Category Archives: Investing

Deirdre McCloskey: market-tested innovation

I cite a citation:

Think of the Bill Gates and Steve Jobs, big wealth accumulators in recent times. It wasn’t the magic of compound interest on capital that made them rich; it was intellectual property. They created billions of dollars of business from virtually nothing at all. If you measure the profits as a return on the small amount of initial capital invested, then it looks huge; but capital was no more important an ingredient of the original Apple or Microsoft than cookies or cucumbers.


Capitalism’s nature is not, contrary to Piketty’s claim, to forever protect and augment existing capital.  Central to capitalism’s nature is what McCloskey calls “market-tested innovation.”  And this innovation inevitably destroys the value of older, less-productive capital that is in competition with with it – in competition with the new capital, the new goods, the new production and consumption processes, and the new knowledge that innovative entrepreneurs create.

All at Cafe Hayek.

Read this Before you Invest in Stock

I was recently told by a friend that she had bought Apple stock in March of this year, at $200 a share, and later sold it for $300 a share, making a profit of 50% in 8 short months. I asked her how much she bought and she said 10 shares (for a total cost of $2,000, which was all she could afford). In other words, she earned a profit of $1,000. Not too shabby you might say.

For those of you who have been readers for some time, you might know that we tend not to advise anyone to buy stock. This has much to do with seeing markets as efficient, and much to do with the fact that, much like gambling in a casino, individual investors will almost always lose out to the bigger, entrenched market players. “But look at your friend, who made a profit of %50 in less than a year!” you might say. And you might continue with: “And if she had more money available to invest, say 10 times as much, she would now be sitting on a profit of $10,000!”.

So let us break down this transaction. First of all, when she bought 2000 shares my friend had to pay commission. Commissions can range from 5% to 33% in general, with mutual funds charging an average of 20%. Let’s be generous and say she only paid 10% commission. Even with low commissions, however, there are many fees that the brokers will tack on, such as IRA fees, paper statement fees, electronic statement fees, exchange fees, odd lot stock fees and withdrawal and deposit fees. However let’s assume these fees totalled no more than 2%. In other words:

10% + 2% of $2,000 = $240

So, a net profit of $760, correct? Still not too shabby. But don’t forget that taxes are paid on stock. These are called capital gains taxes and, since the stock was held less than a year, they will equal the income tax. My friend happens to fall into the 25% tax bracket. Therefore:

25% of $760 = $190.
$760 – $190 = $540 Profit
If we had gone with the $10,000 example, your profit would have been $5,092, since we’d have to place you in a different tax bracket.

So, after all is said and done your profit $540, right? Well, sort of. The crux of the problem is not that fees, taxes and commissions come in, which are easy to calculate, but everything else.

My friend, assuming she did buy Apple at the low and sell it at the high, would have made $540 (or 27% profit) on Apple. But she neglected to mention how her other investments were going. Sadly, although the S&P 500 has earned an average of over 10% in the past 20 years, the average investor has earned a paltry 1.87%. This, simply put, is because when an investor hears about a good stock, she will buy it, and when bad news comes out, she will sell. In other words, she will buy high and sell low, always several steps behind the curve.

So, a more accurate assessment might be to ask how much, total, money was used for investing, and how much, total, was taken out when all is said at done. I’m sure if I asked that of my friend I’d have a very different picture. Even this, however, does not show us all present factors.

When you want to invest in stock, it helps to research various brokerage houses or websites, to read up about investment strategies, keep up to date with the market on a daily basis, if not more, and talk to various friends and colleagues about their investments. You may also want to buy various books by Jim Kramer or Michael Lewis or Warren Buffett or Maria Bartiromo. All of this is before even researching the specific stocks to invest in (not all of which you’ll end up buying). In other words, for every stock an investor invests in, there are about 100 hours of research put in. Now, not to sound too cliché, but time does equal money. The time spent on investments could have been spent on your job, your well-being, on making money via other venues, etc. So, how much is your time worth? Even if we give it a (well) below average value of $20 per hour, this means $2000 spent on each stock. In other words, each stock should earn $2000 just to break even.*

In summary, therefore, I’d advise not to invest in stock. Even judging by the 1.87% average return, you’d have to factor in commissions, taxes, fees, as well as all the time that could have been spent on making a profit by other means, or just playing outside with your kids.

* I include this last statistic at the end, not because I think it is less significant – in fact, since it the most often overlooked portion, it is likely to be more significant than the others – but only because as far as I can tell, no studies have been performed on how many hours research is spent per stock. Investors talk of 6-7 hours for every stock they are seriously considering, but this doesn’t take into account all the background research, such as watching tickers and CNBC and reading journals and books and talking to friends and colleagues. 100 hours seemed very much on the low end, but if anyone has any other numbers I’d be happy to hear them.

