Dimensional Fund Advisors Part V

Posted by Preet on Aug 19, 2008 | 0 comments

This article is one in a long series which I hope will help explain the ins and outs of DFA – Dimensional Fund Advisors. NOTE: This is my interpretation and explanation only. For the final word, please refer to the DFA Canada Website.

A Concession

I will concede that certain investors can beat the markets, for even extended periods of time. And some investors may have tremendous outperformance (perhaps one of their original investments they made was a penny stock that is now a billion dollar company), but this is simply a reflection of the tremendous risks they may have taken. And further I will concede that there are people who exist who can flat out beat the markets (like Peter Lynch and Warren Buffett), however these people are either extremely rare or not known to the public. (Why would anyone who could beat the markets tell you about it and thereby negate their advantage?)

I believe them to be so rare that there is no point in spending time and energy in trying to identify them in advance. According to Dr. Kenneth French – 40 years of 1000′s of Ph.D.s trying to find a way to do so has proved fruitless.

An Assumption

There is one assumption that I will make that will be implied from this point forward: we are dealing with well-diversified portfolios. This is one of the free lunches in investing in that you can eliminate one type of risk that doesn’t seem to have a solid relationship to future returns: non-systematic risk.

With respect to any given securities market there exists Sytematic Risk and Non-Systematic Risk.

Systematic Risk

Systematic risk is the general ebb and flow of the market as a whole – or the tendency for all stocks to increase or decrease in value at the same time with a certain degree of positive correlation. For example, ‘Black Monday’ on October 19^th, 1987 was a Systematic event in that almost all stocks fell in value on that single day. Macro-economic events and stimuli can be expected to have broad systematic effects on capital markets – positive or negative – on an on-going basis such as interest rate levels, political events, war, etc. It is important to note that systematic risk cannot be diversified away. In other words, you could have a portfolio that is diversified with 1000 different stocks from a given market and there will always be a base level of return variance (shown as the asymptote in the figure below).

Non-Systematic Risk

Non-Systematic risk is the element of overall portfolio risk than can be largely eliminated through sufficient diversification within a particular asset class. The best way to describe it is to build an analogy. Let us assume you owned one stock – if that company went bankrupt you will have lost 100% of your portfolio. If you owned one hundred stocks, and one company went bankrupt you would have lost 1% of your portfolio. Conversely, what if that one company doubled in value? You either doubled your money or only gained 1% if you held 1 stock or 100, respectively. Non-Systematic risk is the individual business risk associated with the underlying stock – if this company goes bankrupt – this is a non-systematic risk event and generally has very little to do with the general ebb and flow of the overall markets.

(You can click on the graph for a larger view)

It is generally debated as to how many securities one needs to hold to eliminate non-systematic risk. Research has shown that between thirty and forty securities are enough to eliminate non-systematic risk.

A rational investor would be expected to take measures to eliminate non-systematic risk from one’s portfolio by increasing the number of holdings within each distinct asset class – a task that is easily accomplished through asset class indexing products which may routinely hold hundreds of asset class constituents.

The non-systematic risk amounts to “noise” that an investor doesn’t necessarily get compensated for (the expected return for the random noise is zero), so it would make sense to get rid of this risk if possible. So to re-iterate: going forward the discussion assumes we are talking about well diversified portfolios in all cases.

The next part in this series will look at CAPM (the Capital Asset Pricing Model).

CLICK HERE TO GO TO PART VI

Inteview With A Professional Options Trader

Posted by Preet on Aug 18, 2008 | 1 comment

I’m pleased to present the following interview I conducted with Dr. Mark Wolfinger, an expert on options trading. Mark has decades of experience as a professional options trader and has written three books on options, on top of maintaining his own blog for investors interested in learning more about option trading. My questions appear in bold, and Mark’s answers appear in plain text.

Mark, you have more than 30 years experience trading options. How have the options markets evolved since you first began?

