Financial risk management

Last time, we talked about a game which I claimed is easy to lose despite having the odds in your favor.

What most people do wrong is they bet too much on any one play of the game. For example, if you start with $100, and bet the whole thing on the first play of the game, you have roughly a 46% chance of going broke. That means you don't get to play anymore. Even if you win that round, if you keep betting the whole wad on each play of the game, you will lose sooner or later (probably sooner).

If you bet a smaller fraction—say half, you will still lose, because sooner or later you will run into a string of losses. Let's say that you wager half. Suppose that you lose the first play (which is not particularly unlikely at 46%), then you are down to $50. If you wager $25 on the 2nd play, then at best, if you win the 2nd play, your up to 75$ which is still behind. It would take 2 wins in a row (assuming $25 wagered on both of them) just to get back to where you started, and you only have about 29% chance of pulling it off! It would take 2 wins in a row just to make up for 1 loss, even with odds in your favor!

The correct strategy is to wager smaller amounts, so that you have plenty of reserves to spare against losses. In general, it is possible to estimate the optimal mix of different asset classes according to their expected risk and expected yield. In practice, risk by its very nature is hard to predict, and yields aren't easy to guess right either. Intelligent guesses are still better than blindly throwing the whole wad on the riskiest asset class in hopes of earning the highest reward, which is exactly what most Americans do with their life savings.

This is NOT a plug for something called “diversification”. Scattering one's assets into asset classes all of which have unacceptably high risk/reward ratios is really stupid, and yet most people can be talked into it on the basis of “safety” because they don't understand the nature of the risk and are too trusting of financial advisors with massive conflicts-of-interest. Diversification ONLY works if you are diversifying accross different kinds of asset classes with different risk/reward profiles, with the weighting of assets preferably mathematically optimized according to reasonable guesses as to their risk/reward profiles. You then need to keep re-balancing the portfolio to cash in on profits (buy and hold ultimately means watching it go up, then watching it go down) and take advantage of bargains; this is an asset-allocation scheme that does not rely on being able to accurately time the market, tho you might try to intelligently estimate risk, and therefor the weighting of different asset classes, according to what you think the state of the market it at any one time.

A typical retirement portfolio consists of mutual fund holding S&P 500 stocks, another mutual fund holding Dow stocks, another mutual fund holding stocks and bonds of the same companies, and maybe a money-market mutual fund full of unsecured corporate paper at negligible yields. The owners of these portfolios have been deceived into thinking of them as being “safe”, because they are “diversified”, but the reality is that they are full of different brands of the same kind of garbage! When the stock market moves decisively, most stocks tend to move in the same direction (this is one of those strange self-fulfilling prophecies, by the way), so owning tiny bits of vast numbers of stocks is not going to protect anyone against stock market losses. In the 1990s, bonds rose right along with stocks; as interest rates rise they'll fall right along with stocks. The belief that they tend to run counter to stocks is based on Keynesian economic theory, which has been proven false. Funds that are full of both stocks and bonds are deceptively referred to as “balanced”, as if alternatives are unbalanced. Brokers routinely refer to money in money-market funds as “cash”, misleading their clients into thinking that their money is all sitting in a vault somewhere and they can have it back at any time. It is, in fact, loaned out to corporations some of which are technically insolvent; the risk to reward ratio is outrageously high. If everyone were to withdraw their funds at the same time, as indeed will more-or-less be the case when the Baby Boomers retire and draw down their funds, they will be in for a nasty surprise. And they risked all that money for a fraction of a percent of interest, not even enough to keep up with inflation!

Financial advice is massively-regulated, but the regulations not only allow this kind of deception but actually require it! You could not get certification in any financial advisory capacity unless you subscribe to the orthodoxy, which is nothing but a scheme to transfer risk to unsuspecting masses (Greenspan glibly refers to it as ”spreading risk”). Regulation, and a lot of deceptive talk about risk-management, creates the illusion that somebody else will take care of you and your money. Astonishingly, most people not only fall for this trick, they will angrily defend the very people who are out to fleece them if you point out the risks to their life savings from these schemes! I have found in life that people become very angry when you point out that the universe does not revolve around their personal needs, and that they, themselves alone, are responsible for their own destiny.

Another reason people blow up at me when I try to explain why their retirement accounts are not performing well is called “gambler's fever”. Why do people come back to Las Vegas again and again? Because they keep winning? NO! Because they keep losing! Incredibly, people actually have some sort of bizarre dysfunctional obsession to “win it all back” through the very same mechanism by which they've already lost! I'll write some more about gambler's fever and other dysfunctional choices in upcoming installments.

