The health care legislation that President Obama signed on Tuesday has extremely important implications for all investors. The fact is government will be taking a much larger share of the money you earn through working and investments, even though there were some politicians who claimed this plan would actually save money.

Writing for The New York Times, Douglas Holtz-Eakin, a budget wonk who has studied law for the American Action Forum, says, "In reality, if you strip out all the gimmicks... the health care reform legislation would raise, not lower, federal deficits, by $562 billion."

We are all going to be paying a lot more in taxes to fund this bill. Massively increasing the federal government's role in health care will not be free.

The new taxes come at a time when investing is already much more difficult than it was 15 or 20 years ago. Gone are the days of 10% certificates of deposit. There are no more  7%  AAA rated municipal bonds trading at par. Do you remember 5% passbook savings accounts? Do you remember financial plans that assumed double digit equity returns?

No, investing today is much tougher. The default options like certificates of deposit just don't pay very well today. And if you procrastinate about investing and just put your dollars in a money market fund, you're likely to get a rate that is scarcely higher than 0%.

None of the above is meant to be a political statement about "Obamacare." The Naked Portfolio Manager is apolitical. But the important point for all Americans is that the new law will make it harder to save and accumulate money for retirement, college education, vacation homes, and the American dream.

...Which is why making really good decisions about how to invest is even more important today than it was before the bill became law. So who do you know who needs to read The Naked Portfolio Manager?

Labels: health care, Obama

ForeWord Reviews has named The Naked Portfolio Manager a finalist for its "Book of the Year" Awards!

ForeWord is a respected trade magazine that identifies and reveiws the best books produced by independent publishers. The magazine selected The Naked Portfolio Manager as a finalist in the business and economics category. The winner will be selected by a panel of judges consisting of ForeWord editors and reviewers, librarians, booksellers, and publishing industry pros. Judging criteria will be based on each book's "editorial excellence, professional production, originality of the narrative, author credentials relative to the book, and the value the book adds to its genre." The winner will be announced on May 25th.

The competition in the business and economics category is especially stiff this year with 14 other well-written books in the running.

Of course any competition like this is subjective, but let me tell you why The Naked Portfolio Manager just might win. The book is strong across all judging criteria, but especially strong in the area of originality of subject matter. The book's central message that naked decision-making is a fundamentally superior way to make investment decisions contradicts virtually everything that we see on television, hear on the radio, or read in the newspaper. The very idea that a clearly defined set of rules is better than Wall Street judgment is anathema to the traditionally and commonly held beliefs of the establishment.

But you don't have to look much farther than Sweet Briar College to find evidence that the central thesis of my book is correct. And if you look a little deeper, Sweet Briar is just the tip of the iceberg.

Do you know the fable about the frog and the scorpion? It's a simple story about a scorpion that wants to get across the river. He asks the frog if he could ride on his back. The frog is reluctant, so he asks the scorpion how he can be assured he won't sting him. The scorpion tells the frog he has nothing to worry about. If he were to sting the frog, they would both drown. So the frog agrees to carry him across the river.

When the frog and the scorpion are about half-way across the river, the frog suddenly feels a sharp pain in his back. He looks back and sees the scorpion removing his stinger and starts to feel the numbness caused by the poison.

"Why did you do this Mr. Scorpion? Now we will both drown!", cries the frog.

"I know, but you see, I just could not help myself. It is my nature." says the scorpion.

This fable, made famous by actor Forest Whitaker's retelling in the movie "The Crying Game," has really important implications for investors.

How? Because our brain is like the scorpion. It often sabotages our most important objectives. We want to lose weight but our brain says, "Well, it's only just a small piece of cake." Or when we play golf, we say, "Don't hit it in the water." And then we hit it in the water.

As investors, we know it's important not to make emotional decisions, but it's so easy to get excited about a stock that has enormous potential, or to simply sit on cash yielding 0% because it feels better than taking a risk. The problem is that it's our nature.

This is why rule-based investing, or naked strategies, is much more effective than traditional methods. Statistical rule-based investing takes the emotion, judgment, and self-sabatoge instincts or tendencies out of investment selection.

You can tell a great deal about how a fund manager goes about his business by the vocabulary he uses. For example, watch this video with CNBC's "Mad Money" host Jim Cramer and see how many times he uses words like "think", "see,"and "look."



Traditional judgment-based portfolio managers use words like "think," "expect," "see," "hope," and "worry." Naked portfolio managers, on the other hand, say, "I do." 

