Jack Schwager summarizing some of Ray Dalio’s thoughts on diversification and correlation

Excerpts from Schwager’s book Hedge Fund Market Wizards (also, see a direct quote from Dalio on these topics from the book HERE, under ‘Correlation and diversification’):

Dalio is a strong believer in diversification. In fact, he calls the potential improvement in return/risk through the addition of uncorrelated assets the “Holy Grail of investing.” He states that return/risk can be improved by as much as a factor of 5 to 1 if the assets in the portfolio are truly independent.

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Dalio believes that correlation can be a misleading statistic and poorly suited as a tool for constructing a diversified portfolio. The crux of the problem is that correlations between assets are highly variable and critically dependent on prevailing circumstances. For example, typically, gold and bonds are inversely related because inflation (current or expected) will be bullish for gold and negative for bonds (because higher inflation normally implies higher interest rates). In the early phases of a deleveraging cycle, however, both gold and bonds can move higher together, as aggressive monetary easing will reduce interest rates (i.e., increase bond prices), while at the same time enhancing longer-term concerns over currency depreciation, which will increase gold prices. In this type of environment, gold and bonds can be positively correlated, which is exactly opposite their normal relationship.

Instead of using correlation as a measure of dependence between positions, Dalio focuses on the underlying drivers that are expected to affect those positions. Drivers are the cause; correlations are the consequence. In order to ensure a diversified portfolio, it is necessary to select assets that have different drivers. By determining the future drivers that are likely to impact each market, a forward-looking approach, Dalio can more accurately assess which positions are likely to move in the same direction or inversely—for example, anticipate when gold and bonds are likely to move in the same direction and when they are likely to move in opposite directions. In contrast, making decisions based on correlation, which is backward looking, can lead to faulty decisions in forming portfolios. Dalio constructs portfolios so that the different positions have different drivers rather than simply being uncorrelated.

Photo: Ecuador's Tungurahua volcano

Link: Photos: Ecuador's Tungurahua volcano

Why Mutual Fund Guardians Are Failing

Thanks to Will for passing this along.

When Charles Schwab's popular YieldPlus bond fund started to tank during the financial meltdown, the fund's problems went beyond the queasy markets. YieldPlus, according to the fund's prospectus, was designed to offer "high current income with minimal changes in share price." That didn't turn out to be the case in 2008, when the fund's net asset value plummeted more than 35 percent, some four and a half times what short-term bond funds lost as a whole. Nor was it true in 2009, when shares of the once-stable fund tumbled another 11 percent.

Apart from the obvious financial turmoil of the times, however, there were an array of hidden reasons for the fund's sudden fall. In public disclosures, YieldPlus's managers had said the weighted average maturity of the bonds the fund held was six months, a mark of safety; the Securities and Exchange Commission later said the average reached as high as 2.2 years. As a result, when the broader market imploded, the fund was forced to unload its holdings at fire-sale prices, leading to deeper losses. YieldPlus's registration statement said the managers would not place more than 25 percent of assets in certain types of securities, at least not without explicit shareholder approval. But not long before the market went into free fall, managers stuffed about 50 percent of its portfolio with nongovernment mortgage bonds, the SEC said in a January 2011 cease-and-desist order. And during the crisis, when investors and brokers asked if redemptions were draining the fund, Schwab's lead portfolio manager said in a conference call, "We've got very, very, very slight negative flows," according to the SEC. In fact, the fund had hemorrhaged more than $1 billion in the preceding two weeks.

In the end, Schwab, without admitting or denying wrongdoing, would agree to pay $119 million to settle SEC civil charges that it misled investors; the company also paid $235 million to settle a private case brought by investors. Schwab, saying it was constrained by the settlement terms, declined to comment on the matter. Last year, though, it attributed the fund's losses to an "unforeseeable credit crisis" and said it "would never seek to profit at the expense of its clients."

But while the YieldPlus incident may have directly affected the shareholders of just one Schwab fund, it shines a rare spotlight on something that could well affect any investor in the roughly 7,700 portfolios in the $12 trillion mutual fund industry -- where a quarter of American household assets are now kept. In the case of YieldPlus, say some critics, an important if little-known layer of investor protection failed. This safeguard did not involve a government agency or an outside auditor, but an internal group of highly paid overseers: the fund's own board of trustees. The lapses in oversight that occurred with YieldPlus, experts say, are part of a system of fund governance that is almost designed to fail. "The real puzzle isn't why these safeguards don't work," says John Morley, a University of Virginia Law School professor who has studied the issue extensively. "It's why anybody thinks they could work."

Graham and Dodd quote

From Security Analysis, 1940 edition (the new-era bull market is referring to the mid to late 1920's):

“…it is important to note that mass speculation can flourish only in such an atmosphere of illogic and unreality. The self-deception of the mass speculator must, however, have its element of justification. This is usually some generalized statement, sound enough within its proper field, but twisted to fit the speculative mania. In real estate booms, the “reasoning” is usually based upon the inherent permanence and growth of land values. In the new-era bull market, the “rational” basis was the record of long-term improvement shown by diversified common-stock holdings.”

Mohamed El-Erian on CNBC

Link

Book Review: 'Einstein of Money' details life of Buffett's mentor

Thanks to Lincoln for passing this along.

