The most obvious way to split investment types pertains to investment horizons – there are short term investments and long term investments. These coincidentally align with the way the finance world is split, as you may have read in the past, into the buy side and the sell side. The sell side is more focused on short term investments, such as trading equities, options, forward contracts, and derivatives. On the other hand, the buy side is focused on long-term wealth allocation to numerous investments, some of which can also be long term equities and instruments, but also vehicles such as bonds, some ETFs and foreign currency.

What’s the difference?

Short terms investments are expected to show substantial gains in a short amount of time. For example, expected currency impacts due to an upcoming government legislation change or stock options with an expiry date would classify as short term investments, and often range from a few weeks to a few hours, even minutes at the extreme. On the other side of the playfield, long term investments often have a broader investment horizon such as a year, 2 years, 5 years, or even “forever”, an investment horizon often associated with investing guru Warren Buffett. Long term investments are expected to produce value for a long period of time, such as the stock of a persistent and global company such as Wal-Mart or British Petroleum.

Which is better for me?

The important thing to remember in finance is that risk is often (there are exceptions) correlated with return. The higher the risk, the more profitable an investment can be. On the other hand, the safer an investment is considered (i.e. bank GICs), the lower the return is.

On that train of thought, short term investments have incredible potential in the short term, but for that same reason, are often categorized as more risky investments due to the high volatility and fluctuations they can undergo. Consequently, short term investments often require more attention since the price can change without warning, and often requires greater expertise in the financial markets as they are usually more technical in nature. The chase for a higher yield often lays in short term investments at the risk that a lot of money could be lost.

Long term investments, when chosen with tact and careful analysis, can provide steady and reliable returns for years. For example, purchasing stock in a solid company like Procter & Gamble is not much of a gamble (pun intended), since the company will likely continue flourishing for a long time to come, and the underlying value of its shares involves less risk along the way with a steady return. But, for the safety provided, PG knows it does not need to pay as high dividends, and thus long term investments usually provide lower annual returns.

For the reasons above, people who are closer to retirement invest for the long term. Younger people can handle more risk since they don’t need a nest egg to rely on in their retirement risks. But, as always, there are exceptions to both sides.

Now that you have a good idea of what both consist of, try to assess your risk tolerance and see what types of investments fit better for you. Here’s a way to assess your risk tolerance. http://njaes.rutgers.edu/money/riskquiz/

Side note on Mutual Funds and ETFs (on long-term investing)

Mutual funds have been around for ages, and are often regarded as the simple investment alternative for folks who do not want (or have the technical proficiency) to conduct their own investment research, such as families, doctors, plumbers, and most importantly, young people. Unfortunately, even though mutual funds have a “safe” and “reliable” image, they are one of the worst long-term investment alternatives there are. Here is why. On the other hand, a recent investment vehicle known as ETFs (exchange traded funds), have paved the way for a new type of long term investment. Here’s a great article for why ETFs, specifically active ETFs in this case, trump mutual funds.

Image credit: Amanda Woodward under a Creative Commons license

Here at Young & Invested, we are always looking after our readers and we have a special offer for you.

On March 25th, you will have a chance to see the former Chief Economist and Strategist at CIBC World Markets, Jeff Rubin.

In partnership with University of Toronto, we are giving away 10 special VIP access passes to our readers. You can register with a special promotional code (YIVIP) available through this link available only to Y&I readers.

Here is additional information on the event:

Jeff Rubin was the chief economist and chief strategist at CIBC World Markets. He was one of the first economists to accurately predict soaring oil prices back in 2000, and is now one of the world’s most sought-after energy experts. His newest book, Why Your World is About to Get a Whole Lot Smaller, was the #1 best-selling book on Amazon.com in the spring of 2009.

What do subprime mortgages, Atlantic salmon dinners, SUVs and globalization have in common? According to Rubin, they all depend on cheap oil. And in a world of dwindling oil supplies and steadily mounting demand, there is no such thing as cheap oil. Oil might be less expensive in the middle of a recession, but it will never be cheap again.

