Gentlemen's Stock Picking Club

[greg]

Quote:

Originally Posted by twaddle Now you're getting somewhere! Sorry, but I just couldn't think of any educational value in picking 10 stocks to go long over a 4-month period. I used to speculate with options once in a while. But I talked myself into the "momma says you shouldn't play zero-sum games" bit and cut way back except for the occasional portfolio insurance long put. But I do find Taleb's idea of looking for potential Black Swans kind of interesting. So my approach would be to think about possible low-probability events that the market is basically discounting to zero probability and use a very small portion of my portfolio to place bets on that outlier. I'll have to think about exactly which events I'd like to bet on, but it would be an interesting topic for a thread....

It took me some time to think about what you said. As I see things:

I just don't think it's possible for laymen to find black swans in the financial markets, unless they're incredibly perceptive and diligent. I think black swans are primarily found in the world of primary business ownership, as you mentioned earlier, where someone perceives a need and then fills it: if the need was big enough and the product or service good enough, then jackpot, probably after a number of years of hard work and doing without. Starting McDonalds as a restaurant chain is a good example as I see things. The idea comes and you act on it correctly all the way thru, or at least until you can hand it over to others (for a nice price). All outside the normal box of things.

The financial markets, all the stocks, bonds, derivatives, financial instruments that retail folks can buy, bla and bla, are not blacks swan possibilities--to my mind, theoretically. They are things created by others and then sold to folks. We, as retail folks, aren't privy to all the information in the vast majority of cases. And if that's true, then we are making decisions bases on partial knowledge (And right here I'm making a case for Bogle and indexing.), which almost precludes the possibility of getting enough information to do things well or correctly or to find those wonderful life changing deals/experiences--to my mind. The insiders have a larger quantity of knowledge, and they're the ones who will pick thru the pile first and with the best instruments, finding the best deals.

Brewer has been trained to find the best bond deals in the market; that's his job. How can I compete, unless perhaps if I've gone thru similar training and have access to similar tools and quantities of money? At best, I can do a job that might approach Brewer's ability and skill after a number of years of practice and mistakes. This is basically true about every single financial instrument available to us; there are alot of professionals out there ahead of me. Sometimes we can get the jump on folks if, for example, we buy into a hedge fund with a smart fellow who has a big rolodex and a couple good ideas. But we both know that now even they are doing a bit of crash and burn as they kept doing the same things over and over again with increasing leverage. What they did was a sort of black swan initially, finding a wonderful new product built around a few core services. Now it seems to be primarily a bunch of chunky lemmings waddling toward a cliff--to my mind. Not black swan material for the most part now.

There is also the fact, to my mind anyway, that there is a huge amount of money flooding the system that seems to be working its way thru gradually and pricing out any discrepancies, anomalies and bargains--much less black swans. The professionals mentioned above price all those bargains out of the market with the huge amounts of money they have at their disposal--to my mind. And they see any good stuff coming waaaay before me.

Those are the strikes that I see against finding any black swans. But that doesn't mean they're not out there.

Currently, I have a full hand (five: one gold/metals stock, a pharma, two oil, and one industrial) of individual (what I think are still) 10 bagger stocks. I can't add any more until the ones I have have a hit or miss. I'm not selling nor am I buying speculative stocks right now. I don't even want to think about them for a while because if I think about buying something speculative, then I probably will start looking; and if I start looking, then . . . .

But I currently see option calls as a reasonable way to earn 100%-200% over the next year with limited downside. That appears reasonable to me IF my optimistic view holds up in the real world and if the option market gets whacked a good one soon so that I can get some at a price I like.

I'm watching these calls for a decent dip:

GE: Options for GEN ELECTRIC CO - Yahoo! Finance

[twaddle]

Quote:

Originally Posted by greg I just don't think it's possible for laymen to find black swans in the financial markets, unless they're incredibly perceptive and diligent.

Well, I think that rather than "finding" them, you're supposed to almost stumble upon them. It's a concept I find troubling and intriguing at the same time: positiion yourself for upside explosions without necessarily expecting them.

I believe Taleb plays mostly in the currency markets, where he says you might find 7-sigma events. I vaguely recall that the Great Depression, for example, was something like a 3-sigma event. Very unlikely, but the risk of it happening was mispriced.

