Equities and Alchemy

Equities and Alchemy

Buyer Beware

October. This is one of the peculiarly dangerous months to speculate in stocks. Other dangerous months are July, January, September, April, November, May, March, June, December, August and February.
- Mark Twain


Chinese Media Is Now Warning Canada’s Housing Crash Will Be Worse Than The US


Chinese Media Is Now Warning Canada’s Housing Crash Will Be Worse Than The US

China Begins Warning About The Canadian Real Estate Market
Shots fired! While our media has been pointing out how Chinese buyers are driving up real estate prices, the Chinese media has been dissecting our economy, government, and warning Chinese buyers of the dangers of owning Canadian real estate.
We’re always curious to know how other countries interpret our statistics, political climate and what outside media is reporting about Canada’s economy. Since China has been a hot button subject in Canadian news recently, we thought it was high time we took a look at how Canada is portrayed in China’s State regulated media. While the Chinese media does acknowledge that Chinese buyers are a contributing factor to our prices – and admit they have been capitalizing on it – they also point out some interesting observations that our media has failed to cover. Here are the most interesting points we found from three major Chinese publications.

Worse Than The 2008 US Crash

Hexun, China’s largest finance portal, recently published an article pointing to Canada’s debt fueled economy. They noted that Canadians have the largest debt-to-income ratio of any G7 country, with the average spending 165% of their salary. To contrast, at the height of the US housing crisis in 2008, Americans carried what was then considered an outlandish 147% debt-to-income ratio – 17 points lower than where we currently sit. Canada’s total household debt reached $1.892 trillion dollars, with $1.234 trillion dollars of that as mortgage debt – roughly 65% more than we make per year. To put that 1.82 trillion dollars into perspective, we could have run the US government for 8 months with that amount of money.
 “This is a very big bubble. And it’s going to end in tears.”
–Paul Ashworth
CN Gold, another one of China’s large financial sites, ran an article quoting Toronto-based economist Paul Ashworth who told them “This is a very big bubble. And it’s going to end in tears.” They then went on to say that once this bubble bursts, real estate will likely be a major “blow to the Canadian economy”.

Real Estate As An Economy Booster

Sina.com’s real estate partner, and NYSE listed Leju was quick to point out that while the average home price in Vancouver is up more than 30%, the province is in a state of “stagflation.” Stagflation is a fancy word that describes when the cost of living increases but there is stagnant demand in the economy. They go on to say BC has one of the lowest median incomes in the country, and the BC government is hoping rising home prices will “render some good”.
Real estate and related services were one of the few high paying growth sectors contributing to our economy over the past year. A significant portion of our growth is in low income sectors like retail, and hospitality service.
While they didn’t put statistics to those statements, we recently published an article that showed Vancouver’s home prices have risen 172% in the last 15 years, while income has only moved up 10%. The struggle in VanCity is real.

BC Government Saved This For The Election

Most interesting, Chinese media outlets are questioning the timing of all of this. Afterall, Vancouver’s real estate has been growing at an unsustainable rate for years (more like decades), while incomes have stagnated. An author from Leju wrote that the Asian investment conversation is being brought on as platforms for the Vancouver municipal and BC provincial elections.
Leju also explained that other cities like Toronto, that have substantially more international buyers, are not having discussions about “vacancy taxes” and “restrictions”. They further allege that the government in Vancouver and BC are looking to distract constituents with “other factors” to explain why income in the province is one of the lowest in Canada.
“this crisis threatens the stability of [the Canadian] financial system.”
Hexun was a little more blunt, stating the Government of Canada “must introduce policies to cool the property market, or face collapse”. Further adding that “this crisis threatens the stability of [the Canadian] financial system.”
While you should approach all media with a grain of salt, they bring interesting points to the table that should be part of the discussion. In Vancouver’s market where mayor Gregor Robertson made almost four times his annual salary selling a home he lived in for only 2 years, and BC Finance Minister Mike de Jong has a stake in 7 homes (only 5 mortgages though), are Chinese speculators the problem or are all speculators contributing to the problem? Also, as Canadians we tend to not discuss things like declining income, which is unfortunate because it’s a big part of our housing story.