Benjamin Graham— the financial wiz who taught Warren Buffet[t] to invest — was not unduly interested in money himself.

Graham was a true intellectual — excited by math, languages and classic texts.

And women.

Although he was so honest that he repaid all his investors for their losses during the Great Depression, Graham was a thrice-married philanderer and an absentee dad.

He had so many affairs that Joe Carlen uses the word "swinger" to describe his sex life in a new biography, The Einstein of Money.

Graham divorced his first wife in 1937, when divorce was still socially unacceptable, leaving his four children stigmatized.

The next year, he married a young actress.

Next up, he married his young secretary.

Eventually, he took up with a Frenchwoman who was introduced as the former lover of his own deceased son.

All the while, the rest of Graham's life was the stuff of inspirational kids' books:

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Book: Einstein of Money: The Life and Timeless Financial Wisdom of Benjamin Graham

John Mauldin: How Change Happens

Today we will look at what complexity theory tells us about the reasons for phenomena as apparently diverse as earthquakes and the movement of markets. Then we’ll look at how New Zealand, Fed policy, gold, oil, and that lone investor in St. Louis are all tied together in a critical state. Of course, how critical and which state are the issues.

This is an encore appearance of the letter that is clearly the most popular one I have ever written, updated with a few thoughts from recent times (it was also part of a chapter in Endgame). Numerous reviewers have stated that this one letter should be read every year. As you read, or reread, I’ll be enjoying a week off. I have gone off to a secret location to relax and get away, all by my lonesome, which is something I have really not done for years. It will be interesting to see if I can adjust to all the peace and quiet, but so far I am coping quite well. And now, let’s think about ubiquity.

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Related book: Ubiquity: Why Catastrophes Happen

26 big corporations paid their CEOs more than they paid in taxes

Found via The Big Picture.

Twenty-six big US companies paid their CEOs more last year than they paid the federal government in tax, according to a study released Thursday by a liberal-leaning think tank.

The study, by the Institute for Policy Studies, said the companies, including AT&T, Boeing and Citigroup, paid their CEOs an average of $20.4 million last year while paying little or no federal tax on ample profits, according to regulatory filings.

Astonishingly, nearly all of the companies received net tax refunds of up to $1 billion. Others had a tax bill of $0.

On average, the 26 companies generated net income of more than $1 billion in the US, the study said.

Facebook face plant: Time to friend the company? – By Aswath Damodaran

As Professor Damodaran mentions in the article, he has a limit order out for shares at $18. If you think his valuation is about correct, the heightened volatility in the stock might make it an attractive candidate to sell some cash-secured put options as a way to establish a position. I don’t have any position whatsoever in the stock, but the March 2013 $19 strike price options closed Friday at $3.30 and opened today (before the stock recovered) at $3.40. At that price, your two scenarios if you sold cash-secured put options would essentially be: 1) earning about 21-22% on the cash you reserved in your account (in case they would have gotten exercised) if the options don’t get put to you; or 2) you’d end up owning the shares (if they get put to you) at a net cost of under $16 per share.

If Facebook was over valued at $38, relative to the estimated value of $27/share, is it under valued at $19? To address this question, I revisited my Facebook valuation from May and looked at what I have learned about the company (for the better or worse) since. Has there been enough information that has come out about the firm that could have caused the intrinsic value (at least as I measure it) to drop below $19? The biggest piece of financial information that has emerged on Facebook has been one quarterly earnings report a few weeks ago and it seems to me that not much has changed on either side of the ledger since February. The earnings report was a disappointment to markets, revealing less revenue growth than anticipated and an operating loss, largely as a result of share compensation expenses that were recognized when restricted stock units owned by employees were recognized at the time of the IPO. Facebook remains a company with vast potential (their user base has not shrunk), no clear business plan (is it going to be advertising, product sales or something else) and poor corporate governance. I had not expected any of these issues to be resolved in the one quarterly report and they were not. I did make some adjustments to my valuation: (a) lowering my revenue growth (with my 2022 revenue estimates dropping by about 10%, relative to my May estimates, (b) reducing the operating margin from 35% to 32% to reflect the higher expenses and (c) reducing my sales to capital ratio from 1.50 to 1.20 to incorporate the higher cost of acquisition driven growth. With these changes,  my intrinsic value for Facebook with the updated information is $23.94, a drop of just over 10% from my May 2012 estimate.

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My conclusion is that Facebook is not quite at the threshold of being a buy yet, but it is getting close. I have a limit buy order for the stock at a price of $18.

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Related previous post: Selling Cash-Secured Put Options

Neither I nor any investment product I co-manage have sold puts on the stock(s) mentioned in this article. The company where I work - Chanticleer Holdings, Inc. - has recently launched a registered investment adviser, Chanticleer Investment Partners, LLC. This entity is now accepting outside capital and it will consider selling puts when the situation is attractive, though it has not yet sold any in client accounts as of the date of this post.

This is not a recommendation to buy or sell a security. Please do your own research before making an investment decision.

Daniel Kahneman - Thinking That We Know

Found via Farnam Street.

Link

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Related book: Thinking, Fast and Slow