LIBOR - London Interbank Offered Rate

What is LIBOR?

The London Interbank Offered Rate is the rate at which banks will lend unsecured funds to one another. Based on a survey of global banks, it's the most widely used benchmark for short-term interest rates.

When are LIBOR rates determined?

The British Bankers' Association publishes rates Monday to Friday at 11:00 a.m. London time of varying maturities.

How is LIBOR determined?

Each bank determines how much they will have to pay to borrow money from each other. The number of contributing banks vary depending on the currency.

U.S. dollar LIBOR is determined by 16 global banks, and the final published rate is the average of the middle eight rates.

LIBOR and U.S. interest rates

Historically, LIBOR tends to track the Federal Funds Target Rate. However, as economic uncertainty over the global credit crisis continued and the initial U.S. government-sponsored financial bailout failed, the spread between the two rates widened as LIBOR spiked, indicating a lack of confidence among banks.

LIBOR's relationship to consumers.

LIBOR ultimately determines interest rates on everything from adjustable-rate mortgages and car and student loans to small-business loans and credit cards.


Additional notes

http://www.investopedia.com/terms/l/libor.asp

LIBOR

An interest rate at which banks can borrow funds, in marketable size, from other banks in the London interbank market. The LIBOR is fixed on a daily basis by the British Bankers' Association. The LIBOR is derived from a filtered average of the world's most creditworthy banks' interbank deposit rates for larger loans with maturities between overnight and one full year.

The LIBOR is the world's most widely used benchmark for short-term interest rates. It's important because it is the rate at which the world's most preferred borrowers are able to borrow money. It is also the rate upon which rates for less preferred borrowers are based. For example, a multinational corporation with a very good credit rating may be able to borrow money for one year at LIBOR plus four or five points. Countries that rely on the LIBOR for a reference rate include the United States, Canada, Switzerland and the U.K.


http://en.wikipedia.org/wiki/Federal_funds_rate

Federal funds rate comparison with LIBOR

Though the London Interbank Offered Rate (LIBOR) and the federal funds rate are concerned with the same action, i.e. interbank loans, they are distinct from one another, as following:

1. The federal funds rate is a target interest rate that is fixed by the FOMC for implementing U.S. monetary policies.

2. The federal funds rate is achieved through open market operations at the Domestic Trading Desk at the Federal Reserve Bank of New York which deals primarily in domestic securities (U.S. Treasury and federal agencies' securities).

3. LIBOR is calculated from prevailing interest rates between highly credit-worthy institutions.

4. LIBOR may or may not be used to derive business terms. It is not fixed beforehand and is not meant to have macroeconomic ramifications.

Federal Funds Rate and the Discount Rate

The discount rate, in contrast, is usually about a half to a full percentage point higher than the federal funds rate. The Federal Reserve does control that one. The discount rate is the interest rate the Federal Reserve charges other depository institutions for very short-term (usually overnight) loans.

The Bad News that creates a Buying Situation - Industry Recession

The second kind of situation that presents a buying opportunity is an industry-wide recession. In this case an entire industry suffers a financial setback. These situations vary in their intensity and depth. An industry recession can lead to serious losses or it can mean nothing more than mild reduction in per share earnings. Recovery time from this type of situation can be considerable, one to four years, but it does present excellent buying opportunities. In severe examples, a business may even end up in bankruptcy. Don't be fooled by too cheap a selling price. Stay with a well-capitalized leader, one that was very profitable before the recession.

Capital Cities/ABC Inc. fell victim to this weird manic-depressive stock market behaviour in 1990. Because of a business recession, avertising revenues started to drop, and Capital Cities reported that its net profit for 1990 would be approximately the same as in 1989. The stock market, used to Capital Cities growing its per share earnings at approximately 27% a year, reacted violently to this news and in the space of six months drove the price of its stock down from $63.30 a share to $38 a share. Thus, Capital Cities lost 40% of its per share price, all because it projected that things were going to be the same as they were last year. (In 1995, Capital Cities and the Walt Disney Company agreed to merge. This caused the market-revalued Capital Cities to upward of $125 a share. If you bought it in 1990 for $38 a share and sold it in 1995 for $125 a share, your pretax annual compounding rate of return would be approximately 26%, with a per share profit of $87.)

Warren Buffett used the banking industry recession in 1990 as the impetus for investing in Wells Fargo, an investment that brought him enormous rewards. Remember, in an industry-wide recession, everyone gets hurt. But the strong survive and the weak are removed from the economic landscape. Wells Fargo is one of the most conservative, well run, and financially strong of the key money center banks on the West Coast, and the seventh-largest bank in the nation.