Let’s Have An Honest Discussion About Real Estate

At Better Dwelling we’re exploring the issues around Canadian housing from all sides. Like this post? Like us on Facebook to get notified when the next one goes live.

Link: https://betterdwelling.com/city/vancouver/chinese-media-now-warning-canadas-housing-crash-will-worse-us/


Corporate Canada lacks courage, Deloitte poll suggests


Corporate Canada is a timid place full of risk-averse leaders and it’s hurting the bottom line, says a new study that found that just 11 per cent of businesses in Canada are “truly courageous.”

The conclusion comes from a sweeping poll of 1,200 businesses across Canada by Deloitte, which on Monday released a 36-page report, The Future Belongs To The Bold, illustrated with photographs of Inukshuk and of jack pine trees clinging tenaciously to a cliff.

“At a time when Canada needs its businesses to be bolder and more courageous than ever before, almost 90 per cent aren’t up to the task,” the report concludes. “This lack of courage has serious implications for these organizations and for the Canadian economy overall.”
"Investments aren’t made. New ideas aren’t explored. And Canadian companies slowly fall further and further behind"
The survey measured courage in five ways. It asked whether a business defies existing practices, takes risks, takes moral positions, has leaders who embody their convictions, and taps the potential of Canada’s many cultures.

A pre-screened group of leaders from firms across the business spectrum took part in the interactive voice response poll. For example, the survey asked, “How accurately does ‘Bring diverse perspectives’ fit into your methodology?”

Deloitte categorized 15 per cent of respondents as fearful, 43 per cent as hesitant, 30 per cent as “evolving,” and 11 per cent as courageous.
 Almost half of the respondents said “courageous” described their organization. But when they probed further, the study’s authors found a “courage perception gap” — one third of companies believe themselves bold when they are not.

“The result?” reads the report. “Investments aren’t made. New ideas aren’t explored. And Canadian companies slowly fall further and further behind.”

Canadian firms invest less in machinery and equipment than in comparable industrialized nations, while investments in training have dropped 40 per cent in 20 years, the report notes. These kinds of risk-averse behaviours are a drag on an economy that will grow just 1.3 per cent this year, compared to global growth of over 3 per cent.

Courage helps the bottom line, the report says: 69 per cent of “courageous” firms has rising revenues, and 17 per cent increased their workforce. Just 46 per cent of “fearful” businesses earned more, and only four per cent hired more staff.

Frank Vettese, managing partner of Deloitte Canada, which just moved into a new 44-storey tower in Toronto’s financial district and put its name on the parapet, chose in an interview to look at the bright side.

“I am very encouraged that 11 per cent of the business are truly bold,” said Vettese. “And one third of the companies we surveyed were on the cusp of being courageous.”

“We came to conclusions about Canada being risk-averse,” Vettese added. “Canada has got some serious work to do.”

Sarah Kaplan, a professor at the Rotman School of Management who grew up in the United States, said the notion that Canadian firms lack courage confirms her own perception that corporate Canada prefers everyone to just get along. That’s all very nice, she said, but disruption drives profits.

“It’s an interesting paradox about Canada,” Kaplan said. “I notice in my adopted country that there is a need to not do something that is offside, not to rock the boat. That peaceableness can get in the way of the friction you need to be innovative and to grow.”

She acknowledged that, “the reason the Canadian economy did well in the 2008 crisis was because of its conservativeness. You don’t want banks failing but you do want to encourage creative thinking.”
Canadians shy away from arguments, she added. “I want there to be more conflict at the boardroom table.”

She asked, “How do you be bold and courageous in a country that values cohesiveness?”

Among the examples of Canadian corporate courage celebrated in Deloitte’s report:

• In the category “be proactive”: Loblaw Cos. Ltd.’s purchase, in 2013, of Shoppers Drug Mart, which helped boost the company’s net income by 117 per cent in two years.

• In the section “take calculated risks”: The launch, by 145-year-old Economical Insurance, of their Sonnet platform, which gives auto and home insurance quotes online

• Under the heading “start with yourself:” The commitment by Paramount Fine Foods, which serves Middle East cuisine, to hire 100 Syrian refugees.

