Michael Kaye, a portfolio officer at Standard and Poor's, cites studies that documented the importance of asset allocation over individual stock selection. He defined asset allocation as "the process of determining the optimal way to divide a broad range of categories of assets (stocks, bonds, cash, and others) in a way that suits your investment time horizon and risk tolerance" (p. 10). To make this investment decision, he itemized 5 steps: "Step 1: Identify your goals and objectives; Step 2: Choose the specific asset classes in which to invest; Step 3: Determine what percentage of your total assets belongs in each asset class; Step 4: Decide which investment products to use; Step 5: Monitor the performance of your portfolio and adjust your asset mix if warranted" (p. 13).
Of the common types of asset allocation approaches, the buy and hold strategy becomes the default position. Because after the initial purchases the investor takes no action, transaction costs remain low and the asset allocation can veer far from its original makeup. A less familiar approach to the average investor but one that many unconsciously follow, insured asset allocation strategy, entails selling assets that reach the floor in value and buying more assets that appreciate. As Kaye states, "insured asset allocation assumes that your risk tolerance changes with your level of wealth. You have no tolerance for risk below the floor value and an increasing risk appetite above the floor value" (p. 12).
With strategic allocation, the investor decides what percentages he or she designates for each asset class and rebalances periodically to maintain those percentages. Only because of changing goals or events, does the investor change the percentages. This approach accrues greater transaction costs than buy and hold and, like buy and hold, favors a long-term strategy. Tactical allocation, more short-term oriented, opportunistic, and riskier than strategic allocation, results in a change of percentages based on market conditions. Transaction costs grow from the time taken to follow market trends and the increased costs to buy and sell.
Friday, August 23, 2013
Wednesday, August 21, 2013
Why Tinkering Too Much with Your Portfolio Won't Pay Off
I found the title of this article, circulated on the Australian School of Business newsletter, intriguing. In the age of day traders, I constantly wonder if monthly I should evaluate my portfolio strategy. This article and the research paper that it explains provided an academic view of the issue.
Andrew B. Abel, Janice C. Eberly, and Stavros Panageas, professors at Wharton, Kellogg, and the Booth School of Business at the University of Chicago wrote a highly technical paper entitled, Optimal Inattention to the Stock market with Information Costs and Transaction Costs http://www.nber.org/papers/w15010.pdf?new_window=1 .
The paper makes the assumption that the investor has two accounts, an investment account with equities and a transaction account, a cash account for living expenses. The paper, additionally, considered two transaction cycles or "observation dates", one that occurred at regular intervals--"time dependent", for example, a monthly withdrawal to cover living expenses; and another that occurred far less frequently--"state dependent", for example, once a decade. To assess transaction costs, the authors included two types, "the value of the investor's time, plus commissions and other charges that apply to any action taken" (p.1).
The authors identified "the period of 'optimal inattention'. "Logic says that the higher the investor's cost of time and money, the longer this period is" (p. 1) They concluded that "it would probably not pay to adjust a portfolio more often than every month or two" given commission and other fees" (p.1).
http://www.nber.org/papers/w15010.pdf?new_window=1
Andrew B. Abel, Janice C. Eberly, and Stavros Panageas, professors at Wharton, Kellogg, and the Booth School of Business at the University of Chicago wrote a highly technical paper entitled, Optimal Inattention to the Stock market with Information Costs and Transaction Costs http://www.nber.org/papers/w15010.pdf?new_window=1 .
The paper makes the assumption that the investor has two accounts, an investment account with equities and a transaction account, a cash account for living expenses. The paper, additionally, considered two transaction cycles or "observation dates", one that occurred at regular intervals--"time dependent", for example, a monthly withdrawal to cover living expenses; and another that occurred far less frequently--"state dependent", for example, once a decade. To assess transaction costs, the authors included two types, "the value of the investor's time, plus commissions and other charges that apply to any action taken" (p.1).
The authors identified "the period of 'optimal inattention'. "Logic says that the higher the investor's cost of time and money, the longer this period is" (p. 1) They concluded that "it would probably not pay to adjust a portfolio more often than every month or two" given commission and other fees" (p.1).
http://www.nber.org/papers/w15010.pdf?new_window=1
Tuesday, January 22, 2013
Charles Schwab : You're Fifty--Now What
Sometimes the most basic tasks get overlooked. Fortunately, Schwab has enumerated what one should do, no matter your age. This book offers those guidelines. I will attempt to summarize the ones I found most helpful here. Schwab divided the book into two section, Planning for the Financial Second half of your life and Putting your house in order in the second half.
