DOI: / Intelligent Investing in Irrational Markets

Size: px

Start display at page:

Download "DOI: / Intelligent Investing in Irrational Markets"

Norah Douglas
5 years ago
Views:

1 Intelligent Investing in Irrational Markets

2 Also by Panos Mourdoukoutas BUSINESS STRATEGY IN A SEMIGLOBAL ECONOMY NEW EMERGING JAPANESE ECONOMY: Opportunity and Strategy for World Business NURTURING ENTREPRENEURSHIP: Institutions and Policies CHINA AGAINST HERSELF: Innovation or Imitation in Global Business (with Yoko Arayama) WOM AND BUZZ MARKETING: Crossing the Tipping Point (with George Siomkos) THE TEN GOLDEN RULES: What Ancient Greek Wisdom Teaches About the Good Life (with Michael Soupios)

3 Intelligent Investing in Irrational Markets Panos Mourdoukoutas

4 intelligent investing in irrational markets Copyright Panos Mourdoukoutas, Softcover reprint of the hardcover 1st edition All rights reserved. First published in 2013 by PALGRAVE MACMILLAN in the United States a division of St. Martin s Press LLC, 175 Fifth Avenue, New York, NY Where this book is distributed in the UK, Europe and the rest of the world, this is by Palgrave Macmillan, a division of Macmillan Publishers Limited, registered in England, company number , of Houndmills, Basingstoke, Hampshire RG21 6XS. Palgrave Macmillan is the global academic imprint of the above companies and has companies and representatives throughout the world. Palgrave and Macmillan are registered trademarks in the United States, the United Kingdom, Europe and other countries. ISBN: PDF ISBN: Library of Congress Cataloging-in-Publication Data is available from the Library of Congress. A catalogue record of the book is available from the British Library. First edition: doi: /

5 To my Professors and Mentors, Theofanis Benos and Michael Hatziprokopiou

6 Contents List of Tables List of Figures A Personal Story Preface: Why Another Investment Book Acknowledgments About the Author vii ix x xii xv xvi Introduction: Emotions and Intelligence in Investing 1 1 Rule 1: Don t Pay Others to Lose your Money 10 2 Rule 2: Have a Financial Plan 17 3 Rule 3: Know Which Assets to Buy and Sell 26 4 Rule 4: Know Which Stocks to Buy and Sell 44 5 Rule 5: Stay Focused 60 6 Rule 6: Maintain an Intelligent State of Mind 70 Epilogue 89 Bibliography 94 Index 97 vi

7 List of Tables I.1 The four mistakes rookie investors make How full commission brokers get paid Commission schedule for mutual funds, annuities, and whole life insurance products as of October How major mutual funds fared in the 2008 crash Commission schedule for trading stocks with discount brokers as of October Tips for choosing a financial advisor Financial priorities by age Major types of bonds A sample of bond ETFs Stock types A sample of equity ETFs that match different market indices Commodity ETFs Advantages and disadvantages of different assets Financial planning for different households Business cycle stages Demand driven business cycles Supply driven business cycles What happens to bond prices when interest rates change Selected index funds 46 vii

8 viii List of Tables 4.2 Intrinsic versus market value of Wright Aeronautical Corporation (WAC) in 1922 and SWOT Analysis matrix A sample of companies that have been enjoying sustainable competitive advantage Defenses against competitive threats Three schools of investing Asset allocation by age Selective economic indicators Economic calendar Apple versus Nokia s financials as of August 31, Message versus background noise The four drivers of the disposition effect When fear overtakes greed Fourth quarter 2008 stock market valuations for major equity markets When emotional buttons are turned on How to maintain an intelligent state of mind 84

9 List of Figures 3.1 Bonds rallied in the aftermath of the Great Recession Clorox fared better than Home Depot in the 2008 crash Stocks took a hit in the 2008 crash Commodities took a big hit in the 2008 crash Apple s bullish chart July Nokia s bearish chart Apple s bearish chart February The blow and the burst of the NASDAQ bubble Nikkei average Lennar s stock ix

10 A Personal Story People are under the impression that economists coming off the graduate school are immersed in investing theory and practice. This isn t necessarily true. Economists spend a great deal of time developing mathematical models and studying the principles that guide markets, but very little time in studying institutions, including financial markets and the behavior of investors I do know this very well. When I graduated with a Ph.D. in Economics, sometime in the last century, I had no idea about investing. That s why I hired Sam to manage my little savings chest. The problem, however, is that Sam didn t manage my money himself. He handed it to a mutual fund manager. In the first two years, my portfolio was performing modestly, earning a little-bit more than the money market account it was invested in before it was handed over to Sam. But when the stock market crashed in 1987, it lost 30 percent of its value! In the beginning, I was angry with Sam because he failed to explain to me the risks my portfolio was exposed tothough he handed me a 50-page prospectus that explained these risks in a batch of footnotes. The truth of the matter, however, is that equity markets are highly volatile, and at times crash. But they usually recover. Anyone who was in the market at that time suffered losses in the neighborhood of 30 percent; no one could have anticipated the crash with certainty; following a big dose of money injections by the Fed chairman Alan Greenspan, the market recovered quickly and investors x

11 A Personal Story xi who stayed put and weathered the storm (or even better doubled-down) did very well over a 12-month period. Not me. By then, I had already cashed my chips counting my losses. That s when I stopped being angry with Sam and became angry with myself, raising a question again and again: what did Sam know about investing that I didn t? What were his credentials? A Series 7 (Federal) and a Series 63 (New York State) securities license. Before long, I did fire Sam, took the necessary exams, and became a licensed investment advisor myself. My career as an investment advisor was brief, as I was disenchanted with the way the industry operates. Besides, I was too sophisticated to be a good salesperson. But my career as an individual investor has been long and taught me valuable lessons which I discuss in Forbes.com, Barron s, Seekingalpha.com, and this book.

