Monday, December 30, 2013

Duhigg, The Power of Habit

A new year is right around the corner, and with it will come the usual host of resolutions—sadly, rarely kept. To be more precise, more than 40% of Americans make New Year’s resolutions and just 8% achieve their goals. Sometimes the goals they set are too daunting, sometimes too vague. And, perhaps the biggest problem with the whole resolution business is that people focus on goals rather than processes.

In 2012 Charles Duhigg, a Pulitzer Prize-winning journalist for The New York Times, wrote The Power of Habit, which spent 62 weeks on the paper’s best seller lists and was named one of the best books of the year by The Wall Street Journal and the Financial Times. It is now being reissued with an afterword by the author.

I reviewed the book when it first came out and thought I would write a new post now that I have the reissued edition. But then I reread my original piece and decided that I probably couldn’t improve on it. So instead I’ll republish it here.

* * *

“All our life, so far as it has definite form, is but a mass of habits,” William James wrote in 1892. Well, that might be a bit of an overstatement: a researcher in 2006 knocked that “mass” down to “over 40 percent.” Whatever the percentage, we are creatures of habit. In The Power of Habit: Why We Do What We Do and How to Change It (Random House, 2012) Charles Duhigg explores the work that neurologists, psychologists, sociologists, and marketers have done over the past two decades to figure out how habits work and how they change. It’s a fascinating tale.

So what is a habit anyway and why are habits so important? After we figure out a sequence of actions and practice it sufficiently (Duhigg uses the example of backing out of the driveway), our brain converts that sequence into an automatic routine, a habit, and stores it in our basal ganglia. We no longer have to think about backing out of the driveway; our brain is free to think about something else or to quiet itself. “Habits, scientists say, emerge because the brain is constantly looking for ways to save effort. Left to its own devices, the brain will try to make almost any routine into a habit, because habits allow our minds to ramp down more often.” The brain becomes more efficient; we can devote our mental energy to “inventing spears, irrigation systems, and, eventually, airplanes and video games.” (p. 28)

Most habits are innocuous enough; they don’t make a major difference in our lives. But some habits do, and not always for the better. Moreover, no matter what we do, those bad habits never really disappear; “they’re encoded into the structures of our brain.” The good news is that although old habits never die, they can be “ignored, changed, or replaced.” (pp. 29-30) How? Quite simply, at least in theory: by changing the habit loop of cue, routine, reward.

Ad men figured this out early on. Claude Hopkins, for instance, was responsible for making Pepsodent a sensation at a time when hardly any Americans brushed their teeth; “when the government started drafting men for World War I, so many recruits had rotting teeth that officials said poor dental hygiene was a national security risk.” (p. 39) A decade after the first Pepsodent campaign, more than half the American population brushed their teeth daily and flashed that Pepsodent smile. And they presumably believed that they no longer had that dingy film on their teeth that they could feel when they ran their tongue across their teeth, the cue that Hopkins devised to entice them to brush in the first place. (In fact, the toothpaste did nothing to remove the film, but then ads have never been known for their truthfulness.) So a simple habit loop was formed: cue (tooth film), routine (brushing), reward (beautiful teeth).

What if you already have a habit that you want to change? In that case, “you must keep the old cue, and deliver the old reward, but insert a new routine.” (p. 60) As one of the developers of habit reversal training said, “It seems ridiculously simple, but once you’re aware of how your habit works, once you recognize the cues and rewards, you’re halfway to changing it.” (p. 70) Some people need a support group to reinforce their belief in change, others are fine on their own.