Expectedly, in the first half of the book, this leader of a brokerage firm suggests that readers invest in stock. He presents the historical evidence that stock has outperformed other financial instruments in the past. Furthermore, he proposes that you invest for growth as aggressively as you can tolerate and afford. He argues that asset allocation--stocks, fixed income, and cash equivalents-- determines 90% of your long-term investment returns. Knowing your budget for this period allows you to measure actuals with inflation against budget. For starters, Schwab suggests a Core and Explore asset allocation--a combination of index funds and actively managed mutual funds and individual stocks.
After deciding a strategy, Schwab directs readers to list all their current assets--cash, IRAs, 401Ks, etc. What paperwork should you keep:
1. Tax returns with supporting documents, such as 1099s (up to six years back)
2. Settlement sheets on house closings, improvements or remodeling of the house
3. Retirement Plan records, records of contributions to retirement plans distributions, conversions, and rollovers
4. Purchase of securities that you own, purchases or gifts--for up to three years
The next step requires estimating the income you will need in retirement, after major life changes, etc. factoring in inflation and compounded interest. From there, he proceeds to go deeper into the asset allocation options--aggressive plans, moderate plans, and conservative plans, with varying degrees of each. Then we get to the point of all this planning, paying yourself from the earnings of your investments in a manner that supports your expenses throughout your lifetime. The trick, not running out of money before you run out of time--making your money outlive you with, hopefully, some to spare for progeny. The remainder of the first section deals with the mechanics of managing your portfolio--monitoring and rebalancing it--how to, the frequency, and logic.
The second portion of the book concentrates on financial advice--determining if you need it, where to get
it and the questions you should ask to assess the quality of the potential advisor. Having reviewed your assets and determining your preference for an asset allocation, you should be prepared for any questions that the advisor might ask you. Regarding the questions you should ask him or her:
"What is your education and professional background?
What is your management style and philosophy? What is the best investing decision you've make in the last five years? the worst?
How are fees set?
Do you prefer one type of investment over another?
Have you had success with clients similar to me? What has your past performance been for clients with financial objectives similar to mine?
How will you help me define my investment objectives? Will you provide a customized investment plan? How often will you review my portfolio?
Where will my assets be held?
Schwab recommends that you consider only fee-based managers. Check the fine print : Form ADV (Application for Investment Advisor Registration), required for all investment advisors who manage more than $25 million in customer assets, a registration of the SEC. Needless to say, communication with the advisor, reading and understanding all documents, openness and trust are key.
The book ends with a discussion about insurance--life, term, medical, disability, and long-term care--estate planning, and charitable giving.
**********************************************************
Schwab, C.2001. You're Fifty--Now what? Investing for the second half of your life. New York: Crown Business.
Expectedly, in the first half of the book, this leader of a brokerage firm suggests that readers invest in stock. He presents the historical evidence that stock has outperformed other financial instruments in the past. Furthermore, he proposes that you invest for growth as aggressively as you can tolerate and afford. He argues that asset allocation--stocks, fixed income, and cash equivalents-- determines 90% of your long-term investment returns. Knowing your budget for this period allows you to measure actuals with inflation against budget. For starters, Schwab suggests a Core and Explore asset allocation--a combination of index funds and actively managed mutual funds and individual stocks.
After deciding a strategy, Schwab directs readers to list all their current assets--cash, IRAs, 401Ks, etc. What paperwork should you keep:
1. Tax returns with supporting documents, such as 1099s (up to six years back)
2. Settlement sheets on house closings, improvements or remodeling of the house
3. Retirement Plan records, records of contributions to retirement plans distributions, conversions, and rollovers
4. Purchase of securities that you own, purchases or gifts--for up to three years
The next step requires estimating the income you will need in retirement, after major life changes, etc. factoring in inflation and compounded interest. From there, he proceeds to go deeper into the asset allocation options--aggressive plans, moderate plans, and conservative plans, with varying degrees of each. Then we get to the point of all this planning, paying yourself from the earnings of your investments in a manner that supports your expenses throughout your lifetime. The trick, not running out of money before you run out of time--making your money outlive you with, hopefully, some to spare for progeny. The remainder of the first section deals with the mechanics of managing your portfolio--monitoring and rebalancing it--how to, the frequency, and logic.