12 Preface: Why Another Investment Book Every now and then, scores of books burst off the press telling people how to invest their money, especially at times of financial turmoil, when investing becomes more challenging as has been the case in the aftermath of the financial crisis. The vast majority of these books are written by four kinds of authors, investment gurus with an exceptional investment track record, financial practitioners, motivational speakers, and academicians. Books written by investment gurus provide investors with practical tips of managing money, but they usually suffer from two deficiencies, the lack of theoretical foundations and the overgeneralization of their performance. In Common Sense Investing, legendary Magellan Fund manager Peter Lynch tells investors to buy the stocks of well-known companies that have been happy doing business with, the Procter Gambles, the McDonalds, the Wal-Marts, the Sears, the Walgreens and the Nikes of the world. The trouble with this approach, however, is that financial markets are discounting mechanisms. This means that they have already discounted all the good news, and investors who trade them may end up buying high and selling low. Besides, not every well-known company enhances shareholder value, and some go belly-up. For every Wal-Mart, there is a Kmart that was salvaged by Sears Holdings; and for every Nike, there is an LA Gear which filed for bankruptcy. Peter Lynch s strategy may further xii

13 Preface: Why Another Investment Book xiii lead to a localization bias, whereby investors opt to buy the stocks of local companies as they are more familiar with the companies in their neighborhood than those in distant lands. Obviously, common sense must extend beyond the familiarity with a corporation and its products to its business model and financials, which make it a good investment proposition. Books penned by financial practitioners and motivational speakers, who usually run popular TV shows, oversimplify investing, sometimes telling investors things that may contradict economic theory and financial history. In the aftermath of the financial crisis, some financial practitioners told the clients concerned about the crisis to stay with stocks, as stocks are doing well in the long-term. While these practitioners are right in principle (and was vindicated up to now 2012), there are notable exceptions with catastrophic consequences. Just try to give this advise to Japanese investors who have been holding on to stocks for the period , whereby the Nikkei Index was down 80 percent! Books penned by academicians usually address these deficiencies but are too long and too abstract; tend to ignore the history of markets; separate the economics of investing from the psychology of investing; and fail to connect effectively with the average investor. Benjamin Graham and David Dodd s classic Security Analysis, for instance, is too long and too complex for the average investor who isn t well versed in corporate accounting. Robert A. Haugen s Inefficient Stock Market is also too heavy for the average investor who isn t well versed in econometrics and statistics. Apparently, there is a gap between books from the academic literature, which is built around well-articulated premises but caters to a small crowd, and the more accessible books written by investment gurus and financial planners but lack theoretical foundations. To bridge this gap, this book begins with the premise that investing is both a game of economics and psychology. As a game of economics, investing involves the basic principles of economics that help investors identify financial goals and constraints, and come up with the right asset and portfolio allocation strategy, as outlined in the first three chapters. As a game of psychology, investing involves the basic principles of psychology that helps investors develop and maintain an intelligent state of mind by staying focused on their financial plan, and avoiding

14 xiv Preface: Why Another Investment Book costly cognitive biases and errors associated with emotional investing, as outlined in the last two chapters. The principles of the two disciplines, however, are introduced only when needed to make investment decisions, and presented in a nontechnical fashion. The concept of business cycles, for instance, is introduced to explain how expansions and contractions affect asset allocation. The concept of sustainable competitive advantage is used to explain why some companies make good long-term investments, while others don t. The prospect theory is introduced to explain how pride and regret leads to disposition effect, whereby investors are quick to book gains, but they procrastinate to take losses. Another innovation of the book that separates and sets it apart from other do-it-yourself books is that it breaks and summarizes the art of investing into six simple rules. If you are an active investor anxious to learn the tips and the tricks of investing in financial markets, this book is addressed to you. If you are a passive investor looking to hire a professional adviser, a student in economics and finance anxious to apply what you learn in the classroom to Wall Street, the six rules were written with you in mind. By reading this book, you will learn: Why investors engage in harmful behavior like overtrading, being in the market when valuations are high and out of the markets when valuations are low, and why they sell winning stocks and hold on to losing stocks. How to apply basic economics to make wise investment decisions. How to apply basic psychology to develop and maintain an intelligent state of mind.

15 Acknowledgments Author thanks Sebastien Buttet and Paul Kutasovic for discussions during the early versions of this book. xv

16 About the Author Dr. Panos Mourdoukoutas, Professor and Chair of the Department of Economics at LIU Post in New York, is an active investor and the author of several articles published in professional journals and magazines, including Forbes European Management Review, Management International Review, Barron s, The New York Times, Japan Times, Newsday, Plain Dealer, and Edge Singapore. He has also published several books, including The Economic Foundations of Intelligent Investing, Business Strategy in a Semiglobal Economy, China s Challenge: Imitation or Innovation in International Business, and New Emerging Japanese Economy: Opportunity and Strategy for World Business. He has traveled extensively giving lectures and seminars for private and government organizations, including for the Beijing Academy of Social Science, Nagoya University, Tokyo Science University, Keimung University, University of Adelaide, Saint Gallen University, Duisburg University, University of Edinburgh, and Athens University of Economics and Business. xvi

Estimating SMEs Cost of Equity Using a Value at Risk Approach

Estimating SMEs Cost of Equity Using a Value at Risk Approach This page intentionally left blank Estimating SMEs Cost of Equity Using a Value at Risk Approach The Capital at Risk Model Federico Beltrame