop shops.


"Once you're successful, once you have a system that's making money, you become very secretive because it's very easy for one of your guys to leave and replicate it," he said. That's the reason behind Coca-Cola Co's closely guarded formula for making Coke, he said.


"What are the exact ingredients and proportions of Coca-Cola? Is there something wrong going on at Coca-Cola?" he said. "That's the point. It's replication, ease of replication. The barriers to entry, to competing, are not too high."


(Reporting by Herbert Lash and Jonathan Spicer, editing by Jim Impoco)

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The History of the Stock Market

In recessions and booms alike, stock markets are always at the forefront. Newspapers and financial publications are awash in headlines about the Dow Jones, S&P 500, NASDAQ, rising stock indexes, falling stock indexes, buying, selling, and so forth. And it is tempting to think of a stock market as an impersonal mechanism in the sky, imposing its mandates on us at will. But this is not usually accurate. In reading the history of stock markets, one discovers that, in the words of economist Thomas Sowell: “markets are as personal as the people in them.” With that said, stock markets and their performance reflect the dominant concerns, fears, and hopes of the investing public. We will investigate this history, from the very first stock markets ’til today.

The Early Days of Exchange

Stock markets did not begin as the super-sophisticated, simultaneous, worldwide trading exchanges of today. It was not until 1531 when the first institution roughly approximating a stock market emerged, in Antwerp, Belgium. However, as Investopedia notes, this was, “…the first stock market, sans stock.” Rather than buying and selling shares of companies (which did not yet exist), brokers and lenders congregated there to “deal in business, government and even individual debt issues.”

This changed in the 1600’s, when Britain, France, and the Netherlands all chartered voyages to the East Indies. Realizing that few explorers could afford conducting an overseas trade voyage, limited liability companies were formed to raise money from investors, who received a share of profits commensurate with their investment.


(Wikimedia Commons)

This form of business organization was also necessitated by risk management. As India’s Imperial Gazetteer reports, the earliest British voyages to the Indian Ocean were unsuccessful, resulting in lost ships and the financier’s personal fortunes being seized by creditors. This led a group of London merchants to form a corporation in September of 1599 which would limit each member’s liability to the amount they personally invested. If the voyage failed, nothing more than this amount could be lawfully seized. The Queen granted the merchants a fifteen year charter in 1600, dubbing their corporation the “Governor and Company of Merchants of London trading with the East Indies” (or simply, “The East India Company.”) The limited liability formula proved successful, leading King James I to grant charters to more trading companies by 1609 and triggering business growth in other ocean-bordering European countries.

The Dutch East India company was actually the first to allow outside investors to purchase shares entitling them to a fixed percentage of the company’s profits. They were also the first company to issue stocks and bonds to the general public, doing so via the Amsterdam Stock Exchange in 1602 according to Britannica.


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Category: Research

This is another fantastic guest post by Wayne Whaley, CTA. This time we’re treated to an intriguing historical study of the relationship between interest rates and equity prices.

Yesterday I touched on this very tangentially through the SocGen report on the relationship between inflation and P/E ratios but this goes into much more detail on the true inter-play between the two biggest markets, fixed income and equities. If you’re rushed for time, jump towards the end for a summary of conclusions:

The historical correlation between interest rates and future equity prices is well documented with an abundance of existing studies to support the correlation. For a small sampling of trading strategies tied interest rates, simply google “Three Steps and a Stumble”, “Two Stumbles and a Jump”, or “Don’t Fight the Fed”. The trading theory is very straight forward, “A trend of lower rates tends to be conducive to higher equity prices and vice versa”.

This concept is based on the generally accepted principle that interest bearing securities are the primary source of competition for equity investment dollars. Higher expected returns for one investment, reduces the appeal of its primary alternative. Also, the cost of borrowing money has an influence on the expense of doing business for many companies, such as banks and utilities. The expectation of any changes in future earnings is a primary driving force in determining the appeal of equities.

In theory, this accepted relationship would always hold true, if all other market forces were held constant. But since rate changes can be symptomatic of other underlying factors that impact the direction of equity earnings, it begs the question, “When does the basic interest rate to equity relationship not apply?” And in regard to the current market, “What should one expect for the equity markets when rates begin to rise from the current extremely low levels?”