The second portion of the book concentrates on financial advice--determining if you need it, where to get
it and the questions you should ask to assess the quality of the potential advisor. Having reviewed your assets and determining your preference for an asset allocation, you should be prepared for any questions that the advisor might ask you. Regarding the questions you should ask him or her:
"What is your education and professional background?
What is your management style and philosophy? What is the best investing decision you've make in the last five years? the worst?
How are fees set?
Do you prefer one type of investment over another?
Have you had success with clients similar to me? What has your past performance been for clients with financial objectives similar to mine?
How will you help me define my investment objectives? Will you provide a customized investment plan? How often will you review my portfolio?
Where will my assets be held?
Schwab recommends that you consider only fee-based managers. Check the fine print : Form ADV (Application for Investment Advisor Registration), required for all investment advisors who manage more than $25 million in customer assets, a registration of the SEC. Needless to say, communication with the advisor, reading and understanding all documents, openness and trust are key.
The book ends with a discussion about insurance--life, term, medical, disability, and long-term care--estate planning, and charitable giving.
**********************************************************
Schwab, C.2001. You're Fifty--Now what? Investing for the second half of your life. New York: Crown Business.
Monday, March 21, 2011
Blum, Brian A.Contracts : Examples and Explanations, 4th ed. (2007). New York: Wolters Klywer.
This post limits its focus to Chapter 13. The Judicial Regulation of Improper Bargaining and of Violations of Law and Public Policy. The Introduction of the chapter lists the types of improper bargaining: "misrepresentation, duress, undue influence, and unconscionability. The text described the underlying theme of all these types as the ability to enter into a contractual agreement and the right of a party to uphold to contracts that he or she has assented to voluntarily. Courts determine "if a party's apparent agreement is based on an acceptable degree of volition. They are regulatory in that they allow the court to regulate improper bargaining behavior. They are sometimes call policing doctrines" (p. 385). The second class, violations of law and public policy, differs from the one above by establishing whether "the contract violates a statute, a rule of common law, or an important public policy" (p. 385). Under these circumstances, the court will not enforce the contract.
In the discussion of remedy, the author explained the outcomes of improper bargaining. The first consists of making a contract voidable. He defined a voidable contract as "a valid contract that remains fully effective unless the aggrieved party elects to exercise the right to terminate it" (pp. 387-388). Avoidance indicates that the party subjected to improper bargaining elects to terminate the contract. In this situation, both parties share any restitution.
The aggrieved party has other options, to maintain the contract but have the terms and conditions changed to eliminate the unfairness, to keep the contract but claim damages, for the tort or injury, battery, etc.
Misrepresentation, the first type of improper bargaining, the author characterized as " an assertion not in accord with the acts. It is a factually incorrect representation made by one of the parties at the time of contracting" (p. 390). The subclasses, fraudulent, negligent, and innocent, demonstrate the degrees of severity of misrepresentation. Cases based on misrepresentation rest of "the decision on whether or not to grant relief involves a closer balancing of the relative culpability of the parties, and a stronger focus on the objective importance (materiality) of the misrepresentation and the victim's duty to verify the facts" (p. 391).
The section of the chapter, "the application of the parol evidence rule to misrepresentations made outside the written contract" (p. 391) applies to misrepresentation for numerous reasons--"to prove that a fact represented in the writing is wrong . . . [or] was allegedly made orally before or at the time of execution of the written contract, or was made in a prior written document" (p. 391). Again, consideration would be given to the severity of the misrepresentation--fraudulent, negligent, or innocent.
Fraudulent misrepresentations, either "fraud of inducement" (p. 392) the deception that acts as an enticement to enter the contract or "fraud in the factum" deception in the "nature or effect of a document to be signed" (p. 392) constitute two types of fraud. Concentrating on the first, more prevalent types, Blum explains the "false representation of fact with knowledge of its falsity and with intent to induce the other party to enter the contract" (p. 392). He distinguished fact, opinion, and prediction or a "promise of future performance" (p. 393). The author posits a general rule for the legal ramifications of these: "Only a misrepresentation of fact constitutes fraud. An opinion or a prediction should be understood as nothing m0re than an expression of opinion" (p. 393). Other types of fraud include affirmative false statement ( a lie), concealment, nondisclosure, "knowledge of falsity and intent to induce the contract" (p. 398). On the topic of materiality and its impact on fraud, the author implied that it factors into some cases and not in others.
