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Hope for Riches with Lottery Stocks

October 4, 2010 Leave a comment

On October 1, 2010, you could have bought a share of Fannie Mae (FNMA) for less than 28 cents. Many investors bought that day, and almost 3 million shares moved into the hands of buyers. Even more investors bought shares of Fannie Mae on September 17, 2010, when more than 78 million shares changed hands. “It’s not really a stock anymore — everyone knows this is going to zero,” said Bose T. George, a financial analyst at Keefe Bruyette & Woods. “It’s like a casino.”

Some who aspire to be rich can reasonably expect to reach their aspirations through steady savings invested in safe bonds. But risky investment in lottery tickets and lottery stocks offer many of us the only hope to reach our aspirations, whether millions in bank accounts, ample retirement incomes, or the means to help our children and grandchildren pay college tuition and buy homes of their own.

“I’ve dug so many holes for myself over the years,” said a lottery player, “that, realistically, winning the lottery may be my only ticket out.”  This lottery player’s perceptions of life and its chances are common. When asked about the most practical way to accumulate several hundred thousand dollars, more than half of surveyed Americans said: Save something each month for many years. But more than one in five said: Win the lottery, and most of these were poor.  Res Ball of the Ball Group, a research and advertising company, said: “We found something we called “lottery mentality.” We encountered people who thought it was a complete waste of time to save money. They figured they didn’t have enough money to do anything else, so why not spend the money on lottery tickets?” Lottery players sacrifice the utilitarian benefits of sure money for the emotional benefits of hope. So do football fans who bet on the success of their teams even when the odds favor their opponents.  Investors, like lottery players and football fans, often sacrifice money for hope.

The stock of Fannie Mae is a lottery stock. Lottery stocks, like lottery tickets, offer hope of winning large prizes. Stocks of bankrupt companies are prominent among lottery stocks. Such stocks usually cost only a few pennies yet carry hope of extraordinary returns if bankrupt companies come back to life. Individual investors are attracted to stocks of bankrupt companies, owning on average 90 percent of them. But stocks of bankrupt companies are losers on average, losing more than 28 percent of their value during the year.

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What investors really want: Searching for beat-the-market money managers

September 24, 2010 Leave a comment

Think of investments as ingredients of a stew, some with fat returns and some with lean. Now think of the investment market as a giant well-mixed vat of stew that contains all investments. Some investors dip their ladles into the stew and fill them with fat and lean in proportions equal to the proportions in the market vat. These are index investors who buy index funds that contain all investments. Index investors pay the expenses of their funds, but they can easily find index funds whose expenses are very low, equivalent to a few teaspoons of stew taken out of their ladles. Index investors tend to be buy-and-hold investors who trade only infrequently, as when they invest savings from their paychecks into index funds during their working years and withdraw them in retirement.

While index investors are satisfied with returns equal to risks, beat-the-market investors search for returns higher than risks. Some beat-the-market investors choose handfuls of investments and trade them frequently, hoping to fill their ladles with more fat returns than in the ladles of index investors. Others buy beat-the-market mutual funds, exchange traded funds, or hedge funds, hoping that their managers would find stocks with fat returns. But not all beat-the-market investors can be above average. The ladles of index investors are filled with average amounts of fat returns. If some beat-the-market investors fill their ladles with above-average fat returns, other beat-the-market investors are left with below-average fat returns in their ladles. Moreover, the expenses of beat-the-market investors are higher than those of index investors because beat-the-market investors pay higher costs of trading and the higher costs of beat-the-market managers. Beat-the-market costs are substantial. By one estimate, investors would have saved more than $100 billion each year by investing in low-cost index funds and foregoing attempts to beat-the-market by on their own or by paying money managers to do it for them.

The beat-the-market puzzle

Why don’t beat-the-market investors abandon their game and join index investors? One part of the answer is easy. While average beat-the-market investors cannot beat the market, some beat-the-market investors are above average. Professional investors, such as mutual fund and hedge fund managers, regularly beat the market. Stocks bought by beat-the-market mutual fund managers had higher returns than stocks sold by them. And hedge fund managers are famous for the billion-dollar paychecks they earn by beating the market. But investors in beat-the-market mutual funds trail investors in index funds because the costs of beat-the-market mutual funds detract from the returns passed on to investors more than managers add to them. Hedge funds are riskier than investors believe and the returns they pass on to investors are lower than investors believe.