For example, we have strong historical evidence of the negative impact that deflation (which is accompanied by a collapse in interest rates) has on equity markets. We have the 1930’s depression era as our primary data point, and even as recently as the last decade, we watched the Federal Reserve lower rates to near zero in both 2001 and 2008, long before stocks were able to eventually find a bottom and reverse course. If we accept that “rates very low and declining” are often symptomatic of a deflationary scenario and not necessarily bullish for stocks, then doesn’t it beg the question that “rates very low and rising” might often be bullish? Especially, if the rise in low rates indicates a move from deflation to more normal economic growth.

Impact of Interest Rates on Future Equity Prices
I’m going to avoid getting into the selection of which interest rate along the yield curve is the most important to equity prices and simply use what I refer to as the average interest rate (AIR), which I choose to define as the average of the 3 Month Treasury Bill, 5 Year Treasury Note and 30 Year Treasury Bond.

I defined the direction of interest rates as either one of three categories, rising, declining, or unchanged. The definition of rising interest rates was any six month period in which there was a 10% change in the AIR. For example, if AIR was 5%, then a six month change of more than 0.5% would define either a rising or declining period. A 10% AIR would require a six month change of 1.0% to define a rising or declining period. Rate changes less than this requirement fail into our unchanged rates category.

This may seem a little unnecessarily complicated, but I found that it improved the quality of the results, since 1% moves in rates are much more common when rates are in double digits than when they are below 5%. The study was done on the daily interest data that I currently have access too going back to 1970.

The Table below shows the impact that the “direction of interest rates” have had on equity prices since 1970. As you can see from the first column, being in the market only during periods of declining rates, one could have experienced a 16.31% return in equities, which is twice the 8% average annual return. When rates were rising, the market averaged a modest negative return (-0.91%). The crux of the study is in the last two columns where I separated S&P 500 return vs. the interest rate trend into two categories, days that rates were below 5% and days where rates were above 5%.
S&P500 returns vs interest rate direction table 1
As we surmised might be the case, “low rates and rising” has been a positive category for stocks, averaging 13.21% on those days. Note that when rates were above 5% and declining, the average return has actually been 22.89%. As you would expect, “high rates and rising” is the worst monetary environment for stocks with an average loss of 5.07%.

Impact of the Level of Rates on Equity Prices
Although, not the primary purpose of my study, I was able to make an observation concerning the general impact of the level of interest rates on equity prices (irregardless of the interest rate trend). I divided interest rates into three groups that were approximately equal in historical occurrence. AIR below 5.0% was considered low, above 7.5% was considered high, and anything in between was considered medium. The table below shows how the market performed in each of the three categories.

impact of interest rates on equities table 2

Interest Rate Study Summary

  1. I found that the level of interest rates has some modest impact on the direction of equity prices, but is not nearly as significant as the direction of interest rates. However, medium (5-7.5%) rate periods were observed to have offered twice the returns of either low or high interest rate periods, suggesting that the markets prefers modest inflationary periods.
  2. As a general rule, a trend of lower interest rates leads to substantially higher equity prices and higher rates leads to muted and sometimes negative performance.
  3. The study data suggest that if interest rates are extremely low (which can often coincide with recessionary or deflationary scenarios), signs of economic growth is usually well received by the equity markets, even if it is accompanied by higher interest rates.
  4. Although not addressed in the study, the degree of change in interest rates is important. On those days where rates were high (AIR>7.5) and rising “very” fast (6 mt change > 1.0), the S&P was down on average 7.0% annually.
  5. 5. Over the last 40 years, you would have experienced a 19.3% return by being invested only in the 9.7 years in which interest rates were doing one of the following:
  • AIR above 5.0% and declining or
  • AIR below 5.0% and rising

Conclusion & Relevance to Today’s Market
The bullish “low rates and rising” results that we observed would be more convincing if we had more data points to draw from, but the results have intuitive appeal to me as well. The study only went back to 1970 for which I currently have daily interest rate data, but I have also recently found that Robert Shiller has 10 year treasury note yields listed on a monthly basis.