Night and day! When I started as a CBOE market maker in 1977, we only had call options. Puts did not begin trading until later, and that made hedging more difficult. But everyone was much less sophisticated in those days. We had computer help in determining the theoretical value of an option, but if I wanted to hedge an options trade with stock, I had to call my clearing firm’s desk (clearing firm is to a market maker as a broker is to an individual investor) and have them place the order by phone. Slow process, and there were no immediate fills. We also had to do everything in our heads or with pencil and paper. That includes keeping track of positions, estimating our position delta and gamma etc. That lack of sophistication gave the floor traders an edge over most individuals, but it was much more difficult to minimize risk. We had to do the best we could. Today computers crunch all the numbers instantly.

It’s also very different from the perspective of an individual trader. Being able to see all the bids and offers in real time, the ability to receive fills in less than one second, the ability to see my Greeks instantaneously [for more information on 'greeks' as they relate to options click here] – all makes trading and managing risk so much easier. And commission costs are so low that I pay less as a customer today than I did as a new market maker in 1977!

You spent more than 20 years as a market maker – can you describe briefly what a market maker does?

A market maker makes markets! Thus, when a broker (representing an order from his/her customer) enters the trading pit and asks for a quote on a specific option or spread, the market makers announce a price at which he/she is willing to buy the option quoted (that’s the bid price) as well as an ask price (price at which willing to sell). That must be done for every option that trades in the pit. When I started there were three or four stocks and a bunch of market makers in each pit. The most actively traded options, such as IBM attracted the most market makers, but no pit was vacant. The market makers were supposed to compete amongst themselves to present the highest bid or the lowest offer in order to get the broker (who represented the customer order) to trade with them. Obviously when selling, the broker chose the highest bid. Our bids and offers were posted for all to see, but it was a manual process. When the price of the underlying stock changed, we had to change all the option quotes. That was certainly a nuisance. Today, those bid and ask prices are established by computers. The parameters used to make those bids and offers are established by the specialists and the quotes change as the stock price changes. Much more efficient today.

Many readers of this blog are curious about careers in the financial sector. In today’s world, what qualifications would be necessary to become a professional options trader and what kind of income could someone expect in that career?

I have no idea. The world has changed dramatically since I left the CBOE eight years ago. It’s difficult to get started as an independent market maker. Most now work for large trading firms. Income would vary from poverty level to wealth, depending on the skill of both the individual trader and his or her partner (trading firm). There are proprietary firms that teach and hire traders, but most charge enormous fees to teach, and I simply have no way of knowing how the process works after one is ‘taught.’

Do you have any preferred option trading strategies that you use on a regular basis?

I believe in keeping it simple. When I write, I describe easy to learn, uncomplicated strategies, and those are the only methods I use with my own trading. Right now, I buy iron condors (on broad based indexes) exclusively. When implied volatilites are low (at least low in my opinion), I add double diagonals to my trading arsenal. If I had a strong market opinion, I would still trade iron condors, but ‘lean’ my positions in favor of that bias. I never have such a bias (history has convinced me I am unable to correctly predict direction), but I mention that for your readers who do. I used covered call writing and cash-secured naked put selling for years and believe that’s a decent strategy for people who want to learn how options work. But, those are bullish methods and do not perform well in down markets.

I know that you are an ardent proponent of investors educating themselves and experimenting with paper-trading before putting real money on the line – do you have any recommendations for sites that allow for good paper-trading of option strategies?

No. If an investor’s broker does not offer such capability – at no cost – then it’s time to get a new broker. One extra reason for using a broker to paper trade is that you gain familiarity with the broker’s order entry system and risk management tools. That’s important because you never want to enter an order backwards (selling when you intend to buy) – and that can happen if the trading software is unfamiliar. Because risk management is crucial to long-term success (IMHO) when paper-trading it’s a good time to become very familiar with those risk management tools. To me those tools must include risk graphs and the ability to monitor position ‘Greeks.’

I’ve noticed that the notional interest in derivative products (equities, indices, interest rates, etc) has just exploded in the last five to ten years, and the rate of growth seems to be increasing to boot. Do you have any thoughts as to why the derivative market is growing faster than the traditional equity and fixed income markets? Is this a red flag?