Highly intelligent investors might be able to beat the market, but their success is far from assured because intelligent investors are not always wise. Harvard staff members are intelligent and so are Harvard undergraduate students with SAT scores in the 99th percentile as are Wharton MBA students with SAT scores at the 98th percentile. Staff and students received information about past performance and fees of index funds that track the S&P 500 Index. But the information about the funds varied by the dates when the funds were established and the dates when the funds’ prospectuses were published.

Wise investors faced with a choice among index funds following the S&P 500 Index choose the index fund with the lowest fees since these index funds are otherwise as identical as identical cereal boxes. But nine out of ten staff and college students chose index funds with higher fees and so did eight out of ten MBA students. Staff and students chased returns instead, choosing funds with the highest historical returns, apparently assuming that these offer returns higher than risks.

Insiders Deepen the Beat-the-Market Puzzle

Some investors have access to inside information, such as information about mergers being negotiated or disappointing earnings about to be revealed. Investors with inside information include corporate executives and investors with links to executives, including investment bankers and hedge fund managers. Members of Congress have inside information as well. Only one-third of American senators bought or sold stocks in any one year during the boom years of the 1990s but trading senators did very well. While corporate insiders beat the market by six percentage points each year on average, trading senators beat it by 12 percentage points. “I don’t think you need much of an imagination to realize that they’re in the know,” said Alan Ziobrowski, one of the authors of the study.

The success of insiders in the beat-the-market game only deepens its puzzle. Insiders fill their investment market ladles with above-average proportions of fat returns, while index investors fill their ladles with average proportions of fat returns. This leaves below-average proportions of fat returns in the ladles of outsiders in the beat-the-market game, even if we set aside the cost of playing the game.

A two-part solution to the beat-the-market puzzle

Why don’t outside investors quit the beat-the-market game? Why do investors search for money managers who would bring them ladles of beat-the-market returns even after managers have scooped expenses and compensation from the ladles? One part of the answer is in cognitive errors and emotions which mislead us into thinking and feeling that we or our managers can easily beat the market. The other part is in what we really want from our investments, including our desire to play the investment game and win.

Framing errors are some of the cognitive errors which mislead us into thinking that beating the market is easy. In particular, we fail to frame the investment market as a vat of investment stew where relatively high returns for one investor imply relatively low returns for another. You might object, noting that there are many investment vats rather than one. Some investment vats, such as the private equities vat, might have more fat returns in them than the vat of public equities. Private equity vats, unlike public equities vats, can be consumed only by large investors, undisturbed by hordes of small investors. Yet investors in private equities are far from assured that their managers would share the fat. Tom Perkins, a wealthy manager of a venture capital, tells about Harry, one of his investors, who asked him how he can live with the risk of his investments. “Well, Harry,” laughed Perkins, “it’s your money!”

Emotions join cognitive errors in persuading investors that beating the market is easy. Individual investors are often unrealistically optimistic, but they are regularly joined by professional investors who are flattered as sophisticated players just before they are fleeced. Lloyd Blankfein, the chief of Goldman Sachs, described investors who lost to Goldman at the mortgage securities game as sophisticated investors. But Phil Angelides, who questioned Blankfein at the Financial Crisis Inquiry Commission, said: “Well, I’m just going to be blunt with you. It sounds to me a little bit like selling a car with faulty brakes, and then buying an insurance policy on the buyer of those cars, the pension funds who have the life savings of police officers, teachers.” Jeff Macke, an investment advisor, elaborated: “Of course [Goldman Sachs traders] know more than the other guys,” he said to Paul Solman of PBS’ Newshour. And, if they’re selling it, well, you probably don’t want to be a buyer.” Macke failed to persuade Solman. “But pension funds don’t bring in the math whizzes, the quants, the people that Goldman Sachs has,” said Solman, “They’re no match for Goldman Sachs’ salespeople or traders.” Macke was ready when Solman was done. “Generally speaking, they aren’t,” said Macke. “So, what is a pension fund doing involved in these securities?” Unrealistic optimism is a likely answer. Pension fund managers believed that they had a realistic chance to win their game when, in truth, they were unrealistically optimistic.

What investors really want

J.H.B., the anonymous author of a 1930 book, Watch Your Margin: An Insider Looks at Wall Street, is speaking with W. E. Woodward, his friend:

“Do you know why people go into stock speculation?” asked J.H.B.

“To make money,” answered Woodward.