Changing some habits makes very little impact on other parts of a person’s life; keystone habits, by contrast, have ripple effects. They “start a process that, over time, transforms everything.” (p. 87) “They help other habits to flourish by creating new structures, and they establish cultures where change becomes contagious.” (p. 94) Duhigg recalls Paul O’Neill’s fixation with safety when he became CEO of the troubled Alcoa and how “O’Neill’s plan for getting to zero injuries entailed the most radical realignment in Alcoa’s history.” (p. 91)

Keystone habits, which admittedly are difficult to identify and put into practice, create widespread changes because of the principle of small wins. “A huge body of research has shown that small wins have enormous power, an influence disproportionate to the accomplishments of the victories themselves. ‘Small wins are a steady application of a small advantage,’ one Cornell professor wrote in 1984. ‘Once a small win has been accomplished, forces are set in motion that favor another small win.’ Small wins fuel transformative changes by leveraging tiny advantages into patterns that convince people that bigger achievements are within reach.” (p. 96)

One example of what seems for many people to be a keystone habit is exercising. “Typically, people who exercise start eating better and becoming more productive at work. They smoke less and show more patience with colleagues and family. They use their credit cards less frequently and say they feel less stressed. It’s not completely clear why. But for many people, exercise is a keystone habit that triggers widespread change.” (p. 93)

Duhigg extends his analysis to willpower, how retailers predict (and manipulate) habits, how movements happen, and the neurology of free will. But let me stop here and make a couple of off-the-cuff, not especially profound observations.

Traders often repeat the same mistakes over and over, acting on triggers that have served them poorly time and time again even as they continue to expect a tidy profit as a reward. Not only is this insanity, the problem is that they’ve developed a powerfully destructive habit loop. They need to figure out a new routine—and in this case, I believe, contrary to habit reversal theory, either a new, non-monetary reward or a more probabilistic view of the reward.

Beginning traders sometimes feel compelled to swing a big line, and normally they lose big. Just think how many accounts have been blown out. Small wins are powerful levers (and don’t have the downside risk of using too much leverage). “Levers, not leverage”—it has a nice ring to it!

The Power of Habit is chock full of fascinating information—from Michael Phelps’s training regimen to how Target “targets” pregnant women as potential big-time spenders without seeming intrusive. I thoroughly enjoyed it and learned from it. Who can ask for much more? Now on to that next small win. (If you’re intrigued with this topic, you can follow it up with Peter Sims, Little Bets: How Breakthrough Ideas Emerge from Small Discoveries. I admit I haven’t read it yet.)

Thursday, December 26, 2013

Amazon associates program is back!

As you may recall, for some time my book reviews looked a lot jazzier than they do now. Each review had a picture of the book’s cover, compliments of Amazon. And if you clicked on the picture and actually bought the book, I got a small referral fee—and it cost you nothing extra. Win, win. Then came the brouhaha over Connecticut sales tax and Amazon shut down the associates program in the state. Now it’s back. Actually, it’s been back for some time, but I just found out about its reincarnation.

I’ve never junked up this blog with ads, but I feel differently about the Amazon program. First of all, it improves the look of the blog. Second, I get a few bucks each month if you have a U.S. Amazon account and either buy a book I reviewed by clicking on its image or if you use the search box on the right-hand side bar and buy anything your heart desires from Amazon. It can be a book, a phone or tablet, towels, skis, pet supplies—you name it. Amazon will thank me each month with a small deposit to my checking account. And I will have another incentive to keep on blogging.

Right now Amazon is running a promotion for a 30-day free trial to Amazon Prime. Here’s the link.

Join Amazon Prime - Watch Over 40,000 Movies

Wednesday, December 18, 2013

Faerber, All About Value Investing

I’m not sure why value investing has become such a popular topic. I have reviewed at least half a dozen books on value investing and, to the best of my recollection, not a single one on momentum investing. “Momentum” is a dirty word, associated with burst bubbles, even as it remains a popular strategy with many professional investors. By contrast, value, a concept with an impeccable pedigree, is often touted as an all-seasons strategy, one that doesn’t require keen timing skills and that allows the retail investor to sleep well at night.

Esmé Faerber, a professor of business and accounting at Rosemont College and the author of three previous “All About” investing books, adds to the growing literature with All About Value Investing: The Easy Way to Get Started(McGraw-Hill, 2014). As the subtitle indicates, this book is written for beginners. More experienced value investors should turn to such recent works as Quantitative Value by Gray and Carlisle, The Art of Value Investing by Heins and Tilson, The Manual of Ideas by Mihaljevic, Damodaran’s Investment Valuation, or even his The Little Book of Valuation.