Rubin claims that if you eliminate cheap oil, the global economy is going to get the shock of its life.Interest rates, carbon trading, inflation, farmers’  markets and the wave of trade protectionism washing up all over the world in the wake of various economic stimulus and bailout packages—they all hinge on the new realities of a world where demand for oil eventually outstrips supply.

As stated in our mission, Y&I is dedicated to becoming THE hub for finance and investing insights from the new generation.  We are dedicated to engaging this community of young adults and contributing to the mindshare of knowledge about finance that exists out there. And most of all, we are dedicated to bringing ideas from this generation to the forefront of mainstream discussion and providing them with the attention that any new insight deserves! Y&I is from the new gen, for the new gen.

With those goals in mind, we’d like to share you our vision for Young & Invested and where we hope to be by the time 2011 rolls in. And as in any tightly knit community, we invite your thoughts and feedback on our ideas and especially your suggestions on how we can further engage YOU!

Here’s what you can expect this year:

• NEW: Blogger interviews – Very soon, we’ll be starting featured interviews of prominent financial bloggers to bring you opinions from the best names out there. Keep a look out for that!
• NEW: “Investment Guru” interviews – We’ll be bringing to you interviews from people managing the real dollars. Sharing the tremendous experience and knowledge of these industry leaders will be invaluable.
• MORE: Continued expansion of our contributor base as we search for curious and inquisitive minds looking to put themselves on the map. We love bringing new perspectives such as these to our community. We invite people with a deep interest in finance and investing to contribute, just contact us!
• MORE: You will see more guest posts by invited bloggers/investors/financial experts on topics of their specialty.
• MORE: Continued analysis of financial markets and the economy through insightful and often contrarian articles such as this and this. These have proven to be especially popular, so expect more.

Thank you very much for your support. Cheers to a spectacular 2010!

Your Y&I Team – Dan, Alex & Shishir

From the new generation, for the new generation

Image Credit: seeveeaar under a Creative Commons license.

With the Dubai World fiasco and the recent downgrade of Greece to BBB+ by S&P, people fear a cascading effect on other Eastern European nations just as Abu Dhabi and Qatar saw a crisis of confidence (or contagion) in their businesses when Dubai World became public with its problems.

I first thought of performing this analysis upon reading a post on Zero Hedge (http://www.zerohedge.com/article/sovereign-cds-leverage-correlation) on CDS spreads vs Leverage that Tyler Durden posted. I thought there were other ways and different angles to explore this same topic.

To start off with some basics, a Credit Default Swap (CDS) is insurance written on debt issued by some entity. The party writing the CDS is basically guaranteeing a payout to the owner of the debt if the issuing entity decides to default. Along the same lines, Sovereign CDS is insurance written on debt issued by governments, instead of corporations. In return, the buyer of the CDS pays the issuer a series of payments (known as the “spread”) for that safety. So effectively, the CDS spread represents the riskiness of the underlying asset that’s being insured, since insuring a riskier bond would require a bigger “payment” or spread.

As such, the CDS spread acts as an effective “price” for the contract just as a stock’s price acts as a measure of value for a company. Now, just as the price of a stock is linked to something fundamentally, such as the earning power of the company or its anticipated growth, the “price” or the CDS spread on sovereign debt is also linked to the financial health of the issuing government – which can be measured by the country’s debt-to-GDP ratio as Zero Hedge analyzed it.

In the chart below, you see the 5-yr CDS spread plotted against the public debt-to-GDP ratio for 46 countries for which data was available. The data came from various sources such as the CIA World Factbook, OECD and IMF and most of it from 2008, hence slightly outdated. The CDS spread data is from Dec 15^th, 2009.

In this chart, we would expect to see those countries with a higher debt-to-GDP ratio to have a higher spread on their CDS because writing insurance on debt issued by highly leveraged countries should cost more. Right away, you can notice the outliers such as Ukraine, Argentina and Venezuela who have spreads above 1000 basis points (ie. 10%) even though they have low debt-to-GDP ratios – these can be explained by previous defaults and highly volatile political situations. Then we notice the recent countries that’ve had crises of confidence such as Greece and Iceland that have an elevated spread relative to their debt levels. But if we start looking for profit-making opportunities here, to look for spreads that we can expect to reduce or increase in the future, we see Bulgaria, Philippines and Vietnam – all 3 are developing (or becoming developed) economies with increasingly stable finances and it should get less costly to write insurance on their debt. Hence, the opportunity is to write insurance on their debt now, to get the bigger payments (spreads) now, while knowing that the riskiness of their debt should decrease! On the other end of the spectrum, you see Japan with the highest leverage in the group and the opportunity here lies in buying insurance on Japanese debt while it’s cheap as I would expect the ageing demographics and continuously stagnating economy to pressure government finances even more.