Wells Fargo, in 1990 and 1991, responding to a nationwide recession in the real estate market, set aside for potential loan losses a little over $1.3 billion, or approximately $25 a share of its $55 a share in net worth. When a bank sets aside funds for potential losses it is merely designating part of its net worth as a reserve for potential future losses. It doesn't mean that losses have happened, nor does it mean they will happen. What it means is that there is potential for the losses to occur and that the bank is prepared to meet them.

This means that if Well Fargo lost every penny it had set aside for potential losses, $25 a share, it would still have $28 a share left in net worth. Losses did eventually occur, but they weren't as bad as Well Fargo prepared for. In 1991, they wiped out most of Wells Fargo's earnings. But the bank was still very solvent and still reported in 1991 a small net profit of $21 million, or $0.04 a share.

Wall Street reacted as if Wells Fargo was a regional savings and loan on the brink of insolvency, and in the space of four months hammered Wells Fargo's stock price from $86 a share to $41.30 a share. Wells Fargo lost 52% of its per share market price because it essentially was not going to make any money in 1991. Warren Buffett responded by buying 10% of the company - or 5 million shares - for an average price of $57.80 a share.

What Warren Buffett saw in Wells Fargo was one of the best managed and profitable money-center banks in the country, selling in the stock market for a price that was considerably less than what comparable banks were selling for in the private market. Although all banks compete with each other, as we said, money-center banks like Wells Fargo have a kind of toll brideg monopoly on financial transactions. If you are going to function in society, be it as an individual, a mom and pop business, or a billion-dollar corporation, you need a bank account, a business loan, a car loan, or a mortgage. And with every bank account, business loan, car loan, or mortgage comes the banker charging you fees for the myriad services he provides. California, by the way, has a lot of people, thousands of businesses, and a lot of small and medium size banks, and Wells Fargo is there to serve them all - for a fee.

The loan losses that Well Fargo anticipated never reached the magnitude expected, and nine years later, in 2000, if you wanted to buy a share of Wells Fargo you would have to have paid approximately $270 a share. Warren Buffett ended up with a pretax annual compounding rate of return of approximately 18.6% on his 1991 invetment. For Warren Buffett there is no business like the banking business.

In the cases of both Capital Cities and Wells Fargo, there was a dramatic drop in their share prices because of an industry-wide recession, which created the opportunity for Warren Buffett to make serious investments at bargain prices.

The Bad News that creates a Buying Situation - Stock Market Corrections and Panics

Stock market corrections and panics are easy to spot and usually the safest because they don't tend to change the earnings of the underlying business. That is, unless the company is somehow tied to the investment business, in which case a market downturn tends to reduce general market trading activity, which means brokerage firms and investment banks lose money. Otherwise the underlying economics of most businesses stay the same. During stock market corrections and panics, stock prices drop for reasons having nothing to do with the underlyng economics of their respective companies.

This is the easiest kind of situation to invest in because there is no real business problem for the company to overcome. If you let the price of the security, as Buffett does, determine whether or not the investment gets bought, then this is possibly the safest "buy" situation there is. Buffett began buying The Washington Post during the stock market crash of '73 - '74 and Coca-Cola during the crash of '87. While everyone else was caught in a state of panic, Buffett began buying these companies' shares like a man possessed with a deep thirst for value. He eventually acquired 1,727,765 shares of The Washington Post and 200,000,000 shares of Coca-Cola.

A market correction or panic will more than likely drive all stock prices down, but it will really hammer those that have recently announced bad news, like a recent decline in earnings. Remember, a market panic accents the effect that bad news has on stock price. Buffett believes that the perfect buying situation can be created when there is a stock market panic coupled with bad news about the company.

Any company with a strong consumer monopoly will eventually recover after a market correction or panic. But beware: In a really high market, in which stock prices are trading in excess of fourty times earnings, it may take a considerable amount of time for things to recover after a major correction or panic. Companies of the commodity type may never again see their bull market highs, which means investors can suffer a very real and permanent loss of capital.

After a market correction or panic, stock prices of the consumer monopoly type company will usually rebound withn a year or two. This bounce effect will often provide an investor an opportunity to pick up a great price on an exception business and see a dramatic profit within a year or two of purchasing the stock. Stock market corrections and panics have made Buffett a very happy and a very rich man.