Vettese said Deloitte has its own push for a more diverse staff, which the report says can counter the risk of “groupthink.” “We are trying to get to a place where everyone in our firm feels that they can bring their whole self to work,” Vettese said

Source: http://business.financialpost.com/news/fp-street/corporate-canada-lacks-courage-deloitte-poll-suggests


Be Grateful

 Being grateful helps to increase self-control and reduce impulsive behaviours, new research finds.


Rory Sutherland: Life Lessons from an ad man

Rory Sutherland stands at the center of an advertising revolution in
brand identities, designing cutting-edge, interactive campaigns that
blur the line between ad and entertainment.

Rory Sutherland: Life lessons from an ad man





Human nature hasn’t changed for a million years.

The Wisdom of Bill Bernbach

Despite access to more customer information than ever before product messages are clicking less often with customers. The inescapable truth is we know less about customers than we should, given the $6 billion a year companies spend trying to figure out what makes them tick.

Bill Bernbach, one of advertising’s greatest minds, would understand the problem:
“Human nature hasn’t changed for a million years. It won’t even change in the next million years. Only the superficial things have changed. It is fashionable to talk about the changing man. A communicator must be concerned with the unchanging man – what compulsions drive him, what instincts dominate his every action, even though his language too often camouflages what really motivates him.”
Bernbach was not a psychologist, but had an uncanny intuitive grasp of human behavior. While most of us may lack the intuitive competence of Bernbach, we can get to know our customers better by acquiring a deeper understanding of unchanging man. But we cannot get that understanding through traditional customer research.

Renown brain scientist Richard Restak has observed that "We have reason to doubt that full awareness of our motives, drives, and other mental activities may be possible." Cognitive scientists tell us that with the aid of new brain canning technology, they’ve learned that about 95 percent of the mental activity going into our decision-making takes place behind the curtains of consciousness. Yet, most consumer research concentrates exclusively on the contents of consumers’ conscious minds.

The roots of motivations lie beyond the knowing reach of our conscious minds. When people tell researchers’ why they do what they do, they can only speak to what appears on the screens of their conscious minds. Those images are often at odds with their more primal sources of motivations.

Marketing mostly ignores the silent 95 percent zone in the brain. Why? The “superficial things” that show up in the conscious mind are more visible, measurable and quantifiable. Companies feel more comfortable with the measurable, so they spend vast sums researching customers’ superficial attributes. Procter + Gamble alone conducts 4,000 to 5,000 customer studies a year.

It’s harder to quantify “what compulsions drive customers, what instincts dominate their every action.” To fathom the unchanging man requires understanding behavior at its roots in human biology.
Ever wonder how cravings develop? Be they for sex or chocolate, they are not consciously created. It’s 3:30 PM. Your energy is sagging. A small organ over your kidneys senses a sugar shortage and sets off a flow of neuropeptide Y to alert your brain of a need for carbs. The plea reaches your conscious mind as a craving for chocolate. You ponder whether to stick to your diet or give in, then say to yourself, “What the hell,” pop a piece of Godiva in your mouth and resolve to eat salad for dinner. You enjoy the moment by giving into the craving.

While you exercised free will (hopefully) in reacting to the craving, the action you took had its roots in your biology. So it is with behavior in general. That’s lesson #1 in understanding unchanging man. 


Direct Marketing and Copywriting

  Gary Halbert
What are The Boron Letters?  
 The Boron Letters are a message from a master copywriter, the late Gary Halbert.

Often called the godfather of copywriting, Halbert spent several years in the Boron Federal Prison Camp for fraud in the 1980’s. It was during this “vacation,” as he termed it, that he began his reemergence as a dominant force in direct marketing.

The Boron Letters were meant as an inspiration to Halbert’s children. He called them the “most heartfelt messages that I’ve ever written.” The forcefulness of the prison environment became his inspiration. Pulling no punches in their language, his prison letters became a cult-classic in direct marketing genius and have served as a guiding force ever since.

The letters formed an outline of Halbert’s philosophy of direct marketing. From the basics of good copy writing to the importance of first impressions, The Boron Letters contained ideas that would become the standard by which all copy writing was judged.