In this next chart, I used only the External Debt-to-GDP ratio, instead of using total debt, since the amount of external debt (money loaned from other countries) should be a better determinant of financial health. For example, one reason Japan had such a low spread despite a high debt load is because a majority of its debt requirements are met locally within Japan.

Right away, you see Iceland and Ireland that became infamous for their external debt levels. The opportunity I see here is with the UK and Switzerland – in any crisis situation they encounter, you would see their spreads skyrocket because of the large amount of debt they owe to foreign nations, hence making their currency and economy vulnerable. So, purchase the CDS while it’s cheap and then wait for a black swan to arrive. Other than that, there’s not too much to glean from this data as I felt this it was slightly inconsistent.

Digging further, I plotted the CDS spreads against the credit ratings that S&P gives to the Long Term foreign currency debt issued by these nations. This paints a much clearer picture (having left out outlier > 1000 bps) with a distinct positive slope reflecting a higher spread on nations with poor ratings.

Over here, the opportunity lies in the spreads of countries like Turkey, Peru and Vietnam narrowing as their economies develop and become stable. Take note that even though countries like Vietnam look like they are close to where they “should” be given their S&P ratings, the ratings itself will improve when S&P upgrades healthy economies which will then cause a narrowing in the spreads for that nation. Alternatively, you can bet that the spreads of post-crisis countries like Iceland and Ireland would almost certainly narrow as their economies slowly regain their footing. At the same time, you have to acknowledge that S&P ratings are just a third party opinion and they could be wrong.

What are your thoughts? Which of the 3 metrics do you think makes the best connection with CDS spreads?

Disclosure: No positions in credit default swaps.

Image Credit: Caveman/Grinch under a Creative Commons license.

Young & Invested is THE hub for finance and investing insights from the new generation. Head to our blog for more insights! — http://youngandinvested.com

Disclaimer: Views and opinions expressed on above are those of the author alone and do not in any way represent the official views, positions or opinions of the employers – both past or present – of the author in question, or any other institutions and corporations associated with the author. Neither the information nor any opinions contained or expressed above and elsewhere on Young & Invested constitutes or should be construed as a solicitation or offer by Young & Invested to buy or sell any securities or other financial instruments or to provide any investment advice or recommendations. Young & Invested shall not be liable for any claims or losses of any nature, arising indirectly or directly from use of the information on or accessed through the site. Please see full disclaimers here.

Leveraged ETFs use derivatives to underpin the underlying investment, and suggest investors can earned double (or triple) the expected return on the supporting index, similar to returns from margin investing. This is not without risk. Along with the increased chance at a significant loss, leveraged ETFs experience a form of decay that further deteriorate your potential return. ETF decay occurs as the investment loses value over time when the market price experiences fluctuations. When the market does not have clear direction, leveraged ETFs will experience a loss of value as compared to its multiple on the underlying portfolio.

Some believe a 2x leveraged ETF that loses 5% on day 1 and gains 5% on day 2 has experienced ETF decay since it has not regained its position to the original value (scenario A). This is a common misconception about ETF decay. The stock is trading short of the original value because the companies making up the underlying portfolio have not regained their collective value. Stocks do not trade based on percentage fluctuations; instead, they trade at the underlying asset value. While ETF decay makes up a portion of this difference, this is not how to measure it. Decay should only be measured once the index has returned to its original value, allowing us to determine the difference between the return expected (zero) and the return achieved by the leveraged ETF (including ETF decay).