This record-setting pace is continuing this year. I cannot know for certain, but my belief is that more and more institutions are using derivatives. The amazing profits of hedge funds appears to be a thing of the past, but more and more hedge funds are in business, and they use derivatives on a constant basis. I’m sure the number of individuals who use options is growing as well, but I don’t believe they contribute significantly to the total option volume – which will top 3 billion contracts this year. I don’t see a ‘red flag.’ Bubbles occur all the time, but increased volume should not be such a bubble. Remember that options were designed as risk-reducing tools, and if used that way, nothing terrible should happen to ‘the markets.’ However, as we have seen with Barings Bank, and especially Long-Term Capital Management etc, rogue traders or intelligent trading firms can lose enough money to shake confidence in the entire system.

There seems to be numerous “option seminars” out there that promise to teach people how to trade options based on either proprietary trading algorithms or just a set of rules to follow blindly – in my mind, it seems that these ‘systems’ skip over the fundamental knowledge and understanding required to prudently trade options – which I think is a philosophy that you share: i.e investors need to educate themselves properly first, practice second and then use common sense when trading. What’s your advice to the would-be option trading investor who is just thinking about getting into options?

Those firms that sell costly seminars are out to make money, not educate profitable traders. Consider this: If they had great proprietary methods, they would never sell those methods to anyone at any price. Thus, to me, those algorithms and trading rules are not worth much. To the extent they ‘teach’ the investor to think for him/herself, they may be worth something. But, I’d avoid them as overly expensive and simply a bad idea. The problem is that too many fall for the hype of a ‘get-rich-quick’ scheme and take these classes. Anyone can get lucky, so some people make instant riches. But, the vast majority fall by the wayside. These seminars give the options world a bad name.

I believe, as you say, that each investor should learn for himself. It’s not complicated to adopt the simple strategies I encourage. My recent book: The Rookie’s Guide to Options, provides a detailed explanation of how options work and the benefits of using options. It provides details that allow the reader to learn to use options. By ‘learn’ I mean to think for him/herself and really understand how options work. I stress the importance of risk management. Others may tell a reader how to open a trade, but I discuss opening, managing and closing positions. The goal is long-term profits, not instant riches.

Advice: Go slowly. Read. Paper trade. Ask questions. When using real money, start small. Don’t allow ego to get in the way. If you don’t yet understand what you are trying to accomplish with each trade – and what can go wrong – you are not yet ready to use real money. Again, be patient. You have the rest of your life to trade.

Thanks for taking the time to participate in this interview Mark.

My pleasure. I appreciate what you are trying to do for your readers.

UPDATE: Mark and four of the other top options bloggers on the internet have set up a paid educational site designed for those interested in really learning about trading options for the first time, as well as providing advanced material for those who have been trading options for years. Click here to learn more.

For those who are interested in learning more, make sure to check out Mark’s website (http://www.mdwoptions.com) and his blog (http://blog.mdwoptions.com/options_for_rookies/). Both contain links to a free ebook, which is a sampler version of his most recent book. In total, Mark has authored three books on options which are available through Amazon.com

Dimensional Fund Advisors Part IV

Posted by Preet on Aug 17, 2008 | 0 comments

Okay, so today we are going to talk about some of the differences between investing and gambling. Rather, I should clarify that this is my own personal take on it – if you look up “investing” you may find many different explanations from the one I present here. Feel free to debate it as I think of it as more of a fluid concept rather than a hard and fast delineation.

Gambling

It’s probably best to draw an analogy with going to a Casino. Every now and then, someone comes out ahead. Even more rarely, someone wins big. But for the most part, the house always wins and more people have stories about how they lost money rather than won it.

The potential of making lots of money in a short period of time is the appeal of gambling, or playing the lottery. Consider the lifelong lottery player. If they were to spend $20/week for 40 years (yes there are people who do this) they will have spent $41,600 on lottery tickets. If they had instead regularly added $20/week into an indexed portfolio of equities over 40 years, you might expect a long term rate of return of perhaps 8%. Had they done this, they might have slightly over $300,000 at the end of 40 years.