Value investing is neither easy nor mechanical. Faerber takes the reader through the basics: the balance sheet, income statement, and statement of changes in cash. She explains how ratio analysis “uses a company’s financial information to predict whether it will meet its future projections of earnings.” (p. 130) The investor/analyst can use five groups of ratios: liquidity, activity, profitability, leverage, and common-stock related ratios. The value investor also has to assess qualitative factors, such as the company’s competitiveness and the quality of its management.

For those who don’t want to go through this kind of company-by-company analysis, Faerber explains the use of mutual funds, closed-end funds, and ETFs. She rounds out the book with chapters on bonds, preferred stock, and options, rights, and warrants.

All About Value Investing offers a glimpse into a respected style of investing, perhaps enough to whet the reader’s appetite to delve further.

Monday, December 16, 2013

Pike and Gregory, Why Stocks Go Up and Down

William Pike and Patrick Gregory, who have taught investment courses at the college and professional level, have done the would-be retail investor (and even some experienced investors) a great service by writing Why Stocks Go Up and Down, now in its fourth edition. Naturally, the question posed by the book’s title remains unanswered (and fundamentally unanswerable except at the most obvious level of supply and demand). Instead, the authors direct their attention to the various ways a company can raise capital and the metrics that can be used to assess a company’s financial well-being.

This book starts at the very beginning, with the formation of a private company, and explains the ways the company funds itself and some ratios its investors keep an eye on. It then moves on to the IPO process, explaining primary offerings, secondary offerings, public offerings, private placements, and follow-on offerings.

If the company wants to raise additional funds it might consider issuing bonds. The authors ease the reader into this often ill-understood field before proceeding to more advanced topics, such as “call” and “refunding” provisions and covenants. They also describe convertible bonds, preferred stock, convertible preferred stock, and hybrid preferred securities. By the end of this discussion the reader will probably know more about bonds than 75% of retail investors do.

The third part of the book deals with accounting principles necessary to understand a company’s fundamentals. Although the authors explain such concepts as depreciation, cost versus expense, capitalizing assets, and write-offs, their major focus is cash flow. And wisely so, since it is the key metric for many valuational models.

Finally, the authors relate a company’s stock price to its fundamentals, describing a set of commonly used ratios, including price/earnings, price/cash-flow, and price/sales.

Everyone who buys even a single share of stock should be familiar with the material covered in this book. It provides a necessary foundation for becoming an informed investor. Pike and Gregory are to be commended for writing what they describe as “the book you need to understand other investment books.” Or, as I would suggest, the book you need to read (or some of the stuff you need to know) before you commit hard-earned dollars to the markets.

Sunday, December 15, 2013

Best books of 2013

Readers often urge me to highlight books I reviewed over the course of the year that I found particularly worthwhile. It’s a holiday tradition on practically every site that either sells or reviews books. So, despite the fact that putting a book on a “best” list is a subjective and intrinsically flawed process, here goes. This year I have chosen six books, presented here in alphabetical order by author.

Fitschen, Keith. Building Reliable Trading Systems (Wiley)

Gray, Wesley R. and Tobias E. Carlisle. Quantitative Value (Wiley)

Li, Junheng. Tiger Woman on Wall Street (McGraw-Hill)

Mihaljevic, John. The Manual of Ideas (Wiley)

Paul, Jim and Brendan Moynihan. What I Learned Losing a Million Dollars (Columbia University Press)

Weatherall, James Owen. The Physics of Wall Street (Houghton Mifflin Harcourt)

Wednesday, December 11, 2013

Roach, Unbalanced

Stephen Roach, formerly chairman and chief economist of Morgan Stanley Asia and now a senior fellow at Yale, is singularly well equipped to analyze the complex economic relationship between China and the United States. Unbalanced: The Codependency of America and China, forthcoming from Yale University Press, explores the evolution of this relationship, its current fragility, and future opportunities.