Regarding justifiable inducement, Blum asserts from his review of cases that "One can also detect that courts apply a different degree of objective assessment depending on whether the misrepresentation was active ( a statement or concealment) or by nondisclosure. Courts are more likely to impose a tougher standard of reasonable inquiry on the victim where the fraud lies in failure to disclose facts" ((p. 400).
Although the author details quite extensively duress, contracts negotiated based on force or threats of bodily harm, this post will not address these circumstances. Another topic, unconscionability, does pertain to a small business, such as mine. As Blum acknowledged, "unconscionability is most commonly associated with consumer transactions in which a relatively large and powerful corporation supplies a standard form contract that is signed by a consumer with little or no opportunity to negotiate its terms" (p. 412). These contracts have the characteristics of being "harsh, unfair, or unduly favorable to one of the parties" ((p. 416). In adjudicating cases involving unconscionability, the courts can decide on a number of remedies--refusing to enforce the contract, nullifying, or revising the objectionable portion of the contract.
The vagueness of the unconscionability doctrine makes it difficult to argue and to predict the outcome from the courts.
In the discussion of remedy, the author explained the outcomes of improper bargaining. The first consists of making a contract voidable. He defined a voidable contract as "a valid contract that remains fully effective unless the aggrieved party elects to exercise the right to terminate it" (pp. 387-388). Avoidance indicates that the party subjected to improper bargaining elects to terminate the contract. In this situation, both parties share any restitution.
The aggrieved party has other options, to maintain the contract but have the terms and conditions changed to eliminate the unfairness, to keep the contract but claim damages, for the tort or injury, battery, etc.
Misrepresentation, the first type of improper bargaining, the author characterized as " an assertion not in accord with the acts. It is a factually incorrect representation made by one of the parties at the time of contracting" (p. 390). The subclasses, fraudulent, negligent, and innocent, demonstrate the degrees of severity of misrepresentation. Cases based on misrepresentation rest of "the decision on whether or not to grant relief involves a closer balancing of the relative culpability of the parties, and a stronger focus on the objective importance (materiality) of the misrepresentation and the victim's duty to verify the facts" (p. 391).
The section of the chapter, "the application of the parol evidence rule to misrepresentations made outside the written contract" (p. 391) applies to misrepresentation for numerous reasons--"to prove that a fact represented in the writing is wrong . . . [or] was allegedly made orally before or at the time of execution of the written contract, or was made in a prior written document" (p. 391). Again, consideration would be given to the severity of the misrepresentation--fraudulent, negligent, or innocent.
Fraudulent misrepresentations, either "fraud of inducement" (p. 392) the deception that acts as an enticement to enter the contract or "fraud in the factum" deception in the "nature or effect of a document to be signed" (p. 392) constitute two types of fraud. Concentrating on the first, more prevalent types, Blum explains the "false representation of fact with knowledge of its falsity and with intent to induce the other party to enter the contract" (p. 392). He distinguished fact, opinion, and prediction or a "promise of future performance" (p. 393). The author posits a general rule for the legal ramifications of these: "Only a misrepresentation of fact constitutes fraud. An opinion or a prediction should be understood as nothing m0re than an expression of opinion" (p. 393). Other types of fraud include affirmative false statement ( a lie), concealment, nondisclosure, "knowledge of falsity and intent to induce the contract" (p. 398). On the topic of materiality and its impact on fraud, the author implied that it factors into some cases and not in others.
Regarding justifiable inducement, Blum asserts from his review of cases that "One can also detect that courts apply a different degree of objective assessment depending on whether the misrepresentation was active ( a statement or concealment) or by nondisclosure. Courts are more likely to impose a tougher standard of reasonable inquiry on the victim where the fraud lies in failure to disclose facts" ((p. 400).
Although the author details quite extensively duress, contracts negotiated based on force or threats of bodily harm, this post will not address these circumstances. Another topic, unconscionability, does pertain to a small business, such as mine. As Blum acknowledged, "unconscionability is most commonly associated with consumer transactions in which a relatively large and powerful corporation supplies a standard form contract that is signed by a consumer with little or no opportunity to negotiate its terms" (p. 412). These contracts have the characteristics of being "harsh, unfair, or unduly favorable to one of the parties" ((p. 416). In adjudicating cases involving unconscionability, the courts can decide on a number of remedies--refusing to enforce the contract, nullifying, or revising the objectionable portion of the contract.