I was able to make the following additional observations, concerning “low rates and rising” on data prior to 1970. From the end of 1962 to the end of 1968, the 10 year note yield rose from the low level of 3.86% to 6.03%, while the S&P rose 106.5%. From the end of 1949 to the end of 1958, the 10 year yield rose slowly from 2.32% to 3.86%, while the S&P rose 223%. As for additional data on “low rates and declining”, at the close of 1928, the 10 year note was 3.58 and declined steadily throughout the next decade to a low of 1.97% at the end of 1940. During that same period of declining rates, the S&P lost 54.5%. When rates are extremely low, traditional interest rate trading rules appear to be suspect.

I am not making any predictions on the direction of interest rates, but in regard to the current interest rate implications for the market, I am of the opinion that “if” interest rates rise over the next year, equities will fare better than most anticipate, at least through the first couple rounds of hikes. My instincts are also that it is most likely imperative for the continuation of the upward move in equity prices that rates do rise at least modestly as I also expect that the most ominous interest rate scenario for equities would be a situation where short term rates stay near the current rates of zero (as the Federal Reserve has promised), and long term rates confirm the Feds deflationary concerns by contracting from the current +4% levels to below 3% as the prospects for economic growth diminishes and the odds of deflation increases. Recall that during the 08 crisis, 30 yr bonds got as low as 2.55.

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Category: Market news

Deutsche Bank: Beware Sovereign Defaults And The End Of The Dollar Carry Trade In 2010

dbreportDeutsche Bank is out with an outlook for 2010, which includes various themes and risks investors need to watch out for.

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Category: Research

Just Like That, The Financial Industry Is Overwhelming The Economy Again

It looked like the financial crisis would finally bring the financial sector down to a reasonable size relative to the rest of the economy.

But, the government stepped in, and just like that, finance has resumed its outsize role.

This chart from Deutsche Bank shows it quite vividly. There was a brief reversion to the mean, and then BOOM, it came back.



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Category: Market news
Rumors That Japan May Dump $100 Billion In Treasuries

This morning, this message popped up on Bloomberg:


Said sale in question is rumored to be a U.S. Treasury sell off by the Japanese government.

Adding fuel to the fire is the U.S. and the Federal Reserve. Today, the Fed conducted a reverse repo (repurchase) test that could help with the Japanese UST sale.

On the other hand, this wouldn't seem to jibe with reports that the country's main concern is the rising yen. If anything, you'd think they'd be snapping up more treasuries. So something is amiss.

The Houston Chronicle reports Japan could be selling off as much as $100 billion worth of treasuries.

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Stocks Plunge In Final Hour Of Trading

finviz_final1203The market was relatively quiet all day.

That is, until 3pm came and went. The Dow ended up plunging 90 points while the S&P lost 10. The NASDAQ was the least affected, dropping only 12 points.

Gold gained $1.40 and remains at $1214 an ounce. Oil dropped 60 cents to close at $76 a barrel.

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Active vs. Passive Management

By Rex A. Sinquefield

October 1995

The following paper is a transcript of Rex Sinquefield's opening statement in debate with Donald Yacktman at the Schwab Institutional conference in San Francisco, October 12, 1995.

Let us agree on what we are debating, discussing and disagreeing about: active vs. passive management. Active management is the art of stock picking and market timing. Passive management refers to a buy-and-hold approach to money management. It can be applied to any asset class: big stocks, small stocks, value or growth, foreign or domestic can all be accessed by passive techniques. Neither label, "active" or "passive," is perfect, and there will not always be a complete dichotomy between them. In any event, this is a debate about both market behavior and investor behavior.

With respect to market behavior there are, at the extremes, two views. At one extreme is the well-known efficient market hypothesis which says that the prices are always fair and quickly reflective of information. In such a world neither professional investors nor the proverbial "little investors" will be able to systematically pick winners... or losers. At the other extreme is what I'll call the market failure hypothesis. According to this view, prices react to information slowly enough to allow some investors, presumably professionals, to systematically outperform markets and most other investors.

At the level of investor behavior, this discussion deals with how a financial advisor should handle his or her clients' money. It is my contention that active management does not make sense theoretically and isn't justified empirically. Other than that, it's O.K. But it's easy to understand the allure, the seductive power of active management. After all, it's exciting, fun to dip and dart, pick stocks and time markets; to get paid high fees for this, and to do it all with someone else's money.