Anyway, I haven't yet figured out how to expose myself to such mispriced explosions, so I'll take an iterative approach and learn as I go.

Here's my $100K low-downside hopeful-upside port:

$45K in TIP (TIPS)
$45K in SHY (short-term treasuries)
$3K in DRYS (dry bulk shipping)
$4K in FXI (china)
$3K in FXY (yen)

Nothing really systematic here. No leverage. Probably too tightly correlated. Goal is to beat the S&P500 with lower downside risk. I'll price the shares later this week, after we have some more bad news.

Edit: for this to work, I think I need to swing harder for the fences. If my goal is a 10% return, and expected return on the bonds is 5%, then I'll need a 50% return on the $10K Black Swans....

[greg]

Quote:

Originally Posted by twaddle Well, I think that rather than "finding" them, you're supposed to almost stumble upon them. It's a concept I find troubling and intriguing at the same time: position yourself for upside explosions without necessarily expecting them. I believe Taleb plays mostly in the currency markets, where he says you might find 7-sigma events. I vaguely recall that the Great Depression, for example, was something like a 3-sigma event. Very unlikely, but the risk of it happening was mispriced.

Stumble upon them? wtf?

Is there some web site that has his writings? Someplace where I can get a better idea of what he says--without paying for the book? John Mauldin read his book and wrote a couple essays related to it. That's the extent of my knowledge. Mauldin mostly dealt with the recessionary and negative aspects of Black Swan events (how to save/make money in a big crash) and the unexpectedness of outside the box events. I know zero about the making of Black Swan money in a positive environment. I want to know where outside the box to look--from inside the box of course.

So, Taleb is sort of doing a mix and match of currency products that when combined may go to the moon? I'd like to see his reasoning on that stuff.

[twaddle]

Too lazy to read the book, eh? Yeah, me too. But he responded to a couple of critiques of the book, which I found pretty insightful.

http://www.fooledbyrandomness.com/blackswandebates.htm

I think the only way to place his game is with options or other types of leverage. Otherwise, there's simply not enough upside potential to make it work.

[fmhealth]

Ok here we go. CFC, Countrywide Financial is selling for $19.80 as I write this. This woebegone company is the poster boy for the sub prime meltdown. Beaten down from the 40s to the high teens . Everyone hates this fellow. Nothing but bad loans, defaults, out flows of deposits to literally a run on the bank. What a mess!

PERFECT!! I remember not too long ago when MRK was being unmercifully branded as a BK candidate after they mishandled Vioxx. Same type of doomsday rhetoric. Much the same level of palpable & visceral fear & loathing. The stock was in the low 20s. Fast-foward a few years. What Vioxx problem? Stock is in the low 50s, excellent Div. & wonderful growth prospects. The analysts love it!

CFC is my choice. As a matter of fact I'm going to buy it tomorrow. Only time will tell if it proves to be a sage investment.

[unclemick]

Sooo - are we picking stocks on a forum trying to win a game? Or listing some of the stuff we actually parted with some hard earned cash to buy.

Playing a game is fun. Parting with hard earned cash or getting sweaty palms when I check prices is another.

heh heh heh - heck sometimes I go several months without looking at my Norwegian widow stocks.

[greg]

Quote:

Originally Posted by unclemick Sooo - are we picking stocks on a forum trying to win a game? Or listing some of the stuff we actually parted with some hard earned cash to buy. Playing a game is fun. Parting with hard earned cash or getting sweaty palms when I check prices is another. heh heh heh - heck sometimes I go several months without looking at my Norwegian widow stocks.

One unclemick enters. Two unclemicks leave (the real one and the one who plays with fake money). I don't quite know what the rules are but pick a few stocks, post the price you paid on that day and then every once in a while we'll all post our results, percentagewise or dollarwise, and maybe talk about what we all learned--or no. Don't forget to count your divis. And no turning into that girl young woman from Missoula.

[haha]

Quote:

Originally Posted by twaddle Too lazy to read the book, eh? Yeah, me too. But he responded to a couple of critiques of the book, which I found pretty insightful. http://www.fooledbyrandomness.com/blackswandebates.htm I think the only way to place his game is with options or other types of leverage. Otherwise, there's simply not enough upside potential to make it work.