Halbert understood that good copywriting is written primarily to make money, not to gain praise. His method of turning non-sales into sales turned the direct marketing world on its head, eventually igniting the world of online business. Though he wrote his manifesto long before the World Wide Web became the driving economic force in the world, his methods found their way into the Information Age.

He started with a newsletter. With almost no promotion, Halbert found himself with readers spanning the globe. When yearly subscriptions started lining up, he decided to offer a lifetime subscription. Soon, all of his subscribers paid for the lifetime option.

Halbert realized that his knowledge was important to share with the world, and he began offering it for free on his website. He built a even larger client base with the free information than he could with any other way.

Through it all, Halbert remained one of the most creative minds in the field of copywriting. Even though Halbert was a genius, he would speak in plain English so that everyone could understand his meaning.

Gary Halbert died on April 8, 2007. He left behind one of the most profound legacies in direct marketing, and his ideas continue to influence great copywriters around the globe.

Check out one of Gary Halbert’s presentations below

Or… if you’d like to check out some of Gary’s best material click here.

Gary's Shortest Letter https://youtu.be/O7YwMgBENng



Gary Halbert. Live at the System Seminar. San Francisco, 2004.


Where transportation is headed

.ToyotaFinancial's CFO on where transportation is headed at the 2016 conference.


Lumosity’s games may not improve users’ cognitive functioning


How Lumosity Plans To Move On After Their FTC Complaint

Brain training app company was hit with a $2 million fine by the FTC for deceptive advertising. 

Here's what's next.

Lumosity's Lost In Migration Game
[Photos: courtesy of Lumosity]

Talk about a corporate headache. Lumosity, the brain-training game app whose TV ads and web presence have been near-ubiquitous in recent years, was slapped with a $50 million fine by the FTC earlier this year over claims made about the benefits of its product. (They ended up settling for $2 million but not without a spate of nasty headlines.)

According to the FTC, Lumosity settled charges of deceptive advertising of its games, claiming that the games help users with school or office work, and reduce or delay cognitive impairment in seniors. 

Specifically, the FTC cited practices like purchasing Google AdWords related to memory, dementia, and Alzheimer’s disease for the app, and unfounded claims in the company’s advertisements.

The company says that it is sticking by its core product—and even branching out into new areas like stress management and sleep patterns—but will be more mindful of how it uses Google AdWords, says Steve Berkowitz, the CEO of Lumosity parent company Lumos Labs, in an interview with Fast Company.

Berkowitz joined the company in November 2015, well after the FTC’s investigation was under way. "The settlement was really a small setback in what's a really long journey to make cognitive training accessible to everyone," he said. "Every industry is new, things happen as companies are young, and this is about opportunity going forward."

Lumosity definitely hyped its products, and used an aggressive advertising campaign similar to what you’d see for a regular, non-"brain training" game or consumer electronics product. But was it deceptive advertising?

The jury of its peers is still out.
Adam Gazzaley heads up the University of California San Francisco’s Gazzaley Lab, where he researches the potential for video games, among other tools, to alleviate cognitive deficits. He is one of a group of scientists who signed an open letter saying Lumosity made exaggerated claims in 2014. It’s important to note, however, that Gazzaley serves on the board of a neuroscience gaming company called Akili that works in the same sphere as Lumosity.

Gazzaley, in an email to Fast Company, wrote that it is critical for companies that "create tools to enhance human performance" conduct rigorous scientific studies to "validate their offerings," and that regulators play a critical role in overseeing such firms. But he expressed concern about the impact of the Lumosity fine and that it could cast doubt on the positive effects of cognitive training via interactive media. "I remain cautiously optimistic that with high-level development and careful validation we will create a new category of cognitive enhancement tools for both healthy minds and those suffering from deficits."

USC’s Mara Mather, who heads up the university’s Emotion and Cognition Lab, signed the same open letter as Gazzaley, and says her main worry is that Lumosity’s games may not improve users’ cognitive functioning—they might just, in fact, make it easier for them to play the Lumosity game they are playing.

