Falsehood Recognition Investing

False Analogy

2006-10-03T14:41:00.000-07:00

Beware false analogy, a very dangerous phenomenon. After the Franco-Prussian war and just before WWI, the doctrine of the attack swept through the French officer corps, some of whom adopted it with a religious fervor. But in WWI, technology had developed to give the defensive position the edge. All of the great offensives bogged down before the achieved their objectives. So, by false analogy the Maginot Line was built. But by WWII, the offense, once again, had the edge.

Today, there is a lot of false analogy to 1981, when the price of gold peaked and collapsed and when the oil demand/supply equation started tipping toward a buyer's market. The world has changed a lot since then, not least of all by the extraction of 25 years of oil production. There is just plain less oil in the earth, today. The Chinese economy is much larger than it was back then, but its growing just as fast. I do not think we will see an early 80's repeat. We are in a whole new age of supply and demand.

No Reason Paper Money Cannot Work Just Fine

2006-09-23T15:10:00.000-07:00

So long as the world's central banks behave reponsibly. Alas! They have not. Letting the U.S. trade deficit reach its current gargantuan proportions was not responsible. The U.S. trade deficit is now equal to about $2,600 per U.S. person per year. That is too much. This is why I'm a gold bug. But I do not agree with other bugs that there is anything fundamentally wrong with paper money. The only problem is human nature.

Why it is so Hard to Pick a Picker

2006-09-19T10:11:00.000-07:00

Expanding a little on my last post, one might respond, "It should not be too difficult to pick a good picker, just pick one with a good track record."

Well, that is the obvious approach. The problem is that this is what everyone tries to do. But it is difficult to tell if a good track record is just luck, or the result of true deep insight. Only time can truly show the difference. By the time a stock picker has established a lengthy good record, however, a lot of people want to use him. So...he either restricts the amount of money he will manage, in which case a newcomer cannot hire him, or he does not restrict and he starts to manage a tremendous amount of money, which is far more difficult than managing just a little. So he might not continue to be the best manager around. It isn't that the market is so efficient that it is impossible to beat. The problem is that there is no way for the average investor to know who to hire to beat the market.

Paying for Advice

2006-09-18T14:10:00.000-07:00

When an investor pays for advice, or for investment decision making by way of a mutual fund, he may not be aware of what a tall order he is making. He is asking that the advice giver outsmart the other players in the market, many of whom are extremely sophisticated. My view is that it is just as easy to pick stocks as to pick stock pickers. This is one area where one can avoid unnecessary losses by perceiving and rejecting falsehood. And in this area there is an enormous amount of falsehood. An investment advisor may not really be very insightful into the market and he may not have a very good track record. But he can survive in the industry without either one of those things, so long as he is a good salesman. Likewise a brokerage may prosper, even without a particularly good track record, if its advertising is convincing. In 2005 the financial industry spent over $7 billion dollars in advertising. That is a heap of falsehood, $23/American person. They try every crazy technique imaginable. "Oh, were you once a hippy, a free spirit, and then you had great financial success and you are so remarkable and have played so many different roles in your life: well, we are the financial institution for you!!" Nothing about a success record there. Or, "The polar bear momma takes care of her little polar bear cubs, and we will take care of you." No, you, the investor, are not like the cute little cubs, you are more like the seal that must be slaughtered so that the momma bear can feed her cubs, and the financial advisor can send his kids to an expensive university.

Save some money, ignore it all.

To trade set up an account with a discount broker.

To diversify, buy shares in an exchange traded fund. You can buy in from your discount broker account.

1% a year adds up.
2% a year adds up even more.
3% a year really, really adds up.
Paying 3%-7% at the very start, for a front end loaded fund really, really adds up.

See a CPA for the non stock picking part: how to tax advantage yourself, how much to set aside.

Tell your company that you would really appreciate if they did not force you to invest your 401-k with an actively managed account. There should really be a law against that.