Scenario B considers an index that drops $25 before returning to its original value. The percentage increase on day 3 is larger than 2.50% since the base is $975 and also affects the ETF (increase of 5.13% instead of 5.00%). After a short-term fluctuation, the index is back to its original value ($1,000) whereas the ETF has settled at $99.87. The loss of 0.13% is ETF decay. If the ETF were to mirror the index perfectly (whether up or down) without decay, the ETF should be back at its original value as well.

The above scenario assumes a decrease of 2.5% on the index before recovering over a 2-day period. If we were to run the recurring scenario for 50 trading days, the effective ETF decay would be 3.16% (compared to 0.13%). This percentage is lost value that the investor incurs while holding leveraged positions.

Instead of returning to the original value every second day, consider the scenario where the index falls $25 every day for 25 days, then regains $25 per day. This will again return the index to full value ($1,000) at day 50. In this case, the ETF decay is measured at 8.01% – think twice before holding leveraged ETF’s when the direction is downward. On ETFs that boast 3 times the daily return, the ETF decay in this scenario is magnified to 22.25% (compared to 8.01% for 2x ETFs).

Although you MAY earn more than the index using leveraged ETFs, the decay outlined above indicates that it is typical to earn less than the expected return by using leveraged ETFs. Regardless of the fluctuation pattern over time, leveraged ETF’s will experience decay that cuts into the final return for the investor. Note that non-leveraged ETFs do not experience ETF decay as the daily change will mirror the index.

Key takeaways:

- ALWAYS understand the buildup of the ETF. If it is based on a subsector or index, it is essential to understand the industry and the companies that will have the largest impact on the trading price. Understand that any change to an index company’s valuation may have a significant impact to the corresponding leveraged ETFs.

- ALWAYS understand the major influences of the stock price. For example, HOU (long oil) does NOT fluctuate with the price of oil. Rather, it is base on movements in the futures market of crude.

- Use leveraged ETFs with caution and only for short-term positions. ETF decay does exist and active trading in the leveraged ETF market should only be used if substantial losses can be withstood. Leveraged ETF investing is not for the weak at heart.

Disclosure: Long market.

Image credit: lastnychero under a Creative Commons License.

Young & Invested is THE hub for finance and investing insights from the new generation. Head to our blog for more insights! — http://youngandinvested.com

A study on IFRS showed that 50% of companies demonstrated higher equity under IFRS accounting standards than GAAP, and a huge 65% showed higher earnings. Would that influence your investments? Most investors don’t realize that IFRS will have significant implications on financial statements, and are in danger of using outdated analysis methods and comparison to old benchmarks.

Being one of the few accountants venturing into the financial markets, I thought it would be helpful to provide insight into how the upcoming MASSIVE global shift in accounting standards to IFRS (International Financial Reporting Standards) is going to affect financial statement analysis. The changes, officially being implemented by all publically accountable entities by 2011 are far from being as clear as those in financial reporting would like to see.

Not only is the transition to IFRS pervasive to almost all areas of a company’s operations in terms of data acquisition, but a majority of public companies have been severely affected by the global recession in regards to credit attainment, causing cash flow shortages. Subsequently, it has been an unsuccessful effort to provoke company-wide transition to the IFRS system. On a similar note, investors have paid less than deserved attention to survey the IFRS terrain.

In regards to current accounting standards in the US and Canada (called GAAP; mostly similar between the two countries), there are a few significant IFRS and GAAP differences that will affect your analysis of financial statements, and therefore investments and profitability. The first IFRS-compliant financial statements you will see will be for the 3 months ended March 31, 2011 (with comparatives of March 31, 2010.

Here are a few of the most significant (upon more) differences you can expect:

Disclosure

On a good note, disclosure requirements under IFRS are heavier and will require companies to provide a higher degree of transparency (more fun reading materials). Although companies reporting in Canada and USA currently follow GAAP disclosure requirements, they tend to limit the number of financial statement subtotals used and disclosure provided in the notes for competitive reasons. IFRS requires more broken down income statements and balance sheets, so be prepared to see more subtotals and categories.

MD&A will also require escalating amounts of detail. Interim reports during 2010 must have quantified information about how IFRS will affect the financial statements and company. Reconciliations between GAAP and IFRS must also be provided.