“Not at all,” said J.H.B., “They go in for the pleasure of getting something for nothing….What they want is a thrill. That is why we…drink bootleg whisky, and kiss the girls, and take new jobs. We want thrills. It’s perfectly human, but Wall Street is a poor place to look for thrills, for the simple reason that thrills in Wall Street are very expensive.”

J.H.B. was speaking in 1930, when Prohibition was the law, and whisky was bootlegged. The world has changed greatly since then, but our wants remain the same. Woodward is not entirely wrong. We do want to make money from investing and speculating. But J.H.B. is surely right. We want pleasure from investing and speculating, and we want thrills from playing the beat-the-market game and winning it. Wall Street is still a poor place to look for thrills and Wall Street thrills remain expensive, but we are willing to pay the price.

Investments offer three kinds of benefits: utilitarian, expressive, and emotional, and we face tradeoffs as we choose among them. The utilitarian benefits of investments are in what they do for our pocketbooks. The expressive benefits of investments are in what they convey to us and to others about our values, tastes, and status. Some express their values by investing in companies that treat their employees well. Others express their status by investing in hedge funds. And the emotional benefits of investments are in how they make us feel. Bonds make us feel secure and stocks give us hope.

Profits are the utilitarian benefits of winning the beat-the-market game, and cognitive errors and emotions mislead us into thinking that winning is easy. But we are also drawn into the game by the promise of expressive and emotional benefits. Indeed, we are willing to forego the utilitarian benefits of profits for the expressive and emotional benefits of playing the beat-the-market game and hoping to win that game.

Dutch investors care about the expressive and emotional benefits of investing more than they care about its utilitarian benefits. They tend to agree with the statement “I invest because I like to analyze problems, look for new constructions, and learn” and the statement “I invest because it is a nice free-time activity” more than they agreed with the statement “I invest because I want to safeguard my retirement.” German investors who find investing enjoyable trade twice as much as other investors. And a quarter of American investors buy stocks as a hobby or because it is something they enjoy.

Mutual Funds magazine interviewed Charles Schwab, the founder of the investment company bearing his name. Schwab said: “If you get… an S&P Index return, 11% or 12% probably compounded for 10, 15, 20 years, you’ll be in the 85th percentile of performance. Why would you screw it up?”

The interviewer went on to ask Schwab why he thought people invested in actively managed funds at all. “It’s fun to play around,” answered Schwab. “People love doing that, they love to find winners… it’s human nature to try to select the right horse. It’s fun. There’s much more sport to it than just buying an index fund.”

It is often hard to distinguish facts from cognitive errors and even harder to distinguish cognitive errors from wants of expressive and emotional benefits. We should empathize with fellow investors who do not share our wants. Some of us are passionate players of the investment game, willing to pay commissions for trades, subscriptions for newsletters that promise to foresee the market, and fees for money managers that promise to beat it. I empathize with their passions even if I don’t share them. Yet I see no benefit in cognitive errors and emotions that mislead us into sacrificing utilitarian benefits for no benefits at all. No benefit comes from playing the beat-the-market game because we fail to understand that it is difficult to win. And no benefit comes from failing to make wise choices among utilitarian, expressive, and emotional benefits. We can increase the sum of our benefits if we understand our investment wants, overcome our cognitive errors and misleading emotions, weigh the tradeoffs between benefits, and choose wisely.

Financial Advisors are Financial Physicians

September 16, 2010 Leave a comment

Good financial advisers are good financial physicians. Good advisors posses the knowledge of finance, as good physicians possess knowledge of medicine, and good advisors add to it the skills of good physicians: asking, listening, empathizing, educating, and prescribing.

Physicians face “non-complying” patients who do not take their prescribed medicine as instructed, and financial advisors face non-complying clients who imperil their future by spending too much in the present. Compelling clients to comply is a difficult task when clients are young athletes or actors. ”These kids are making serious money,” said Scott Feinstein, a financial advisor. ”They don’t realize the pressure that friends and family will put on them. They don’t have the maturity to say no.” One young client called to say that he wanted to buy a $35,000 watch. “What time does it say?” asked Feinstein. “Ten minutes after 3,” answered the client.”Mine says 10 after 3 too, and it cost me 60 bucks,” said Feinstein. “Put the watch down.”