The odds of winning the 6/49 are approximately 1 in 13,983,816 according to this website. Compare this to perhaps a 9 in 10 chance of having $300,000 by the time you retire. If people were completely rational, they would just stick with investing in an indexed portfolio over playing the lottery. But of course, people are not Vulcans. I play the lottery on occasion too – even though I know the odds are against me. The reason I play, and the reason most other people play, is that you have the chance of creating incredible wealth in a very short period of time. Instant gratification.

Investing

Investing is boring (relatively). There is almost no instant gratification in the sense that you will never create phenomenal wealth in a very short period of time. I define investing in equity markets as the participation in the long term growth that the capital markets overall will provide. I believe Capitalism works, and that the market does a fairly good job of setting relative prices with respect to risk and return.

A true investor looks at a stock and sees a business first and foremost. A gambler looks at a stock and sees a number first and foremost. However, even for the investor, there can be elements of gambling.

Most Investors are Gamblers

I’ve given an extreme example of what a “gambler” is, and I don’t anyone to shoot me for saying this but most investors are gamblers to varying degrees. Fortunately the dichotomy between investing and gambling is not as extreme as between playing the lottery versus systematically saving to a well diversified portfolio. But let me provide an example: I recently spoke with someone who posited that by just selecting the top 10 companies by market cap in the market, they would’ve handily beaten the mutual funds his advisor had put him into over the last 10 years. That may very well be true. However, simply because a strategy may have worked out better does not make it qualify as prudent investing. Picking the 10 stocks still has an element of gambling in it.

Let’s suppose we had a very well respected analyst from Bay Street (or Wall Street) who was really known for doing his homework. He decides to pick only three companies to invest his own personal money in because he wants the biggest bang he can get for his buck. No one could accuse this guy of not knowing what he was buying and based on his analysis he could convince anyone that his decisions were sound. But what if one of the companies he bought had improper accounting and ended up going bankrupt suddenly? One third of his portfolio will have vanished. This example is just to show that no matter how well you think you know a situation, you can’t account for “life” happening.

Setting The Record Straight

I want to be clear that when I refer to prudent investing I am referring to the fact that you are making a trade-off. Prudent investing is giving up the chance at a making a killing for the certainty of never getting killed. It’s possible to stray a bit from prudent investing and take small bets against the market, and it’s possible to stray a lot from it by taking large bets against the market (by only investing in one area, or sector, or even just a handful of stocks for example).

DFAs approach is very much along the lines of not betting against the market. But while people may point to the DFA fund returns being different from the market returns I will give a bit of a prelude now: what most people believe to be the “market” is actually not the market… (more on this later)

In Part V on the DFA series, we will look at systematic versus non-systematic risk. I was going to include it in this post, but it would’ve been too long. Our discussion of CAPM (Capital Asset Pricing Model) will begin in Part VI.

CLICK HERE TO GO TO PART V

A Lap Of The Blogs

Posted by Preet on Aug 14, 2008 | 4 comments

If you are new to WhereDoesAllMyMoneyGo.com, every Friday I run a post called “A Lap Of The Blogs” which provides links to articles I found interesting and think that others may want to read for themselves. I also include some commentary on what’s going on in my personal life and a weekly “racing video” since my former life was in the auto-racing industry. The name “Lap of the Blogs” is in reference to “A Lap Of The Gods” which is an old video series which chronicled on-board footage of the world’s greatest F1 drivers lapping various racetracks from around the world.

Not much to report this week so I’ll get right to it…

From Around The Blogosphere

Larry MacDonald shows us that investors are pulling their money out of investments they were supposed to hold for a long time.

The Million Dollar Journey puts Cash Back Mortgages under the microscope.

The Canadian Capitalist reminds us that you don’t have to use ETFs to track indices, you can use mutual funds to do that as well. (Make sure to check out the article he references in the Globe – it’s bloody brilliant!) :)

Michael James on Money explains that he sees right through a promotional offer designed to entice him back to a previous service provider.

Four Pillars chronicles his experience in creating his last will and testament. If anyone needs a contingent beneficiary for their wills, please feel free to name me: I will then give away your estate as a prize for an upcoming contest.