Financial Instruments

This should be an interesting one! Entities will have to evaluate the significance of financial instruments for their financial position and performance, as well as present the nature of related risks to which the entity is exposed to during the reporting period and how management handles those risks (qualitatively and quantitatively). Interestingly, this is coupled with a disclosure requirement for management to assess the company’s going concern assumption in MD&A.

Hmm… I wonder if this rule to assess impact of financial instruments would have made a difference before 2008?

But on a serious note, I hope this really serious standard is addressed with strict measures by auditors and companies. By the way, this applies to ALL companies owning financial instruments, even if it’s as simple as receivables and payables.

Capital Assets

Whereas GAAP does not allow revaluation to fair value (except write-downs due to impairment), IFRS allows companies to revalue assets at fair value if reliable measures allow to do so. For example, under current GAAP, buying a company Ferrari F430 at $160,000 would require me to record it at cost and take annual depreciation on it (less any additional impairments). Under IFRS, if my Ferrari F430 were suddenly considered rare, I can actually write it up in value to $200,000 or even $1,000,000 if the values are reliable. Although the revaluations can only be recognized in other comprehensive income (not part of continuing operations on the income statement), you can definitely expect A LOT more volatility on balance sheets and financial statements. Even if revaluations won’t be seen in continuing operations, the final total on the income statement will be affected by this, as will asset classes on the balance sheet.

Make sure that your investment analysis scouts for any revaluations to fair value and accounts for it accordingly, giving it enough skeptical criticism to understand that sometimes it may not be as meaningful as it seems or an indicator of a solid competitive advantage.

Revenue

In general, revenue treatment in IFRS is similar to GAAP. It may be reasonable to use the same investing implications for revenue figures as current practice dictates.

Other Major Differences

Other major differences you will see pertain to measurement of capital assets, provisions such as allowance for doubtful accounts, accounting for leases, pension accounting and much more. This article cannot afford to be technically exhaustive, so I urge you to study the effects of IFRS further. Take a course, read a pamphlet, talk to your local CA/CPA – just be aware that the changes will be significant. I’d recommend to visit http://www.iasb.org/Home.htm.

Although addressing these changes will be technically demanding, the risk of not doing so is high. Most investors will underestimate the impact of IFRS on their investing processes – a process that’s challenging enough already. Taking a proactive approach to IFRS’ effect on your investing analysis should help minimize the risks and maximize the benefits that a majority of investors won’t see coming.

Image Credit: thinkpanama under a Creative Commons license.

The Industry

The easiest way to think about the Global Energy sector is by segmenting it into two main industries: Oil, Gas & Consumable Fuels and Energy Equipment & Services. Most people associate their daily interactions with the former – it includes the Essos, Sunocos, and Petro Canadas of the world. The Equipment & Services sector assists the Oil & Gas industry with exploration, but the process really starts at the top with the Oil and Gas Industry.

Oil & Gas Industry – The Integrated Process

The Integrated Process includes firms engaged in the exploration, production, delivery, refinement, and marketing of petroleum products to consumers. This process includes Upstream, Midstream, and Downstream processes. The Upstream process deals mostly with the exploration of hydrocarbons like oil and natural gas. Some companies like Devon Energy (NYSE:DVN), Targa Resources (NYSE: NGLS) and Anadarko Petroleum (NYSE:APC) search the globe for oil and gas reserves.   The Midstream process includes the processing, storage, and transportation of hydrocarbons. Some Canadian companies engaged in this process include TransCanada (TSE:TRP) and Enbridge (TSE:ENB). Finally, the Downstream process includes the refinement of oil and natural gas into usable petroleum products for sale to consumers. Companies involved in this process include Sunoco (NYSE:SUN) and Valero Energy (NYSE:VLO)

Energy Equipment & Services Industry

As previously mentioned, the Energy Equipment & Services firms assist oil and gas firms with exploring, drilling, and producing reserves, but generally don’t own oil and gas deposits directly. These firms are hired by pure upstream oil and gas producers and integrated firms like Exxon Mobil to assist in getting hydrocarbons out of the ground. There are two main types: Oil & Gas Drilling and Energy Equipment & Services. Oil & Gas drilling companies perform mainly one function: renting out their rigs to other companies to use for exploration. Oil & Gas Equipment & Services companies (a big one being Schlumberger) provide all the equipment, services, and expertise required for oil field exploration, development, and production. In short, firms within the encompassing Energy Equipment & Services Industry provide products and services to companies in every aspect of the energy cycle.