Here’s her take:
To date, most laboratory studies looking at effects of practicing various types of cognitive tasks have yielded disappointing results. Yes, people get much better at the task they are practicing, but they don’t usually show any benefits for other types of tasks. So practicing crossword puzzles should definitely improve your performance on crossword puzzles but might not help you remember what you need to buy at the store or the name of an acquaintance.
Mather wasn’t completely critical of Lumosity, however. She praised the company’s ongoing outreach to academia and willingness to work with outside researchers on projects related to human cognition.
Lumosity's Train of Thought Game
At Lumosity, Berkowitz seems eager to move on. As a recent hire, he wasn't named as a defendant in the FTC suit. The company’s former CEO, Kunal Sarkar, and former chief scientific officer, Michael Scanlon, were both named as co-defendants alongside Lumosity in the suit; both Scanlon and Sarkar are currently listed on Lumosity/Lumos Lab’s leadership page, and Sarkar remains the company’s chairman.

Our conversation ended up with three interesting takeaways:

New products and areas of interest: Berkowitz says part of Lumosity’s strategy for 2016 involves expanding the company’s product line into areas such as stress management and sleep patterns.

When I asked Berkowitz if this marked a departure from its emphasis on cognitive training, he told me that "If you think about it, we're about health and wellness. Introducing people to the concept of health and wellness isn’t just physical. It’s also mental health and wellness, and our goal is to introduce those things."

Those Google AdWords keyword buys might not have been the best idea: "We never focused on diseased populations," Berkowitz asserted. He also emphasized that "When ads were purchased, Google gave a suggestion of what keywords to buy. It gives thousands and thousands of suggestions, and we purchased them. We purchased a minimal number of those kind of things, and our intent continues to be on healthy adults. Our idea there is we want to give training tools and learning to help adults."

Lumosity's sticking by its core product: Berkowitz explained with a chuckle that "The best way to kill a low-quality product on the Internet is to market it. It's so easy to switch (to another product)." He added, "We recognize that, and that’s our goal. I feel like this is, as I said earlier, a small dunk in whats going to be a long future."

Though it's common for app companies using AdWords to take a carpet-bombing approach to large clouds of semi-related keywords to see what works and what doesn't, the FTC is particularly sensitive to exaggerated health claims. One of the key challenges for Lumosity is how to straddle the fine line between recreational game and cognitive improvement tool, without pushing it too far.

In the meantime, Lumosity and Lumos Labs aren’t going anywhere. The company, despite the FTC spanking, has a healthy user base, lots of name recognition, and a favorable market position. Now, they need to refine their product and embrace the exuberance of app marketing without crossing the line.

 Link: http://www.fastcompany.com/3055942/how-brain-game-app-lumosity-plans-to-move-on-after-those-deceptive-ad-claims


'Weapons of Financial Mass Destruction'

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Wednesday, January 30, 2013

In Defense of 'Weapons of Financial Mass Destruction'

Research on derivatives concludes they can add to a company’s leverage and market value.
"Allowing firms to focus on the risks they are in business to take, while hedging against risks that they are not in business to take, can add value."
Francisco Pérez-González
Assistant Professor of finance, Stanford GSB
Financial derivatives have been in the doghouse of public opinion ever since the financial meltdown of 2008, when Warren Buffett famously described them as "weapons of mass financial destruction."
Today, a battle is still underway in Washington over how — or whether — to rein them in. But corporations and finance experts have long debated a more basic question: Does hedging actually increase the market value of corporations?
Every business exposes itself to a long list of risks. Abrupt changes in consumer demand for smartphones, for example, drastically reduced the outlook for once-dominant firms such as Nokia and Research in Motion. A sudden drop in the value of the dollar can sharply improve prospects of U.S. exporters at the expense of foreign rivals. Changes in oil prices have a big impact on airlines, trucking, and other oil-consuming industries.
Yet hedging by itself isn't inherently profitable: Some firms reap gains, while others pay for insurance they don't use. The overall effect over time is likely to be a wash.
As a result, the traditional view in corporate finance is that hedging adds nothing to overall shareholder value, especially at publicly traded firms.These firms tend to be owned by diversified investors, and investors can hedge for themselves by holding a diverse portfolio of stocks.