One success can wipe out 10,000 failures.

Harness the stunning power of financial regret

Regret over past financial decisions can have a powerful hold on you.

At 23, you may regret running up $20,000 in credit card debt during college. At 35, you may regret never having gone to college. At 45, you may regret having never started that consulting business you always dreamed of pursing. And at 65, you may regret not having saved more for retirement. In recent days, many financial chickens have come home to roost.

Regret, financial or otherwise, can have a powerful grip on your life. For most, the question is not whether you have financial regret. The question is how you harness the power of that regret to make sound financial decisions today that you will not regret tomorrow.

Here are some ideas to help you do just that:

We all have made stupid financial decisions. Even Warren Buffett has made dumb investments, which he readily admits. We can spend a lot of time and energy lamenting those past decisions, but it will not help us make better decisions today. We need to stop obsessing about the past and, instead, use the lessons it can teach us to make better decisions today.

It is better to look ahead and prepare than to look back and regret. -- Jackie Joyner-Kersee

Regret for wasted time is more wasted time. -- Mason Cooley

Learn from that which you regret. If regret has any positive value, it comes from evaluating the decisions you made that caused the regret. Take out a piece of paper and write down your financial regrets in as much detail as possible. Think about not only regrets from things you did, but also regrets from things you chose not to do. It is the things we did not do that often cause the most pain. We will use this list of regrets to make new and fresh decisions today that can at least keep the regretful decisions from continuing.

Never regret. If it's good, it's wonderful. If it's bad, it's experience. -- Victoria Holt

Regret for the things we did can be tempered by time; it is regret for the things we did not do that is inconsolable. -- Sidney J. Harris

To regret deeply is to live afresh. -- Henry David Thoreau

It is never too late. Reread the quote from Sidney Harris above. Does it describe any of the financial regrets you wrote down on the piece of paper? In most cases, our most profound regrets come from things we were too scared or busy or distracted to do. Whether it was going into business, going to college, or investing in the stock market, what we chose not to do can be a major source of regret.

If you are reading this article, it is not too late. Many go to college during retirement, or start investing in their 50s (or later), or start a business only after retiring from a career. Sometimes we convince ourselves that it is too late to accomplish this or that because it eases the pain of regret. But it is a lie. Believing that it is too late to change may make us feel better, but it also causes us to repeat the same inaction that caused the regret in the first place. Look at it this way. If you are 45 and considering getting a college degree, you have two choices: turn 50 with a college degree, or turn 50 without one.

There is no old age. There is, as there always was, just you. -- Carol Matthau

Do not go gentle into that good night,
Old age should burn and rave at close of day;
Rage, rage against the dying of the light. -- Dylan Thomas

Change the bad habits. Many regrets are born out of a lifetime of small, insignificant bad money-management decisions. You may have lived for years spending just a little more than you make. But after a lifetime of such living, you find yourself in unimaginable debt, with little or no savings. It wasn't one big mistake, it was thousands of small financial missteps. If that describes some of the regrets you have written down, changing those bad habits will be much like breaking free from addiction.

People are addicted to eating out. They are addicting to shopping. They are addicted to their gadgets. Of course, nothing is wrong with any of these things if you are properly managing your money. But if you are not, these are some of the daily, weekly and monthly decisions you make that have added up over a lifetime to create the financial regret you now experience.

As a starting point, wipe your financial slate clean. Put your past financial decisions where they belong, in the past. The question now is what financial decisions are you going to make today. If regret is born out of uncontrollable shopping, put something else in your life to take the place of the shopping. Ask a friend to hold you accountable. Give your spouse your cash and credit cards to hold for you. Do whatever it takes so that tomorrow you will not regret the decisions you make today.

My one regret in life is that I am not someone else. -- Woody Allen

Focus on today and tomorrow, not yesterday. Take another look at that piece of paper that lists all of your financial regrets. That paper represents the past. Take stock of the regrets, and make decisions today so that those regrets do not repeat themselves. And once you have done that, throw the paper away. Make decisions today so that tomorrow you will look back without regret.

When one door closes, another door opens; but we often look so long and so regretfully upon the closed door that we do not see the ones which open for us. -- Alexander Graham Bell

All saints have a past; all sinners have a future. -- Warren Buffett

Regret is a stunningly powerful emotion. Allowed to run amok, regret can ruin a life and even a family. With some honest introspection, however, you can turn that powerful emotion into a motivator that helps you make better choices today. Whatever your past, make today great, so tomorrow can be even better.

