GGSM huge volume on news announcement that they are acquiring 50 aditional acres of prime Alluvial Diamond and Gold Mining Concessions in Sierra Leone. Stock already up from yesterday!

MPT – Strike 1: Investors Are Rational

A friend of mine told me that I should look at the Modern Portfolio Theory (MPT) for some ideas on what to write about. Boy was he right. But first, what is MPT?

MPT is a theory of investment which attempts to maximize a portfolio’s expected return for a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return, by carefully choosing the proportions of various assets. It is also a form of diversification (and you know how I feel about that (if not read my post on diversification)).

MPT is best explained by using a mathematical model, which, in my own opinion, is a bunch of baloney. The only mathematics you need to evaluate companies or stocks is simple adding, subtracting, multiplication and division. That’s it. Now the model works in theory, but in the real world, where there are no save points, it doesn’t even come close to working. This is due to the FACT that it makes a few very grave assumptions. So part one of our journey through the pitfalls of MPT starts now with the assumption that………….

INVESTORS ARRRRRRRE RATIONAL

One of the assumptions that enables MPT to work (in theory) is that investors are rational. I find great difficulty in believing this to be true due to the simple fact that investors are not any different from other people. Investors are people; plain and simple. Now how many people do you know who are completely rational? Take a few pauses here to really think about that……………keep thinking……….




Probably not that many right? And that is because the majority of people (please do not take offense here) are too emotionally driven to be rational. I know you’re not though.

So now how can investors be rational? Are they some sort of superior being that has evolved to totally abide by the rules of logic and circumstance and admonish most, if not all, of their emotionally weak mindset? Of course not. The majority of investors are not rational. They can be greedy, overzealous, and sometimes frightened when their favourite stock takes a plunge.
As an example let’s look back a few years at some irrational investors who were buying technology stocks. And remember any smart individual (who knows at least a little accounting) could see that the majority of “tech” stocks were grossly overvalued at this time, even though they were very popular.

1.   In 1999, Alexander Cheung of (what once was) Monument Internet Fund, after earning 117.3% in the first 5 months of the year, claimed that his fund would gain 50% over the next three to five years and would achieve an annual average of 35% over the next twenty years.  Now is he rational? Well, considering most of the fund’s portfolio was comprised of internet stocks which were grossly overvalued, I’d say no he isn’t rational. He got caught up in the market mayhem of internet stocks. Another point to look at is that the highest 20 year return for any mutual fund in history was about 25.8% per year (performed by the great Peter Lynch). Peter’s performance during that period turned $10,000 into more than $982,000, and yet Cheung was saying that he could turn it into over $4,000,000! Obviously that is ridiculously overoptimistic. And here is the point….investors bought it. These “rational” investors threw more than $100,000,000 into Cheungs fund over the next year. By the end of 2002, that $100,000,000 was worth about $20,000,000. A loss of 80%.

2.   Alberto Vilar of Amerindo Technology Fund, after a whopping 249% return for 1999, ridiculed anyone who doubted that the internet was a perpetual money making machine: “If you’re out of this sector, you’re going to underperform. You’re in a horse and buggy, and I’m in a Porsche (personally I loled there). Clearly Mr. Vilar was not rational in saying this, as the backbone of the economy at the time was the brick and mortar companies (companies with tangible assets). So clearly this investor, who ran a multimillion dollar mutual fund, is not rational. To showcase this, if you had invested $10,000 at the end of 1999 you would have about $1,195 left by the end of 2002. Makes you sick doesn’t it?

3.   James J. Cramer, a hedge fund manager, proclaimed in 2000 that Internet-related companies “are the only ones worth owning right now.” These “winners of the new world are the only ones that are going higher consistently in good days and bad.” Oh man. As with the above examples, he isn’t looking at what these companies are worth. He is looking at the price of the stock. Sorry James, you’re being branded as irrational. By year end 2002, one of the 10 companies in the fund went bankrupt, and a $10,000 investment would have shrunk to about $597.44. That is freaking scary. I’m not sure which new world James was referring to here….oh wait, an irrational world, where people pay for overvalued stocks that won’t make them any money.

The majority of investors are obviously not rational and as long as people are guided by their emotions they never will be.
Strike one MPT. Swing and a miss. The first assumption that investors are rational does not stand up for modern portfolio theory to work. 

MPT – Strike 2: Markets Are Efficient

Ready for the next blunder that Modern Portfolio Theory assumes? Are you?!?! Well get ready for the next big assumption that MPT makes which is……………………………

MARKETS ARRRRRRRE EFFICIENT

What this means in that in order for MPT to work the model assumes that markets are efficient, meaning (more or less) that at any given time the price of a stock reflects what a company is worth based on all readily available public information and that prices instantly change to reflect new public information. In very simple terms efficient markets are saying that the market is a weighing machine. Stock prices accurately reflect, at any given moment, what a company is worth.

