Can You Get Rich With CDs?

[ERD50]

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Originally Posted by landonew Could you expand on this a little? At what age is it ok to "stick a toe, foot, or leg" into the tiger's cage. (metephore for 20-30% of your portfollio). Seems that if you are making a good income in your early-mid 30s (and LBYM) that putting 30% of your portfollio into a large cap equity and watching it closely may be an acceptable risk. Hell, if it hits big it could put your kids through college. If it tanks, you have time to recover.

I would not recommend it for anyone at any age, but that's me. Watching it closely is of little value, IMO. So it drops 10% - what do you do? Sell it because you are watching it closely, and want to avoid further losses, or buy more because if it was a good deal 10 points ago, it is a screaming deal now?

When a single stock makes up more than 5% of your portfolio, those decisions get very emotional. And they often leave you cursing either with "I should have sold that POS when it first dropped!", or.... " I should have bought more when I had the urge - I would be rich today!". And how can you know until after the fact?

It gets argued from time to time on this forum, but I think it's tough to do better than an index fund by trying to pick winning stocks. I hold a few from time to time (usually blamed on testosterone, or just a little gambling urge). I have not been able to convince myself that I can do better on average.

haha likes to roll his own, I take it. I'm pretty sure he stays well diversified though. I know there is the argument that you can weed out the "obvious" dead weight in an index portfolio, but I've also seen studies that show it is the current down-and-out stocks that reap superior returns over time.

Maybe haha tries to pick those out? I know he refers to "undervalued" stocks. I know what he means, but I also have trouble deciding that my vision of "undervalued" is better than the markets' vision. At least on average.

At any rate, if you stay diversified across sectors and have no more than 5% company specific risk, you are much more likely to avoid a big meltdown (or at least bigger than the overall market). You won't do better either - that's the tradeoff. As far as "time to recover", that's why it is generally accepted that a younger person has a higher equity exposure (but diversified), they have time on their side, and over the long run, equities are likely to have higher returns than fixed investments.

-ERD50

[landonew]

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Originally Posted by samclem Yes, it is probably better to do this kind of gambling early in your investing experience rather than when you are near/in retirement, but it is still poor practice in my opinion. Concentrating your assets exposes you to uncompensated risk (that is, risk that is not rewarded by better returns, so it doesn't make good investment sense at any age). Also, the losses that are taken early don't get the benefit of decades of compounding growth: that $10k lost while speculating on the fantastic stock of your employer would have grown to $100k over the course of 30 years (8% annual growth). And, if a young investor gets burned by investing in a single stock and "watching it closely" (?), it could be very costly if he learns that he shouldn't invest any more, or if he chooses assets that are so "safe" that the anemic growth doesn't allow him to achieve his goals.

Thanks for the clarification.

However, how does investing heavily in a "quality stock" (who knows if they exist anymore) expose you to 'uncompensated risk'?

It certainly has the opportunity to take "a dive", but it could also skyrocket. It seems as if the risk would match the reward.

[samclem]

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Originally Posted by landonew However, how does investing heavily in a "quality stock" (who knows if they exist anymore) expose you to 'uncompensated risk'? It certainly has the opportunity to take "a dive", but it could also skyrocket. It seems as if the risk would match the reward.

"Uncompensated risk" is any risk that the market does not reward the investor for having taken. There are lots of types risks in equity investing: For example, there is the very risk of owning equities (as opposed to owning bonds), there are risks attendant with owning various asset classes (e.g. small growth stocks as a class have higher beta than large value stocks), and there are risks with owning the stocks of individual companies. Since investors can easily reduce single-company risk by purchasing a diversified basket of the stocks of similar companies, the market does not reward investors for taking this risk. It is uncompensated risk. In general, any risk that can be eliminated through diversification is an uncompensated risk.

That doesn't mean the speculator won't make money by buying this stock. It only means that, in general, investing in individual securities exposes people to risks for which there is no commensurate reward. That may strike some people as a sub-optimal way to choose investments.

[landonew]

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Originally Posted by samclem "Uncompensated risk" is any risk that the market does not reward the investor for having taken. There are lots of types risks in equity investing: For example, there is the very risk of owning equities (as opposed to owning bonds), there are risks attendant with owning various asset classes (e.g. small growth stocks as a class have higher beta than large value stocks), and there are risks with owning the stocks of individual companies. Since investors can easily reduce single-company risk by purchasing a diversified basket of the stocks of similar companies, the market does not reward investors for taking this risk. It is uncompensated risk. In general, any risk that can be eliminated through diversification is an uncompensated risk. That doesn't mean the speculator won't make money by buying this stock. It only means that, in general, investing in individual securities exposes people to risks for which there is no commensurate reward. That may strike some people as a sub-optimal way to choose investments.