One success can wipe out 10,000 failures. -- The Dough Roller

http://blogs.moneycentral.msn.com/smartspending/archive/2008/10/08/harness-the-stunning-power-of-financial-regret.aspx

Understanding FEAR and PANIC

October 8, 2008

Forget Logic; Fear Appears to Have Edge
By VIKAS BAJAJ

The technical term for it is “negative feedback loop.” The rest of us just call it a panic.
How else to explain yet another plunge in the stock market Tuesday that sent the Standard & Poor’s 500-stock index to its lowest level in five years — particularly in the absence of another nasty surprise?

If anything, the markets should have been buoyed by the Federal Reserve saying it would shore up another troubled corner of finance by lending money directly to companies. Stocks did open higher, but then quickly tumbled as rumors swirled about the viability of big financial firms like Morgan Stanley and the Royal Bank of Scotland.

Anybody searching for cause-and-effect logic in the daily gyrations of the market will be disappointed — even if the overarching problem of a crisis of confidence in the global economy is now becoming clear.

Instead, the market has become a case study in the psychology of crowds, many experts say. In normal times, it runs on a healthy mix of fear and greed. But fear now seems to rule, with investors often exhibiting a Wall Street version of the fight-or-flight mechanism — they are selling first, and asking questions later.

“What’s happening is people are crawling into a bunker and pulling an iron sheet over their heads because they think the sky is falling,” said William Ackman, a prominent hedge fund manager in New York.

And that bunker is getting very crowded, so much so that some analysts are starting to suggest the markets are showing signs of “capitulation” — another term of art to describe what happens when even the bullish holdouts, the unflagging optimists, throw up their hands and join the stampede out of the market.

Fear can be seen at every turn — in headlines raising questions about another Great Depression, and in the crowds gathered around office televisions to track stocks or to parse the latest pronouncements from the Federal Reserve chairman, Ben S. Bernanke, or the Treasury secretary, Henry M. Paulson Jr.

Even James Cramer, the voluble and long-bullish host of an investing show on CNBC, advised investors to sell some stock during appearances on the “Today” show Monday and Tuesday mornings.

To some, signs of capitulation can be read as an indicator that the bottom may be near. Indeed, Sam Stovall, chief investment strategist at Standard & Poor’s Equity Research, is among those who say the market may be close to a bottom.

In addition to his analysis of the market, he was swayed by the numerous telephone calls he has received in recent days from professional acquaintances and his sister-in-law, all saying they are getting out of stocks.

“More and more people are doing that and selling out,” Mr. Stovall said.

The opposite of capitulation, of course, is investing at the height of a bubble. One oft-cited sign of the housing market’s top: when dinner parties are dominated by stories about fast profits on flipped condominiums.

During the dot-com boom in the late 1990s, it seemed everybody and their grandmothers were piling into stocks. Now they are bailing out. Tuesday was the fourth consecutive day that the S.& P. 500-stock index registered a decline of 1 percent or more. The last time that happened was October 2002, when the index reached its lowest point during the bear market that started in 2000. The S.& P. is now down 36 percent from its peak a year ago, almost to the day, on Oct. 9, 2007.

Another barometer of panic: volatility, reflected in the so-called Fear Index (or the VIX), which tracks options trades that investors use to protect against future losses. On Tuesday, it climbed to its highest level since the 1987 stock market crash.

Fear is an immensely powerful force, perhaps more so than greed, said Andrew W. Lo, a professor at the Massachusetts Institute of Technology who has studied investor behavior.
Scientists who have studied the brain function have found that the amygdala, the part of the brain that controls fear, responds faster than the parts of the brain that handle cognitive functions, he said.

“Fear is a much stronger motivational force,” Mr. Lo added. “The loss of $1,000 has a much bigger impact than the gain of a $1,000.”

He cites a series of groundbreaking experiments in the 1970s by psychologists Daniel Kahneman and Amos Tversky. In one test, they asked students to choose between a sure bet of $3,000, or an 80 percent chance of winning $4,000 (meaning there was a 20 percent chance of winning nothing). Most students said they would take the $3,000.

The same question, framed differently, asked them if they would rather lose $3,000 or accept an 80 percent chance of losing $4,000 (with a 20 percent chance of losing nothing). In this case, they said they would take the riskier bet.

In other words, they were willing to take a bigger risk to avoid losing money than they were when they stood to make more money.

Those instincts seem to be taking over.