What all investors need to understand is that the market is only a weighing machine (and only sometimes) in the long run. In the short run, it is a voting machine, and a poor voting machine at that. There will be all sorts of price discrepancies in the short run due to, overconfidence, overreaction, representative bias, information bias, and various other predictable human errors in reasoning and information processing.

And if markets were efficient there would be very little money to be made, as companies would never become undervalued nor overvalued. Furthermore there would be zero arbitrage opportunities (taking advantage of a price difference between two or more markets). But let’s look at some examples of a few market inefficiencies.

1.   The 2000 – 2002 financial crisis. Things were going so well in the stock market before 2000. The market was reaching new highs and people were making money. But of course we know that the market was grossly overvalued at this point. By believing in this idea that markets are efficient, financial leaders were inconsiderate to the chronic underestimation of the dangers of asset bubbles breaking. This inevitably led to one of our great recessions as the market corrected itself.

2.   Lululemon at its current price of around $60 is disgustingly overvalued. It is currently trading at over 60X what it is earning. Meaning that for every dollar you put into it you will earn, as an owner of the business (in theory), less than two cents on that dollar. Even its price to book ratio is huge at about 20X, meaning that even if the company liquidated for every dollar that you put into it right now you would only get back about five cents! Now don’t get me wrong Lululemon is an amazing company, but the current price that some people are buying into it at right now is extremely overvalued. Its prospects and growth don’t even justify a price this high! Even the average price to earnings ratio for the industry is only about 27X!! So even if we use this average (although this is still very overvalued) it should be trading at about $25. But in my opinion that is still too high. $15 or $20 would be more understandable. There is no safety of principle with Lululemon at its current price, and if the market were efficient, the price of Lululemons stock would be much lower. (Please note that when I originally wrote this Lulu was trading at about $120, however recently they did a stock split so the share price is halved. The ratios are the same however.

3.   China Linen Textile Industry at its current price of around 2.25 is disgustingly UNDERvalued. The company sells linen and yarn in China, and has both excellent management and fantastic prospects. What is more interesting to note is that it should be trading at about $18.00 based on some calculations that I have done (see my analysis on CTXIF for a plethora of information). Its current EPS for the first quarter of 2011 was a whopping $0.46! We can also safely assume that this number will continue in subsequent quarters, as their business is not cyclical or seasonal, meaning they should finish the year with an EPS of about 1.84. That means the P/E ratio is only 1.2X! This means that if you were to buy today you would make back (as an owner) more than half of your initial investment in one year. Furthermore, the company is poised for growth, as it plans to take over other companies in the surrounding area, and also receives some unique help from the Chinese government (again, see my analysis on CTXIF). So why the price discrepancy? Who knows?! The point here is that the market is not efficient. If it were, this company would be trading at a price much higher than what it is currently trading at.

So there are three examples on how the market is not efficient. Obviously we would need only one to disprove this assumption, but three really drives the point home. And of course there are many other examples out there, but we’ll stick with these ones for now.
Strike two MPT. The second assumption that the market is efficient does not stand up for modern portfolio theory to work.
“Here batter batter! Swing batter batter!”

MPT – Strike Three: Investing Is A Trade-Off Between Risk And Expected Return

Now here is where I start to get a little frustrated. You might even say that I get a little pissed off. This is less of an assumption of MPT but rather a STATEMENT that really brings the whole structure of what the model intends to do to its knees. The statement proposed by MPT is that……………..

 INVESTING ISSSS A TRADE-OFF BETWEEN RISK AANNDD EXPECTEDDD REEETUUUURNN

It is saying that the higher the risk, the higher return. Remember when you were a little kid watching cartoons and when the characters got so angry that steam came out their ears? That’s me when I read that statement.

That statement is so far from the truth that I find it appalling that institutional investors actually say that. Investing is NOT a trade-off between risk and expected return. In fact the opposite is true. Stocks and portfolios with lower risk tend to provide higher returns than stocks and portfolios that carry higher risk. And if any investor or financial advisor tells you anything different, do not give them a single penny! Just stand up, and politely leave. They have no idea what they are talking about.

Furthermore, let’s clear up what risk is defined as in the stock market. “Risk is based on the amount of research one is willing to put into ones portfolio.” And, ultimately, the higher the price paid for a stock, the higher the risk. Investors who gamble in the stock market are not investors; they are gamblers. So please do not confuse risk in the stock market with anything else that is outside of what I have just stated.