We know that emotions play a huge role in traditional portfolio managers' decision-making. Alternately, for the naked portfolio manager, he or she will simply follow a set of predetermined rules and factor emotions out of his or her thinking.

                            

Can you tell the difference?

I want to continue on this theme of "cocaine brain" for a little bit because I think it can explain how a judgment-based manager can lose all objectivity. . .

Several years ago, I was listening to a very successful fund manager talk about his portfolio. Let's call him Will. Will was telling me and a few other colleagues about how well his portfolio was doing, especially two stocks that were performing exceptionally well. As he explained it, he initially estimated he'd make 5x his money on these stocks, but as it turns out, he was wrong. Over a period of several years he made 30x his initial investment on the two stocks. When Will told this story, everyone laughed. Will attributed his outstanding performance to the notion that he and his team were much smarter and worked much harder than everyone else. So they deserved to do better. Right?

Wrong. Notice a couple things here. First, Will initially thought he'd make 5x his money on the two stocks, but instead, he made 30x his money. He misjudged the price of the stock by a magnitude of 6! It's not like he thought the stock would trade at 50 and it went to 60 and he missed by 20%. Will missed the magnitude of the move by a huge margin! Therein lies the important revelation that he overlooked. Will is really bad at forecasting stock prices!

Okay, I know what you're saying: "Hey, I'd be delighted if my manager made that kind of mistake!" But let's look at it from another perspective. Suppose an economist says inflation will increase to 3% over a period of time, and instead it increases to 18%. Same magnitude of mistake. Would you want to use that economist?

But notice how Will's brain works. He doesn't say, "Wow, I really missed the mark on that stock. I was lucky it moved in the right direction. I should be more careful about risking my client's money going forward." No, he says, "I'm a brilliant portfolio manager and I will keep looking for other stocks that have the potential to appreciate 30x."

Remember when you buy a stock that does this well and you attribute it to your fantastic judgment, it can release endorphins in your brain that cause intense emotional pleasure. Just as winning at craps can cause a great deal of excitement and adrenaline in a gambler, the same pleasure centers in the brain can be stimulated by a winning investment.

Will got a tremendous amount of positive publicity and accolades as a result of the stellar performance of those two stocks. Unfortunately, all of this attention made it highly difficult for Will to be objective about his own ability going forward. Eventually, his fund performance lagged badly. I think if he hadn't had such an amazing run in the 90's, he would have done much better in the 2000's. Part of his problem was major overconfidence in his own ability. This may have been compounded by a natural desire to rescue his fund by identifying additional stocks that would eventually produce huge returns.

Naked strategies help investors avoid all of this messy emotional thinking. I never get all that excited about a stock that does extremely well because it was selected based on rules. After all, I can't attribute that stock's performance to my brilliant judgment. I attribute it to simply following a set of rules that have been created to maximize performance and expecting that because of the law of averages some of the stocks will do very well.

In my two previous posts, I discussed Atul Gawande, author of The Checklist Manifesto, and his contention that simple checklists can make an incredibly complex processes like surgery or flying an airplane safer and more effective. While reading his book, I was happy to see that Gawande also has something to say about checklists and investing.

In chapter 8, Gawande states that regimentation - sticking to a disciplined, repeatable process - can offer many benefits beyond the area of medicine, and he cites finance as an example. While researching his book, he talked with a number of portfolio managers who employ checklists; hedge fund manager Mohnish Pabrai's comments were especially interesting.

Pabrai is from India. He was trained as an engineer and then built a successful technology company before starting his investment firm where he manages a 500 million dollar fund. Gawande says Pabrai ought to know a thing or two about being dispassionate and unemotional about decision-making given his background. But when it comes to investing, Pabrai actually has to fight to control his emotions.

"No matter how objective he tried to be ...he found his brain working against him, latching on to evidence that confirmed his initial hunch and dismissing the signs of the downside. It's what the brain does." Gawande wrote. Readers of The Naked Portfolio Manager know this phenomenon as "confirmation bias," as discussed in chapters 7 and 8 of my book.

Or in a bear market he can go into "fear mode" and start seeing risks where they don't exist. "You see people around you losing their shirts, and you overestimate the danger."

Another portfolio manager that Gawande intervied, Guy Spier, also talked about "greed mode." That means the investor sees an exciting investment and starts to think about the hundreds of millions of dollars he can make. Spier calls it "cocaine brain."