I read both his books. He is smart; but so is Warren Buffet and Buffet is also rich and uses a very different method.

The only kind of leverage that fits Taleb's model is options. I have a feeling that Taleb has made a lot more money from his second book than he ever made trading. In interviews he is now introduced as an ex-trader. In an interview with Consuelo Mack he clearly stated that he looks to investments as a way to maintain wealth at best; he hopes to generate wealth through his professional activities of writing, speaking, etc. Additionally, it likely would not hurt to remember that gurus are highly incentivized to lie about the more awkward aspects of their schemes.

If you were already quite rich the Taleb approach would give great peace of mind, and some upside potential. It really won't work for someone with the need to live off a small or medium sized portfolio. Like it or not, people in that position will have to continue taking a fair degree of risk.

IMO he is 100% right that for the most part people do not understand the almost open-ended risks that they are accepting in day to day investing. The background supposition of almost everyone on this board is an example of this. We do many spreadsheets and many FIRECalc runs with ever more finely drawn allocations. Meanwhile we forget that this is textbook data-mining, and also that our largest risk is outside the model- the risk that the past has not experienced what the future may bring- or stated alternatively that we don't know the distributions of the stuff we are "modeling".

The only real security is a good job, lots of various insurances, and an iron-clad pre-nup. But we all know at some level that security is a mirage.

Oh wait, I forgot one other source of economic security- a good vested government retirement plan.

Ha

[greg]

Ha:

So I read all the stuff that twaddle posted and will always remember this simile from Taleb:

Investing is like picking up pennies in front of a steam roller.

[unclemick]

Sooo - in equal amounts:

ATK at 105 - ammo and space, the solid rocket cats.
BUD at - regular season football starts soon. Saints play Indy 9/6 - good day to buy.
ILA at 3.98 - local power co. is getting hosed/sold out
TKF at 18 - those Turks are gonna wup ass on China and India business wise - all because they're secretly ticked the Europeans won't let them in the EU.

heh heh heh - couldda used a monkey and darts but he was busy. .

[Brat]

Twaddle, if you goal is an average of 10% return then put your money in Oakmark Balanced and sleep while they work hard.

OK, I admit that this is not exactly what those of us who frequently the stock picking club want to do. However, I have been taking a look at recent market performance and am not unhappy with OAKBX fund managers during the recent instability. I have a high % of our investments in balanced funds and managed global funds, 5 years in cash/I-bonds, the rest in equities where I would like +20% return... fun money so to speak.

High return = high risk. IMHO it is better to lower your cash position and find equities that are solid investments than go swan hunting.

[twaddle]

Quote:

Originally Posted by Brat High return = high risk. IMHO it is better to lower your cash position and find equities that are solid investments than go swan hunting.

Well, that's sort of the question I'm trying to answer: which is better, the conventional wisdom or some of these less conventional approaches.

OAKBX is a pretty pedestrian 60/40 fund. Nothing wrong with that, but Swedroe and Taleb both have proposed significantly different approaches that in theory could have higher return with lower downside risk.

Consider Swedroe's approach for example. He's 70% in bonds, and 30% in a mix of ScV, Intl ScV, EM, and commodities. Expected return is > 10%, which is about the same as the expected return of 100% stocks. But expected volatility is about 1/2 that of 100% stocks. I find that an interesting approach.

Taleb takes this one step further with 90-95% in bonds, and 5-10% in highly speculative investments like far OTM options. I have no idea if his approach actually works, and I haven't seen any sort of backtesting for it, so it would be interesting to construct a portfolio using that style and compare it to the more conventional approaches going forward.

BTW, I'm out of town now and haven't had a chance to acutally watch the market in the last couple days. I'll try to get back on this experiment next week.

[roadtoharvard]

I'll be the babe that ventures out from the woods for a bit.

Here's my picks

$70,000 split 7 ways

398 AHL @ 25.09
665 HW @ 16.52
443 KEP @ 22.53
1851 DFC @ 5.40
462 INDM @ 21.64
393 IPCR @ 25.42
324 YRCW @ 30.81

$30,000 split 2 ways

241 VUG @ 62.19
217 VPL @ 69.00

I hope the monkey is off his game this year.