But you are compensated in taking the higher risk by the greater potential reward aren't you?

Suppose you have 2 investors, each with $100.
Investor A puts the entire $200 in megacorp
Investor B puts $100 in megacorp and $100 in a CD.

B is diversified (albeit not very well diversified) and will suffer a lower degree of loss if the bottom falls out of megacorp.
A is non-diversified, but will derivive more benifit if megacorp is the next Microsoft.

How is investor A "not compensated" for his risk? And By that logic, how is anything short of PERFECT DIVERSIFICATION no uncompensated?

I always understood diversication as a method for lowering risk which has the ancillary consequence of decreasing your potential reward. I don't understand why this would be considered "uncompensated." It seems like it may be unwise or unnecessary, but "uncompensated"?

I suppose I am just a newbie that is not "down" with the lingo yet.

[samclem]

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Originally Posted by landonew I always understood diversication as a method for lowering risk which has the ancillary consequence of decreasing your potential reward. I don't understand why this would be considered "uncompensated." It seems like it may be unwise or unnecessary, but "uncompensated"? I suppose I am just a newbie that is not "down" with the lingo yet.

The good news is that diversification (of the right kind) can allow an investor to obtain the same expected return with lower volatility (risk). It can be somewhat of a free lunch.

One of the difficulties is that "risk" here means "price volatility." That's a slightly different meaning than we experience in our daily life--"John took a big risk with his money and lost everything" would translate in "investor lingo" as "John's investment experienced extreme volatility and negative price growth."

Imagine two investors:

Investor A: Buys one stock
Investor B: Buys 100 stocks that are widely diversified across various industries, market capitalization, etc.

Fast forward 20 years. Amazingly, the annual average growth of the accounts of both investors was identical (say, 8%). But, imagine a monthly plot of the value of each investor's holdings. Investor A's can be expected to be all over the chart based on the ups and downs of the business cycle, expected corporate earnings, etc, etc. The trace of Investor B's values also go up and down, but not nearly so much--he has lots f stocks in various industries and various sizes. If we agree that "price volatility" = "risk", then Investor B got a free lunch: The same return but with less risk. The risk that Investor A took was uncompensated. That's what happens, in general.

Modern Portfolio Theory is all about selecting investments across asset classes to improve returns while reducing risk. It does work, but it isn't perfect.

[ERD50]

Quote:

Originally Posted by landonew But you are compensated in taking the higher risk by the greater potential reward aren't you? Suppose you have 2 investors, each with $100. Investor A puts the entire $200 in megacorp Investor B puts $100 in megacorp and $100 in a CD. .

landonew, try it again, but compare a single stock to a group of stocks. That is the point samclem is making.

You are not compensated for taking that single stock risk, as we can't really predict that it will do better than a group. It may do better, or it may do worse. That is risk. The single stock does not pay you more just because it is the only one you own. It will pay what it will pay (or take for that matter).

edit - ooops, I keep cross posting with sAmclem - oh well, I'm out fotr the evening - take it away samclem!

-ERD50

[landonew]

Quote:

Originally Posted by samclem The good news is that diversification (of the right kind) can allow an investor to obtain the same expected return with lower volatility (risk). It can be somewhat of a free lunch. One of the difficulties is that "risk" here means "price volatility." That's a slightly different meaning than we experience in our daily life--"John took a big risk with his money and lost everything" would translate in "investor lingo" as "John's investment experienced extreme volatility and negative price growth." Imagine two investors: Investor A: Buys one stock Investor B: Buys 100 stocks that are widely diversified across various industries, market capitalization, etc. Fast forward 20 years. Amazingly, the annual average growth of the accounts of both investors was identical (say, 8%). But, imagine a monthly plot of the value of each investor's holdings. Investor A's can be expected to be all over the chart based on the ups and downs of the business cycle, expected corporate earnings, etc, etc. The trace of Investor B's values also go up and down, but not nearly so much--he has lots f stocks in various industries and various sizes. If we agree that "price volatility" = "risk", then Investor B got a free lunch: The same return but with less risk. The risk that Investor A took was uncompensated. That's what happens, in general. Modern Portfolio Theory is all about selecting investments across asset classes to improve returns while reducing risk. It does work, but it isn't perfect.

