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Sweet Briar College student Jenny Young, who is testing rules-based investing models in Professor Tom Scott's "Principles of Investing" class, addressed a small group of investors at a cooking class in Richmond, Virginia last Saturday. Watch the video below to hear what she had to say about The Naked Portfolio Manager.



Want an update on Sweet Briar's performance v. Wall Street? Go to Professor Scott's website. (New to The Naked Portfolio Manager blog? For a description of the Sweet Briar experiment, read "How Sweet Briar students plan to outthink Wall Street" by Professor Scott.

Labels: Richmond, Sweet Briar, Wall Street

A friend of mine recently asked me what I thought of a derivative investment called "equity-linked reverse convertibles." Before I explain my answer, I want to tell you a story about something that happened to me when I was a cadet at West Point.

I was on leave in New York City when I happened upon some men playing a card game. There were only three cards; one was red and two were black. I later learned this game was called Three-Card Monte. One man, who we'll call the "operator," would expose all three cards, turn them over, and then quickly move them around. The objective was to identify the red card. With a minimum bet of $40, you wagered on where the red card ended up. If you correctly identified where the red card was, you doubled your money.



Another player, who we'll call the "mark" a.k.a victim, was dressed much better than the operator who was running the game, and was consistently losing his money. I watched for a while and found it easy to follow the red card. Of course, I was encouraged to play by the onlookers, but $40 was a lot of money to risk back then. Yet I kept watching the mark lose his bankroll, meanwhile, every time I knew exactly where the red card was.

Finally, the lure of easy money proved too great. I pulled out my wallet and plunked down my $40. And for the first time, I guessed wrong! Undeterred, I tried again and guessed wrong again. At this point I was ready to leave, but just then the mark grabbed me by the shoulders. "Hey, let's not let this guy beat us out of our money!" he said, as he implored me to keep playing.

I reached into my wallet and pulled out my last $20. I didn't have enough for a full bet, but they let me slide. I was going to lose anyway. And so $100 dollars lighter, I found a pay phone and called my dad to get him to wire money to Western Union so I could buy a bus ticket back to the Academy.

On the ride home I realized I had been tricked. The supposed "mark" who kept losing his money was not a mark at all. He was actually a shill or a person who encourages others to play a gambling game and a confederate of the operator who ran the game. My initial perception had been entirely wrong. **I** was the mark or sucker.

In retrospect, I could have evaluated the situation differently. Obviously, the fellow running the game was no fool. The game was his livelihood, and he knew what he was doing. It was foolish of me to think I could beat him at his own game.

...Which brings me back to my friend who asked me about the equity-linked reverse convertible. Remember, whenever Wall Street creates a complicated product that's difficult to understand, it's extremely unlikely that ordinary investors are getting the best end of the deal. After all, the people who create these products are highly sophisticated and the game is their livelihood. In "Wall Street Monte," they know how to play the role of the operator.

I told my friend to pass on the equity-linked reverse convertibles. Stick to transparent rules and keep your investment decision-making simple. By using what I call "naked investing" - meaning you know the rules just like everyone else - then you can avoid the bad market odds that come with many of Wall Street's trumped-up creations.

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How's this for an investment. . . I'm pledging to donate $1 to the Families of the Wounded Fund Inc. for EACH person who clicks on this link and votes for my ChangeThis.com proposal, "Time To Get Naked" (up to $1,000 total).

What's ChangeThis.com? It's a website created by best-selling author Seth Godin, who had a desire to spread ideas designed to make the world a better place. Godin's idea was to create a website where people could submit proposals to write e-books sharing those great ideas. Each month a new batch of proposals would be listed on ChangeThis.com, and voters would "cast their online ballot" for the ones they liked best. Those highest vote-getting proposals would be turned into professionally crafted e-book manifestos for wide distribution through social media.

Since the creation of ChangeThis.com in 2004, many manifestos have been written that resulted in best-selling books. People like Tom Peters, Chris Anderson, David Meerman Scott, and Guy Kawaski have all written manifestos as a result of Godin's website. And this month, my proposal, Time To Get Naked, is being considered along with 19 other proposals. In a nutshell, my proposed manifesto argues that each year investors spend hundreds of millions of dollars in mutual fund fees for investments that perform below the market averages. There's no reason to continue to pay for subpar performance. By using rules-based methodologies, a.k.a. "naked strategies," investors can systematically improve their results and reduce their costs.

So how do we get $20,000 for charity? I'm challenging the other 19 people who submitted a proposal to pick a charity and donate $1 for every vote they get just like I am. If everyone does this, we will raise $20,000 for some wonderfully worthy charities and also spread some great ideas through e-book manifestos and social media.