Deterministic Rules Cannot Be True

2006-09-09T16:06:00.000-07:00

Expanding a trifle over my previous post, deterministic rules cannot be true because the broad acceptance of any deterministic rule will defeat the rule. Let us say that it turns out to be true that the best stock investments are in companies having had at least 15% revenue growth per year in the past three years. As more and more people follow this rule, however, the price of stocks fitting this description will be bid up too high. The rule will become false when the price of the stocks in the favored category becomes so great as to negate the implications for future growth that past growth has had. If the 15% for three years growth rule became truly widely accepted, it would make good sense to avoid this class of companies, as they would be overpriced. A fair test for a rule is: What if everyone did that? Would it still work?? If the answer is no, then there is a popularity point where the rule will negate itself and become a minus in the equation.

The really big money players, of course, likely pay no attention whatsoever to Investors' Business Daily, so one cannot expect to get a tremendous amount of benefit from the falsehood of their silly rules. But there may be some benefit to be had, sometimes.

Is the Market Efficient?

2006-09-07T19:51:00.000-07:00

Is the Market Efficient?? This is the eternal subject of debate. I believe that the answer depends entirely on how we define the terms. Let us say that someone had this plan for beating the market: "I will research and find the most broadly accepted method of evaluating the stock price of a company and I will work hard at applying it to the price of stocks." This person will not beat the market because he is using the most broadly accepted method and it is very hard to apply that method better than others who are applying it. In this sense the market is efficient. It is hard to out-analyze the other analysts, if using the same underlying assumptions. And in many, many fields this is exactly what you would want to do. I would rather go to a dentist that uses the most broadly accepted methods of dentistry, rather than the dentist who has decided to think for himself and "will" my cavities away or use some other highly imaginitive and creative method of dentistry. In many fields, going against the norm would simply be folly. Typically, the best methods win the greatest number of adherents, so it makes sense to use the broadly accepted methods.

The problem with the "most broadly accepted" technique in investing is that assumptions and beliefs change over time, affecting valuations. When an asset or asset class is valuable, the most broadly accepted belief is that it should be valuable. As this belief changes over time, the value of the asset changes. So if one follows the most broadly held techniques for valueing assets, you are likely to buy at the peak, when the popular belief is that the asset should be valuable, and is likely to become more so.

Beliefs are affected to a great degree by recent history. Typically recent history or experience wins out over logic. It certainly did in the dot com boom. Recent experience is reality, logic mere mind games. We know recent experience for certain, logic is a little less trustworthy because most people have been misled by their sense of logic at least once.

If the market were truly efficient, it would be right more often. But history tells us that just before the dotcom bust, the market was not right. Just before the great bull market of the 1980s the market was not right. So it is absolutely possible to outsmart a market that is frequently wrong, but not if we accept the most widely accepted means of market analysis. We should not defer to the most widely accepted means just because they are widely accepted. Investing is not dentistry. We should view the most widely accepted means very critically, to see what within them does not stand up to logic. It is easy to look back and to say, "the greater fool theory was foolish," or "the old rules still did apply during the dotcom boom, it just took a little while for them to be asserted." But what is illogical now? That is the question we must ask. See my current situation blog for an analysis.

All Deterministic Rules are False

2006-09-04T19:24:00.000-07:00

To me, this is so obvious that it hardly merits addressing. Nevertheless, the Investor's Business Daily has rules for investing, and they seem pretty deterministic. It would be crazy to follow their nutty rules. Yet people do, and it may be possible to profit from the insane delusion that a deterministic rule could ever be true.

A deterministic rule cannot be true because investing is all about human beliefs and investment behaviour, both of which are constantly changing. Let's take a look at the IBD first and second assinine rules of investing:

1. Consider buying stocks with each of the last three years' earnings up 25%+, return on equity of 17%+ and recent earnings and sales accelerating.

2. Recent quarterly earnings and sales should be up 25% or more.

First off, how completely chicken s--t to say "consider." Hey, buddy, you're either sayin' it or your not. None of this "consider" crap, pleeeeeaaaase. So, we should buy stocks with really hot performance. Well, that is easy. But things change and times change and there was a time when GM would have been in this category and Merck and so forth and so on, and if you bought them when everything was coming up roses you would have lost your shirt when they wilted. Buying high flyers is really dangerous. Look at what happened to Calpine, one moment flying high, then... chopped down to a small fraction of its former price.