The vagueness of the unconscionability doctrine makes it difficult to argue and to predict the outcome from the courts.
Monday, October 25, 2010
What is Six Sigma: Pete Pande and Larry Holpp
Financial analysts have examined companies by comparing their pre-ISO or other process improvements with post-quality performance. In order to perform a similar evaluation of firms that have engaged in Six Sigma transformations, I needed to understand the basic elements of Six Sigma.
This very short book, under 100 pages, explains the fundamental concepts of Six Sigma. After introducing the term Six Sigma to the uninformed reader, it relates the process to various organizational structures and industries and outlines the types of implementations. Characterizing implementations as 'on-ramps', the author distinguished the three types, (1) the business transformation--the complete over-haul, (2) strategic improvement--limited overhaul of a single process or business unit, and (3) problem solving, targeted improvement by investigating significant issues and discovering the problems' root causes. Individuals that engage in the Six Sigma process include Black Belts--the full-time person dedicated to the process, the Master Black Belt-- the process coach, Green Belts--a person trained in Six Sigma skill but one who has functional responsibilities, the Champion and/or Sponsor--the initiator and the executive support, and the Implementation Leader-- the orchestrator of the Six Sigma effort.
Six Sigma contains a number of phases, referred to as DMAIC--define, measure, analyze, improve, and control. The authors elaborated on these steps:
Define the problem
Measuring the problem: Quantifying inputs, processes, and outputs
Focusing on the customer: Documenting the VOC (voice of the customer)
Analyzing root cause
Calculating Sigma
Managing risks
Improve:Measuring results
Control : Sustaining change
To calculate Sigma requires three pieces of information, the unit of work or item delivered to the customer, the "'requirement' that makes the unit good or bad for the customer" and the "number of requirements, or defects opportunities, for each unit" (p. 37). The formula that results from this information follows:
(incidents of defect 1) + (incidents of defect 2) + (incidents of defect 3)
__________________________________________________
500 X 3 (the number of incident types)
The decimal result is call defects per opportunity (DPO).
Six Sigma employs a number of tools to facilitate the process--brainstorming, affinity diagramming, multivoting, structure tree (tree diagram), high-level process map or the SIPOC diagram (Supplier, Input, Process, Output, Customer) , Flowchart (process map), and cause-and-effect (fishbone) diagrams. Teams gather the requisite data through sampling with clear operational definitions, Voice of the Customer methods (market research, requirement analysis concepts, data warehousing, and data mining. To communicate the findings, six sigma participants display data in checksheets and spreadsheets. They verify the data obtained through Measurement Systems Analysis (MSA), which affirms the repeatability and reproducibility (Gage R & R) of the analyzed results. Types of charts and graphs range from Pareto charts, histogram, trend charts, and scatter plot or correlation diagrams. Statistical analysis of the data can test significance, correlation and regression, and controlled experiments (designed of experiments)--"conducting controlled assessments of how a process or product performs, usually testing two or more characteristics under different conditions" (p. 65).
These skills contribute to a successful six sigma process, project management, problem analysis and failure mode and effects analysis, stakeholder analysis, force field diagrams, and process documentation. Six Sigma fits within the Balanced Scorecard framework by supplying the means to ascertain the measures--the performance, trends, and issues, on the dashboard.
This very short book, under 100 pages, explains the fundamental concepts of Six Sigma. After introducing the term Six Sigma to the uninformed reader, it relates the process to various organizational structures and industries and outlines the types of implementations. Characterizing implementations as 'on-ramps', the author distinguished the three types, (1) the business transformation--the complete over-haul, (2) strategic improvement--limited overhaul of a single process or business unit, and (3) problem solving, targeted improvement by investigating significant issues and discovering the problems' root causes. Individuals that engage in the Six Sigma process include Black Belts--the full-time person dedicated to the process, the Master Black Belt-- the process coach, Green Belts--a person trained in Six Sigma skill but one who has functional responsibilities, the Champion and/or Sponsor--the initiator and the executive support, and the Implementation Leader-- the orchestrator of the Six Sigma effort.