Why I Don’t Buy Stocks Anymore

Apart from the reason listed here, put simply: Sum Zero.

According to Divya Narenda, its founder, Sum Zero is a “Wikipedia-like” investment idea database structured within a social network dedicated to the buyside. In other words, if you are an analyst, portfolio manager or researcher you can access their system and discuss stocks with other people like you, to the exclusion of the general populace.

This might not sound too bad. After all, it is like a global water cooler where like-minded people can hang out. It can however, cause problems when these people work for competing companies and are all providing similar products to individual investors.

Narenda continues:

It’s fair to say that SumZero members can use the site to spread awareness on companies that they own. I personally do not see this as a bad thing, and many see this as an important signal of the conviction behind an idea [...]
Currently we do not measure the performance of each idea, but all ideas are time stamped and have an associated target price [...]
SumZero does not currently require disclosure of holdings, but members will sometimes voluntarily make disclosure statements within their write-ups.

The problems here are obvious. Combining a Wikipedia-like system with social networks is great, but excluding a swathe of people who may end up buying these products can be disastrous. Basically, members will be talking amongst themselves (I fail to see how this doesn’t amount to collusion and/or insider information) and issuing ideas and proclamations touting what they decide are good stocks.

Members of Sum Zero will apparently issue periodic recommendations of stocks to buy through its site. The performance of the products they promote is not measured, so no accountability has to be taken. It can therefore be safe to say that if you buy these, you are helping Sum Zero members increase value of their products and little else.

“A consortium of independent organizations formed by controlling the production and/or distribution of a product or service and thereby limiting competition” is a safe way to characterize Sum Zero. It is also the dictionary definition of Cartel.

Next Bubble Watch

As if there hasn’t been enough talk of bubbles recently, we thought we would draw your attention to Alternative Investments. Two Swiss economists, Philippe Masset and Jean-Philippe Weisskopf, analyzed the prices of wine in comparison to the Russell 3000 index (odd comparison) and found that wine would have had the highest return between the two during the last 13 years (the years of the study).

This is all very well, but what does it tell us? Well, for starters it tells us that if you have been a wine investor and have sold off your investment, you probably made money off of it. Peter Boockvar, an equity strategist at Miller Tabak & Co. in New York has another takeaway, which he told Bloomberg:

“In a world where interest rates are zero and money is being printed around the world, there’s a demand for hard assets — whether it is wine, comic books or baseball cards — because they can protect the investor from that environment,”

So, if you read this correctly you just found another place to look for the next bubble: Alternative investments. To be fair, alternative investments have always been prime territory for bubbles. In essence bubbles occur in other industries when they are treated as alternative investments, so if an alternative investment becomes popular enough, you can expect to see a bubble. In other words, if this study catches on, more and more people may start buying wines. The richest will buy the best, but others will notice that second and third tier wines have appreciated as well. Therefore many will buy until it becomes a self-fulfilling prophecy: you know you can find buyers because they will want to sell to other buyers. This, then, will all come crashing down in a wine bubble.

Of course, we are far from bubble territory at the moment. We just wanted to give our readers plenty of advance notice as to what to look out for.

Find the original study here.

Yes Virginia, Markets are Efficient

In the wake of the recent controversy surrounding Free Markets, and more specifically, the “How could we be so stupid as to believe markets could work?” statements, we feel it is time to clear the air and make a couple blanket statements:

Efficient Markets does Not mean continuous growth
It is excusable in a way. We equate efficiency with working well, and we assume that an economy which works well will continue to rise. On the other hand, for an economy to work well it will have to get rid of the dead weight companies every now and again. Schumpeter famously called this “Creative destruction” and we (not as famously) declared that once the dust settled, our economy should be better off thanks to this downturn. Lehman Brothers, Bear Sterns, AIG and the like were riddled with bad management, overly risky investment, unrealistic expectations and outright fraud. Are these companies that deserve to continue operating? And what does it take for them to stop? A financial crisis, that’s what.

Free Markets does not mean “at no cost”
Although we sort of assumed this was obvious, we have seen some misconception in this regard (this might be our fault for following on Twitter). Free Markets means Free of intervention, so that market forces can operate without obstruction. It does not mean Free as in the “Buy one get one free” variety. There are obviously costs for participating in the market. If markets are efficient, the costs are entailed and understood. Every time a stock rises, someone buys and someone else sells, then when the stock falls, someone sells and someone buys. By definition, someone will have gained and someone will have lost. On the other hand, these are the risks entailed. The interesting thing is that outside of the stockmarket, there can be many participants, all of whom are winners.

