Great advice from Warren Buffett. He spoke to students at UTexas at Austin business school and one of the students, Dang Le, posted notes of the discussion online. The internet is great.
On diversification:
Great advice. Warren Buffett uses great concentration (little diversification) but you are not Warren Buffett.
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Getting turned down by HBS [Harvard Business School] was one of the best things that could have happened to me, bad luck can turn out to be good.
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We did an informal office survey by looking at the total tax footprint versus the total income. I earned 46 million and paid a tax rate of 17.5%. My rate was the lowest, the average was 33%, and my cleaning lady paid 40%. The system is tilted towards the rich. The Forbes 400 total net worth has gone from 220 billion to 1.54 trillion, an increase of 7-to-1. You see in legislature that there is lobbying carried on by the powerful over issues such as the estate tax and carried interest for private equity investments. We need to flatten income and payroll taxes, and those making under $30,000 shouldn’t be bothered.
It is hard to beat reading Warren Buffet’s ideas on investing and economics.
Related: Buffett on Taxes – The Berkshire Hathaway Meeting 2007 – Buffett’s 2006 Letter to Shareholders – Warren Buffett’s 2004 Annual Report – books on investing
Options are a tool that investors can use within their portfolio in various ways. They can be used to speculate and they can be used to provide a bit of extra income (with the cost of potentially losing big gains). Mainly they are for more sophisticated investors. Form the Curious Cat Investing Glossary – Stock Options:
For example, if you own 100 shares of Cisco you could sell a covered call option giving someone the right to buy your shares at a specific price by a certain date. So, for example, they pay you $200 for the right to buy you 100 shares at $1 more than it is selling at right now anytime in the next 2 months. They might chose to do so, in order to leverage their investment as it only cost them $200 to benefit from the rise of 100 shares of Cisco. Of course, if it doesn’t go up in 2 months you benefit because you get to keep the cash and your stock.
Selling covered call options allows the investor to earn a bit of extra money but they will lose out if the stock shoots up as then the investor that bought the option can buy your shares at the agreed to price even if it now is $5 a share more. Read more on options including naked puts, naked calls…
Employees may receive options to buy company stock at a Company’s stock at a set price for several years in the future. In general, those options cannot be traded on the market (the employee must keep them or exercise them – pay the strike price to purchase the stock). Why are options such a nice perk if you must pay the strike price? Because they are often good for years and the strike price is set at today’s price (though this doesn’t have to be the case). On the whole stocks go up over time so most of the time the stock will increase in value over the years and the options to buy it at the price several years ago is very valuable. For startup companies, there is often a high likelihood of going out of business in which case the options are worthless, but if the company is successful the options can be worth a great deal.
Related: Hedging an investment – Books on Speculation with Investment – Google to Let Workers Sell Options Online
The Dow Jones Industrial Average is a widely followed stock market measure of 30 stocks. I think the S&P 500 is a better measure to pay attention to, but the DJIA continues to be used and it has some historical interest. Today 2 stocks (Altria and Honeywell) were removed and two new stocks we added (Bank of America and Chevron). They were the two largest cap USA based companies (other than Berkshire Hathaway, Warren Buffett’s company) not in the DJIA. Bank of America has a market capitalization of $186 billion and Chevron’s is $165 billion. Google’s market cap is $160 billion.
I mentioned before I would replace GM with Toyota (though that might violate one of their traditions). I also would have added Google, with this update, rather than Bank of America (Citigroup, JPMorgan Chase, American Express and AIG are all financial industry companies and GE has huge financing components also).
The current DJIA stocks:
| Stock | Market Capitalization | Year Added |
|---|---|---|
| Exxon (XOM) | $438 Billion | 1928 |
| GE | 337 | 1896 |
| Microsoft | 260 | 1999 |
| AT&T (T) | 217 | 1999 |
| Proctor & Gamble (PG) | 200 | 1932 |
| Walmart (WMT) | 195 | 1997 |
| Bank of America (BAC) | 186 | 2007 |
| Johnson & Johnson (JNJ) | 178 | 1997 |
| Chevron (CVX) | 165 | 2007 |
| Pfizer (PFE) | 150 | 2004 |
| JPMorgan Chase (JPM) | 145 | 1991 |
| IBM | 145 | 1979 |
Jimmy Rodgers is one of the most successful investors ever. He and George Soros were partners during the amazing run with Quantum Fund (up over 4000% in 10 years) and he has been successful since. This interview provides his current thoughts – ‘It’s going to be much worse’
Rogers looks at the Fed’s willingness to add liquidity to an already inflationary environment and sees the history of the 1970s repeating itself. Does that mean stagflation? “It is a real danger and, in fact, a probability.”
One smart investor, no matter how smart, will have many wrong guesses about the future. Still he is someone worth listening to.