Six Sigma contains a number of phases, referred to as DMAIC--define, measure, analyze, improve, and control. The authors elaborated on these steps:
Define the problem
Measuring the problem: Quantifying inputs, processes, and outputs
Focusing on the customer: Documenting the VOC (voice of the customer)
Analyzing root cause
Calculating Sigma
Managing risks
Improve:Measuring results
Control : Sustaining change
To calculate Sigma requires three pieces of information, the unit of work or item delivered to the customer, the "'requirement' that makes the unit good or bad for the customer" and the "number of requirements, or defects opportunities, for each unit" (p. 37). The formula that results from this information follows:
(incidents of defect 1) + (incidents of defect 2) + (incidents of defect 3)
__________________________________________________
500 X 3 (the number of incident types)
The decimal result is call defects per opportunity (DPO).
Six Sigma employs a number of tools to facilitate the process--brainstorming, affinity diagramming, multivoting, structure tree (tree diagram), high-level process map or the SIPOC diagram (Supplier, Input, Process, Output, Customer) , Flowchart (process map), and cause-and-effect (fishbone) diagrams. Teams gather the requisite data through sampling with clear operational definitions, Voice of the Customer methods (market research, requirement analysis concepts, data warehousing, and data mining. To communicate the findings, six sigma participants display data in checksheets and spreadsheets. They verify the data obtained through Measurement Systems Analysis (MSA), which affirms the repeatability and reproducibility (Gage R & R) of the analyzed results. Types of charts and graphs range from Pareto charts, histogram, trend charts, and scatter plot or correlation diagrams. Statistical analysis of the data can test significance, correlation and regression, and controlled experiments (designed of experiments)--"conducting controlled assessments of how a process or product performs, usually testing two or more characteristics under different conditions" (p. 65).
These skills contribute to a successful six sigma process, project management, problem analysis and failure mode and effects analysis, stakeholder analysis, force field diagrams, and process documentation. Six Sigma fits within the Balanced Scorecard framework by supplying the means to ascertain the measures--the performance, trends, and issues, on the dashboard.
Wednesday, May 5, 2010
The Predictioneer's Game: Using the logic of brazen self-interest to see and shape the future. Bruce Bueno de Mesquita
Not within the traditional category of a financial book, Bueno de Mesquita's the Predictioneer's Game claimed, "that it is possible for us to anticipate actions, to predict the future, and, by looking for ways to change incentives, to engineer the future across a stunning range of considerations that involve human decision making" (p. xiv). Such knowledge should improve financial decision making. Based on game theory and using models, the author processes information on his subjects' self interest and determines what the subjects will do and why. Bueno de Mesquita acknowledged the limitations of this method. Some problems find better solutions with applied game theory or statistical forecasting.
The audit project that the author engaged in for Arthur Andersen in 2000 to assess the risk that some of their clients would engage in fraud pricked my interest. According to Bueno de Mesquita, his models with publicly available data on companies could "predict the likelihood of fraud two years in advance of its commission" (p. 116). Enron landed in the high risk category. The following flags signal fraud--decreases in dividends, management compensation packages below expectations, the size of institutional investor ownership, the number of directors, among others.
The author presented the steps for predictions with credibility. First, structure the question addressed into the choices or options available to the subject. Second, acknowledge the environmental context, the " 'what if' questions . . . background conditions . . . scenarios" (p. 49) that would influence the subject. Finally, gather the facts. The author lists four:
1. Identify every individual or group with a meaningful interest in trying to influence the outcome. Don't just pay attention to the final decision makers.
2. Estimate as accurately as possible with available information what policy each of the players identified in point 1 is advocating when they talk in private to each other--that is, what do they say they want.
3. Approximate how big an issue this is for each of the players--that is, how salient is it to them. Are they so concerned that they would drop whatever they're doing to address this problem when it comes up, or are they likely to want to postpone discussions while they deal with more pressing matters?
4. Relative to all of the other players, how influential can each player be in persuading others to change their position on the issue.
