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2010-04-27T15:51:00.001-04:00

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Jenny Young of Sweet Briar College Talks About The Naked Portolio Manager

2010-04-27T10:40:00.001-04:00

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.

Are Your Fund Managers Black Box Managers?

2010-04-22T10:37:00.001-04:00

What You Must Understand About Derivatives and Other Wall Street Creations

2010-04-20T10:27:00.001-04:00

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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Help Me Raise $20,000 for Charity And Promote Great Ideas That Can Save The World

2010-04-15T23:16:00.001-04:00

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.

How Naked Strategies Can Make April 15th Less Painful Next Year

2010-04-15T07:42:00.001-04:00

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!

Sweet Briar's Rules-Based Models Are Crushing the Market!

2010-04-13T10:34:00.001-04:00

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.

Who Would Give You The Skin Off His Back and Steal Your Eyeballs? Charles Ponzi.

2010-04-08T10:20:00.001-04:00

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.

Book Contest: Win an Autographed Copy of The Naked Portfolio Manager!

2010-04-06T10:12:00.001-04:00

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!).

Yes, Naked Strategies Can Adjust to Changing Market Conditions!

2010-04-01T10:21:00.001-04:00

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.

Your Brain, The Media, and Naked Strategies

2010-03-30T09:37:00.000-04:00

What Health Care Reform Means for All Investors

2010-03-26T10:32:00.001-04:00

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?

The Naked Portfolio Manager is a ForeWord "Book of the Year" Finalist

2010-03-25T11:18:00.003-04:00

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.

What Investors Can Learn From the Frog and the Scorpion

2010-03-23T12:25:00.001-04:00

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.

The Difference Between Jim Cramer and Naked Portfolio Managers

2010-03-18T10:34:00.001-04:00

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?

Podcast: Sweet Briar Junior Beats S&P 500 Using Rules-Based Investing Strategies

2010-03-16T10:42:00.001-04:00

As you know, for the past several months, students in Professor Tom Scott's "Principles of Investing" class at Sweet Briar College have been testing the application of rules-based investing on the stock market.

Junior Jenny Young is one of those students. She read The Naked Portfolio Manager last fall and used the principles to develop her own criteria for selecting securities. So far, her three models have outstripped the S&P 500 by a wide margin. I interviewed her recently for a podcast, which you can download below.

"Every time we get our results back for the month, I'm completely shocked that I was able to create a portfolio that's done so much better than the S&P 500. The only real thing that I knew was reading your book and going on the stockscreener123.com website and just trying out some rules," Jenny says.

In the interview, Jenny details the variables used in her models, such as improved dividend growth, P/E and P/S ratios, market cap and improved sales growth. She also opted to use another "creative" rule "that no one had ever really done before," yet which produced surprisingly good results for her.

For a complete list of all of the stocks that were selected by Jenny's models as well as the monthly performance, plus the selections of the other Sweet Briar students, go to Professor Scott's website.

CLICK HERE to listen to my complete podcast interview with Jenny.

How Making 30x Your Money on a Stock Can Be a Bad Thing

2010-03-11T11:39:00.002-05:00

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.

Does Your Portfolio Manager Suffer From Cocaine Brain?

2010-03-09T14:27:00.001-05:00

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!

What Investors Can Learn From Pilots

2010-03-05T10:26:00.001-05:00

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.

Is Investing About Being Super Smart or Not Being Dumb?

2010-03-02T10:20:00.001-05:00

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.

How to Go on an Investment Diet

2010-02-18T11:50:00.001-05:00

One of my New Year's resolutions is to lose some weight. So I started a strict diet on January 1st. I go to Dunkin' Donuts each morning and eat four jelly-filled doughnuts for breakfast. Mid-morning, I stop by Starbucks and get a Vanilla Crème Frappuccino. By lunch time, I'm really hungry so I go to McDonald's and get two Big Macs, a super-sized order of fries, and a large Coke. This will usually hold me over until dinner, when I go to see the Colonel and get a bucket of extra crispy fried chicken. And then I'll top it off with a stop at Cold Stone Creamery, and get Founder's Favorite ice cream.

To my surprise, I recently learned the above food purveyors don't care if I gain weight by eating at their establishments. In fact, they're more interested in me spending money than hitting my weight goal.

...Of course, I really don't eat like this. I used the fast food industry as a metaphor for so much of what passes for investment advice published by the financial tabloids. While McDonald's does have healthy salads and Cold Stone has sinless ice cream and non-fat smoothies, both of these businesses are primarily concerned with making a profit, not producing low-fat, nutritious meals. And the financial media is no different.

What financial magazine editors and television producers try to do is produce a product that people want to buy. That's why you see so many magazine covers with fund managers who have great investment records. Reading about hot funds, stocks, or sectors has never worked for investors trying to make money though, but it is a great way to sell magazines to those who aren't savvy about financial matters.

Just like a dieter cannot count on a fast food restauranteur to help them meet their goals, an investor cannot count on the financial tabloids to make them wealthy. The restauranteur and publisher have different objectives in mind when it comes to dieters and investors, and they're typically contrary to what is healthy for you, physically and financially, whatever the case may be.

Empirically based, naked strategies are created to achieve a financial objective and are not influenced by circulation, advertising, or fashion.

Full disclosure: I do own two Cold Stone Creameries. You can get a delicious, low-fat shake that I call the "Bob Special" at Cold Stone if you ask the crew members to mix sinless ice cream with milk and strawberries in a blender. Have them throw in a little chocolate malt too if you like...

It Was the Best of Funds. It Was the Worst of Funds.