At this point, any spreadsheet analysis of underlying and intrinsic values of stocks becomes meaningless, and concern for preserving wealth overrides the desire to grow it — what some may call greed.

“With negative emotions we tend to have a desire to change the situation,” said Ellen Peters, a senior scientist at Decision Research in Eugene, Ore. But “when things are good there is not much desire to change.”

That perhaps explains why investors are willing to earn virtually no return in Treasury bills just to be assured that they will get their money back, rather than investing in short-term corporate debt that offers a better return but carries some risk. Investors were reminded of that risk after Lehman Brothers sought bankruptcy protection last month.

Even banks, which make money by lending to businesses, consumers and each other, are hoarding cash. That is why the Federal Reserve said on Tuesday that it would buy commercial paper, the short-term loans issued by companies and banks.

If the market is indeed close to the bottom, history suggests any rally in the next few weeks will probably be big. Since World War II, Mr. Stovall estimates stocks have recouped about a third of their bear market losses in the first 40 days after the market hits bottom.

But enough investors have to first be persuaded that the economy and housing market will begin recovering soon. Another major test will be third-quarter corporate earnings announcements that will trickle out in the next three weeks.

Perhaps the most important indicator will be the credit markets: Investors will regain confidence when they believe financial firms are adequately capitalized and money is flowing more freely through the financial system.

Mr. Ackman, the hedge fund manager who has been vocal about his bearish views of some financial companies in recent years, said it is hard to precisely time the market. But, he added, “I do think that stocks are getting extremely cheap.”

David Bertocchi, a portfolio manager for Baring Asset Management in London, echoed that sentiment, saying he was beginning to increase his stake in certain companies.

He is taking advantage, he said, of panicked selling by hedge funds that have to pay back loans to their brokers. “That’s what drives markets to attractive levels,” he said.


http://www.nytimes.com/2008/10/08/business/08fear.html?em

__________

A Day (Gasp) Like Any Other


This panic is taking place in such a compressed time frame that it is just astonishing. Mr. Chernow pointed out that while the stock market crash of 1929 took place over three brutal trading days in October 1929, it took nearly three years to reach bottom. By then, stocks had lost a shocking 89 percent of their value.

This crisis, by contrast, seems to be moving at hyper-speed — one day it is Lehman Brothers, the next A.I.G., the day after that Washington Mutual. This crisis doesn’t wear you down over time. It hits you over the head with a two-by-four. On a daily basis.

A third problem, though, is that confidence keeps eroding. The latest wrinkle is that many hedge fund investors, fearing big losses, no longer have confidence in their hedge fund managers. Thus, hedge fund managers are preparing for huge withdrawals at the end of the year, and so they are selling billions of dollars worth of stock preparing to pay redemptions. That is one reason the stock market is under pressure.

“It becomes a self-fulfilling prophecy,” said one hedge fund manager. Firms fearing redemptions sell off stocks, which hurts their performance. Which undermines their investors’ confidence. Which means there are likely to be even more redemptions. Around and around it goes.

Twelve years ago, Alan Greenspan invented the term “irrational exuberance.” That era seems tame compared with this one. What is going on in the markets is anything but exuberant — at this point, though, it is undeniably irrational.

http://www.nytimes.com/2008/10/07/business/07nocera.html?em

The Gifts that Keep on Giving

Short-Sightedness and the Bad News Phenomenon.

Warren Buffett discovered that everyone from mutual fund managers to Internet day traders are stuck playing the short-term game. It is the nature of the stock market.

The bad news phenomenon is a constant - people sell on bad news.

Companies that have consumer monopolies have the economic power to pull themselves out of most bad news situations.

Warren Buffett made all his big money investing in consumer monopolies.

The Bad News that Creates a Buying Situation

Bad news situations come in four basic flavours:

1. Stock market correction or panic
2. Industry recession
3. Individual business calamity, and,
4. Structural changes.

The perfect buying situation is created when a stock market correction or panic is coupled with an industry recession or individual business calamity.

Where to Look for a Consumer Monopoly

Warren Buffett has discovered that there are basically four types of consumer monopolies:

1. Businesses that make products that wear out fast or are used up quickly, that have brand name appeal, and that merchants have to carry or use to stay in business.

2. Communications businesses that provide a repetitive service that manufacturers must use to persuade the public to buy their products.