Larry Ellison, the head of the Oracle Corporation, is one of the richest men in the world and a winner of America’s Cup sailing competition. But the life of his financial advisor is difficult. Documents in a trial revealed that Ellison lives well. His annual “lifestyle” expenses amount to $20 million. A villa in Japan costs $25 million, a new yacht costs $194 million, and preparations for America’s Cup cost $80 million. The documents include emails to Ellison from his financial advisor. One email said “I know this e-mail may/will depress you. However, I believe it’s my job to address issues you’d prefer not to confront. You told me years ago that it’s OK to raise the “diversification issue” with you quarterly….Well, I’m doing so. View this as a call to arms.”

Fees come between financial advisors and their clients as they come between physicians and their patients. “I have a million dollars in my portfolio,” thinks a client. “I don’t mind paying a fee for the management of stocks. Stocks are complicated and I cannot manage them on my own. But the management of bonds is easy and cash needs no management at all. Why am I paying you a fee for these?” Financial advisers hope that clients would understand the value of their services and the fairness of their fees, yet fees are difficult to discuss because clients regularly misperceive the value of the services of financial advisors.

Imagine that you are seeing a physician because your stomach hurts. The physician asks many questions, examines your body, provides a diagnosis and concludes with education and advice. The examination, diagnosis, and education are free, says the physician. All you have to pay is the price of the pill you received. That would be $200, please.

Financial advisers act regularly as the physician in this story. Financial advisors frame themselves as investment managers, providers of “beat-the-market” pills, when they are, in truth, mostly investor managers, professionals who examine the financial resources and goals of investors, diagnose deficiencies, and educate investors about financial health.

Financial advisors are not capricious as they frame themselves as managers of investments when, in truth, they are mostly managers of investors. They merely respond to the perceptions of investors. They do so by framing fees for managing investors as fees for managing investments. “12b-1 fees” are one example. The fees were originally designed to help mutual fund companies attract new investors and eventually save investors money as funds grow and their costs decline. Yet the fees go to financial advisors who recommended the funds to their investors, and payment to advisors can extend into decades, long after money was placed into the funds. Mary Schapiro, the chairwoman of the Securities and Exchange Commission, is critical of 12b-1 fees. “Despite paying billions of dollars, many investors do not understand what 12b-1 fees are, and it’s likely that some don’t even know that these fees are being deducted from their funds or who they are ultimately compensating.” The S.E.C. is drafting new rules “designed to enhance clarity, fairness and competition when investors buy mutual funds.” Yet Robert Kurucza, partner in a law firm serving mutual fund companies, noted the downside of the proposed SEC. rule. 12b-1 fees compensate financial advisors for investment advice they continue to provide decades after they have placed clients into funds. Decreased compensation is likely to decrease advice.

Are Stocks like iPods?

September 8, 2010 Leave a comment

The author of recent Buttonwood column in The Economist begins by telling us that “The demand for financial assets is not like the demand for iPods.”  He or she notes that the desire for products such as iPods “may be driven by fashion or a desire to enhance our status.” In contrast, “Financial assets appeal for one reason only: their ability to enhance, or conserve, the buyer’s wealth.” Yet the author contradicts this distinction between iPod and financial assets in the next sentence, “There is nothing that induces a change in attitude as seeing a friend get rich.”

In truth, financial assets are very much like iPods. Pension fund managers were swept into private equity investments by fashion as much as by the prospect of profits. Who among pension fund managers would want to wear public-equity suits when the managers of the endowments of Yale and Harvard wear private-equity suits? And wealthy individual investors are drawn into hedge funds because they let them brag about their wealth without appearing to brag. “I’m into hedge funds,” they say to fellow dinner party guests, hinting that their wealth is in the millions. In contrast, “I’m into mutual funds” says that we have managed to scrape together the $3,000 minimum investment. Desire for status ensnared Bernard Madoff’s investors as much as desire for profits.

Moreover, what are profits for? We want the joy of being envied by our friends for getting rich rather than the sorrow of envying rich friends. We want to be number one and beat the market. We want to feel pride when our investments bring gains and avoid regret when they bring losses. We want the sophistication and status of hedge funds and the virtue and warm glow of socially responsible funds. We want to leave a legacy for our children when we are gone. And we want to leave nothing for the taxman.

Financial services companies understand well that financial assets are like iPods and advertize them accordingly. It is time for the rest of us to catch up.