Codependency is a psychological term for a relationship disorder, probably most commonly associated with the relationship between an alcoholic and his family and friends. Roach extends it to economics. “The relationship between the U.S. and Chinese economies, with the world’s ultimate consumer locked in a tight embrace with the world’s ultimate producer, exemplifies this syndrome—not just in the cross-border transfer of goods but also in the exchange of financial capital. Two large, dynamic economies, both plagued with unbalanced and unstable tendencies, have become very needy in what they ask and expect of each other. This relationship obviously brings important benefits but there are serious risks. Psychologists warn that codependency ultimately leads to identity crisis, denial of responsibility, and the tendency to blame others for problems. China and the United States manifest most aspects of that mutual pathology.” (p. 250)

Although Roach focuses on codependency, he stresses that “there are no bilateral fixes to multilateral problems.” (p. 127) America’s current account deficit and trade imbalance, for instance, are not “made in China” and hence there is no Chinese “fix” for our economic woes. In 2012 the U.S. “ran deficits with 102 countries—up from 98 in 2011 and 88 in 2010.” (p. 126) China is “the hub of a massive, integrated, pan-regional export machine—in effect, a proxy for a large collection of tightly connected Asian economies that provide low-cost goods to a savings-short U.S. economy. … While China may be the final stop in this chain of production, assembly, and distribution, it is far from the only cog in the global trade machine that the U.S. has come to rely on.” (p. 140)

A theoretical sidebar for those who believe that David Ricardo’s work on comparative advantage and international specialization provides the intellectual underpinning for what Roach calls Globalization 2.0. Roach argues that, although Ricardian trade theory remains a pillar of economic theory and practice, it is not directly relevant to today’s world and that “the simple Ricardian models of exchange between producer and consumer economies [are] largely obsolete.” (p. 117)

Even though the U.S.-Chinese codependency cannot be viewed in isolation, the fact remains that “they suffer similar maladies: they are the most unbalanced major economies in the world today.” And, Roach warns, “no unbalanced economy is ultimately sustainable.” (p. 213) Both countries must undergo structural change. The U.S. should reduce its personal consumption share of GDP (currently at a record high of around 71%); China should reduce its combined share of exports and investments (more than 70% of GDP).

Structural reforms will face stiff resistance in both countries. In China “the national mantra of ‘reforms and opening up’ has been almost exclusively directed at strengthening China’s producer culture.” And the U.S. seems unwilling to stem the excesses of personal spending and false prosperity; consumerism is seen as personifying the American self-image. (p. 216)

Despite the extraordinary difficulties, “rebalancing is the only solution for unstable codependency.” It will “require a coherent framework of action—what might even be called a strategy. China excels at that—America abhors anything that even hints of a plan.” The endgame, as Roach admits, “is anyone’s guess. … [T]he strategic thinking and economic management skills of both the United States and China could ultimately determine whether this transition is both stable and peaceful.” (p. xiii)

Roach offers specific recommendations on how to move toward a stable relationship between the Next China and the Next America. Policy makers should pay heed.

Monday, December 9, 2013

Sander, All About Low Volatility Investing

A 2011 study in the Financial Analysts Journal highlighted, and sought to explain, the seemingly anomalous long-term success of low-volatility and low-beta stock portfolios. The success of these portfolios is anomalous because their high average returns and small drawdowns “run counter to the fundamental principle that risk is compensated with higher expected return.” Over the 41 years between January 1968 and December 2008 a dollar invested in the lowest-volatility portfolio, assuming no transaction costs, increased to $59.55 whereas a dollar invested in the highest-volatility portfolio was worth a mere 58 cents by the end. In real terms, the former produced a gain of $10.12, the latter a loss of more than 90 cents (or 90%). The authors of the study argued that low volatility portfolios outperformed because “exploiting [the anomaly] involves holding stocks with more or less similar long-term returns (which does not help a typical investment manager’s excess returns) but with different risks, which only increases tracking error. So, even though irrational investors happily overpay for high risk and shun low risk, investment managers are generally not incentivized to exploit such mispricing.” And, they concluded, “so long as most of the investing world sticks with standard benchmarks,” the advantage will go to low volatility investors.

Critics will be quick to point out that volatility and risk are not the same. That’s true, of course, but let’s not get tripped up over theoretical distinctions, however important. The fact remains that, for whatever reason—and some would point to the tough uphill climb after large drawdowns, low-volatility low-beta investing has outperformed handily.