3. Businesses that provide repetitive consumer services that people and business are consistently in need of.

4. Retail stores that have acquired a quasi-monopoly position selling such items as jewelry and furniture.

Determining if the Business Has a Consumer Monopoly

A consumer monopoly is usually evidenced by a brand name product or key service.

Warren Buffett looks for the consumer monopoly to produce earnings that are strong and show an upward trend.

A company that benefits from the high profits that a consumer monopoly produces will usually be conservatively financed. Often it carries no debt at all, which means that it has considerable financial punch to solve problems and to take advantage of new business prospects.

Warren Buffett believes that in order for a company to make shareholders rich over the long run it must earn high rates of return on shareholders' equity.

He also believes that the company must be able to retain its earnings and not have to spend it all on maintaining current operations.

The Healthy Business: The Consumer Monopoly (Where Warren Finds all the Money)

A consumer monopoly is a type of toll bridge business. If you want to buy a certain product you have to purchase it from that one company and no one else.

Warren Buffett's test for a consumer monopoly is to ask himself whether it would be possible to create a competing business even if one didn't care about losing money.

A consumer monopoly sells a product where quality and uniqueness are the most important factors in the consumer's decision to buy.

Consumer monopolies, though excellent businesses, are still subject to the ups and downs of the business cycle and the occasional business calamity.

Identifying the Commodity Type Businesses

Commodity type businesses have the following characteristics:

• Low profit margins on sales coupled with low inventory turnover
• Low returns on shareholders' equity
• Absence of any brand loyalty
• Presence of multiple producers
• Existence of substantial excess production capacity in the industry
• Erratic profits
• Profitability that is almost entirely dependent upon management's abilities to efficiently utilise tangible assets.

The Economic Engine Buffett Wants to Own

Warren Buffett has separated the world of business into two different categories:

1. the healthy consumer monopoly type business and
2. the sick commodity type business.

A consumer monopoly is a type of business that sells a brand name product or has a unique position that allows it to act like a monopoly.

A commodity type business is the kind that manufactures a generic product or service that a lot of companies produce and sell.

Warren Buffett believes that if you can't identify these two different types of businesses, you will be unable to exploit the pricing mistakes of a short-sighted stock market.

Stick to it

If you have got a formula that could make money, STICK TO IT.

No one can make all the money, let others make some.

Generally, any tactic that results in profits in terms of shares investment should be followed consistently. Unfortunately, rarely does one stick to sound investment tactics. This is because we are often swayed by others who claim that their tactics are better. However, the truth is that these persons may have only told you about the profitable side of their story and not the losses they have incurred.

Therefore, if you have found a certain strategy which enables you to make money, you should continue to use it. The bottom line is not to be greedy as it can be costly.

As such, the most important thing that you must remember is to follow a strategy that consistently gives you profits. The size of the profit is not as important as the method because with the correct method, you can improve on the amount of profits eventually.

Heuristic-driven biases: 5. Innumeracy

5. Innumeracy

People have difficulty with numbers.

Trouble with numbers is reflected in the folowing:

People confuse between "nominal" changes (greater or lesser numbers of actual dollars) and "real" changes (greater or lesser purchasing power). Economists call this "money illusion".

People have difficulty in figuring out the "true" probabilities. Put differently, the odds are that they don't know what the odds are. To illustrate this point, consider an example. In a lottery in which six numbers are selected out of fifty, what are the chances that the six numbers will be 1, 2, 3, 4, 5, and 6? Most people think that such an outcome is virtually impossible. The reality, of course, is that the probabiliy of selecting 1 through 6 is the same as the probability of selecting any six numbers.

People tend to pay more attention to big numbers and give less weight to small figures.

People estimate the likelihood of an event on the basis of how vivid the past examples are and not on the basis of how frequently the event has actually occurred.

People tend to ignore the "base rate" which represents the normal experience and go more by the "case rate", which reflects the most recent experience.

Heuristic-driven biases: 4. Aversion to Ambiguity

4. Aversion to Ambiguity

People are fearful of ambiguous situations where they feel that they have little information about the possible outcomes.

In experiments, people are more inclined to bet when they know the probabilities of various outcomes than when they are ignorant of the same.

In the world of investments, aversion to ambiguity means that investors are wary of stocks that they feel they don't understand. On the flip side it means that investors have a preference for the familiar.

This is manifested in home country bias (investors prefer stocks of their country), local company bias (investors prefer stocks of their local area), and own company bias (employees of a company have a preference for their own company's stock).

Heuristic-driven biases: 3. Anchoring

3. Anchoring

After forming an opinon, people are often unwilling to change it, even though they receive new information that is relevant.