Efficient market theory is the theory postulating that market prices reflect the knowledge and expectations of all investors. It asserts that any new development is instantaneously priced into a security, thus making it impossible to consistently beat the market.

Passive management, on the other hand, stands on solid theoretical grounds, has enormous empirical support, and works very well for investors.

At the end of 1973 there was $50 million invested in index funds. Today, there is roughly $1 trillion invested in passive portfolios of all sorts in the United States and abroad. Clearly, this is an idea that is here to stay. A rather impressive group of investors worldwide believes it is difficult to beat markets and perhaps better not to try. These investors are responding to a mountain of evidence that markets work. Such investors believe that in every asset class they choose, their best course of action is to accept market returns.

Where is this mountain of evidence? The 20th century has produced two grand experiments that bear directly on the question "do markets work?" One experiment took place on the geopolitical stage and the other in the halls of academia.

The intellectual origin for the role of free markets and the price system goes back to Adam Smith. He was the first to offer a comprehensive statement that markets work and that a free market is the best way for a social order to allocate resources. In his Wealth of Nations he shows that countries with such a system prosper, while those without do not.

Friedrich Hayek extended the work of Smith and tried to provide insight as to why and how the free market system works. The key idea is that the price system is a mechanism for communicating information. The knowledge that is relevant for producing any good or service is never possessed by a single individual or a single group. Rather, it is dispersed among many market participants. The price system acts to spread this knowledge and coordinate the actions of individuals. Perhaps an example from Hayek will help.

Suppose somewhere in the world a new use for some material, say silver, has arisen, or that an important source of supply is eliminated. It is significant that it does not matter what is the cause of this new scarcity. All that the users of silver need to know is that silver is now more profitably employed elsewhere and they should economize. It is not even necessary that the majority of silver users know the new need. If only some know, they can direct silver to it highest use and fill in from other sources of supply. This, in turn, will influence the other users and suppliers of silver, and the substitutes of silver, and so on. And all the while, the vast majority may be unaware of the original causes of these changes. The whole acts as one market, not because anyone surveys the whole field or knows all the facts, but because the participants' limited fields of vision sufficiently overlap and, through intermediaries, communicate the relevant information to all. Because there is only one price—allowing for transport costs—means that had there been an all-knowing person possessing all the dispersed knowledge of the market, his pricing solution could only be the same as the one chosen by the market. As Hayek pointed out in his Nobel laureate lecture, we are only beginning to understand how subtle and efficient is the communication mechanism we call the market. It garners, comprehends and disseminates widely dispersed information better and faster than any system man has deliberately designed.

But there is another side to this story. The ideas advanced by Adam Smith were not only ideas. An abiding faith in the power of man's reason was augmented by the success in the physical sciences. From the middle of the 19th century to the 20th century there was a growing belief among some intellectuals that man's success in the physical world could be applied to the social order as well.

This was in part the intellectual genesis of the first grand experiment referred to earlier. In 1917, much of the world began organizing itself—forcibly and brutally—on a belief that centrally administered prices and planning is superior to a system based on free market prices. Surely, a group of bright people by intelligent design and management could increase social welfare better than a system that was undesigned and unmanaged. So, much of the world was subjected to socialism. But deprived of a mechanism to gather and disseminate the widely dispersed information on how to deploy society's resources for the production of goods and services, deprived of free market prices, it was inevitable that socialist countries would collapse. In retrospect, it would be impossible to design a more controlled experiment at the geopolitical level than the one we witnessed for most of this century. The verdict is in. The socialists have thrown in the towel. And in some of these countries, the new emergent hero is none other than Adam Smith.

So who still believes markets don't work? Apparently it is only the North Koreans, the Cubans and the active managers.

Now let us consider the second big experiment, that which began in academia in the 1950s. The early work of Markowitz, Miller, Sharpe and Fama was transforming the field of finance from an ad hoc collection of courses to a serious and legitimate field of academic and scientific inquiry. Their work shaped and defined the field of finance and how the investigation of market activity would proceed over the next thirty years. They spelled out the idea of market efficiency and provided evidence on its behalf.

The notion of efficient markets was simply a specific application to the financial markets of the more general idea that free and competitive markets work. Most people in the western world and especially in the US are ardent defenders of free enterprise, which depends on the idea that markets work. The literature on efficient markets over the last thirty years is a test of that proposition applied to the capital markets. The resounding success of these tests should bring joy to any fan of free markets.