My chosen charity, Families of the Wounded Fund, Inc. (FOTWF), was created to help the men and women who sustain the most serious injuries while serving in Iraq and Afghanistan. Many of these returning soldiers are treated at McGuire Veterans Hospital in Richmond, Virginia, where I live. They come from all over the country and very much need their families to be with them during their long and difficult road to recovery. While the federal government provides for their medical expenses, many of the costs of traveling from their homes to be with their injured family members are paid for by the families themselves. And many times, this places a severe financial hardship on them. FOTWF provides funds directly to those that need it most. Village Bank absorbs most of the administrative costs of running the fund so almost 100% of the money donated to FOTWF goes directly to help the families.

To vote for my proposal, go here and click "Yes, please write this manifesto" in favor of "Time to Get Naked." Also, please share the link to this blog post on your Facebook page or profile and/or send an email with this link to your friends who have had the privilege to serve our nation in the United States military.

To get updates on this project and the "Time To Get Naked" manifesto, you can subscribe to my blog by entering your email in the window at the top right.

Sunday's New York Times had an article titled "The Low-Cost Power of Naked Investment Strategies."

Okay, I made that up.

The real title was "The Low-Cost Power of Exchange-Traded Funds." The majority of exchange-traded funds employ rule-based methods, which I of course call "naked strategies." Most are not managed the traditional way using an investment manager's judgment, which is used by the majority of open-ended mutual funds.

The article suggests that assets in exchange-traded funds are growing -- practically eating traditional mutual fund managers for lunch! The Times points out that these kinds of funds have two big advantages over traditional funds. 1. They are less expensive. 2. They are more "tax efficient."

Exchange-traded funds offer a great opportunity for small investors to take advantage of the benefits of naked investing. Affluent investors, on the other hand, should use separately managed accounts. As I explain in Chapter 12 of The Naked Portfolio Manager, rules-based investing is both more economical than traditional mutual funds, and much more tax efficient that exchange-traded funds. This is because when you use an index fund or exchange-traded fund, you have much less flexibility about how and when to take your gains and losses. With a separately managed account, you have a host of tax minimization strategies that are not available to investors who use this fund. For more information, see page 109 and 110 of my book.

P.S. Like what you read here? Don't forget to subscribe to my blog by entering your email address in the box at the very top right!

Labels: exchange-traded funds, index funds, tax minimization, taxes

Long-time readers of this blog know that Professor Tom Scott of Sweet Briar College introduced my book The Naked Portfolio Manager to his "Principles of Investment" class last fall, and asked his students to construct rules-based models that followed the book's principles. Professor Scott has been tracking the results of these models on his website since the first of the year, and the preliminary results are amazing. So far, the students' models have impressively outstripped the SP 500, and now the entire college is keeping tabs on the results!

According to Professor Scott, the Sweet Briar composite has returned 11.64% for the first quarter of the year, beat the SP 500's return of 4.87 by more than two to one. That's very exciting, and congrats to the ladies for doing such a GREAT job. You can find a complete description of all the Sweet Briar models, a list of the stocks selected, and monthly performance updates here.

I had the opportunity to interview Laura Jett, one of the "Principles of Investing" students last week. Click here to listen to the six minute interview with Laura. After you listen to what she has to say and review the results at Professor Scott's website, you may find yourself wondering if traditional approaches to portfolio management may well be on their way out. Is rules-based a.k.a. "naked" investing the way of the future? I think so.

Stay up-to-date on the developments coming out of the Sweet Briar experiment; simply subscribe to my blog in the upper right-hand corner of this page.

I got several wrong guesses, but no one was able to correctly answer the question, "What is the name of the famous Italian financier who once donated 122 square inches of his own skin to help a young woman who had been burned after a gas stove burst into flames?" The answer is Charlie Ponzi, whose name is inextricably linked to the infamous scheme in which dollars are "borrowed" from new investors to pay old ones.

Almost everybody has heard of a Ponzi Scheme, but few people know the history of Charlie Ponzi himself. In 1920 when Ponzi was a newly married immigrant living in Boston, he became aware of international postal coupons. These were coupons issued by sovereign nations that could be exchanged for stamps in another country. The idea behind the coupon program was to promote international trade. Ponzi realized that the price of these coupons in Italy was so low, he could buy six cents worth of U.S. stamps for about the equivalent of one cent in Italian Lira. Ponzi thought if he could get enough money together to buy a bunch of these coupons and then sell the stamps, he could make a large profit. Unfortunately for Ponzi, none of the banks he talked to would loan him any money.

So he decided to turn to plan B. He rented a small office at 27 School Street in Boston and hired an Italian grocer to be his agent, and began selling Ponzi notes that promised a 50% interest rate in 90 days. A month later, he had his first set of investors. Eighteen people put up $1770 to invest in the first group of notes. According to Mitchell Zuckoff, author of Ponzi's Scheme, Ponzi would have had to purchase 53,000 coupons to invest the original $1770.