Related: Investment Biker – Charge It to My Kids – Buffett’s 2007 Letter to Shareholders
I originally setup the 10 stocks for 10 years portfolio in April of 2005. With Microsoft’s move to buy Yahoo I have sold Yahoo and replaced it with Danaher, a stock I have been considering for this portfolio from the start. I have also sold some Templeton Dragon Fund since the last update, as I indicated I would. Unfortunately, Petro China just missed reaching the price I had set to sell a portion of the position before falling dramatically (the gain at the last update was 298% now it is “only” 132%).
The performance since the last update has not been good but that isn’t much of a concern to me. The long term prospects remain very good for this portfolio, I believe. At this time the stocks in the sleep well portfolio in order of returns -
| Stock | Current Return | % of sleep well portfolio now | % of the portfolio if I were buying today | |
|---|---|---|---|---|
| Google – GOOG | 137% | 16% | 14% | |
| PetroChina – PTR | 132% | 8% | 8% | |
| Amazon – AMZN | 106% | 7% | 6% | |
| Templeton Dragon Fund – TDF | 85% | 10% | 10% | |
| Toyota – TM | 44% | 10% | 10% | |
| Templeton Emerging Market Fund – EMF | 39% | 3.5% | 4% | |
| Cisco – CSCO | 32% | 6.5% | 8% | |
| Tesco – TSCDY | 9% | 0% | 10% | |
| Danaher – DHR | -4% | 4.5% | 8% | |
| Intel – INTC | -4% | 4% | 6% | |
| Pfizer – PFE | -11% | 6% | 8% | |
| Dell | -40% | 6% | 6% |
The Yahoo position was closed at an 11% loss. It was the second of the original 10 stocks to be effectively removed due to changes in ownership. At this point I am most positive on Google, Petro China, Toyota, Templeton Dragon Fund and Tesco. I am wary of Dell – they seem to be moving in the wrong direction, but I am willing to give them longer to improve.
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Shorting is selling first and buying later. The idea is to sell high and then buy low. It can be a bit risky. Since there is no cap on how high a stock can go you can loose more than you invest. Still, as part of a portfolio, using short positions can possibly be a useful strategy at times. You can use shorting to do things like hedge against existing gains (without selling those positions and incurring taxes).
Business Week had an article on Shorting for the 21st Century using inverse funds. These are mutual funds that are structured to behave as short positions – that is to go up if the target portfolio goes down in value. One advantage of using these funds (at this time they are all ETFs – exchange traded funds, I believe) is that you losses are limited to your investment. You do incur additional expenses charged by the fund however.
Experienced investors may find value in exploring the use of inverse funds. Some funds are engineered to move 1 for 1 with the market (that is the fund increases 1% for every 1% decline in the index) and some are engineered to move up 2% for every 1% decline – which also means they go down 2% for every 1% gain in the actual index. Index funds can also be used in retirement accounts (where shorting is not allowed).
Most investors need much more experience and to do a great deal of reading before they would be ready to try these funds. Since markets general go up over time and timing the market is extremely difficult it is unlikely novice investors will succeed in trying to guess right. The usefulness is mainly as a hedging strategy when the investors has determined the portfolio could benefit from a partial hedge.
Related: Risk and reward of exposure – investment speculation books – Ignorance of Many Mortgage Holders – The Greatest Wall Street Danger of All? You – How Not to Convert Equity
It is not your parents world. In case you hadn’t noticed the economic power in the world has been changing quickly. Many are missing the magnitude of these changes. One visible example is explored by the Economist in Emerging-market Multinationals:
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By 2006 foreign direct investment (including mergers and acquisitions) from developing economies had reached $174 billion, 14% of the world’s total, giving such countries a 13% share (worth $1.6 trillion) of the stock of global FDI. In 1990 emerging economies accounted for just 5% of the flow and 8% of the stock.
This is just one visible sign of shifting economic power. And it shows no sign of slowing down. Our 12 Stocks for 10 Years portfolio is heavily invested for overseas growth. Close to 20% directly in emerging markets (through Templeton funds). PetroChina, Google, Toyota and Tesco all are very well positioned to grow quickly in emerging markets. And other stocks are likely do do well too – I am not clear on how well Pfizer, Amazon and Dell are positioned at this time.
Emerging stock markets will continue to be very volatile I believe. However looking decades out and at a pool of 20 countries it is hard to imagine they won’t do very well: China, Singapore, Mexico, India, Thailand, Brazil, South Africa, Vietnam, etc.
Related: Growing Size of non-USA Economies – Why Investing is Safer Overseas – South Korea To Invest $22 Billion in Overseas Energy Projects – Changing Economic Clout and Science Research
Goldman Sachs Rakes In Profit in Credit Crisis
But for Goldman’s chief executive, Lloyd C. Blankfein, this is turning out to be a very good year. He will surely earn more than the $54.3 million he made last year. If he gets a 20 percent raise – in line with the growth of Goldman’s compensation pool – he will take home at least $65 million. Some expect his pay, which is directly tied to the firm’s performance, to climb as high as $75 million.