I would also like to point out here what the actual definition of investing is: “Investing is allocating capital into an operation that provides a safety of principle (your money) while providing an adequate return.”

But let’s get back to the point. Let’s look at how this statement is far from true, and how MPT is seriously flawed in stating this.
It is actually very easy to prove how this point is flawed. All I would need to look at is the fund with the lowest possible risk and compare it with ANY other fund that offered even slightly higher risk (which would be all of them). It has been shown that over any large time period, lower risk funds actually produce greater gains than higher risk funds. The lowest risk funds in history are the index funds; the S&P 500, the DJIA, the Nasdaq, and the rest. Unsurprisingly, they outperform the vast majority of high risk funds over any large time period (5-10 years).

Taking large time periods into account, lower risk mutual funds only return (on average) between 2.5% and 3.7% annually, with the higher risk portfolios generating only 0.2% per year! If we even take a look at the performance of mutual funds just over the last year we find that the average return was only about 1%! If anyone can show me a high risk fund that has outperformed the market over a 10 year span I would love to hear from you.

So when does the higher risk pay off? I mean, with higher risk there should eventually be higher reward right? Well, obviously not. There can be the POTENTIAL for higher returns with higher risk in the short run, but nothing more. Even saying this we would be speculating a great deal, as some investors have a vastly different definition of risk than what we should use (other financial institutions assign a level of risk based on the standard deviation of the historical returns or average returns of a specific investment).

But, I guess the statement isn’t totally untrue. There is a trade-off between risk and expected return, but in the opposite way that you would think. Lower risk will often produce higher returns. But the statement that MPT assumes to be true is false. So again, there is evidence to dismiss the modern portfolio theory.

 â€œStrike three! Yerrr ooutttt!”

MPT – Conclusion

MPT is a seriously flawed model based on a few large assumptions that are not necessarily true. Investors are not rational, the market is not efficient, and investing is NOT a trade-off between risk and expected return, where higher risks are associated with higher returns.

It is a mathematical model used by the majority of financial institutions to justify some of the absurd investments they invest in (and try to get others to invest in) and the investment strategies that they use. The only true way to invest is by using a value oriented approach to investing.

However I must give thanks to the modern portfolio theory, as it has increased the amount of mistakes that the financial industry makes, and may have been a cause of the recession in 2008. So why am I thanking people who use MPT? Because it creates excellent buying opportunities for people like me. Stocks were so cheap at that time you could have bought into almost any company at a discount. And that is how a real investor makes money, by buying into something that provides a margin of safety.

I hope you all enjoyed my take on modern portfolio theory and I strongly encourage everyone to check out my newest stock pick China Linen Textile Industry LTD. And feel free to follow me on twitter at JustinG101!

1.   Focus on the Intrinsic Value of Companies – This is by far the most important rule for the value investor. Intrinsic value can be defined as “the actual value of a company or an asset based on an underlying perception of its true value including all aspects of the business, in terms of both tangible and intangible factors. This value may or may not be the same as the current market value.” Value investors look at the fundamentals of a company NOT THE TECHNICAL ASPECTS OF A STOCK. And as history has shown, value investors outperform technical traders in the long run. The key here is to buy stocks at levels that are below the level of intrinsic value for a particular company. This not only provides a margin of safety but also the opportunity for gains when the market corrects itself.

2.   Practice Emotional Stability – You do not need to be overly intelligent to be a good investor, but you do need strong emotional intelligence. Very few investors have made substantial money by getting caught up in market “swings” (although there are many who have lost money). As a value investor you should already be buying a stock at a level that is below what the company is actually worth, so if the stock goes down, all that means is that you can now buy even more of this company at a better price! Do not sell just because the price has dipped if the price of a stock is still below the value of the company. On the other side of things, just because the price has gone up does not mean that you should sell! A value investor should only sell once the price of the stock has surpassed the value of the company. So if the price has gone up but the price of the stock is still below the value of the company don’t sell! There is still some money to be made. If you don’t think you will be able to handle this don’t invest in the stock market.

A great example of not having emotional control comes from “The Intelligent Investor” by Benjamin Graham. In the Spring of 1720, Sir Isaac Newton, one of the great geniuses of all time, sensed that the stock market was getting out of hand and dumped all of his South Sea Company stocks (one of the hottest stocks in England at the time). He pocketed a 100% gain totalling 7000 pounds. However, months later, by getting swept up in the wild enthusiasm of the market, Newton jumped back in at a much higher price, and subsequently lost about 20,000 pounds (which is over 3 million by today’s standards) :S. Now Newton wasn’t an idiot. But he did not have the emotional discipline that is necessary to be an intelligent investor. So if you’ve failed so far, it’s not because you’re stupid (probably not anyway), it’s because you haven’t developed the emotional intelligence required to be a successful investor. So control your actions! Don’t be a sheep. Be the wolf.