The BP disaster of socially responsible investing

August 19, 2010 Leave a comment

Clearing the waters of BP’s oil will take years but we should not take years to clear the waters of socially responsible investing. BP’s stock was held by many socially responsible mutual funds before the April 2010 spill, including Pax World which professes sustainable investing. Pax cleansed itself of BP after the spill, selling its shares. The Dow Jones Sustainability Indexes (DJSI) branded BP “Sustainability Leader” in the years before the spill and wrote that “BP is leading its peers in corporate sustainability and is committed to shaping the oil and gas industry in the social and environmental aspects of business…Eco-efficiency indicators show that BP delivers well on its lower carbon growth strategy by increasing production whilst stabilizing greenhouse gas emissions.”  DJSI cleansed itself of BP by expelling it from its indexes after the spill, writing that “The extent of the oil-spill catastrophe in the Gulf of Mexico and its foreseeable long-term effects on the environment and the local population – in addition to the economic effects and the long-term damage to the reputation of the company – were included in the analysis leading up to BP’s removal.”

The origins of the social responsibility investment movements are in values, most often rooted in religion. Weapons and slavery offended the religious tenets of the Quakers who settled North America, and the Quakers refused to invest in them.  We know the screens used by the Quakers as “negative screens,” aimed at excluding companies that offend particular values of investors without regard to the cost of such exclusion. The original socially responsible investors were modest in their expectations from such investments. The provost of a Quaker college was asked why his college does not invest in manufacturers of armaments. Did the college’s board of trustees think it was going to stop the armament building? “No,” he responded, “our board isn’t out to change the world. We’re seeking oneness between ourselves and our Lord.”

Values differ and negative screens vary along with them. The Amana funds screen out interest-paying investments, such as bonds, because they violate the Islamic prohibition on interest or riba. The Ave Maria Catholic Values fund screens out stocks of companies associated with contraceptives, abortions, or benefits to unmarried partners of employees. Ave Maria disposed of the stock of the Eli Lilly pharmaceutical company when it began offering benefits to unmarried partners of its employees.  Yet Eli Lilly would not have been excluded by Meyers Pride Value Fund which appealed to investors eager for inclusive policies toward gays and lesbians.

Socially responsible investing with negative screens is easy. We can exclude stocks of tobacco, alcohol, or gambling. We can even exclude all three.  But complications arise when positive screens augment negative ones. Positive screens confer preferences on companies with positive characteristics, such as good employee relations, solid environmental records, or strong corporate governance. But positive screen open the door to critics. Paul Hawken, the co-founder of Smith & Hawken, criticized the Domini fund for straying away from purity by including in its portfolio companies such as McDonald’s, but Amy Domini defended her inclusion of McDonald’s as a good choice, even if an imperfect one. “I personally may prefer slow food to fast food.  I personally prefer the ambiance of organic over non-organic.  But I don’t have a mandate from the public to avoid fast food… When I look at McDonald’s versus [other companies in] the fast-food industry, I see them on a path toward human dignity and environmental sustainability.  I can live with myself for investing in McDonald’s.”

It is easy to empathize with Amy Domini. After all, we would have no friends if we insisted on associating only with perfect ones. Indeed, we would not have us as our own friends if we were to demand perfection. Corporations are no more perfect than people. Anadarko Petroleum had a very low overall score on social responsibility by the criteria of community, corporate governance, diversity, employee relations, environment, human rights, and products. Xerox had a very high overall score and so did IBM. Yet Anadarko’s score on employee relations was better than Xerox’s and its score on corporate governance was better than IBM’s. Socially responsibly funds cannot choose perfect companies because perfect companies do not exist. Instead, they choose good companies. Yet people perceive the selection of a company into socially responsible funds as a ‘perfect company seal’ and stand ready to ridicule funds when one their stocks, such as BP, turns out to be less than perfect.

The socially responsible community can free itself from its bind by returning to its negative screens origins, abandoning positive screens. A mutual fund which includes BP because it has a solid environmental record will be embarrassed by news that BP is responsible for an oil spill, but a mutual fund which excludes Altria because it produces cigarettes would never be embarrassed by news that  news that Altria also has good employee relations or high stock returns.

We can create a suite of low-cost index funds with negative screens appealing to particular groups of investors. One fund might exclude interest paying companies, another might excludes companies producing contraceptives, yet another might exclude companies producing tobacco. Successful funds will combine exclusions that appeal to large enough investors segments. A fund that excludes tobacco, alcohol and gambling might succeed, but one that excludes both alcohol and contraceptives might not. Socially responsible investors would save a lot of money with such low-cost index funds, money they can use to change the world.