Canadian Dream: Free at 45 shows us a simple way to cut your family’s food bill.

Canadian Financial DIY uncovers some interesting information about the evolving Chinese capital markets.

This Week’s Racing Video

Found a bit of a gem from yesteryear. This week’s video is one of the smoothest drivers of all time (Jackie Stewart) narrating a lap around the famed Nordshcleife (also known as the Nurburgring), which has over 100 turns and laps are almost 10 minutes long. It was deemed to be much to dangerous for Formula 1 years ago. This clip is only two minutes but has some of the most beautiful footage I have seen from this era.

Dimensional Fund Advisors Part III

Posted by Preet on Aug 13, 2008 | 5 comments

While many readers of this blog are completely up to speed on the debate between active and passive management and are eager to move beyond this, I feel it is necessary to continue with supporting this background information for those readers who are new to this concept. So for those who find this information redundant, I will ask you to please bear with me a bit longer… :)

The Warren Buffett Argument

Undoubtedly one of the best defenses surrounding active management has to be the performance record of Warren Buffett. But consider that Warren Buffett himself has indicated that he only comes up with a few good ideas every couple of years and then contrast this to the average money manager who may easily have 100 ideas per year. Clearly we are dealing with two separate schools of thought on active management and even though there are many money managers out there declaring they follow a deep value investment philosophy, they do not have the same results as good old Warren. Part of this is due to the ‘institutional imperative’.

The institutional imperative can be thought of as the tendency for managers to do what everyone else is doing out of fear (or ignorance). For example, if a manager follows the crowd there is less chance that he will get fired as if everyone does poorly he can simply point to his relative performance being no worse than everyone else. If everyone does well, than he can look good because he has done well notwithstanding how everyone else has done. But consider what happens when someone decides to stick their neck out and do something different. In this case, if you outperform the crowd you can look like a star. But if you underperform the crowd than you are more likely to be pointed towards the door.

So, if you follow the crowd you should be fine. If you stick your neck out and do something different, you stand to potentially lose your job (or investors who invest their money with you). In order for a money manager to reference Warren Buffett as proof that active management works, they will need to be as different from the crowd as Buffett is. Otherwise, it’s a meaningless assertion in my mind.

The Berk Green Study

In the 2002 paper entitled Mutual Fund Flows and Performance in Rational Markets the authors find that 80% of money managers actually have enough skill to make back their fees. However, while some people have erroneously cited this paper as being support for actively managed investing, that is not the case the paper is trying to make. Rather, it explains that capital flows freely to managers who are perceived to add value to the point where the manager can no longer add value. The paper is in effect an argument for capitalism. In a rational market, investors will see the past performance of a manager and direct their capital to the exceptional managers to the point where the inflows become less and less effectively deployed by the manager. In the end, the study concludes that partly due to this reason, future outperformance cannot be predicted by past performance.

In Part IV of this series, we are going to look at investing versus gambling after which I will start getting into some of the details I know many people have been waiting for. Part V will start by examining the Capital Asset Pricing Model – which is where we get the concepts of Alpha and Beta from – and serves as a good launching point to get into the Fama-French 3 Factor model details which plays an instrumental part of DFA’s philosophy and products.

CLICK HERE TO GO TO PART IV

The Benefits of a Professional Executor

Posted by Preet on Aug 13, 2008 | 10 comments

Today is a group writing project conducted by a few blogs on the topic of estate planning. I’ve written about The Benefits of a Professional Executor today, but the following bloggers have written articles about estate planning as well please feel free to check them out:

The Quest for Four Pillars wrote: “My last will and testament”
The Million Dollar Journey wrote: “Why you need a will and the basics of estate planning”
The Financial Blogger wrote: “Common mistakes in a will”
Thicken My Wallet wrote: “5 myths about wills”
The Canadian Capitalist wrote: “Getting your wills done through your lawyer”

…and now on to my contribution:

The Benefits of a Professional Executor

When you are creating your will (or updating it) you should probably consider your choice of executor carefully. The job of an executor is not a trivial one and in some cases can be very complex and time consuming. Since many people choose a close and trusted person to fill the role of executor, chances are pretty good that this person will also be emotionally affected by your death as well. The loss of a loved one can affect some more than others, and there is the possibility of impartiality and emotional drain of being in the middle of any potential family quibbles.