Somehow, Ponzi forgot his original intent was to use the cash to buy international postal coupons. Instead, he used money from new Ponzi notes to pay off the older notes. The early investors, delighted at the fast money, told their friends and many of them reinvested their profits into more Ponzi notes. And the cash continued to roll in. In April, Ponzi sold 471 notes, collecting over $140,000, and opened his first branch office to sell even more notes. May saw even more growth as 1525 investors bought over $440,000 worth of the Ponzi notes.

Ponzi, ever the showman, bought a large house and a fancy car as he got richer. In July 1920, Ponzi's business, the Securities Exchange Company, brought in over $6,500,000 from over 20,000 investors. Remember, that just eight months earlier, Ponzi had been refused a $2,000 loan, and now he was sitting on almost $10 million dollars. Adjusted for inflation, this equals roughly a billion dollars in today's money. The major newspapers of the day began following his rags-to-riches story. For a short while, Ponzi was perhaps the most famous man in America.

Of course, you know that a story like this must have a tragic end. The Boston Post eventually broke the story of Ponzi's prior prison record for forgery, and the paper published articles questioning the viability of his strategy. The Boston Post won a Pulitzer Prize for its reporting and Ponzi went to jail. Those still holding Ponzi notes after the money ran out eventually recovered only a fraction of what they invested.

I re-tell this story because the many parallels between Charles Ponzi and Bernie Madoff are important for investors to be reminded of today. While many of Ponzi's victims were Italian immigrants, many of Madoff victims were, like him, Jewish. It is just human nature to believe in people who are "like" us. Both Ponzi's victims and Madoff's victims ignored clear warning signs because they wanted to believe in these charismatic men. This is the classic confirmation bias that we discuss in chapters 7 and 8 of my book.  And both Madoff and Ponzi attributed their success to a secret or "proprietary" trading mechanism or "black box" that they could not share with the public. (see page 121 of The Naked Portfolio Manager for more on this).

The story of Charlie Ponzi goes to show that it is clearly best to not put your confidence in charismatic men, secret trading strategies, or unexplainable "black boxes" when it comes to investing. Demand answers, and stick with clearly defined, transparent rules - what we call "naked strategies" - and you will be much better off as you develop your portfolio.

Don't get grossed out by my question, but your answer could win you an autographed copy of my book!

What is the name of the famous Italian financier who once donated 122 square inches of his own skin to help a young woman who had been burned after a gas stove burst into flames? 72 square inches of skin was removed from his hips and thighs for the skin graft. A few weeks later he donated an additional 50 inches from his back.

So... who was this generous, well-known financier? (Hint: If you have my book, check out the picture on page 120.)

Again, the first person to comment and leave the correct answer will receive a free autographed copy of The Naked Portfolio Manger (and for those who already have a copy, you have the chance to win another with my John Hancock so you  can give it to a friend!).

Static models are used frequently in medicine. For example, the methods that apply to diagnosing the flu do not change from week to week or month to month.

In cardiology, radiology, and psychology, static models are used to make diagnoses and recommend treatments for patients with all types of symptoms. In The Naked Portfolio Manager, I gave examples in each of these disciplines where statistical prediction models proved more reliable than the judgment-based methods of clinicians in the field. For example, the Goldman Chest Pain Decision Aide model proved more reliable at making better triage decisions than the emergency room doctors and cardiologists at Cooke County Hospital in Chicago.

Although some traditional portfolio managers argue that decision-making, when it comes to the stock market, is different. People with chest pains do not change their symptoms based on what other people with chest pains are doing to gain an advantage. But investors, at least to some degree, change their behavior based on what other investors are doing. For this reason, many traditional judgment-based portfolio managers reject "naked strategies" because they say a rule-based method is inflexible and thus cannot change based on market conditions. This is why the best portfolio managers that rely on judgment, they argue, are able to outperform naked managers.

Phooey!

Naked strategies don't have to be static. They can be flexible and adjust to market conditions. The rules for adjusting to market conditions need to be created when the strategy is designed. The Cripps Model, discussed in The Naked Portfolio Manager, is a perfect example of this. This model measures how investors react to news on a stock and then applies those measurements to calculate a fair price. Stocks are purchased when the market price is substantially below this calculated fair price.

Note here that the Cripps Model calculates the value of a stock based on the collective judgments of all market participants and then gives a buy signal when the stock price deviates substantially from that price. This is much different than an analyst forming his own opinion about what a stock should be worth.

Labels: Cripps Model, Goldman chest pain decision aide, judgement