Suppose that investors have formed an opinion that company A has above-average long-term earnings prospect. Suddenly, A reports much lower earnings than expected. Thanks to anchoring (also referred to as conservatism), investors will persist in the belief that the compny is above-average and will not react sufficiently to the bad news. So, on the day of earnings announcement the stock price would move very little. Gradually, however, the stock price would drift downwards over a period of time as investors shed their initial conservatism.

Anchoring manifests itself in a phenomenon called the "post-earnings announcement drift," which is well-documented empirically.

Companies that report unexpectedly bad (good) earnings news generally produce unusually low (high) returns after the announcement.

Heuristic-driven biases: 2. Overconfidence

2. Overconfidence

People tend to be overconfident and hence overestimate the accuracy of their forecasts. Overconfidence stems partly from the illusion of knowledge.

The human mind is perhaps designed to extract as much information as possible from what is available, but may not be aware that the available information is not adequate to develop an accurate forecast in uncertain situations.

Overconfidence is particularly seductive when people have special information or experience - no matter how insignificant - that persuades them to think that they have an investment edge. In reality, however, most of the so called sophisticated and knowledgeable investors do not outperform the market consistently.

Another factor contributing to overconfidence is the illusion of control. People tend to believe that they have influence over future outcomes in an uncertain environment. such an illusion may be fostered by factors like active involvement and positive early outcomes. Active involvement in a task like online investing gives investors a sense of control. Positive early outcomes, although they may be purely fortuitous, create a illusion of control.

Is overconfidence not likely to get corrected in the wake of failures? It does not happen as much as it should. Why?

People perhaps remain overconfident, despite failures, because they remember their successes and forget their failures.

Harvard psychologist Langer describes this phenomenon as "head I win, tail it's chance". Referred to as self-attribution bias, it means that people tend to ascribe their success to their skill and their failure to bad luck. Another reason for persistent overconfidence and optimism is the human tendency to focus on future plans rather than on past experience.

Overconfidence manifests itself in excessive trading in financial markets. It also explains the dominance of active portfolio management, despite the disappointing performance of many actively managed funds.

Heuristic-driven biases: 1. Representativeness

1. Representativeness

Representativeness refers to the tendency to form judgements based on stereotypes.

For example, you may form an opinion about how a student would perform academically in college on the basis of how he has performed academically in school. While representativeness may be a good rule of thumb, it can also lead people astray.

For example: Investors may be too quick to detect patterns in data that are in fact random.

Investors may believe that a healthy growth of earnings in the past may be representative of high growth rate in future. They may not realise that there is a lot of randomness in earnings growth rates.

Investors may be drawn to mutual funds with a good track record because such funds are believed to be representative of well-performing funds. They may forget that even unskilled managers can earn high returns by chance.

Investors may become overly optimistic about past winners and overly pessimistic about past losers.

Investors generally assume that good companies are good stocks, although the opposite holds true most of the time.

Behavioural Finance: Heuristic-Driven Biases

The important heuristic-driven biases and cogniive errors that impair judgement are:

• Representativeness
• Overconfidence
• Anchoring
• Aversion to ambiguity
• Innumeracy

1. Representativeness

http://myinvestingnotes.blogspot.com/2008/09/heuristic-driven-biases.html

Representativeness refers to the tendency to form judgements based on stereotypes. For example, you may form an opinion about how a student would perform academically in college on the basis of how he has performed academically in school

2. Overconfidence

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People tend to be overconfident and hence overestimate the accuracy of their forecasts. Overconfidence stems partly from the illusion of knowledge.

3. Anchoring

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After forming an opinon, people are often unwilling to change it, even though they receive new information that is relevant.

4. Aversion to Ambiguity

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People are fearful of ambiguous situations where they feel that they have little information about the possible outcomes. In experiments, people are more inclined to bet when they know the probabilities of various outcomes than when they are ignorant of the same.

5. Innumeracy

http://myinvestingnotes.blogspot.com/2008/09/heuristic-driven-biases-5-innumeracy.html

People have difficulty with numbers.

Strategies for Overcoming Psychological Biases

The field of behavioural finance highlights many psychological biases can impair the quality of investment decision making. Here are some strategies for overcoming the psychological biases:

1. Understanding the Biases.

Pogo, the folk philosopher created by the cartoonist Walt Kelly, provided an insight that is particularly relevant for investors, "We have met the enemy - and it's us". So, understand your biases (the enemy within) as this is an important step in avoiding them.