[Brat]

Twaddle, I agree that OAKBX is 'pedestrian' so to speak. I wouldn't choose it if I had more than 15 years to go to retirement. But I was there, had 40% of our retirement assets in Exxon, probably should have stayed put.. BUT, we are retired and for many reasons need to limit my swan hunting to tags with short hunting seasons.

What makes me wonder is your huge % in cash = and relatively small % for hot equities. Too much like playing poker with a weak draw.

[twaddle]

Quote:

Originally Posted by Brat What makes me wonder is your huge % in cash = and relatively small % for hot equities. Too much like playing poker with a weak draw.

Well, to clarify, I'm not talking about my actual portfolio (although I do hold FXI and DRYS -- woohoo!).

Everybody knows that the long-term return of the S&P 500 is around 10% nominal, right? Most people also know that the std dev is about 15%, and every once in a while you'll experience a drawdown of around 30% with a 100% S&P 500 portfolio. Obviously, that downside volatility matters to a lot of people, especially retirees who are living off their portfolio.

So, let's play a game. How many ways can we find that will return that same 10% on average but with less downside risk? The conventional wisdom is that if you reduce your downside exposure, you also reduce expected returns.

Swedroe found a way to reduce the std dev to about 7%, with a maximum drawdown (in theory) of about 14% and the same 10% average return. Pretty neat, eh?

So, the idea behind 90% bonds and 10% highly-speculative investments is that you can minimize your downside risk to 10% (or whatever you allocate to speculative investments) with the idea that the speculative portion of your portfolio can provide high enough returns on average to bring you up to the level of S&P 500 returns (with much less risk).

I'm not sure it actually works, and I'm not even sure how to test the idea. How do you cast your net wide enough to capture those high risk returns without diluting the returns you'd need? How often does a black swan come along to provide the needed returns?

Taleb's position is that very high-impact low-probability risks are significantly mispriced by the market. The idea of a "black swan" is that we all have confirmation biases that cause us to systematically underestimate unforseen risks. The name comes from the idea that most people only saw white swans. Every time they saw a swan, their assumption that swans only came in white was confirmed. Then, one day, somebody went to Australia and saw a black swan and all those confirming observations were rendered meaningless.

His premise is that you want to minimize your exposure to negative black swans (like Great Depression magnitude events) and expose yourself to positive black swans (like the dot-com bubble). I just find it an interesting idea that also applies to life beyond investing....

[greg]

How this fellow does it--as an individual investor--seems simple, practical, and straightforward:

Stay Away From Stocks

One problem I see with this system is that one MAY start to obsess in a distorted manner. My guess is that he could spend a bit too much time worrying about his 5%-10% Black Swan money and what may or may not happen to it; it may very well include a constant fretting about the direction of the macro economy. It's sort of the anti-thesis of indexing. Indexing: own a little bit of everything, let it ride without thinking about it too much, and then automatically rebalance according to some pre-established formula. Anyway this guy's approach seems to eliminate a lot of system/market risk and worry.

.................................................. .................................................. .........................

I'm having a very tough time thinking of ways to reduce risk without it (the risk) squirting out somewhere else--unexpectedly. Just look at the Japanese carry trade that may now be unwinding. It seemed perfect at the beginning: borrow low interest money and buy high interest bonds elsewhere. Pretty soon folks (hedge funds?) are leveraging the whole process up and then suddenly incremental interest rate fluctuations may lead to enormous negative consequences (a serious black swan event?). LTCM (Long Term Capital Management) was filled with rocket scientists with little black boxes. It appears on the surface--to me--that the actual hunt for 'risk free' may contribute to system risk over time? Any I don't even want to talk about mortgages and lending and AAA ratings in this country and what developed there.

[twaddle]

Quote:

Originally Posted by greg One problem I see with this system is that one MAY start to obsess in a distorted manner. My guess is that he could spend a bit too much time worrying about his 5%-10% Black Swan money and what may or may not happen to it; it may very well include a constant fretting about the direction of the macro economy.