I understand that, but you are assuming that the stock will perform in a similar manner as the aggregate of the diverified portfollio. In that case, yes he is not compensated.

But, you could say that about anything from a retrospective vantagepoint. It would have been an "uncompensated" risk to bet the farm on OU to win the national championship game or for Germany to win WWII.

When you leverage yourself in one security, you are gambling that it will outperform the market.

If you compare it to betting on horses (I know a bad analogy).... diversification is similar to betting on "lots of horses"(equities) in "lots of races"(sectors) held in different "race tracks"(domestic v. foreign).

You mitigate your losses this way. I mean, what are the chances that everyhorse will pull up lame Very low.

At the same time, you decrease the up-side potential. What are the chances that EVERY horse will win their race? Also very low.


This is why I don't understand why someone would call it "uncompensated." Compensated, intuitivally, means a quid-pro-quo (one-thing-for-another). Leveraging your portfollio heavily in one equity increases your risk while at the same time maximizes your potential profit.


I know you are right, and I agree with your principals. The word "uncompensated" bothers me though. I would not call a risk "uncompensated" unless It was not matched with an equally attractive potential reward.

Anyhow, thanks for conversation. I appreciate you taking the time to explain it to me. I have alot to learn about investing.

[haha]

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Originally Posted by samclem Yes, it is probably better to do this kind of gambling early in your investing experience rather than when you are near/in retirement, but it is still poor practice in my opinion. Concentrating your assets exposes you to uncompensated risk (that is, risk that is not rewarded by better returns, so it doesn't make good investment sense at any age).

I agree with you on principle. But some of the happiest people I know are the P&G retirees that I visit when I go to Cincy. Survivor bias for sure, but they are glad no one talked them into diversification. Of course P&G is already diversified. It would take a psychotic CEO to make it go bad in a big way. And they have a strong board which likely would nip that in the bud anyway.

Ha

[samclem]

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Originally Posted by haha I agree with you on principle. But some of the happiest people I know are the P&G retirees that I visit when I go to Cincy. Survivor bias for sure, but they are glad no one talked them into diversification. Of course P&G is already diversified. It would take a psychotic CEO to make it go bad in a big way. And they have a strong board which likely would nip that in the bud anyway. Ha

Yep, sometimes it works out. But some of the unhappiest people in the last 10 years were the employees of Enron who had a huge chunk of money in their company stock. "It's going up and up--this company is sure doing something right!" Enron was no P&G--but there's a vast landscape of companies in between where things are not clear cut.

[samclem]

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Originally Posted by landonew I have alot to learn about investing.

Me, too!
You are right--Investor A is being compensated for his risk. But, Investor B got exactly the same return but with lower risk. So, we say that Investor A had uncompensated risk to the degree his risk (the volatility of his portfolio) exceeded the risks of Investor B. It's not that Investor A didn't get any compensation for his risk, it's just that he didn't get compensated for the extra risk he took for buying a single stock rather than a more diversified portfolio.

Sorry for dragging this out.

[haha]

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Originally Posted by samclem Sorry for dragging this out.

This really can't be dragged out too much. Our board has had a huge lesson compliments of VaCollector, and we should be sure we understand the meaning of it.

Many of us, me included, are inclined to want to go in heavy if we really like something. My limit is 5% per single stock, but I sometimes violate that though I think I have not gone above 10% in 5 or 6 years.

There is also the issue of financial and business vulnerability. You can afford to go heavier in a stable business which is self financed, and where asset mark to market is not an issue.

ha

[ERD50]

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Originally Posted by haha This really can't be dragged out too much. Our board has had a huge lesson compliments of VaCollector, and we should be sure we understand the meaning of it. Many of us, me included, are inclined to want to go in heavy if we really like something. My limit is 5% per single stock, but I sometimes violate that though I think I have not gone above 10% in 5 or 6 years. There is also the issue of financial and business vulnerability. You can afford to go heavier in a stable business which is self financed, and where asset mark to market is not an issue. ha

I agree haha.

To your last point, I occasionally look into some of these downtrodden stocks, thinking that this just has to be the deal of a lifetime, and I'll be kicking myself in 5 or 10 years for not loading up. Most of the time, I see that they have a lot of debt - it makes me think that they certainly could go to zero, if the bad economy hangs in there longer than they can weather.