No, Virgina, stocks won’t always rise
This brings us to the final point. While the first two points were more a question of semantics, this is an outright fallacy. If you had bought into the S&P 500 at the beginning of 1999, right now you would have an 8% loss, and this is not counting for inflation. You can argue that we are in a downturn. On the other hand, between this recession, the dot com bubble, the 1987 crisis, etc. we can see these downturns are more commonplace than we might have thought.
A stockmarket should, in theory, reflect the economy as a whole, which is where this fallacy arises. On the other hand, the S&P 500 (generally agreed to have the broadest scope), lost more in the 00′s than in the 1930′s, while the economy grew at around double the rate. As more online companies and small business start gaining credence and traction, the top 500 companies of the country will be having less and less influence. Expect it.

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How to invest in Currencies – Kiplinger’s method

Along the same vein of our last article on this subject, we continue to find amusing investment tips in Kiplinger’s:

Page 31 of their February 2010 edition is called:
Make a Buck off a Sagging Dollar – by Andrew Tanzer
This articles states how, since the US Dollar is falling, what alternatives an investor should find in order to make money.

Page 34 of this same edition has:
Don’t Write Off the Dollar Yet – by Jeff Kosnett
And you guessed it, Kosnett is saying that the Dollar is still going to ride strong. His blurb states: “The Dollar continues to account for 65% of the world’s currency reserves.”

Of course, the conclusion to draw here is that Kiplinger’s will provide different points of view, so for investors to look to them for investment advice will not provide definite answers. This is namely because there are no definite answers, just the same various theories recycled over and over. None of which is full proof. We can’t help wondering how much is really gained by reading this type of advice regularly.

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How to invest in Stocks – Kiplinger’s method

As long time proponents of market efficiency, we are still amused by the investment methods that keep getting regurgitated. They tend to fall under two main camps: The Charting methods, that analyze past performance and try to find trends, and the Fundamentals method, which analyzes various companies and determines which is undervalued. Of these two, the Charting method provides most amusement.

Anyone who has bought a stock or bond, or even glanced at a relevant brochure, has seen the small print: “Past performance is no indication of future earnings.”, or some paraphrase thereof. Yet people still think they can get ahead by ignoring precisely that point. This leads to back to back articles in Kiplinger on investment strategies, which read as follows:

Opening Shot – by James K. Glassman

Stocks, as I have said too many times to count, are meant to be long-term investments. So one challenge for investors is to figure out which companies will perform best over, say, the next ten years. But how? A good way to start is to look at past performance, so I asked the number crunchers at Morningstar to calculate which stocks gained the most over the past ten years.

And five pages later:
Don’t Bet on the Past – by Robert Frick

Investors can learn much from Wile E. Coyote. Hearing Road Runner’s signature meep meep each time the bird rounds a bend, Wile E., knife and fork in hand, coils and springs on the next meep — only to be flattened by a bus with a meep-sounding horn.

As you can guess, Frick is saying investors are Wile E. Coyote, and they are getting flattened by following past stock performance. His blurb says: “Investors became overly optimistic about past market winners and overly pessimistic about losers.”

Needless to say, we think Frick actually provides sounds stock market investment advice, and we think he should pay a visit to Glassman down the hall.

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Notice to All Investors

If you enjoy investing in the stock market every now and then, especially if you consider yourself none too bad at it, and definitely before you start telling your friends what to invest in and what not to, we would like to point out an article in Businessweek dealing with taxes.

Here they explain how to see (based on the state in which you reside) if it’s worth investing in stocks or if you should stick to non-taxed investments, like municipal bonds. Remember, the more often you trade, the more often you’re liable to be taxed. Also remember that any deductions you may have (here we’re talking to you rich folks) may be voided if your income comes from untaxed munis rather than stocks. And remember there are many other variables that come into play, each in its own different way depending on your level of diversification and allocation.

In short, it can get complicated. This is why tax advisors and financial consultants are paid what they are. On the other hand, it would have been nice if Businessweek had included a calculator to figure out these allocations, rather than a picture with some generic tax rates. It seems that if you could set up a calculator where people can enter their personal information and states of residence, it could spit out your real return. Then if you play around with the numbers you could figure out the optimal allocation.

If any of you have a knowledge of taxes, we’d love to work with you on this, and we’d be happy to give you full recognition.