No. 3 is even worse:

3. Avoid cheap stocks. Buy higher quality stocks selling $15 a share and higher. There was a time, within the last three years, when U.S. Steel was at $11/share. If you'd bought it then you would have kiced a--. There have been a ton of stocks that went from cheap to very dear. Hey...didn't someone say, "buy cheap, sell dear." Well, half of that is buying cheap. And why$15/share. Not $14/share, Not $16/share. Are you sure you have that exactly correct, Mr IBD smarty pants???

4. Learn how to use charts to see sound bases and exact buy points.

Exact????? Nothing is exact in the investment world. Warren Buffet could have a cold that day and throw your calculations entirely off.

5. Cut every loss when it’s 8% below your cost. Make no exceptions so you can always avoid huge, damaging losses. Never average down in price.

OK. I'm going to have to stop with this one, because it is just sooooooooooo crazy that I'm gonnna get crazy if I see any more of these. Let us count the illogical nuggets of nonsense that go into this. First....your sell point is based on your personal history with that stock. So, if one guy buys at 40, he should sell at $36.80, but another guy bought at 50, so he should sell at 46. Why?????? How can the smart decision for one person be the wrong decision for another. The one guy should sell, the other hold on at 46. When person A bought the stock has zero, zed, zip, nada and nothing whatsoever to do with the future price performance. What is more, let us say that everyone followed the inane and insane IBD rules, which also include "Don't buy in a down market." Stocks would drop to a price of nothing at all, overnight. So, Mr. IBD, if your not supposed to buy in a down market, could you at least accept some stock for free? A would sell, when his 8% was reached, triggering downward movement, causing B to sell, more of the same, so C sells. It would be a stop loss cascade that would not stop until they were giving it away. All in a matter of minutes. You know, I sincerely hope that a great many fools follow the IBD rules. It will create buying opportunities for the rest of us.

Reputational Risk Avoidance as a Source of Falsehood

2006-09-03T20:14:00.001-07:00

One reason why we have the illogical phenomenon of stocks that are highly rated by all analysts, is reputational risk avoidance. For an analyst, there is genuinely greater reputational (read carreer) risk in disagreeing with the other analysts than in agreeing. If you agree and you are wrong, together with the others, well you were not alone in your error. How can you really be blamed when other, perhaps even more august analysts, were wrong too. But if you disagreed and are wrong? Well, well, how could you be so very foolish. The other analysts knew better, but you had to try standing on your own two feet and thinking for yourself. Don't try that again! Why should anyone trust you with their money.

In any event, it is an exercise in group illogic to think that a stock can be underpriced when all the great authorities believe it to be underpriced. With all those recommendations pulling the price up, it is very unlikely to actually be too low.

Disagree, and be right

2006-09-03T06:53:00.000-07:00

When there is a consensus opinion, and it is right, there is little advantage in going along with it. The correct view has already been recognized and the price will reflect this. In a sense every price of every item is the consensus opinion of what that item is worth. If its right, and you buy the item (shares of GE for example), then you can expect that the price will continue, about as it is, with some adjustment for inflation along the way. Not a great deal of excitement there. But if you buy the item and the consensus opinion turns out to be wrong, then that could be very painful, or very pleasurable, depending on how the consensus was in error. So, the trick is to disagree, and be right. But how???

The first step is to understand that profits in investing require disagreement with others. So don't be afraid to disagree and don't accept what you hear or read at face value. Also, this gives one another way of viewing the recommendation of experts. When the experts say, for example, that GE is s "strong buy," this means that they are saying that the consensus view of what a share of GE stock is worth (ie. the current price of GE stock) is in serious error, on the low side. I think that it is worth asking: WHY???? Where has this valuation error come from??? Is it because some other expert is in error?? But GE is highly rated by just about every analyst who issues a rating. So who is undervaluing GE and why??? I DON'T SEE IT. So, I don't believe that GE is a "strong buy." In general I'm very leery of any stock that has an average analyst rating of under 2.0 (more "strong buy" recommendations than recommendations of "hold," "sell," or "strong sell" put together). If all the analysts believe a stock is a "buy" or a "strong buy" to me this is just a logical inconsistency. I believe that the undervalued stocks, (the "buy" stocks) are the ones that carry a few "sell" ratings, along with the "buy" ratings. Disagreement is healthy and I believe that at least in that case the downside has been more fully taken into account in the pricing of the stock. Moreover, for a stock with mixed ratings, there is a reason why the stock would be undervalued: because some analysts give it a "sell" recommendation and are wrong. Unfortunately, if it was smart to buy stocks with a very, very low rating, that would make things just too easy. I think the middle rated stocks are best, but of course this still leaves the investor with a very tough choice, because there are a lot of stocks that have a middle rating. Well, if it was easy we'd all be rich.