It seems as if once you explain how the smoke-and-mirrors work, they would become disillusioned because these are objective facts they can verify for themselves. Instead, they usually become ANGRY. They want to believe, and here you are trying to pop their balloons!

Last time, we talked about a game which I claimed is easy to lose despite having the odds in your favor.

What most people do wrong is they bet too much on any one play of the game. For example, if you start with $100, and bet the whole thing on the first play of the game, you have roughly a 46% chance of going broke. Once you're broke, you don't get to play anymore. Even if you win that round, if you keep betting the whole wad on each play of the game, you will lose sooner or later (probably sooner).

If you bet a smaller fraction—say half, you will still lose, because sooner or later you will run into a string of losses. Let's say that you wager half. Suppose that you lose the first play (which is not particularly unlikely at 46%), then you are down to $50. If you wager $25 on the 2nd play, then at best, if you win the 2nd play, your up to 75$ which is still behind. It would take 2 wins in a row (assuming $25 wagered on both of them) just to get back to where you started, and you only have about 29% chance of pulling it off! It would take 2 wins in a row just to make up for 1 loss, even with odds in your favor!

The correct strategy is to wager smaller amounts, so that you have plenty of reserves to spare against losses. In general, it is possible to estimate the optimal mix of different asset classes according to their expected risk and expected yield. In practice, risk by its very nature is hard to predict, and yields aren't easy to guess right either. Intelligent guesses are still better than blindly throwing the whole wad on the riskiest asset class in hopes of earning the highest reward, which is exactly what most Americans do with their life savings.

This is NOT a plug for something called “diversification”. Scattering one's assets into asset classes all of which have unacceptably high risk/reward ratios is really stupid, and yet most people can be talked into it on the basis of “safety” because they don't understand the nature of the risk and are too trusting of financial advisors with massive conflicts-of-interest. Diversification ONLY works if you are diversifying accross different kinds of asset classes with different risk/reward profiles, with the weighting of assets preferably mathematically optimized according to reasonable guesses as to their risk/reward profiles. You then need to keep re-balancing the portfolio to cash in on profits (buy and hold ultimately means watching it go up, then watching it go down) and take advantage of bargains; this is an asset-allocation scheme that does not rely on being able to accurately time the market, tho you might try to intelligently estimate risk, and therefor the weighting of different asset classes, according to what you think the state of the market it at any one time.

A typical retirement portfolio consists of mutual fund holding S&P 500 stocks, another mutual fund holding Dow stocks, another mutual fund holding stocks and bonds of the same companies, and maybe a money-market mutual fund full of unsecured corporate paper at negligible yields. The owners of these portfolios have been deceived into thinking of them as being “safe”, because they are “diversified”, but the reality is that they are full of different brands of the same kind of garbage! When the stock market moves decisively, most stocks tend to move in the same direction (this is one of those strange self-fulfilling prophecies, by the way), so owning tiny bits of vast numbers of stocks is not going to protect anyone against stock market losses. In the 1990s, bonds rose right along with stocks; as interest rates rise they'll fall right along with stocks. The belief that they tend to run counter to stocks is based on Keynesian economic theory, which has been proven false. Funds that are full of both stocks and bonds are deceptively referred to as “balanced”, as if alternatives are unbalanced. Brokers routinely refer to money in money-market funds as “cash”, misleading their clients into thinking that their money is all sitting in a vault somewhere and they can have it back at any time. It is, in fact, loaned out to corporations some of which are technically insolvent; the risk to reward ratio is outrageously high. If everyone were to withdraw their funds at the same time, as indeed will more-or-less be the case when the Baby Boomers retire and draw down their funds, they will be in for a nasty surprise. And they risked all that money for a fraction of a percent of interest, not even enough to keep up with inflation!

Financial advice is massively-regulated, but the regulations not only allow this kind of deception but actually require it! You could not get certification in any financial advisory capacity unless you subscribe to the orthodoxy, which is nothing but a scheme to transfer risk to unsuspecting masses (Greenspan glibly refers to it as ”spreading risk”). Regulation, and a lot of deceptive talk about risk-management, creates the illusion that somebody else will take care of you and your money. Astonishingly, most people not only fall for this trick, they will angrily defend the very people who are out to fleece them if you point out the risks to their life savings from these schemes! I have found in life that people become very angry when you point out that the universe does not revolve around their personal needs, and that they, themselves alone, are responsible for their own destiny.