Thanks for that link. I didn't realize Zvi Bodie had joined the Taleb camp.

My problem with the Black Swan bet is that you don't know when or if it'll pay off. So, that means you must be willing to lose your speculative bet. A 5% downside doesn't look too bad until you realize that you might be losing 5% per year for several years in a row. You need some pretty strong faith to believe that you'll actually witness the Black Swan and that the bet on it has a payoff asymmetric to the cost of the bet.

I think Swedroe's approach is more palatible to most investors since it follows pretty simply from Fama and French data. You're simply concentrating risk in a chunk of your portfolio (say, 30%) and reducing the dispersion of annual returns.

In theory, Taleb's and Bodie's approach do the same thing as Swedroe's, but the difference is that you can't calculate an expected return or the dispersion of returns with their approach. And that can be somewhat unsettling.

[greg]

twaddle:

When reading me, please remember I always sort of jump the gun a bit. By that I mean I start looking for some sort of rational (not empirical-based) organizing principle. The one I just used in the above post was placing all known methods of making money from financial instruments between two ends of a continuum: on one end, an individual who strikes out to make a big pile of money based on a single idea (e.g. Ray Kroc); on the other, to my mind, is indexing, taking as little risk as possible by buying a tiny bit of everything. This use of this idea comes from your cues on how you made money in a previous life (and you are very important to the process). Most everyone, including you, me, and Swedroe and Taleb can all be placed somewhere on that line between the two end points of this continuum. (And I can make lots and lots of mistakes at this preliminary level. Lots. Be forwarned)

So, to my mind, if you can bear with me and wait me out on this goofy methodology I'll promise some sort of insight into risk and BS (Black Swans).


First, on this continuum and at near the extremes, risk is different at each chosen point. If one holds short term Treasuries for instance, bills, there is only macro risk and very little--if any--economic market risk: the risk is primarily the trust in gov't, the risk of inflation, and loss of principle if interest rates go crazy. No? The addition of TIPs and or I bonds to this mix modifies/reduces that risk even more but may very well reduce gains too.

On the other end, indexing, we have no worry of any individual stock going belly up. But we do have a large risk of macro recession, e.g. the S&P tanking or falling below bond rates for many years.

It's in the middle of this continuum where all the interesting crap stuff happens, all the mixing and matching or risk components occurs and the various elements of risk, types of risk and what they are attached to and where and how--all the permutations and combinations. And it can get muddled very quickly.

Enough for today. Thank you.

PS

As I see it, Taleb tries to deal with all this stuff by reducing everything to numbers, factoring out all the human emotions of events. This may work for a while but, ultimately, will always fail. See LTCM. Black boxes don't work, at least for very long/

Warren Buffett, as I see things, is almost the complete opposite. He uses emotions, understands them , creates his advantages (and humanity's) thru a well developed understanding of them. A start up business, more than anything, needs owners that understand and use emotions wisely and prudently. It is this ability to use emotions and also think outside the box flexibly that sees possibilities and takes advantage. By example, Ray Kroc began McDonalds, I'm almost sure, by understanding that folks wanted a clean, reliable, consistent fast food experience--everywhere. He 'scaled up' the building and expansion process from understanding the emotions of his individual customers and creating a product.

As I see things.

[haha]

Greg, it is awfully early in the day to be drinking.

Ha

[twaddle]

Greg, remember the poet Donald Rumsfeld? He said:

As we know,
There are known knowns.
There are things we know we know.
We also know
There are known unknowns.
That is to say
We know there are some things
We do not know.
But there are also unknown unknowns,
The ones we don't know
We don't know.

Taleb is simply telling us that unknown unknowns -- the real surprises -- are always present and always mispriced. It's not a traditional risk that is included in some risk premium.

In fact, the traditional risk premia associated with beta, size, and value may be going away. What happens to a market in which the mindset du jour is "I can ride out short-term volatility, so I'm going with 100% stocks?" The risk premium decreases as more and more believe that. But there will always be a Real Surprise(TM) that knocks those people on their butts. Such as Japan 1990 or USA 1929. Those weren't just speculative busts. Those were mindset-changing busts that had unpredictable repercusions throughout the economy. A risk that everybody underestimated.