An alternative to choosing someone close to you is to hire a professional executor – for example a trust company. They can assign a designated trust officer who has years of experience in settling estates and final affairs in a very efficient, and impartial manner. An alternative arrangement is to ask the trust company to act as co-executor or to provide estate assistance services for the non-professional executor.

I think readers of this blog know me to not usually talk about my employer, but in this case I will make an exception. Scotiatrust is under the umbrella of BNS and provides a wonderful service for our clients through a team of dedicated will and estate planners. As you may know, executors may be entitled to collecting an executor’s fee. In exchange for naming Scotiatrust as executor of the estate, the will and estate planners will assist in the full blown will and estate plan and additionally review it every three years for no other charge than the executor’s fee which they will receive later. (Note – they can work in conjunction with your lawyer in the preparation and execution of the will, and sometimes they have net worth thresholds for this service.)

I’m years away from having a complex estate plan (I’m 30, not married, no kids), but as my situation develops, I would not think twice about engaging a trust company to act as executor for my estate. Asides from the reasons listed above, the trust company has continuity. They will be around when I die. I can’t necessarily say that about any individual I know. To me, paying a professional for this service is money well spent – knowing that my wishes will be carried out with all the i’s dotted and the t’s crossed, and knowing that I wont be leaving potentially onerous amounts of tedious work for a loved one who may not be as financially “involved” as I am.

Dimensional Fund Advisors Part II

Posted by Preet on Aug 11, 2008 | 4 comments

Markets Work, Capitalism Works

This is one of the core beliefs behind DFA. The Director of Research, Eugene Fama, is often credited as the father of the efficient markets hypothesis which is widely quoted within the industry and between investors. However, they will explain that they prefer using the term “equilibrium markets”. This is based on the realization that there ARE mispricings periodically in the market, and efficient market hypothesis is too rigid. But the premise behind it is sound: capitalism works. There are so many people out there watching the markets that any potential mispricings that can be exploited do not crop up often enough. The competition is just too stiff.

It’s possible to beat the market, but it doesn’t happen nearly as often as we think

DFA believes that it is possible to beat the market, and that some managers can do it even after having accounted for chance – in other words there ARE truly skilled money managers out there. The problem then, is that this happens much less often than you think, and there is no way to pick them in advance anyways. There are numerous studies they cite that support this argument, but let me highlight some powerful observations.

Peter Lynch

I’m skipping ahead a bit because we have yet to talk about the Fama-French 3 factor model versus CAPM (Capital Asset Pricing Model), but take my word for now: according to a more improved metric for measuring money manager performance than the one predominantly used now (CAPM), Peter Lynch did indeed provide Alpha (returns greater than predicted by the models). In other words, Lynch was identified as being one of the truly skilled managers who could beat the market. For those who don’t know, Peter Lynch was manager of the Fidelity Magellan fund from 1977 to 1990 during which time the fund returned an annualized 29% per year. He is widely cited as one of the best stock-pickers who ever lived – and I think it is safe to say that he is a better stock picker than you or I could ever be.

The performance of Magellan from 1990 (after Lynch left) until the end of 2006 when compared against the improved model exhibited negative alpha (meaning it underperformed what would be expected when using the 3 factor model). Some people may point out that it continued to outperform the S&P500 – and that is true, but again, you will have to take a leap for now until I explain later: the S&P500 is an almost meaningless benchmark for Magellan. (I will back up that assertion later in this series.)

I don’t think it is a stretch to say that part of Lynch’s job nearing the end of his tenure running Magellan was to select and/or train his replacements. So the moral of this observation is that if Peter Lynch, arguably one of the best stock pickers of all time, cannot find the next great manager, what makes other people think they can?

More to come…

The next part in this series on DFA will look at an observation about Warren Buffett and we will also look at some more research on active management versus passive management.

CLICK HERE TO GO TO PART III