Peter Sander’s new book (he has written 39!), All About Low Volatility Investing: The Easy Way to Get Started (McGraw-Hill, 2014), introduces investors to this strategy. He wants it to be accessible to math-phobes and stresses that “informed common sense will help you more than [quantitative models] in making the right decisions.” (p. 84) But the reality is that you can’t write about volatility without describing it statistically. So Sander succumbs even as he maintains that investors need to know concepts and relationships, not formulas. It’s about the thought process, he claims, not the actual measurement.

The second part of the book moves beyond the somewhat tortured “what” of volatility to the “how” of becoming a low volatility investor.

Sander begins at the level of portfolio construction. He suggests building a three-tiered portfolio comprised of foundational, rotational, and opportunistic investments. Low-volatility investments belong to the foundational portion of the portfolio, along with such long-term investments as real estate, trusts, and collectibles. Rotational investments are those that take advantage of business cycles such as sector-specific ETFs. Opportunistic investments/trades include high beta stocks and options. The weightings of these categories of investments will depend on how conservative or aggressive the investor is. A sample tiered portfolio would consist of classic low volatility stocks (30%), low volatility funds (30%), real estate income (10%), inflation hedge (10%), sector funds (5%), inverse/low correlated (5%), strategy funds (5%), and “hot stuff” (5%).

The investor, of course, still has to figure out what stocks and funds to buy to fill out his tiered portfolio. Sander gives some pointers on what to screen for; he suggests that among the core indicators of low volatility are dividends, beta, size, and growth. When all else fails, look at a chart, especially one with Bollinger bands.

Sander’s book is elementary, but for investors intrigued with low volatility investing it’s a decent starting point.

Wednesday, December 4, 2013

Mauldin & Tepper, Code Red

Extraordinary measures for extraordinary circumstances. But have the central banks overplayed their hands? How, and how quickly, will they be able to scale back their operations? As you might surmise from the book’s title—Code Red: How to Protect Your Savings from the Coming Crisis, John Mauldin and Jonathan Tepper are skeptics.

A little more than half of this book is devoted to explaining (and decrying) current policies. The book is written in laymen’s terms. The authors have, as they say, “written Code Red with cab drivers in mind.” (p. 251) Well, that may be a bit of a stretch. But the prose is engaging, so even if you’re familiar with its macroeconomic themes it’s a good, sometimes ghoulishly funny read.

Then comes chapter eight, entitled “What Will Happen When It All Goes Wrong.” “In theory,” the authors write, “the Fed could reverse its Code Red policies in a second. However, the problems with undoing Code Red policies are all political and practical, not technical.” (p. 210) They foresee a scenario in which the Fed becomes technically insolvent as its starts to wind down its Code Red policies; in fact, they “pretty much guarantee” this outcome. (p. 214) The Fed is leveraged some 59-to-1, having borrowed more than $3.24 trillion and with only $55 billion of equity. Since it pays out its net income every year to the U.S. Treasury, it has no built-up equity. Hence the prediction of a technical insolvency. But, the authors ask rhetorically, “if the Fed is borrowing money from the government and not the other way around, how long do you think the Fed could keep its independence?” (p. 215)

They also suggest that the Fed will be forced to pay ever higher rates of interest on the large excess reserves banks are holding. These banks will then lend out the money again, multiplying it 10 times. “Money growth would surge and create very high levels of inflation.” (p. 220)

How should an investor manage through the bubbles, booms, and busts that central banks create? Enter the investor’s old friend, diversification. The chapter on diversification is introduced with a great quotation from Ray Dalio: “He who lives by the crystal ball will eat shattered glass,” perhaps written in connection with Bridgewater’s All-Weather funds. The authors recommend that the investor build his own all-weather portfolio. To help the investor along, they include a chapter on “commodities, gold, and other real assets.”

If as the Fed unwinds its portfolio the investor is confronted with an inflationary environment, he should own stock in companies that have pricing power. These are companies that have, in Warren Buffett ‘s words, moats around them. Types of moats are: intangible assets, the network effect, low-cost producer, high switching costs, and efficient scale. Taking just one example to illustrate each kind of moat, we have: Disney, MasterCard, Walmart, Oracle, and pipelines.