And of course, the stable, self financed businesses don't seem to be on a fire sale (but very possibly attractive at this point). I'm sure there are some winners in there and maybe some folks can do better than average in picking them, I just don't trust my instincts to be able to ferret them out.

-ERD50

[kyounge1956]

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Originally Posted by landonew (snip) If you compare it to betting on horses (I know a bad analogy).... diversification is similar to betting on "lots of horses"(equities) in "lots of races"(sectors) held in different "race tracks"(domestic v. foreign). You mitigate your losses this way. I mean, what are the chances that everyhorse will pull up lame Very low. At the same time, you decrease the up-side potential. What are the chances that EVERY horse will win their race? Also very low. (snip).

But if you bet on every horse in the race, you are certain to have money on the winner. Your chances of winning at least some money on the race are now 100% (unless they all go lame, which as you point out is unlikely). If you put all your money on one horse, it may be un-placed, and then you lose your whole stake. This is not just hindsight. By betting on every horse you can know before the race that you will win some of your bets.

[Hamlet]

GE is a pretty diversified company. I bet if you asked a few years ago, you would have gotten a fair number of people to say it was just as safe as P&G.

Who's to say that P&G doesn't have six guys selling CDS's somewhere?

That is all it takes to destroy a company nowadays.

Quote:

Originally Posted by haha I agree with you on principle. But some of the happiest people I know are the P&G retirees that I visit when I go to Cincy. Survivor bias for sure, but they are glad no one talked them into diversification. Of course P&G is already diversified. It would take a psychotic CEO to make it go bad in a big way. And they have a strong board which likely would nip that in the bud anyway. Ha

[Running_Man]

I will always prefer owning a percentage of individual stocks.

I am not concerned about non-compensated risk, I prefer owning more stocks of businesses I understand and can share in the profits when I feel they are very good value and less when I feel they are overvalued. Agreeing with modern portfolio theory inevitably leads to agreeing one can never know anything about the market other than a core belief that markets always go up.

Selling of this academic thesis by the very "best" and "brightest" has led to the creation of CDO's, the junk bond fiasco of Michael Miliken, the bailout of Long Term Capital Management - which was led by the creator of risk derivative valuation - Myron Sholes, who when the theory proves not to be as accurate as the mathematical models indicate, merely change and retread their models to include recent data in a new format and new organization. And this in turn has to massive bailouts by the Federal Reserve and the Treasury Department for their academic "cohorts" all making bets on the same side of the academic coin flipping contest. Note it was Henry Paulson who replaced the John Corzine at Goldman Sachs after the LTCM fiasco and Robert Rubin who "oversaw" the CDO mess at Citibank after being a Goldman Sachs employee previous to being the Secretary of the Treasury "solving" the LTCM fiasco.


If I am going to retire in 5 years and live the rest of my life on my investments I will assume that responsibility myself. For that I admire VA Collector even if he was proven wrong and could have limited his loss to about 50 percent instead of 80 percent by being fullly indexed instead of single stocked. His retirement would have been, as many no doubt are but not willing to put to a public stage, at huge risk in either situation.

The risk of stocks held is offset by my fixed portion of the portfolio. For some, as the point of the OP, market risk of stocks is so high they want to eliminate all market risk. Indexing to me increases ignorance risk.

If one truly understands investments well enough to insure their life savings and future with them, picking individual businesses to share in the profits should be a continual part of the portfolio review. I believe it is the refusal to accept risk without understanding what the heck is going on which leads many to an all fixed income strategy over investing in stocks or other alternative investments.

All views have their camps, the most important thing is to make sure the camp you choose to take is one which will position you in the most comfortable position of your choice.

[haha]

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Originally Posted by kyounge1956 But if you bet on every horse in the race, you are certain to have money on the winner. Your chances of winning at least some money on the race are now 100% (unless they all go lame, which as you point out is unlikely). If you put all your money on one horse, it may be un-placed, and then you lose your whole stake. This is not just hindsight. By betting on every horse you can know before the race that you will win some of your bets.

Don't take that to the track. If you bet on every horse, you are a guaranteed loser by the amount of the takeout and breakage.

Ha

[samclem]

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Originally Posted by Running_Man I will always prefer owning a percentage of individual stocks. I am not concerned about non-compensated risk, I prefer owning more stocks of businesses I understand and can share in the profits when I feel they are very good value and less when I feel they are overvalued.

