Our book is meant to be an educational journey that slowly builds confidence in one's own ability to manage a portfolio. In our book, we explore a potential solution that can be applicable to a wide-variety of investors, from the ultra-high-net-worth to middle-class individual, all of whom are focused on similar goals of preserving and growing their capital over time.
Acknowledgments
We have had enormous support from many colleagues, friends, and family in making this book a reality. We thank our wives, Katie Gray, Meg Vogel, and Eliza Foulke for their continual support and for managing our chaotic kids so we could write our manuscript. We'd also like to thank the entire team at Alpha Architect, for dealing with the three of us while we drafted the initial manuscript. Tian Yao, Yang Xu, Tao Wang, Pat Cleary, Carl Kanner, and Xin Song – we are forever indebted! We'd also like to thank outside readers for their early comments: Sam Lee at Morningstar, Ben Carlson at AWealthofCommonSense.com, and Sam Taylor at Fidelity Investments. Finally, Edward Stern and his team at Hartz Capital, and Bob Kanner and his team at PUBCO, have been invaluable mentors in our endeavor to understand how one should operate a family office.
Part One
Why You Can Beat the Experts
This book is organized into two parts. Part One sets out the rationale and evidence supporting simple, systematic processes. We begin by questioning society's reliance on “expert” opinion. Highlighting the evidence behind the performance of expert opinion, we explain why experts are self-interested and (surprise) are prone to the same behavioral biases that afflict all human beings. Finally, we highlight that experts often rely on stories, not facts.
Part Two outlines how individual investors, managing from $50 thousand to $5 billion, can beat the experts. We outline the reasons why a do-it-yourself (DIY) approach makes sense. Next, we outline various asset allocation frameworks and explain why a simple approach is probably most effective. Next, following this discussion, we explore simple evidence-based risk-management concepts, which help a DIY investor avoid large losses when investing his capital. Next, we outline ways in which a DIY investor can develop a systematic approach to add value to his equity portfolios by incorporating simple value-based and momentum-based security selection techniques. We then highlight techniques to implement approaches to momentum-based security selection processes. We move on to simple asset allocation frameworks, and we end with a discussion of simple, evidence-based risk-management concepts. Finally, we end Part Two by integrating the knowledge discussed on asset allocation, risk-management, and security selection into a full-fledged investment program with an overview of what we believe to be a reasonable DIY Financial Advisor solution.
Chapter 1
Are Experts Trying Too Hard?
“A speculator can always be beset by an unfathomable event – a constellation of unpredictable and unforeseen events – that leads to a disaster that seemingly was impossible, and it's always important to keep this in mind.”
It took Victor Niederhoffer many years of study and a lot of hard work to become widely known as an expert in financial markets. After graduating from Harvard and receiving his PhD in finance from the University of Chicago, he continued his ascent within academia, teaching at Berkeley for five years. As an academic, he authored numerous research papers on market anomalies and how one might profit from following clever trading strategies.
As Niederhoffer learned more, and became increasingly sophisticated, he sensed an opportunity to use his academic knowledge to make money. Retiring from academia in 1980, he chose to pursue a career as a practitioner in financial markets. His firm, Niederhoffer Investments, was so successful that he caught the notice of investing guru George Soros. Niederhoffer began working with Soros in the 1980s, advising him on commodities and fixed-income trading. Eventually, Soros allocated $100 million to his firm. During the early 1990s, it was rumored in the financial press that Niederhoffer had been generating returns of 30 percent, or more, per year.
In 1996, based on an illustrious track record and a distinguished trading career, Niederhoffer published his personal cookbook, The Education of a Speculator, in which he revealed his approach to trading and making money in the markets. Who couldn't learn from this titan of finance? And he was a titan. When his book hit the shelves, Niederhoffer was among the best-known hedge fund managers in the United States, was at the pinnacle of his profession, and had become known as one of the foremost experts on investing worldwide. Niederhoffer was not only an expert, he was an expert's expert.
And so, in 1997, as a widely respected expert in financial markets, Niederhoffer may have been surprised when he experienced steep losses on a Thai currency bet. But Niederhoffer had experienced volatility before; he just needed to apply his prodigious investing skill and pull yet another rabbit out of a hat. While Niederhoffer had fallen behind during early 1997, his real problems began when he chose a risky strategy to recover from those losses: He began selling out-of-the-money puts on the S&P 500.2
Selling out-of-the-money puts has been likened to picking up nickels in front of a steamroller. You get a little bit of money (the nickel) for the contract, but you agree to purchase a stock at a future price (the steamroller). Everything works so long as the steam roller doesn't accelerate. However, should our steam roller operator drop his sandwich and inadvertently step on the gas (decrease the stock price), you could find yourself in a pressing situation…
This pressing situation can become downright perilous when market prices approach or fall below the put strike price. If you promise to buy a stock for $10 and its price on the open market is $5, you can be sure that your creditors will come to collect. And if you can't honor your promise to fulfill the contract, well, that's when you need to worry about the steamroller.
In late October, Niederhoffer's out-of-the-money November puts were trading at $0.60, but the Asian financial crisis continued to unfold and began to rattle US markets. The value of his puts quadrupled to $2.40, although they were still over 15 percent out of the money. Niederhoffer was confident, stayed the course, and left his position intact (he had come back from worse than this).
The following week, the S&P plunged by 7 percent, and the implied volatility of the puts skyrocketed. The puts were both closer to being “in the money” and had more implied volatility (the market believed the chance of them ending in the money was greater). Each of these effects made them more expensive. With this put valuation double-whammy, the value of Niederhoffer's puts exploded, which was very bad, since Niederhoffer had sold them. In just over a week's time, Niederhoffer's short position had moved against him by a factor of 25 times or more. This extreme move proved to be too much, even for the master. Shortly thereafter, Niederhoffer had a margin call that he could not meet; his fund's account had gone bankrupt.3Cue the steamroller.
How can it be that Victor Niederhoffer – a noted academic, a respected financial expert, a lion on Wall Street, and a financial press darling – could bankrupt his fund by pursuing a volatile options strategy that first year business school students are cautioned against as being too risky? And what did this say about Niederhoffer's expertise?
Some might argue that once Niederhoffer took losses on his Thai currency bet, his incentives changed and affected his perspective. Facing such losses, perhaps this risky option strategy seemed like a reasonable response. Perhaps it was at this point that Niederhoffer became a slave to his emotions, and therefore ceased to be an expert. Perhaps he simply believed in his innate abilities. Perhaps he just wanted to take on more risk. We will never know.
Yet we rely on experts like Niederhoffer because they are supposed to