Another reason people blow up at me when I try to explain why their retirement accounts are not performing well (as even they themselves will admit) is called “gambler's fever”. Why do people come back to Las Vegas again and again? Because they keep winning? NO! Because they keep losing! Humans tend to have some sort of obsession to “win it all back” through the very same mechanism by which they've already lost! I'll write some more about gambler's fever and other dysfunctional choices (such as confirmation bias) in upcoming installments.

It seems as if once someone explains how the smoke-and-mirrors work, his friends would become disillusioned because these are objective facts they can verify for themselves. Instead, they usually become ANGRY. They want to believe, and here you are trying to pop their balloons! They come to hate their friends and love their enemies.

An illuminating game

Let's play a game.

I'll give you $100 in Monopoly money. I'll be “the house”. I'll shuffle some a fair deck of some playing cards (52), and set the deck down on the table. You will pick up cards and lay them face-up on the table so that we can both see each card you drew.

The cards rank in this order, lowest to highest: 2 3 4 5 6 7 8 9 10 J Q K A. Every time you pick up a card, you win if the card is an 8 or higher (Ace is high). If you win, I will give whatever you wagered. If you lose, I will take whatever you wagered. Each time you draw a card, you can wager whatever you want, up to the total amount of money you have. So, for example, the first time you draw a card, you have the initial $100, so you could wage any amount from $0 to $100. On the second turn, you could wager any amount from $0 to whatever you end up with after the first turn.

The odds are in your favor, because there are 7 cards 8 or higher, but only 6 cards lower than 8. In fact, unless I shuffle the cards after each one is drawn, you should have a windfall on the last few turns if your memory is good!

You can't lose this game, right? Even if you get unlucky on the first few plays, eventually your wins will outnumber your losses, and you will come out ahead.

Well, there is a way to lose this game, and it proves that nothing is foolproof, because fools show remarkable ingenuity. In fact, most people are prone to losing these kinds of games.

Before my next installment, think about these questions:

1. How can people lose these games when the odds are in their favor?


2. What real-life activity is analogous to this game?

I've given you plenty of hints. Try to figure out the answers (there may be more than one) for yourself. I'll have my take on the problem in my next installment.

Personal economy, Level 0

In my other blog, I claim that we have been judged by our economic policymakers and found lacking. They are clearly encouraging capital flight to Asia, and gutting our livelihoods.

I don't think we're guilty. We're not the ones who asked for Socialism and other capital destroyers; in fact our accusers are the guilty ones. Among their other objectives, they wanted to collect interest on the credit created to finance deficit spending. Be that as it may, they intend to hold us accountable. We need to defend ourselves from them. In order to defend yourself against economic attack, you need some economic strength.

Most Americans and some Europeans (notably Scandinavians) don't have any. Americans have negative savings (that is, they are in debt) and Scandinavians traditionally have negligible savings rates. Without savings, one does not enjoy any financial freedom. One can't make decisions like starting a business, and even decisions like switching jobs become difficult.

Most of us (including me, truth be told) have a lot to do to get their personal business in order, and I don't think it is practical to try to get it all done at once, especially since it involves breaking old and deeply-engrained habits and establishing new habits. I'm going to try to break this up into stages. The first stage is level 0 (computer programmers start counting at zero!). It's level 0 in part to remind you than until you reach this level, you're below water.

These are old habits of mine, so I haven't given this as much thought as it deserves. These are off the top of my head, and may be revised after additional consideration:

• If you have any bad habits, get rid of them.


• Pay yourself first (that means have a savings goal and whatever is leftover is what you have to live on until the next paycheck).


• If you don't have the cash for it, you can't afford it.


• Plan your purchases (don't buy on impulse).


• Think twice before signing up for reoccurring payments (loans, monthly services like cable television).


• Plan for infrequent, extraordinary, and “unforeseen” expenses.


• Don't lose money. (That means, don't take unnecessary risks with it in the stockmarket or elsewhere.)


• Don't invest other people's money (if you are in debt, you have no money to “invest” in equities or bonds). I am aware of the benefits of leveraged investing; it is unsuitable for most people. Poor judgement is more likely the reason for it than shrewd investing.


• Write a will and keep it up-to-date.

There is actually some theory behind this list, but this blog will focus on practice, not theory. Keep reading the companion blog to this one, Atar's Light. In the near future the posts on this blog will get fairly brief, without a lot of commentary.

First post

This is where I will post all my insights for handling the problems and issues I discuss on my other blog, Atar's Light. Watch this space!