A 'Natural Experiment'

Does that mean derivatives and other forms of hedging are a waste of money? Not necessarily.New research, coauthored by Francisco Pérez-González, an assistant professor of finance at the Stanford Graduate School of Business, shows that hedging has indirect benefits that can increase a firm's overall value.
It has always been difficult to estimate the effects of hedging on firm value. Companies that decide to hedge are often different from companies that don't hedge, making it difficult to interpret the effect of derivatives from differences in company valuations. Financial economists don't have the luxury of setting up random experiments between comparable companies that do and don't hedge.
"We cannot randomly and unexpectedly induce large publicly traded firms to hedge, or to drop an existing risk-management program, just to observe the consequences,” says Pérez-González.
To get around that problem, he and Hayong Yun at the University of Notre Dame took a novel approach. They created a "natural experiment" by examining what had happened to weather-sensitive firms — mainly natural gas and electricity providers — after the introduction of weather derivatives for hedging against unusual swings in temperature.
Weather-derivatives first surfaced in 1997, and the Chicago Mercantile Exchange began trading options tied to unusual hot and cold spells in 1999. The contracts work like any other type of insurance: You pay for it in good times, and it only pays off if the unwanted problem arrives. For utilities, especially in some areas of the country, exceptionally hot or cold weather can dramatically affect their business costs and revenue.
Pérez-González and Yun call their study a "natural experiment" because the sudden availability of new weather derivatives created a natural control group within a given industry. That made it possible to isolate the impact of derivatives by comparing companies with large weather risk before and after the new hedging tools became available.
Not surprisingly, the researchers found that weather-sensitive utilities embraced the new derivatives more frequently than those that faced less risk. More surprisingly, the researchers found that weather-sensitive firms increased their value — as measured in ratio of market value to book value — by at least 6%.

Taking the Right Risk

But why? If hedging is ultimately a wash, sometimes paying off and sometimes not, how did the firms as a group end up ahead?
Pérez-González and Yun think they have the answer: The companies that reduced their exposure to weather risk were able to make more productive use of their capital and reap higher rewards for investors. The researchers found that companies became more financially aggressive after using the derivatives, apparently because they didn't have to reserve as much money for unpredictable weather shocks. The companies increased their leverage and their capital expenditures as weather derivatives were introduced. That, in turn, led to higher market valuations.
"Allowing firms to focus on the risks they are in business to take, while hedging against risks that they are not in business to take, can add value," says Pérez-González. "The goal of the hedging strategy should be to maximize the firm cash-flows. Our evidence shows that firms increased their cash-flows by using their balance sheets more aggressively and by investing more.”
The same lessons should apply to many other kinds of hedging, such as against swings in foreign exchange rates, oil prices, or interest rates. If the risk of such fluctuations limits management's ability to concentrate on the main business, Pérez-González says, companies have a case for managing the risks.

A Fine Line Between Hedging and Speculation

The study doesn't settle all the questions about the impact of derivatives. Banks and Wall Street firms thought credit-default swaps could reduce, if not eliminate, their risk on subprime mortgages. But when the entire financial industry became over-confident, the total risk exposure became far higher than it would have been if no one had hedged in the first place.
"Derivatives can exacerbate both firm and systemic risk exposures," Pérez-González and Yun acknowledged in their paper. "Not surprisingly, financial derivatives have played a central role in recent financial crises."
Pérez-González cautions that there is a fine line between hedging and speculating. "Most non-financial corporations have no expertise in predicting the direction of foreign exchange rates or commodity prices, for example, but many risk managers attempt to take a view, and those bets frequently turn out to be costly. A hedge should seek to reduce risk exposure; it should not be a gamble on the direction of the market."

The Science Of Investing And The Evolving Definition Of Alpha

The Science Of Investing And The Evolving Definition Of Alpha

Aug 21 2013

includes: MMTM, TILT, TLTD, TLTE

By Samuel Lee

Though it sometimes is hijacked by ideologues, the scientific method works. 


The most successful societies entrust scientifically trained workers with the most specialized tasks, such as performing brain surgery, designing airplanes, and setting marketwide interest rates. And yet, many individuals regularly entrust their fortunes to the investing equivalents of witch doctors and astrologers. Or they take matters into their own hands for no good reason other than a vague belief that they can do it if they put their minds to it. Unlike good scientists, they're not skeptical enough of themselves or others.