How Does It Affect Me?

Understanding the Oil & Gas Industry is not only important for individuals in Finance, but also to normal every day people. How? When you pay for a litre of Gas at the station, you are directly affected by the industry. Most people don’t realize this, but gas stations usually make more profit selling candy and refreshments than gas sold to drivers like you and me. The industry is very competitive, and any cost that may be cut will count towards the bottom line. In the next part of the series, we will discuss how Supply and Demand plays a factor in the industry, and what the key drivers of profitability are.

_____

Derrick Fung is a guest contributor on Young & Invested. He has experience in Sales & Trading at Merrill Lynch, and was previously a member of the Global Equities and Commodity Derivatives Group at BNP Paribas. He is a recent graduate of the BBA program at the University of Toronto. You can follow him on twitter at http://www.twitter.com/derrickfung

Note: See important disclaimers below article.

Just as there are bubbles of positive sentiment (ie. Manias), there are also bubbles of negative sentiment (ie. Panic) where investors generally believe the end of the world is near and the last thing they want to be caught doing is holding stocks. This, I believe, was the situation in the early days of March 2009, just before the market bottomed.

The situation has definitely improved much since then, but has it improved for the right reasons? Should investors still be bearish? In this second edition, I explore the biggest justifications held out by the “bears”.

Top 5 reasons to be BEARISH

“What’s with the insiders?”

Insiders are those people who have access to non-public information about a company – ie. Employees, senior management, executives. In recent months, insider selling has FAR outweighed insider buying by many multiples. With figures courtesy of TrimTabs (which tracks insider transactions), during August, insiders averaged $210 million worth of shares bought, while they sold $6.3 billion worth. That’s a whopping 30x sell-to-buy ratio! In the last week of August alone, there were $8 million worth of insider buys corresponding to $520 million of insider sales. That means a ratio of nearly 62x! If insiders are selling, and they know more than the market, then what does that show?

“Where is the volume?” ­

One of the cornerstones of trading wisdom is to follow the volume. Some go so far as to say that a trend holds little meaning if it is not on rising volume. For the rally starting in March, the volume, unfortunately, peaked in March as well. A look at the chart below shows that the ride up has been on declining volume. This makes the rally technically “un-sound”. Even in daily trading, dips have been on high volume, while gains have been on below average volume. And volume usually supports the “correct” trend.

“Show me the money (ie. Revenues)”

While analysts have rejoiced over earnings beats during both Q1 and Q2, the fact is that the beats have been on the bottom-line (ie. Net Income). Companies have had smaller losses than expected, but these have been the result of aggressive cost-cutting, instead of better than expected revenue numbers. Such cost-cutting is not a sustainable solution to maintain better than expected profitability. What’s necessary is revenue improvement which can only result from demand returning to the fore. This has so far not been seen and it remains unclear when it might return as the savings rate in the US shoots up towards 10%, unemployment continues to rise and businesses hold back on investments.

“Rally is stimulus driven” ­

The start of the March rally coincided with some of the largest aid programs initiated by the US Treasury and the Fed. For example, the Public-Private Investment Program (PPIP) and the American Recovery and Reinvestment Act, initiated by Barrack Obama, both came into play during March. As such, it is easy to postulate that the market rally is the result of excess liquidity provided being channelled into the markets. Following from that, when these temporary programs and government guarantees are rolled back in, the un-natural support for the equity markets might evaporate overnight. Already, the markets have seen a negative impact on the car manufacturers as the cash-for-clunkers program ended with US car sales declining 41% month-on-month in September. With a massively increasing US debt burden, other government programs cannot continue indefinitely.