Falsehood Recognition

2006-09-02T06:28:00.000-07:00

From the first post, a reader can see why I have named my blog "Falsehood Recognition Investing." Publicly available truth is valueless. Publicly available falsehood is very valuable, if you recognize it, because it will lead others astray, giving you a strategic advantage. At the extreme, of course, is falsehood creation investing, which runs afoul of SEC regulations. I am referring to "pump and dump" schemes in which someone buys some of the stock of a company (typically with a very low market capitalization) and then gives stock recommendations that he knows are baseless just to drive the price up so he can unload at a profit. Remarkably, and just as one more example of how naively optimistic many souls are, these schemes have been known to work pretty well (e.g. Stockster). One way to make money would be to react to a "pump and dump" recommendation (they are usually pretty easy to recognize) by selling short. Unfortunately, I don't know of any brokers who will permit you to sell short a penny stock and all the pump and dumps are aimed at penny stocks.

Falsehood, of course, exists for many different reasons. Here is a listing of some:

1. Self promoting falsehood (including 2nd generation of this type)
2. Self protecting falsehood
3. Innocent logical fallacy falsehood
4. False analogy
4a. False analogy to recent experience
5. False reliance on historical pattern
6. Falsehood in group opinion

First Rule

2006-09-01T16:17:00.000-07:00

I plan to list rules, one at a time, for successful investing. The first rule is: All publicly available information is useless , unless you draw from it an inference that others have missed. Of course, if you get the information before it is publicly available, that is another story. But at the time it is publicly available, many others will be trying to glean a market advantage from the information. It is naively optimistic to imagine that by reading an article in the financial press one is gaining a strategic advantage over other investors. The big money investors will have already known much of what the article states, before it was published. Unless you have an inside track, others will have seen the article before you do, and the price of the stock will already reflect whatever truth the article contains. So it is pointless to try to outwit the market by following any recommendation found in the financial press, be it a finance magazine, a newsletter (even with fairly limited circulation) or a service such as Value Line.

If, on the other hand, you note some specious reasoning in the article or it is apparent that the article reflects an interview with a company executive or agent who is just pushing his company, it might be a good time to sell short. Others might be tricked into bidding up the price and you may be able to profit from them.

If the article details a course of heady expansion for the company, others will have seen that information and the price of the stock will reflect it. But what does it mean for competitors. In many cases it is impossible to justify all of the stock prices in an industry. If ABC is priced for continued heady growth, DEF should be priced to have some of its market share taken by ABC. If it is not, it might be a good shorting opportunity. On the other hand, DEF might just fight back, foiling ABC's efforts at continued growth. Now that Circuit City is once again well led, things cannot look quite so bright for Best Buy as they did before.

On the flip side, when troubles plague one company, I think it is worth considering the opportunities this might open up for their competitors. When Rite Aid stumbled, the price of Walgreen did not immediately rise. But Walgreen has profited immensely from the troubles at Rite Aid, and this has, over time, greatly helped the price of Walgreen stock.

So, when reading an article touting a stock, it is better to ask: "Is this a good time to short?" rather than "Is this a good time to buy?" Do the arguments presented really stack up. Sure, ABC is entering into this or that initiative, but isn't everyone else in that industry.

When the article suggests that a stock is best avoided, ask: "Are they going too far? What are the counter arguments?" If the article drives the price down, that could be a great buying opportunity. And always think about competitors and suppliers. Draw a larger web of inferences than others do.