Debate about active management vs. passive management began in earnest in the early 1970s. Already by then, researchers had uncovered considerable evidence that past prices were of little benefit in forecasting future prices in ways that would earn excess profits; that fundamental data was too quickly reflected in prices to allow such data to be used for beat-the-market purposes; and, most importantly for us, that professional money managers could simply not outperform markets in any meaningful sense. The latter tests are most pertinent for us, and of these, there is not one major published study that successfully claims that managers beat markets by more than one would expect by chance.

Several recent studies deserve brief mention. In the first major study of bond market performance, Blake, Elton and Gruber examine as many as 361 bond funds for the period starting in 1977. They compare the various active funds to simple index strategy alternatives. The authors find that the active funds, on average, underperform the index strategies by 85 basis points a year. Depending on the benchmark, between 65 and 80 percent of the funds generate excess performance that is negative.

In a study of equity mutual funds, Elton, Gruber, Hlavka and Das examine all funds that existed for the period of 1965-1984, 143 funds in all. These funds are compared to the set of index funds—big stocks, small stocks and fixed income—that most closely correspond to the actual investment choices made by the mutual funds. The result: on average these funds underperform the index funds by a whopping 159 basis points a year. Not a single fund generated positive performance that was statistically significant. In the most recent and comprehensive study done to date, a dissertation at the University of Chicago, Mark Carhart studies a total of 1,892 funds that existed any time between 1961 and 1993. After adjusting for the common factors in returns, an equal-weighted portfolio of the funds underperformed by 1.8% per year.

These studies, along with earlier studies, provide a fifty-year history of professional investment management. The message is clear: the beat-the-market efforts of professionals are impressively and overwhelmingly negative. In any asset class, the only consistently superior performer is the market itself.

It is well to consider, briefly, the connection between the socialists and the active managers. I believe they are cut from the same cloth. What links them is a disbelief or skepticism about the efficacy of market prices in gathering and conveying information.

Fortunately, there is something that makes these two groups dissimilar as well. The socialists, all too often, would impose their view on society, thus producing all the well-known painful consequences. The cost they impose is a public cost borne by nearly all members of a society. Active managers, on the other hand, are far more benign. They do their picking and timing, and because they do it too often, they impose costs on their clients. But the cost they impose is a private cost borne voluntarily by their clients. But the bottom line is, given all the evidence from history, geopolitics and academia, it just doesn't make sense to believe markets don't work. It is no longer a credible position.

Finally, aside from these considerations of theory and evidence, there is a very practical advantage to passive management. Passive management when applied to a client's entire portfolio is really asset class investing. This means investing literally in asset classes via passive portfolios that capture, in their entirety, the asset class or classes under consideration. For most asset classes there are long-time series of historical data that allow us to form reliable estimates of the risk of a given class and how closely the behavior of that class correlates with the behavior of other classes. An advisor can estimate the risk of different combinations of asset categories and find the overall portfolio strategy that best suits the circumstances and risk tolerance of his or her client. Thus, a financial advisor can use historical data to form a long-run plan. That plan can be implemented exactly by investing in those same asset classes via passive or asset class portfolios.

A policy formed this way is easy to communicate, is verifiable, and is eminently defensible. But, in addition, as all studies to date cogently show, such portfolios will outperform about 75% of all conventional portfolios.

But a financial advisor forfeits all of these advantages if he or she abandons passive investing. Actively managed portfolios seldom bear a reliable relation to any asset class. It is generally difficult to estimate future risk levels of actively managed portfolios, or to know how an active portfolio will relate to various asset classes in the future because such portfolios may experience radical shifts in their strategy. Thus, it is nearly impossible to engage in or implement long-range planning if the inputs are actively managed portfolios.

In short, asset class investing is consistent with what we know about how free and fair markets function. Active management is not. Asset class investing is supported by the results of scores of empirical studies of fifty years of professionally managed portfolios. Active management is not. Finally, asset class investing allows reliable planning and implementation of portfolio strategies. It is demonstrably successful and the most prudent way to invest a client's money.

By now, ladies and gentlemen, all of you probably agree with me. Those of you who have been seduced by the dark side of the force are surely eager to return home. But there is still one person who disagrees with us. And now it is time to hear from him.