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Brave New Paradigm

For this generation of investors, the paradigm that is ingrained is the concept of “boom times, crash, boom time restarts”.  The United States stock market is returning to relatively new highs due to the rally in stocks that has made some investors feel that “happy times are here again”.  This has created the psychology that the “boom time” has restarted as more individuals have used 0% interest rates and government financing to purchase cars, homes, and appliances. There is little thought given to the possibility of systemic collapse.

Unfortunately, it is another attempt to revive the system through government spending.  Due to the privileged status of having a reserve currency and years of economic prosperity, the United States was able to forego the inevitable bust for multiple decades.  The situation is analogous to a drug addict continuing to shoot up, refusing to cleanse himself of the toxins that harm his body.  The body can barely stand up, the addict wants to stop, but the doctor continues to recommend he continue his habit.

Crisis of Confidence

‘Confidence is the most important thing, more important than gold or currency’ – Wen Jiabao

Years of fiscal mismanagement coupled with lax oversight and enforcement have cast a blanket of uncertainty over basic rights in the United States.  Contract law was one of the most sacred tenements that world business leaders could depend on the United States to enforce.  The events in the past two years have made investors question the sanctity of their business agreements.  Mortgage modifications and government intervention have considerably raised the amount of risk of business transactions.  Lenders to the United States are now demanding higher interest rates since the government can now modify terms of an agreement in a loan.  Government intervention into interest rates have mispriced capital in terms of United States currency, and have forced investors to seek gains abroad. In investor’s minds, why allow the United States to borrow money at low interest rates when the risk has never been any higher?

The Silent Crash

Nominal prices in stocks look promising, but is it really a sign that boom times are here again? When measured in US dollars, it appears that the market has rebounded.  If we modify the measuring stick from US dollars to gold, a different picture emerges:

S&P 500 Large Cap - November 11, 2009
S&P 500 Large Cap vs Comex Gold - November 11, 2009


The performance of gold has outpaced stocks despite having the 30% correction during the Lehman Brothers crisis in 2008.  Recently, hedge fund managers David Einhorn and Paul Tudor Jones have allocated funds into the shiny metal.

When a currency is viewed as stable, money can stored as a store of value. However during times of overt monetization, hyperinflation, or when questions arise about the stability of a banking system, gold prevails as a more reliable store of value. Gold has an economic value even in the worst of times.
- Paul Tudor Jones

I have seen many people debate whether gold is a bet on inflation or deflation.  As I see it, it is neither.  Gold does well when monetary and fiscal policies are poor and does poorly when they appear sensible.  Gold did very well during the Great Depression when FDR debased the currency.  It did well again in the money printing 1970s, but collapsed in response to Paul Volcker’s austerity.  It ultimately made a bottom around 2001 when the excitement about our future budget surpluses peaked.
- David Einhorn

Low interest rates create the risk that the United States could experience a currency crisis.  There occurs when there is no confidence in its currency to be a reliable store of value.  What makes this situation unique, is that a reserve currency is being both domestically and internationally scorned. It is the fear that the US dollar will be further debased which is causing capital to seek out gold.

Market Update

Many unfavorable factors lie ahead for the world economy.  This shift in the reserve status of the United States dollar is going to lead to transitions in power on the economic stage.  Exporting nations now have to deal with not having a trade consumer in the United States, and now have to find both internal and outside external markets to stimulate demand for products.  This will depend on whether the emerging economies will allow their currencies to rise after years of deliberately creating trade surpluses.  The two factors to watch will be the US dollar and the 30-year US treasury yield.  If foreigners are not buying United States debt, and the US policy does not change with regard to monetizing its debt, the money will flow towards alternative stores of value. As Martin Armstrong points out:

The deflation scenario requires a capital concentration to the dollar internationally. if the opposite takes place, we end up with inflation. It is hard to see a flight to the dollar today

Chart: 30 Year Treasury Bond

Another Fools’ Recap

Since we mentioned our Fools Being Dumbagents article last week, we thought we should probably give a recap of how the investments are going.

As a recap, Motley Fool’s CAPS is a website where investors can gather to rate stocks. Each member can rate a stock, and say whether they think it will outperform or underperform the trading indexes, by how much, and within which time frame. The results are then aggregated by Motley Fool in order to show which stocks are rated highest and which lowest.

Being proponents of the Dumb Agent Theory, we thought this would be a good chance to see it at work. So we recorded the stock prices of the top 10 rated stocks, as well as the bottom 10 and decided to see how we would’ve performed had be bought the Top 10 and shorted the Bottom 10.

We had a recap 3 months later, but then neglected it for some time. Now that almost a full year has passed, we thought it would be a good time to check back in.

As can be seen, if we had bought 100 shares each of the Top 10 and shorted 100 shares each of the Bottom 10 we would have a net profit of $8,829.10. Not bad.