3.   Avoid Permanent Losses – Investing is not just about making money, it’s also about not losing money. Enterprising value investors outperform the majority of other investors because they do not lose money. If an investment does not offer an adequate amount of safety of principle (i.e. buying below intrinsic value etc.) then it is not an investment. It is a speculative operation, a big no-no in the value investing world. Most other value investors will say that a true value investor is not concerned with outperforming benchmarks. However, taking my own little spin on things, I believe that over the long term, an enterprising investor should use benchmarking tools (such as the performance of the market indexes) to evaluate their performance, or else there really is no point in putting in the time and effort into researching companies, especially if you are not going to outperform the market in the long run.

4.   Diversify Less – Today all you will hear from the majority of investors is to diversify. By now you should know that I’m not a fan of it (check out my article on diversification) because if you’re already using a value oriented approach to investing diversification will actually limit your gains, as a value oriented approach already provides a margin of safety. There is no point in using two techniques which both provide greater safety. It’s like wearing two life-jackets when you go boating. There’s not really a point in it. SO I’m actually going to go AGAINST Benjamin Graham here and tell you to diversify less, but only if you are willing to put in the time and effort to research the companies that you invest in (or just listen to the stock picks that I give you ). If you’re not willing to put in the time and effort then yes, you should diversify. But as an enterprising investor, diversification will not even be a part of your vocabulary.

5.   Continue to Learn – This is a no brainer. If you’re not willing to continue to learn then don’t become an enterprising investor. You are always going to need to learn about new industries and new companies. You’re going to do a ton of reading, especially on various company’s financial statements. And if you don’t understand something in them, then you’re going to have to figure that out. You’re going to lean about different industries and how they operate, what their average profit margin is, and any threats that may hinder the industry in the future. And you’re going to love every waking minute of it.
Stay tuned for my next stock pick which should be posted in the next few weeks. I know it’s been a while I’m sorry! 
Twitter – JustinG101

This question first came to me while I was thinking of another blog that I intend to (hopefully) complete one day, the basis of which was about having emotional control while investing. I began to think about how backwards the thinking is for the majority of investors out there and about an ex-girlfriend of mine (keep your pants on fella’s it was PG) when it dawned on me that I had something great to write about here. Let’s explore this question further shall we?

What is the thinking for the majority of investors out there? As I come to see it, the majority of people buy while the market is going up and sell while the market is going down. They are drawn in by the lure of increasing prices and get frightened should their stock go through any sort of decline. This is also especially true of the technical trader, who often times will buy as the market is advancing, as their “magic formula” shows that the stock price is advancing upwards, hoping that the climb will continue up to the peak of financial independence. And if the market declines? Well abandon ship! “SELL! SELL! SELL!” they will yell, hoping to retain as much of their hard earned principle as possible so they can start buying as the market turns, bringing with it another perilous journey up the slopes of a monetary Mount Everest. But enough about the market, let’s talk about girls.

The one thing you should know about my ex is that she loved to shop. Almost every day we hung out she would tell me that she bought some new earring or bathing suit or a new pair of shoes or a purse or some lip gloss or new sunglasses or a new bra or a ring or some glitter or a necklace. Personally I am terrified about spending my money on such frivolous things, and I still wonder why she bought all the things that she did, but her rational for buying those items rings true to me to this very day.

They were on sale.

Imagine if the whole of the investment community took this ideology to heart, what a world we would live in! Instead of newscasters saying that the market took a beating today they would rejoice! “Stocks are becoming more attractive yet again today as the S&P dropped another 3% on heavy volume – the second day in a row that stocks have gotten cheaper! Mining investors faired even better, with leading companies like Goldcorp losing 5% on the day, making its price even more affordable! And some prominent analysts are optimistic that the stock price will continue to drop in the upcoming weeks and months.” They would go on like this, all the while having a large sign with bold letters reading “SALE! 30% OFF” hanging above their heads.

Now I’m not saying you can’t make money by buying high and selling low (although I do think it would be extremely difficult) I just don’t see the logic in it, as even fools can win the lottery. All I’m saying is that the justification for buying high and selling low doesn’t make financial sense and that the average investor (and you technical traders out there) should be careful should you continue along this path and have fears of losing your principle.

What DOES make sense is this: “Buy low, sell high.” This statement is both simple and logical. And should the market decline, well then it’s time to buy more of course, not sell off at a discount!

So this brings us back to our original question: Are women better investors than the average trader?

The answer is,

Undoubtedly,

Yes.