Thank you very much.

This article contains the opinions of the author(s) and those interviewed by the author(s) but not necessarily Dimensional Fund Advisors or DFA Securities LLC, and does not represent a recommendation of any particular security, strategy or investment product. The opinions of the author(s) are subject to change without notice. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed. This article is distributed for educational purposes and should not be considered investment advice or an offer of any security for sale. Past performance is not indicative of future results and no representation is made that the stated results will be replicated.

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Developing your investment strategy


  Investing vs. speculating alt

As many investors discover, mapping out an investment plan is the easy part. Sticking with that plan is what separates investors from speculators.
Learn more in "Timing the economy: A very dangerous game"


To make the most of your investment opportunities, allow your lifestyle — not stock market gyrations — to dictate your investment approach. Your goals are what count, so keep them firmly in mind when you make financial decisions.

Are you an investor or a speculator?
Many investors use a consistent, long-term strategy to build a more secure financial future through steady purchases of well-diversified investments.

Speculators and market timers are usually less concerned about consistency. They may switch investment philosophies on an emotional whim, sometimes treating their investments more like play money than the serious money needed for their financial future.

Most people would probably say they are investors, but the question is not so easily answered. During a bull market, it can be relatively easy to be a long-term investor. However, when the stock market starts gyrating, investors' mettle can be tested — revealing many closet speculators.

The risks of market timing
Market timers follow a fairly predictable cycle. When prices seem low relative to historical norms, they buy. When an investment's value seems to peak, they sell. This cycle is repeated with the next "hot tip."

In theory, market timing seems fairly rational, but in practice it rarely works. Even the most sophisticated investors, with years of experience and the best analytical tools, cannot predict the whims of the financial markets. What's more, market timers are often misled by emotional factors such as greed or fear. Many end up buying at the tail end of a market rally or selling in a panic at a loss.

The difficulty of timing the markets is complicated by the fact that most market rallies occur in brief spurts. Market timers waiting for the right opportunity to buy or sell risk being out of the market during these sudden market changes.

To benefit from market timing, you must accurately predict the future, not once, but twice. First you must correctly determine when to sell. Second, you must accurately determine when to get back in. Because falling markets can rise steeply within days, your timing must be nearly perfect.
Making decisions like an investor
To avoid falling into the speculator's trap, focus on the term "individual" before making any investment decision. Your individual long-term goals and your individual financial circumstances — not the daily gyrations of the stock market — should govern your decision.

By focusing on your individual needs and sticking to your investment plan, you could actually benefit from the stock market's gyrations. For example, a good long-term investment strategy generally includes investing a set amount at regular intervals. If you maintain this schedule during a market dip, you may be purchasing some strong stocks at discount prices.

Of course, changing your investments during a gyrating market is not always speculating. It can be the mark of an astute investor if the reasons for your changes are consistent with your individual long-term goals.

Lifestyle timing: Making decisions based on your goals
Instead of market timing, try lifestyle timing. Look at your own investment portfolio and compare it to your long- and short-term goals.

Do you need to withdraw money within the next year or so to begin financing your retirement or to make some other lifestyle change? If so, you might want to rebalance your portfolio to a more conservative mix of assets.

What about your long-term goals? Short-term market gyrations will probably not significantly affect your long-term plans, and it may be wise to stick with your current strategy.

To make the most of your investment opportunities, use disciplined, systematic investing — like dollar cost averaging.

Dollar cost averaging
Dollar cost averaging is a policy by which the same dollar amount is placed in your investments at fixed, successive intervals, enabling you to average the purchase of your shares over time. Assuming that each investment is for the same number of dollars, a greater number of shares are purchased when the price is low and fewer when the price is high. So you may get a satisfactory average price, instead of buying all the shares at the high levels of the market.

Over the long run, dollar cost averaging helps market fluctuations work for you, not against you. Because you buy more shares when prices are lower, and fewer shares when prices are higher, the average cost of your total accumulated shares in an investment increasing in value over time is below the average market price for all of the shares you purchased.

Disciplined, systematic investing does not promise a profit or protect you from a loss, but it does reduce the odds of you putting too much money into an investment when prices are high, and it also removes the emotional factor from your investment strategy.

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