I have personally experienced cocaine brain myself. (I am speaking metaphorically here. I have never used illegal drugs of any sort in my life). I remember in 1999 I was using a judgment-based portfolio approach that relied heavily on chart reading. I bought several stocks that climbed many points over my buy price immediately after I bought them. I experienced a tremendous rush of adrenaline and began to feel as if I could make money at will. Still, a little voice inside me kept saying, "This can't be so easy." Then the bear market came along and fortunately I realized that naked investing strategies were a much better approach.

While I agree with Gawande that a checklist can be an effective tool for judgment-based portfolio managers to reduce the risk of making emotional decisions, remember that the best tool to avoid emotional errors is rules-based investing, a.k.a. naked strategies. I think Gawande really caught Speir and Parabai with their guards down and got them to speak candidly about how emotions effect their judgment. All the more reason to use naked strategies!

Did you know the Model 299 "Flying Fortress" was the most advanced airplane Boeing ever made? It could fly faster and almost twice as far as the other bombers of its day - and carry more bombs too. It had an imposing 103-foot wing span, and it's four-engine instead of the usual two design made it an impressive sight for the United States Army.

On October 30, 1935 at Wright Air Field in Dayton, Ohio, a small group of Army brass gathered to watch the Model 299's test flight. It was supposed to be a mere formality. Major Ployer Hill, one of the Army's most experienced test pilots,  roared down the tarmac and lifted the plane into the air, rising to about three hundred feet. Seconds later, the plane abruptly turned sideways and crashed into a fiery explosion, killing Major Hill and one other crew member.

The investigation later revealed that the cause of the crash was pilot error. The Flying Fortress was substantially more complex than previous airplanes. It required the pilot attend to four engines, each with a separate fuel-oil mix, retractable landing gear, wing flaps, and electric trim tabs that needed to be adjusted to maintain air speed. All of this had to be monitored while regulating the pitch of the propellers with hydraulic controls.

The Army opted for a less capable plane designed by Martin and Douglas. Military historian Phillip Meilinger explained that many thought the 299 was just "too much airplane" for one person to fly.

Still, some of the top Army brass thought the plane was flyable. So they came up with an interesting plan, and it didn't involve longer or more extensive pilot training. It was a very simple set of rules to be followed in a disciplined, repeatable fashion. Essentially, it was a naked strategy, although the Army called it a checklist. And with this strategy in place, the incredibly complex aircraft became much easier to fly. Test pilots logged almost two million miles without an incident.

Later, the US Army gave the Boeing 299 a new name. They called it the B-17. They ultimately bought over 12,000 of them, while the airplane played an integral role in the Allies victory over Nazi Germany.

This is another one of the stories that Atul Gawande retells in his book, The Checklist Manifesto. It's a terrific example of how a disciplined, repeatable process can take something incredibly complex - like flying a highly sophisticated airplane - and reduce it to a series of simply steps that can be successfully performed by an ordinary pilot. The same goes for investing; naked strategies apply a simple set of disciplined, repeatable rules to portfolio management, making it easy for everyday investors to do.

I just finished up reading a fascinating book by Atul Gawande called The Checklist Manifesto. Gawande is a well-known surgeon who was asked by the World Health Organization to help make surgery safer for their 193 member nations.

The problem seemed staggering. How could you come up with a program to make surgery safer in 193 different countries? These countries have different economic systems, different cultures, and different educational systems. To improve surgery worldwide would take a massive expenditure of resources and involve tens of thousands of people, wouldn't it?

Actually, no.

Gawande's surprising answer to the problem was a checklist. By formulating a set of official standards for safe surgical care and publishing them under the World Health Organization's name, he felt he could reduce many of the errors that surgeons make. 

According to Gawande, surgery has four big risk factors: bleeding, infection, unsafe anesthesia, and what he calls "the unexpected." For the first three, Gawande says science and medicine have given us some straightforward and valuable preventative measures. Unfortunately, surgeons sometimes miss these simple things. For example, a 2005 study of the Children's Hospital in Columbus, Ohio determined that over one-third of the time, appendectomy patients failed to get the right antibiotic at the right time. Gawande said if you give the antibiotic too soon, it can wear off before surgery, and if you give it too late it won't work at all.

While giving the antibiotic at the right time may seem like a simple notion, Gawande points out that many simple requisites can easily be overlooked. And it is these oversights that cause major complications.

Are there parallels between surgery and traditional portfolio management? Gawande suggests there are. While on the surface, both seem incredibly complicated, Gawande suggests much of surgery is a series of simple tasks. Isn't this what naked investing is about too?

I will have much more to say about this wonderful book in future posts.