In a simple example of the process, the author suggested interviewing subjects via a survey on a simple question, such as which movie would be their preference movie A or movie B and rate the "salience" (p. 53) of the question on a scale to the subjects. Their responses demonstrate their position, the strength of their conviction to the position, and the power they bear. By making a decision, the subject exhibits the basic premise of game theory, that self interest motivates individuals. Another primary motivator, according to the author, is the desire for glory, "the ego satisfaction that comes from the recognition by others that they played an important part in putting a deal together" (p. 55). Another formula for predicting entails employing the weighted mean: "multiply the influence of each player (calling influence I) by his or her salience (S) and multiply that result by the numerical value of the position each player advocates (p), then add those totals up for all of the players and divide that total by the sum of the influence time salience for each of the players (sum of I x S x P)/(sum of I x S)" (p. 59). These manual methods, with a 75 percent accuracy rate do not replace the more exact computer models. Bruce Bueno de Mesquite applied his methods to various situations, described in the remainder of the book.
The audit project that the author engaged in for Arthur Andersen in 2000 to assess the risk that some of their clients would engage in fraud pricked my interest. According to Bueno de Mesquita, his models with publicly available data on companies could "predict the likelihood of fraud two years in advance of its commission" (p. 116). Enron landed in the high risk category. The following flags signal fraud--decreases in dividends, management compensation packages below expectations, the size of institutional investor ownership, the number of directors, among others.
The author presented the steps for predictions with credibility. First, structure the question addressed into the choices or options available to the subject. Second, acknowledge the environmental context, the " 'what if' questions . . . background conditions . . . scenarios" (p. 49) that would influence the subject. Finally, gather the facts. The author lists four:
1. Identify every individual or group with a meaningful interest in trying to influence the outcome. Don't just pay attention to the final decision makers.
2. Estimate as accurately as possible with available information what policy each of the players identified in point 1 is advocating when they talk in private to each other--that is, what do they say they want.
3. Approximate how big an issue this is for each of the players--that is, how salient is it to them. Are they so concerned that they would drop whatever they're doing to address this problem when it comes up, or are they likely to want to postpone discussions while they deal with more pressing matters?
4. Relative to all of the other players, how influential can each player be in persuading others to change their position on the issue.
In a simple example of the process, the author suggested interviewing subjects via a survey on a simple question, such as which movie would be their preference movie A or movie B and rate the "salience" (p. 53) of the question on a scale to the subjects. Their responses demonstrate their position, the strength of their conviction to the position, and the power they bear. By making a decision, the subject exhibits the basic premise of game theory, that self interest motivates individuals. Another primary motivator, according to the author, is the desire for glory, "the ego satisfaction that comes from the recognition by others that they played an important part in putting a deal together" (p. 55). Another formula for predicting entails employing the weighted mean: "multiply the influence of each player (calling influence I) by his or her salience (S) and multiply that result by the numerical value of the position each player advocates (p), then add those totals up for all of the players and divide that total by the sum of the influence time salience for each of the players (sum of I x S x P)/(sum of I x S)" (p. 59). These manual methods, with a 75 percent accuracy rate do not replace the more exact computer models. Bruce Bueno de Mesquite applied his methods to various situations, described in the remainder of the book.
Friday, April 16, 2010
Bogle, J. C. The little book of common sense investing. Hoboken, NJ: John Wiley & Sons, inc.
CEO and founder of the Vanguard Mutual Fund Group, John C. Bogle wrote on the first page of chapter 1 his essential thesis: "Successful investing is all about common sense . . . the best way to implement this strategy is simple . . . buying a fund that holds this market portfolio, and holding it forever. Such a fund is called an index fund" (p. xi-xii). By purchasing an index fund, which contains a basket of stocks, the investor distributes the risk of depending on one company's performance to multiple companies. Furthermore, by maintaining the account for the long term, the investor reaps the rewards of compounding returns. He attested that the holders of individual stocks "returns have probably lagged the market by about 2.5 percentage points per year" (p. xiv); owners of mutual funds have fared worse. Bogle argued that this plan conforms to "Occan's Razor: When there are multiple solutions to a problem, choose the simplest one" (p. 25).
If those of us near retirement age had followed Bogle's advice, we would have amassed, according to him, enough income to adhere to the prescription of holding bond positions equal to your age, 20 percent at 20 and 70 percent at seventy. Itching to own individual stocks? Bogle recommended that to satisfy the urge, allot only 5 percent of a portfolio to personal choices.
If those of us near retirement age had followed Bogle's advice, we would have amassed, according to him, enough income to adhere to the prescription of holding bond positions equal to your age, 20 percent at 20 and 70 percent at seventy. Itching to own individual stocks? Bogle recommended that to satisfy the urge, allot only 5 percent of a portfolio to personal choices.
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