Anyone Can Learn Finance

Yuval Bar-Or's 'Anyone Can Learn Finance' Blog Has Moved

2009-12-10T19:04:00.007-05:00

We've recently modernized and reconfigured our corporate websites. This has provided us with the opportunity to move this blog to a new central site. This link will take you directly to the new blog: The Light Brigade.

Please drop by and let us know what you think.

The following sites have been connected to the new central site:

Best wishes from The Light Brigade, and remember: "Enlightened Decisions. Lower Risk."

Why the Small Investor Often Gets Hammered

2009-07-22T15:30:00.001-04:00

The small or unsophisticated investor loses money for a number of reasons. Here are three:

(1) poor asset selection, (2) poor timing, and (3) excessive fees.

Poor asset selection refers to the tendency to invest in assets which are riskier than initially assumed. Often, novice investors chase financial instruments which have exhibited fast price appreciation in the recent past. This fast appreciation is evidence of high risk. Inevitably, over time the higher risk is realized in the form of fast price declines.

Poor timing refers to the tendency to under-invest in stocks when these are undervalued (investors buy too few cheap stocks), and to over-invest in stocks when these are overvalued (investors buy too many stocks which have already peaked and are destined to decrease in value). Poor timing often occurs because the novice investors watch as stocks appreciate in value, and eventually become worried that they will lose out while everyone else appears to be benefiting. Finally, they decide to ‘go for it’ and buy the now significantly appreciated stock. All too often, their decision to purchase is made just around the time the firm falls out of favor, leading to steep price declines and big losses.

Excessive fees are often paid by novice investors. Unknowingly, they accept investments with relatively high fees when very similar investment vehicles are available at lower cost. Higher fees dramatically undermine wealth accumulation over extended periods of time.

Often, passive investment strategies are the best frameworks for avoiding poor asset selection, poor timing, as well as excessive fees.

Passive versus Active Investing Styles

2009-07-16T11:36:00.003-04:00

Passively Managed (Indexed) Mutual Funds

Passively managed or indexed mutual funds are created by acquiring the stock of all firms meeting certain criteria. Often, the only or most important criterion is membership in a broadly diversified index reflecting an overall market's movements. Examples are large cap indexes that try to match the S&P 500 index or an index of the largest firms traded on the NASDAQ exchange. Because the managers of passive funds don’t need to expend time and money researching individual stocks, they incur relatively low costs and can make their funds available to investors with relatively low expenses.
Passively managed mutual funds are typically characterized by:

high degree of diversification
low transaction costs
low management expense ratios
minimal taxes
appropriate for long term investing

Actively Managed Mutual Funds

As the name implies, the stocks or bonds that make up a particular actively managed fund are individually or actively selected by the funds’ management team. The team often applies a variety of criteria in the selection, beginning with very detailed fundamental analysis of individual stocks or bonds. Only those instruments that meet the requirements are selected. Active managers believe they have the ability to identify and buy stocks or bonds that are relatively undervalued and then sell them once they appreciate in value. The proceeds from those sales are then used to buy other stocks or bonds that appear undervalued. The deep analysis required prior to each transaction, along with the frequent buying and selling of instruments means higher expenses for the management team, and these expenses are passed on to the investors. Thus, actively managed funds exhibit higher fees than passively managed ones.
Actively managed mutual funds are typically characterized by:

high portfolio turnover
high transactions costs
high management expense ratios
higher tax liabilities

So how does one choose whether to go with Active or Passive funds?

Active funds are only appropriate if the investor believes the fund's management team has the ability to select stocks that subsequently appreciate and simultaneously sell stocks that subsequently depreciate. While it's tempting to believe that managers have this ability, the rigorous academic literature has repeatedly found that few managers appear to be able to identify winners and losers consistently, and even those few who appear to show such consistency, may simply have been lucky over an extended period. This observation, combined with the higher expenses associated with Actively managed funds, implies that most investors are better off relying on Passively managed funds.

Too Big to Fail: Too Big to Bail

2009-05-11T14:15:00.001-04:00

Large banks have historically benefited from an implicit guarantee known as too big to fail. The idea is that even if not legally obligated to do so, governments may have to provide assistance to financial institutions whose bankruptcy could lead to a destructive domino effect throughout the entire financial system.

The logic invoked in defense of too big to fail is that it serves at least two important functions: it can calm skittish depositors who would otherwise withdraw their funds from the bank, causing a panic and a run on the bank that would surely force it into insolvency, and it can protect investors who would otherwise likely see the value of their entire investment wiped out by panic.

The problem is that with so many large banks struggling for survival, taxpayers are now facing upward spiraling bailout costs in the hundreds of billions (and possibly trillions) of dollars. Too big to fail has become too big to bail.

Poorly-Prepared Finance Professionals

2009-04-29T07:42:00.019-04:00

I recently returned to teaching Investments in a graduate business program.

In an effort to make the coursework as relevant and hands-on as possible, I arranged for student access to a simulated stock trading platform, which allows participants to trade many stocks, along with some bonds, futures, and other financial instruments, in a realistic environment.

To my surprise, I discovered that over two thirds of the class had never traded a financial instrument before in their lives. While this may not be unusual for a randomly selected group of people, the course in question was Advanced Portfolio Management. Despite professed interest in business, completion of undergraduate programs in economics, commerce, and related disciplines, as well as a number of introductory and intermediate graduate level courses in finance, the majority of the students in the class had not been exposed to a very basic set of experiences.

In several months, these graduates would be taking their higher education credentials and joining the finance professionals community.

The point here is not to criticize students of finance, but rather to (anecdotally) highlight deficiencies in the system of education and to shed some light on how we got into this financial crisis: generations of MBA and Masters of Science in Finance graduates have been joining the work force with deep gaps in their knowledge.

Is it any wonder that the average financial markets professional lacks a complete understanding of his or her job, and is therefore unable to fully understand the implications of his or her mistakes?

More to the point of this blog: if the professionals are so ill-prepared, what hope is there for the average person on the street?

Insult to Injury

2009-04-25T19:56:00.003-04:00

Rising unemployment, record level home foreclosures, and ever-shrinking 401Ks characterize our now gloomy economic state. Investment losses in the trillions of dollars have devastated many households. Adding insult to these injuries, some in the media, government, and business communities have implicated hapless consumers as willing and guilty participants in the debauchery that led us to this humble state.

The most common accusations are based on observations that many consumers willingly accepted loan amounts and loan terms that were well beyond their means, and/or made reckless investments without a proper understanding of underlying risks. In both cases, consumers laid the groundwork for their own financial destruction.

The painful fact is that these accusations are at least partly correct!

Many consumers contributed to their own financial problems through a combination of ignorance and greed. The good news is that the former is relatively easy to remedy. Evolution from ignorance to knowledge is the objective of this blogging platform.

This blog is intended as a first step to equipping the average consumer with a better understanding of:

financial markets
risk exposures
investment strategies

It is not about stock tips.

It is about education.

It is about taking back control of one's financial future and ensuring the mistakes of the past are not repeated.

This is meant to be the first of several mechanisms intended to improve financial literacy. It is expected that different approaches may be required in order to properly connect with people of different backgrounds and generations.

Please stay tuned for more, and share thoughts about how and what you'd like to learn.