Brains and education are no panacea. My father is a tenured professor of electrical engineering at one of South Korea's top research universities. When he designs a microchip, he draws on his years of education, consults industry journals, and relies heavily on the work of other engineers. When he speculates in small-cap technology stocks, his efforts are far more casual and sometimes include asking me which ones I like--I always profess ignorance. Despite admittedly subpar performance over 20-something years of investing, he refuses to give up control and index his holdings. It's as if the logical, skeptical part of his brain shuts down, and a more animal, overconfident part of his brain takes over in all matters investing. Would I, armed with nothing more than the efforts of a few spare hours each week, go into the chip-design business to compete with the likes of Intel and ARM? Of course not.

There is a science to investing. Though you may not know them by their technical names, chances are you're familiar with the fruits of Modern Portfolio Theory, the connection between risk and return, the theory of interest, and the efficient market hypothesis. Parts of financial theory are so integral to the practice of investing that most investors have forgotten they originated in academia. That said, some domains are more amenable to scientific expertise than others. The sweetest fruits of biomedicine originate from trained scientists; the best investment results don't always originate from finance Ph.D.s. In fact, some of the greatest investors are derisive of "scientific" approaches to investing. Warren Buffett warned, "Beware of geeks bearing formulas."

Why aren't finance professors dominant in investing? I can think of several reasons. The foremost reason is certainly emotion, which can consume even the finest minds. Famed logician Kurt Gödel was terrified of being poisoned and ate only food prepared by his wife, Adele. When she was hospitalized for six months, he starved himself to death. Even very smart investors can kill their retirement plans when they're in thrall to their animal brains. Investing requires unusual discipline that, by definition, most people lack. Moreover, this quality, in my experience, seems unrelated to brainpower.

Second, finance and economic researchers often don't have powerful enough tools to divine as much meaning from the available data as they'd like. That doesn't stop them from trying, though, and they often end up making astrologers look good by comparison. Not helping matters is how their work can have profound economic, social, and political implications, tempting researchers into the morass of politics, where their impartiality often withers and dies. Find me an economist who assumes nuanced positions that can't be neatly described as Democrat or Republican, and I'll show you someone who's practically irrelevant in the nation's political discourse.

Third, most of the information in the markets is not quantifiable with the tools at our disposal. By restricting themselves to hard numbers, scientific investors sometimes miss what qualitative investors see clear as day. Franco Modigliani, of the Modigliani-Miller theorem, was puzzled that so many firms paid dividends. Investors have known since the days of Ben Graham that dividends impose discipline on corporate managers, keeping them from doing too many stupid things. Soft qualities such as culture and incentives matter, even if you can't easily assign numbers to them or model them in a closed-form solution.

There are good reasons be skeptical of the things that come out of finance researchers' mouths, but it's a big mistake to completely dismiss them. I'd go as far as to say evidence-driven investing is the best approach for the majority of investors, because it's based on an efficient learning strategy. Many investors pick a terrible learning strategy: personal experience. Experience is unreliable; colored by emotions and the zeitgeist, it captures a period that's short by the standards of history. Investors traumatized by the Great Depression learned that stocks are dangerous and should be avoided; investors who rode the bull markets of the 1980s and 1990s learned that stocks are unstoppable engines of wealth. Both learned the hard way that personal experience is a flawed teacher.

A better strategy is to learn from history, so you don't repeat the mistakes past generations made. Scientific investing, at its best, is about engaging the data honestly, with the intention of learning something new, hopefully something discordant with previously held beliefs. Science as it's currently practiced has plenty of flaws, but it's still the most reliable method of acquiring the truth that I know of.

What are the fruits of science as it pertains to investing? There's a lot of nonsense, but also a great deal of sense: Factors are important, and most investors should focus on investing in them.

Factor Investing

Unless you like to open the occasional dusty academic tome, chances are you're not intimately familiar with factor investing. It's really not as esoteric as it sounds. You've heard of style investing--small cap versus large cap, or value versus growth. If you've ever tilted to a particular style, you've engaged in factor investing. Style investing is a kind of factor investing, dealing with only two factors: size (large-small) and value (value-growth).