2010-02-16T11:10:00.001-05:00

According to The Wall Street Journal, the CGM Focus Fund was the best performing mutual fund in the last decade. In a time when the Standard and Poor's 500 lost money, the CGM Focus Fund turned in a stellar return, averaging 18% per year. So why did most of the fund's shareholders lose money?

The problem is a matter of timing. The fund produced an amazing return of 80% in 2007. The financial media went wild. Fortune magazine called fund manager Ken Heebner America's hottest investor . His picture adorned the cover of Kiplinger's Personnel Finance magazine. Investor's Business Daily crowed about the fund's stellar performance as well. Yet, The Wall Street Journal said the fund sucked in almost three billion dollars in new assets in 2008, but then proceeded to produce a disastrous return, losing nearly half its value.

Page 72 of The Naked Portfolio Manager talks about the difference between time-weighted returns and dollar-weighted returns. When a fund is as volatile as the CFM Fund is, it can produce eye-popping, time-weighted returns in excess of 18% per year while still losing money for its average shareholder.

This is yet another example of the availability error discussed on pages 38 and 39 of The Naked Portfolio Manager. My new e-book, available for download now, discusses an allocation strategy that might prove helpful if you're thinking about investing in funds that have this type of volatility.

How You Can Test Naked Strategies With Your Computer

2010-02-11T10:11:00.002-05:00

With this blog, I have emphasized over and over again that by ignoring the stock market forecasters and prognosticators and simply following a set of empirically based rules in a disciplined manner, you can meaningfully improve your investment results. Here's an experiment you can do with your own computer to see the results of naked strategies for yourself.

One very simple thing you can do to enhance your return is rebalance your portfolio at regularly scheduled intervals. To test this, select up to ten stocks and then select a time period to test. Go to Google Finance Historical Stock Prices and download excel spreadsheets with the historical stock prices and the time period you have chosen. Then you can copy and past those historical prices into this spreadsheet that Professor Tom Scott of Sweet Briar College (I'm helping guide his "Principles of Investing" class apply rules-based investing strategies) was kind enough to share with us.

The spreadsheet compares the difference in return between a buy-and-hold portfolio with no rebalancing and a portfolio that is rebalanced at regularly scheduled intervals. You can download weekly data, monthly data, or yearly data and enter it into the spreadsheet. The calculation assumes that you rebalance your portfolio back to an equal weighting for each security at the end of each time period.

In most cases, you'll find that the rebalanced portfolio does better than the buy-and-hold. Depending on the volatility of the stocks you select, the difference can in some cases be 2% or more per year.

Now stop and think about this. We're comparing two strategies for investing for the exact same stocks. Yet one strategy results in meaningful differences in return. How is that?

Stocks are constantly oscillating on a range. When you rebalance, what happens is you sell stocks that are trading in the high part of the range and buy stocks that are in the low part of their range.

Now remember, no strategy works all the time for all stocks. It's possible to find time periods and stocks where systematic rebalancing does not produce better results than the buy-and-hold. And you of course need to consider the effects of taxes and trading costs. But if you do this experiment enough times, I think you'll agree that over time, you can add significant value by rebalancing at regularly scheduled intervals in a disciplined manner.

Support the Wintergreen Alpine Race Team! Win a Free Dinner with The Naked Portfolio Manager!

2010-02-09T08:48:00.003-05:00

I think I set Wintergreen's record for the fastest time to becoming a homeowner this year.

I first visited the green and white slopes of Wintergreen on December 31st when my friend Patrick Morin invited me to a New Year's Eve Party there. I met some really great people and pretty much fell in love with the place.

The next weekend, I brought my whole family up to the mountain for a visit. While my oldest children snowboarded, I watched my six-year-old - on skis for the first time - ski circles around me. When I suggested we might buy a townhouse at Wintergreen, my thirteen-year-old son exclaimed that was "the best idea I ever had"!

The next weekend I met with real estate agent Brian Chase, and after being assured we were at the absolute bottom of the real estate market, I made an offer on a lovely home in Trillium. If all goes well, we close on Thursday of this week.

As the newest Wintergreen homeowner, long time resident and race team booster Janice Smeallie invited me to a party this weekend, which includes a silent auction to benefit the Wintergreen Alpine Race Team. The team has a supportive group of parents behind them who raise funds to help pay for the young athletes' training and coaching. The team competes against others in the Southern Alpine Racing Association. To show my appreciation for the invite and to support the community, I decided to donate two autographed copies of The Naked Portfolio Manager and to take the winning bidders to The Tobacco Company for an illuminating discussion of rules-based investing. A complete list of items that are going to be auctioned will be available here this Thursday, so check back then and make a bid. Go Wintergreen Racing!

Sweet Briar Crushes the S&P 500 In January

2010-02-08T11:03:00.001-05:00

Professor Tom Scott of Sweet Briar College has compiled the results for the first month of our test.

If you will recall, the students in Professor Scott's "Principles of Investing" class created five "naked strategies" or rules-based methods and produced a portfolio based on empirical research. Each of these models is purely mechanical. There's no human judgment involved. You simply apply the rules to determine the stocks in each portfolio.

Obviously, we cannot draw conclusions after just one month, but according to Professor Scott, four of the models did indeed outperform the S&P 500, and only one trailed the Index in the first month. By the end of the year, we'll have a total of 60 data points (five models and twelve months) and may be able to draw some inferences based on the results.

You can go to Professor Scott's website and see the results for yourself for month #1. You'll also see the stocks the students' models identified for February.

Sign up for email alerts to my blog so you won't miss out on future updates on the Sweet Briar experiment!