This is a well stated explanation of a POV to which many subscribe. It has served some investors well, and some very poorly. But, there's no getting around the fact that those who (primarily) index are dependent on analysts and investors like you who continually make judgments on the values of individual securities. Without these millions of hours of research (some of it better than others) which is distilled down to a market price for each stock, the market would not be efficient and indexing would not work as well as it does. And it does work.

Quote:

Originally Posted by Running_Man Agreeing with modern portfolio theory inevitably leads to agreeing one can never know anything about the market other than a core belief that markets always go up.

I would say instead that the efficient market hypothesis says that I don't know more about the stocks you follow than you do. Likewise for every other stock out there--I am not smarter or a better judge of the value of that stock in the future than all the thousands of those who make it their business to follow these things. And, I'm seldom wrong when I bet that I'm ignorant!

[landonew]

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Originally Posted by kyounge1956 But if you bet on every horse in the race, you are certain to have money on the winner. Your chances of winning at least some money on the race are now 100% (unless they all go lame, which as you point out is unlikely). If you put all your money on one horse, it may be un-placed, and then you lose your whole stake. This is not just hindsight. By betting on every horse you can know before the race that you will win some of your bets.

Precisely My point.... By betting on all of the horses you know that you will not lose all your money.

But you also know that you will make less that if you had focused your entire investment on the winning horse. Your compensation (regarding the risk) is the potential to see a significant return on your entire investment. For instance, say you have 10 horses each of which has 11:1 odds (impossible, but assuming the assets appreciate on the whole).

If you place $100 on each to win, you are ensured that you will recieve $1,100.... after all one horse must win.

If you place the entire $1,000 on 1 horse, then you have a 90% chance of losing the entire investment..

Thus the risk is 90%. However, you have a 10% chance of walking away with $11,000.

Thus, you are compensated for taking a higher risk with the opportunity to recieve a higher rate of interest.


The sam can be said with equities. Invest heavily in one equity with the hopes that it outperforms the market, and you will obtain a higher rate of return then someone with a diversified portfolio. That opportuntiy to realize a higher rate of return is what "compensates" for the added risk.


Anyhow, this is really just an argument concerning semantics. I understand now... uncompensated = high risk

[landonew]

Quote:

Originally Posted by samclem This is a well stated explanation of a POV to which many subscribe. It has served some investors well, and some very poorly. But, there's no getting around the fact that those who (primarily) index are dependent on analysts and investors like you who continually make judgments on the values of individual securities. Without these millions of hours of research (some of it better than others) which is distilled down to a market price for each stock, the market would not be efficient and indexing would not work as well as it does. And it does work. I would say instead that the efficient market hypothesis says that I don't know more about the stocks you follow than you do. Likewise for every other stock out there--I am not smarter or a better judge of the value of that stock in the future than all the thousands of those who make it their business to follow these things. And, I'm seldom wrong when I bet that I'm ignorant!

I never bought into the efficient market hypothesis. I was introduced to the theory in law school (securities regulation class) and thought it was BS.

Truth be known, the market appears to be dominated by a handful of whales (institutional investors). The minows (guye like you and me) that are able to react most quickly when the whales change direction are able to occassionally make a "quick buck".

However, when slow minows think their quick, they get eaten by the sharks. That is what happened to my father.


Maybe it is best to be an piece of coral. Stay put and grow with the ocean? (i.e. buy and hold)

[Alan]

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Originally Posted by landonew Precisely My point.... By betting on all of the horses you know that you will not lose all your money. But you also know that you will make less that if you had focused your entire investment on the winning horse. Your compensation (regarding the risk) is the potential to see a significant return on your entire investment. For instance, say you have 10 horses each of which has 11:1 odds (impossible, but assuming the assets appreciate on the whole). If you place $100 on each to win, you are ensured that you will recieve $1,100.... after all one horse must win. If you place the entire $1,000 on 1 horse, then you have a 90% chance of losing the entire investment.. Thus the risk is 90%. However, you have a 10% chance of walking away with $11,000. Thus, you are compensated for taking a higher risk with the opportunity to recieve a higher rate of interest. The sam can be said with equities. Invest heavily in one equity with the hopes that it outperforms the market, and you will obtain a higher rate of return then someone with a diversified portfolio. That opportuntiy to realize a higher rate of return is what "compensates" for the added risk. Anyhow, this is really just an argument concerning semantics. I understand now... uncompensated = high risk

I don't think betting works like this. Favorites usually win races so if you put $100 on every horse in a 10 horse race the chances of the favorite winning at say, evens, means that you are much more likely to win $100, rather than $1000 on the 10-1 outsider.