“It’s all those computers”

Program trading makes up about 70% of the trading volume on the NYSE. Program trading refers to the high-frequency trading that takes place between computers which take advantage of things like liquidity rebates offered by the exchanges, co-location benefits etc. Program trading is rarely motivated by company fundamentals, which leads to the question of whether the direction of the market is even related to fundamentals, since program trading accounts for such a large proportion of trading. In recent weeks, the effect of such trading has been quite obvious with trading in just 5 stocks – Citigroup, Bank of America, AIG, Fannie Mae and CIT – making up roughly 40% of the total NYSE daily volume. This is very unusual, even ignoring the fact that 3 of those 5 companies are already bankrupt. And on several days, the shares of even long defunct Lehman Brothers, were bid up causing them to triple in a few days, showing the huge disconnect with fundamentals again.

Toss a coin?

Where the rally goes from here is anyone’s call. It’s relatively easy to identify the factors that play into setting the direction of a market but close to impossible to ascertain the magnitude of the impact that each will have in determining what that direction is.

Whether it’s a bear-market rally or a new bull-market, a minor bubble in a largely imploding market or a new bubble all together, the goal would be to understand the dynamics either way and take advantage of them. Unfortunately for us, we can’t use the “heads I win, tails you lose” formula.

Disclosure: Long the market

Image credit: Jenny Downing

Disclaimer: Views and opinions expressed on above are those of the author alone and do not in any way represent the official views, positions or opinions of the employers – both past or present – of the author in question, or any other institutions and corporations associated with the author. Neither the information nor any opinions contained or expressed above and elsewhere on Young & Invested constitutes or should be construed as a solicitation or offer by Young & Invested to buy or sell any securities or other financial instruments or to provide any investment advice or recommendations. Young & Invested shall not be liable for any claims or losses of any nature, arising indirectly or directly from use of the information on or accessed through the site. Please see full disclaimers here.

A contrarian is the odd one out.

As a follow up to my previous post on contrarian investing, I’d like to explain to you why a majority of investors, both in industry and personal, undergo flawed investment strategies. These findings originated from David Dreman and his market research team, although I’m sure it has been noted by many others.

1. The story starts with human limitations. Have you ever heared that the reason phone numbers are only 7 digits long (in Canada anyway) is because that is the maximum our minds can retain? Similarly, the average person can only entertain 2-3 ideas at a time. The idea I am leading towards is human beings have a massive lack of ability in analyzing a lot of data configuraly (means analyzing data not only on their own accord, but also on how data affect each other).

2. The other side of the story has to do with a general human trait to be overoptimistic. Over 60% of drivers say they are better than average – yup! 80% of entrepreneurs believe their chances of success are over 70%, whereas survival rate in reality is about 33% after 5 years – yup! Investors are also human – yup!

So, any human being who is exposed to masses of equity data, economic data, interest rates, competitive factors, future projections and plans etc., has 0% chance of being completely right, and most often very far from estimates to even be a successful investor. What’s more is that “experts” in the industry tend to be even more optimistic and confident due to their status, but in reality analyze SOOO much information and charts and reports and tables that they are incredibly vulnerable to mistakes.

In fact, here’s a pretty self-evident survey showing the number of forecasts made by “experts” and the amount of times they performed lower in the market (it’s a little outdated, but whatever, the data still speaks for itself; modern financial models haven’t changed dramatically in the last decade). As I said, these “experts” who have tons of experience just feel like they built the ability to analyze more and more data as it comes at them through their professional demands are in fact being highly over-optimistic of their skills. Point proven:

What I took from all this research performed by Dreman is that correlations are so easy to misinterpret so decisions based on factors like beta, interest rates, future projections, economic factors, oil prices etc. should be avoided.

As humans and investors, we have to appreciate our limitations of working with mass information. Few of us can get it right (i.e. Buffett). In-depth information does NOT translate into in-depth profits in 99% of all cases; quite the contrary. Facts that are mere coincidences can seem like obvious correlations. There are NO highly predictable industries in which you can count on analyst estimates, because being exposed to so much data (and being highly overconfident), they are more likely to be wrong than even individual investors.

Overall: skip the academics. Current security analysis requires precision in estimates of earnings, cashflow, dividends etc. that is impossible to provide. Investment strategies that circumvent stumbling into these masses of data are out there. More coming in the next article!