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This contrast in performance has been hard for competitors to swallow. The bank that seems to have a hand in so many deals and products and regions made more money in the boom and, at least so far, has managed to keep making money through the bust. In turn, Goldman’s stock has significantly outperformed its peers. At the end of last week it was up about 13 percent for the year, compared with a drop of almost 14 percent for the XBD, the broker-dealer index that includes the leading Wall Street banks. Merrill Lynch, Bear Stearns and Citigroup are down almost 40 percent this year.
Interesting story with at least a couple of good points to remember. First it does make a difference what company you chose. There are many market conditions where anyone can make money, but those conditions will change. Also look at the type of pay these people get. The CEO’s take huge risks to possibly get even more obscenely paid. It is absolutely no surprise to me the companies write off hundreds of millions in losses. It happens constantly. Executives are paid ludicrous salaries. In order to try and justify them they take huge risks. When the gambles pay off they pocket even huger bonuses. When they fail they pocket huge severance packages. Who wouldn’t bet the future of the company for that kind of money. Some people wouldn’t but not many that fight there way to the top of the corporate world. Right now it is banks writing off hundreds of millions but just watch every year companies do it. It is not some isolated rare event – it is predictable, common happening.
And third the financal markets are much riskier than people think. Combine that with leverage and you get huge swings – huge profits and huge losses. I suppose some company may be able to guess just write about when to leverage and make the changes at just the right time – but I doubt it. A few great investors might be able too much of the time.
I originally setup the 10 stocks for 10 years portfolio in April of 2005. At this time the stocks in the sleep well portfolio in order of returns -
| Stock | Current Return | % of sleep well portfolio now | % of the portfolio if I were buying today | |
|---|---|---|---|---|
| PetroChina – PTR | 298% | 11% | 7% | |
| Google – GOOG | 210% | 17% | 13% | |
| Amazon – AMZN | 173% | 7.5% | 7% | |
| Templeton Dragon Fund – TDF | 116% | 17% | 13% | |
| Cisco – CSCO | 67% | 6.5% | 8% | |
| Templeton Emerging Market Fund – EMF | 67% | 3.5% | 5% | |
| Toyota – TM | 48% | 7% | 10% | |
| Tesco – TSCDY | 25% | 0% | 10% | |
| Intel – INTC | 18% | 4% | 8% | |
| Yahoo – YHOO | -2% | 4% | 5% | |
| Pfizer – PFE | -9% | 5% | 8% | |
| Dell | -16% | 7% | 10% |
In order to track performance I setup a marketocracy portfolio but had to make some adjustment to comply with the diversification rules. In December of 2006 I announced a new 11 stocks for the next 10 years (9 are the same, I dropped First Data Corporation, which had split into 2 companies and added Tesco and Yahoo). Earlier this year I added Templeton Emerging Market Fund (EMF) and reduced the TDF portion. Tesco also pays a dividend which I am not including in the calculation – that is one reason marketocracy is so nice it keeps track of all those details for you.
I have orders in to sell some of the PTR and TDF if the prices rises a bit more. In the marketocracy portfolio I have several smaller positions. I do this to comply with marketocracy’s diversity rules – I also have about 8% in cash (they still won’t let me buy Tesco). Google, PetroChina and Amazon have had an incredible few months. I am getting a little tired of Yahoo’s failure to deliver. I also think Amazon’s price has gotten a bit ahead of the performance but I think the performance is great and the long term looks strong.
The current marketocracy calculated annualized rate or return (which excludes Tesco – reducing the return, and has a significant cash position reducing the return) is 20% (the S&P 500 annualized return for the period is 13.4% – in addition to the other reductions in the return, marketocracy subtracts the equivalent of 2% of assets annually to simulate management fees – as though the portfolio were a mutual fund). View the current marketocracy Sleep Well portfolio page.
Related: 12 Stocks for 10 Years Update (Jun 2007) – 10 Stocks for 10 Years Update (Feb 2007) – 10 Stocks for 10 Years Update (Dec 2005)
The quantitative schools of investing rely on very high powered mathematics (often drawing on physics and engineering graduate students). They tread on very dangerous ground (often engaging in complex and highly leveraged speculation) and make errors in assumptions about the market conditions upon which the mathematical models they use to invest are based. Fat Tails and Limitations of Normal Distributions describes one common mistake:
Stock market data clearly shows that a normal distribution does not provide a good model of the market. Not every system is defined by a normal distribution – it is common for distributions to be close to normal but there is no reason any system need be. Many statistical tools have as an underlying assumption that the system in question is a normal distribution (therefore to use the tools you need to determine if the system can be classified that way – if not some tools can’t be used).
Crazy as it seems, very smart people continually forget that the markets often experience panics, euphoria, behave in ways that models do not predict, seize up and fail to function… Against the Gods by Peter Bernstein provides a good picture of the chaotic nature of financial market risks. A good book on an example of a mathematical model failure, Long Term Capital Management: When Genius Failed. Another excellent book on financial market chaos is: Manias, Panics, and Crashes: A History of Financial Crises.
I keep thinking people will learn but so far the faith in numbers seems to outweigh the past examples of overconfident failures.
Related: Data doesn’t lie but you can be fooled – investment risk – Statistics for Experimenters