Mauldin is, as he writes, “long on humanity but short government,” (p. 340) a bias that’s evident throughout the book. Despite this bias (or, others would argue, because of it) Code Red is a worthwhile read.

Monday, December 2, 2013

Wasik, Keynes’s Way to Wealth

John Maynard Keynes was not only a renowned economist, he was an investor. He managed his own money as well as that of King’s College, his friends and family, and insurance companies. As John C. Bogle writes in his introduction to the book, “His spectacular success showed not only his passion for making money, but his growing aversion to losing it. As someone who had gained two fortunes through his trading prowess and lost them through his hubris, Keynes is a stellar example of how an investor can learn, fall on his face more than once, and still come out ahead.” (p. xxxiv)

John S. Wasik explores this investing journey in Keynes’s Way to Wealth: Timeless Investment Lessons from the Great Economist (McGraw-Hill, 2014). Let me start with the rewards of the journey: what Keynes did with his wealth. He bought art as well as rare books and manuscripts. The Keynes collection of rare books, bequeathed to King’s College in 1946, is, according to the college’s web site, “especially strong in editions of Hume, Newton and Locke, and in sixteenth and seventeenth century literature. About 1300 books in this collection have been catalogued on the online catalogue. … Keynes’s collection of manuscripts by Newton, Bentham, John Stuart Mill, etc., is housed in the Modern Archive Centre.” A man after my own heart, but with a bigger budget.

Keynes was a speculator. According to his own definition, “The essential characteristic of speculation … is superior knowledge. We do not mean by this the investment’s actual future yield … we mean the expected probability of the yield. The probability depends upon the degree of knowledge in a sense, therefore it’s subjective. If we regard speculation as a reasoned effort to gauge the future from present known data, it may be said to form the reins of all intelligent investing.” (p. 8)

In 1920 he set up an investing syndicate to trade currencies, both long and short. Initially, he was successful, but then in the space of four weeks the syndicate’s entire capital was wiped out. With the help of a “birthday present” from his father and a loan from a financier Keynes got back in the game and by the end of 1922 was able to repay all of his investors and then some. At that point he decided to add even more volatile commodities to his trading portfolio. “When it came to commodities, Keynes was an absolute data wonk. His documenting of commodity price supplies and fluctuations fills nearly 400 pages of Volume 12 of his collected writings.” (p. 26)

His commodities trading seemed to go well for some time, but then came the stock market crash of 1929 and the attendant collapse in demand for commodities. He lost some 80 percent of his net worth.

“Although Keynes was well known for his arrogance and his air of intellectual superiority, the humbling experience of having nearly lost two fortunes changed his thinking on the best way to invest. The macro view of trying to guess where the economy was moving, and to link currency and commodity trades to those hunches, had failed in a big way. His new focus on confidence, sentiment, and psychology made all of his extensive research into prices, supply/demand ratios, and monetary movement seem irrelevant.” (pp. 48-49)

Keynes became a bottom-up investor, holding concentrated positions in companies that he was familiar with and in whose management he “thoroughly believe[d].” (p. 116) He used leverage; from 1929 to 1945 it “amplified his winnings” (and of course his losses as well), “multiplying his net wealth by a factor of 52.” (p. 118)

As for asset allocation, he was a tactical investor. As he wrote in 1938, “the whole art is to vary the emphasis and the center of gravity of one’s portfolio according to circumstances.” (p. 115) But for the most part he now focused on the long-term profitability of companies. His investment philosophy rested on three principles: (1) “a careful selection of a few investments (or a few types of investment) having regard to their cheapness in relation to their probable actual and potential intrinsic value over a period of years ahead and in relation to alternative investments at the time; (2) a steadfast holding of these in fairly large units through thick and thin, perhaps for several years, until they have fulfilled their promise or it is evident that they were purchased on a mistake; (3) a balanced investment position, i.e., a variety of risks in spite of individual holdings being large, and if possible opposed risks (e.g., a holding of gold shares amongst other equities, since they are likely to move in the opposite directions when there are general fluctuations).” (pp. 111-12)

His principles have certainly had lasting power; they underlie some of the most successful investment portfolios today.