Return on investment: Two million percent

The stock market's recent performance has cost a lot of people a lot of money in their retirement accounts... except for one individual I know, who has made a return of somewhere between one and two million percent on an investment she made a year ago.

Most people follow the conventional advice for portfolio management: diversify, diversify, diversify. Choose an array of index funds: some stocks, some bonds; the percent you should allocate to bonds should be about the same as your age.

It just has to be a good strategy: it's the result of decades of work by really smart people such as Markowitz, Sharpe, Bachelier, Black, Merton, and Scholes. They developed modern portfolio theory, the Capital Asset Pricing Model, option pricing models, and other sophisticated tools. Some won Nobel prizes for their work, and then started hedge funds to parlay their nest eggs.

Their theories work well almost all of the time. In the long run, they said, one can expect an average annual return of 8%, 10%, even 12% or more using the new, smart strategies. [Micro-quiz: What's the most important word in the first sentence?]

But after investing in the two books pictured here (and reading them), the individual I know decided those theories weren't convincing enough. The books:

• Fooled by Randomness, by N. N. Taleb, and
• The (Mis)Behavior of Markets, by Benoit Mandelbrot.

Here are eight excerpts from those two books:

[In economics,] you can disguise charlatanism under the weight of equations, and nobody can catch you since there is no such thing as a controlled experiment.

...the precision of the language of mathematics could lead people to believe that they had solutions when in fact they had none.

Harry Markowitz received something called the Nobel Memorial Prize in Economics. What is his achievement? Creating an elaborate method of computing future risk if one knows future uncertainty... An immediate result of Dr. Markowitz's theory was the near collapse of the financial system in the summer of 1998.

Economics is a science of fashion... The profession burns through new theories the way a teenager hops from one new date to another.

The market is very risky — far more risky than if you blithely assume that prices meander around a polite Gaussian average [i.e., the bell-shaped curve].

Anywhere the bell-curve assumption enters the financial calculations, an error can come out.

In 1993, [Scholes and Merton] joined some heavyweight Wall Street bond traders in the creation of a new hedge fund, Long-Term Capital Management... The had at one point twenty-five PhD's on the payroll... In August 1998 the Russian government defaulted on its bonds, triggering a market meltdown. LTCM... was stuck without buyers... In the end, several banks reluctantly agreed to bail out the fund... only at the behest of the Federal Reserve Board, which was concerned about a wave of bankruptcies if LTCM went under.

[Merton and Scholes] made absolutely no allowance in the LTCM episode for the possibility of their not understanding markets and their methods being wrong. That was not a hypothesis to be considered... The fact that these "scientists" pronounced the catastrophic losses a "ten sigma" event reveals a Wittgenstein's ruler problem: Someone saying this is a ten-sigma either (a) knows what he is talking about with near perfection... or (b) just does not know what he is talking about... and it is an event that has a probability higher than once every several times the history of the universe. I will let the reader pick from these two mutually exclusive interpretations which one is more plausible.

Passages like those prompted a switch away from trusting the smart people armed with their bell curves, to a different, non-Nobel-prizewinning strategy: Move 80% of one's funds into safe, short-term Treasury securities; do whatever you want with the remaining 20%.

Result of that strategy switch after 12 months: Avoidance of the 30% drop in equity index fund values. Almost a two million percent return on her two-book investment in just one short year.

A lot better than a hedge fund, don't you think?

[ps- I read both books, too. Wish I'd paid closer attention.]

Comments

[Boghie]

Brilliant!!!

How will the FED resolve the deflation crisis?

They will initiate inflation.

They have already started. We have an understanding on how to fight inflation – even spiraling inflation. We have little or no understanding of how to fight deflation – especially deflation that hits the spiral. So, we induce inflation. We can fight it.

For now, that individual feels like he/she is making money. He/She is definitely not losing money.

Later, with inflation – hopefully a moderate 5% - 10% inflation – eating away at his/her cash like assets he/she will not be as happy. Time to jump back into the already expanding stock market, eh.

A more balanced approach would have lost him/her about 12% - 16% as of now from the highs. That difference would be made up in a year or two of normalcy. He/she will miss the first 10% - 15% growth before reallocation.

But, these are not normal times. Been thinking about it, am not happy about it, and wish I had not moved from a 70% Treasury/Bond to 30% Stock ratio to a 45%/55% ratio in August – but, oh well… Still doing 9% better than the S&P YTD and 13% better YOY – Yippie!!!

So conflicted. So liberal. I think I’ll stand around and wait for the 100% guaranteed good information before I make any move. Sometime around 1024, eh.

[Mike H]

Does that mean you're changing your asset allocation Steve? Or was is already much on the conservative side since you are in retirement?

[Optimist123]

Mike:
I had already changed it in that direction, but not to the degree I now wish I had. The only change I've made recently is a bet against the euro (ticker DRR), which has been working out nicely; it has more than covered the money I lost on the bet I made two years ago (that the budget would balance by the end of '09, a bet on which I have thrown in the towel).

[Boghie]

Yippie!!!!

I'm on my way to a defensive allocation.

In mid-August I was 45% in cash and bonds, 55% in stocks.

Now, I am 51% cash and bonds, 49% stocks.

Oh, the market is a wonderful thing.

Soon enough, I'll be able to watch the market tumble and not have a care in the world.

Yippieeeeee.....

[OBloodyHell]

> Result of that strategy switch after 12 months: Avoidance of the 30% drop in equity index fund values. Almost a two million percent return on her two-book investment in just one short year.
A lot better than a hedge fund, don't you think?

Oh, Come on. A bit lucky on the timing, don't you think?

By that argument,
a) She never should have put that 20% into anything but T-Bills, as those would have been massively boosted in valuation, too.
b) The principle is that "safe investments are never bad investments"... Well, THAT sounds like a Nobel-prize winning pronouncement, don't it?

Essentially, it's betting on catastrophe. Granted, not necessarily a bad bet on the whole, but I'd argue it's probably better, right now (or at least soon) for her to take that money and put it back heavily into the market for about five years (OK, all bets are off on that claim if Obama wins.) As the probability of another meltdown happening in that time frame is small, and the markets should bounce back steadily (again, as long as Obama isn't running things). THEN assume another catastrophe is coming within 5-10 years, and go into that turtle-shell safety mode.

P.S. what would have been the return if she'd put the money into Gold funds and gold stocks instead? I mean, if you're gonna bet on catastrophe, why not do it up right?