A working definition of a factor is an attribute of an asset that both explains and produces excess returns. Factor investing can be thought of as buying these return-generating attributes rather than buying asset classes or picking stocks.

None of this is new. The original factor theory, dating back to the 1960s, is the capital asset pricing model, or CAPM, which predicts that the only determinant of an asset's expected return is how strongly its returns move (or, in technical terms, covary) with the market's. The strength of the relationship is summarized in a variable called beta. A beta of 1 indicates that for each percentage point the market moves, an asset's price moves in the same direction by a percentage point. CAPM predicts asset returns are linearly related to market beta. However, since the 1970s, academics have known that stock returns don't seem to be related to beta. This finding spurred many fruitless or convoluted attempts to explain how market efficiency could be squared with a world in which CAPM didn't work.

Eugene Fama and Kenneth French "fixed" the CAPM, at least for stocks, by adding two factors: size and value. They observed that smaller stocks outperformed larger stocks and stocks with high book/market outperformed stocks with low book/market. More importantly, the relationships were smooth; the smaller or more value-laden the stock, the higher its return. Fama and French interpret the smoothness of the relationship as indicating the market is rationally "pricing" these attributes, which implies that size and value strategies enjoy higher expected returns for being riskier.

Further research has uncovered more stock factors, including momentum, quality, and low volatility, in nearly every equity market studied. They also display the same smooth relationship: The stronger the factor attribute, the higher the excess returns. The interpretation of these factors depends on whether you believe the market is efficient. In an efficient market, they must be connected to risk. However, if the market is not perfectly rational, some may represent quantitative strategies that exploit mispricings to produce excess returns.

I don't believe value, quality, momentum, and low-volatility strategies work because they are riskier. The strategies were exploited by investors before academics triumphantly published them in journals as "discoveries." It's also hard to reconcile them all as representing risk because if you lump them all together, you get an eerily smooth return stream.

This does not mean that all factors earn profits by identifying mispricings. Some attributes, such as illiquidity, are associated with higher returns because they obviously represent risk. So factor investing encompasses two different approaches:

Rational factor theory, which deals with the rewards that accrue to different types of risk and how the market prices them. Factor investing in this context is about finding the optimal portfolio of factor risks.

Factor investing as commonly understood by practitioners, which is the identification of simple quantitative strategies associated with excess returns.

Though it's been around for decades, factor investing has only in the past decade gained adherents. Recent converts include the Government Pension Fund of Norway, the biggest pension fund in Europe, and CalPERS, the biggest public pension fund in the United States. They've seen the light after realizing that the active managers they were richly compensating were simply offering factor risks and factor-based strategies under the guise of skill.

Redefining Alpha

An implication of factor-based investing is that what was once legitimately deemed "alpha"--excess returns attributable to skill--has morphed into "beta" (or a factor) once researchers identify a simple strategy that replicates the alpha. For instance, certain hedge fund managers in the 1980s and 1990s pursued then-exotic strategies such as merger arbitrage that produced excellent returns uncorrelated to the market. However, once researchers identified how the arbitrage strategies worked and created mechanical replications, the managers' alpha became beta.

A consequence of this process is that the hurdle for being declared a truly skilled manager has risen over time. In the 1980s, it was good enough to beat your benchmarks. These days, studies looking for evidence of skill in equity mutual funds control for exposure to size, value, and momentum factors. In other words, if your excess returns come during times that value, smaller-cap, or momentum stocks outperform, the procedure will adjust your "excess" return to zero and declare you unskilled.

If you believe the excess returns of value and momentum strategies reflect risk, then it's a reasonable adjustment. If you believe value and momentum produce excess returns because of market inefficiency, then it's not--what you've done is redefine outperformance. I'm of the latter view. From my perspective, the mountains of studies purporting to show that active equity managers can't beat the market are really showing that much of their excess returns can be replicated by a handful of factor strategies.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the bench marking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.

Source: http://seekingalpha.com/article/1649412-the-science-of-investing-and-the-evolving-definition-of-alpha


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Jennifer believes we live in the garden of Eden and I believe that we are destroying it. Our saving grace is within ourselves, our faith, and our mindfulness. We need to make a conscious effort to respect and preserve all life.