2. Focus on the Big Picture.

Develop an investment policy and put it down on paper. Doing so will make you react less impulsively to the gyrations of the market.

3. Follow a Set of Quantitative Investment Criteria.

It is helpful to use a set of quantitative criteria such as

• the price-earnings ratio being not more than 15,
• the price to book ratio not more than 5,
• the growth rate of earnings being at least 12%, and so on.

Quantitative criteria tend to mitigate the influence of emotion, hearsay, rumour and psychological biases.

4. Diversify

If you own a fairly diversified portfolio of say 12 to 15 stocks from different industries, you are less prone to do something drastically when you incur losses in one or two stocks because these losses are likely to be offset by gains elsewhere.

5. Control Your Investment Environment

If you are on a diet, you should not have tempting sweets and savouries on your dining table. Likewise, if you want to discipline your investment activity, you should regulate or control your investment environment. Here are some ways of doing so:

• Check your stocks only once every month.
• Trade only once every month and preferably on the same day of the month.
• Review your portfolio once or twice a year.

6. Strive to Earn Market Returns

Seek to earn returns in line with what the market offers. If you strive to outperform the market, you are likely to succumb to psychological biases.

7. Review Your Biases Periodically

Once in a year, review your psychological biases. This will throw up pointers to contain such biases in the future.

Behavioural finance - The Irrational Influences

From the mid-1950s, the field of finance has been dominated by the traditional finance model (also referred to as the standard finance model) developed primarily by the economists of the University of Chicago. The central assumption of the traditional finance model is that people are rational.

However, psychologists challenged this assumption. They argued that people often suffer from cognitive and emotional biases and act in a seemingly irrational manner.

The finance field was reluctant to accept the view of psychologists who proposed the behavioural finance model. As the evidence of the influence of psychology and emotions on decisions became more convincing, behavioural finance has received greater acceptance.

Although there is diagreement about when, how, and why psychology influences investment decisions, the award of 2002 Nobel Prize in Economics to psychologist Daniel Kahneman and experimental economist Vernon Smith is seen by many as a vindication of the field of behavioural finance.

Key differences

The key differences between "traditional finance" and "behavioural finance" are as follows:

1. Traditional finance assumes that people process data appropriately and correctly. In contrast, behavioural finance recognises that people employ imperfect rules of thumb (heuristics) to process data which induces biases in their beliefs and predisposes them to commit errors.

2. Traditional finance presupposes that people view all decisions throgh the transparent and objective lens of risk and return. Put differently, the form (or frame) used to describe a problem is inconsequential. In contrast, behavioural finance postulates that perceptions of risk and return are significantly influence by how decision problems are framed. In other words, behavioural finance assumes frame dependence.

3. Traditional finance assumes that people are guided by reason and logic and independent judgment. Behavioural finance, on the other hand, recognises that emotions and herd instincts play an important role in influencing decisions.

4. Traditional finance argues that markets are efficient, implying that the price of each security is an unbiased estimate of its intrinsic value. In contrast, behavioural finance contends that heuristic-driven biases and errors, frame dependence, and effects of emotions and social influence often lead to discrepancy between market price and fundamental value, thus market inefficiencies.

Types of Risk (Total risk = Unique risk + Market risk)

Modern portfolio theory looks at risk from a different perspective. It divides total risk as follows:

Total risk = Unique risk + Market risk

Unique risk (Diversifiable risk or Unsystematic risk)

The unique risk of security represents that portion of its total risk which stems from firm-specific factors like

• the development of a new product,
• a labour strike, or
• the emergence of a new competitor.

Events of this nature primarily affect the specific firm and not all firms in general.

Hence, the unique risk of a stock can be washed away by combining it with other stocks. In a diversified portfolio, unique risks of different stocks tend to cancel each other - a favourable development in one firm may offset an adverse happening in another and vice versa.

Hence, unique risk is also referred to as diversifiable risk or unsystematic risk.

Market risk (Non-diversifiable risk or Systematic risk)

The market risk of a stock represents that portion of its risk which is attributable to economy-wide factors like

• the growth rate of GDP,
• the level of government spending,
• money supply,
• interest rate structure, and
• inflation rate.

Since these factors affect all firms to a greateror lesser degree, investors cannot avoid the risk arising from them, however diversified their portfolios may be.

Hence, it is also referred to as systematic (as it affects all securities) or non-diversifiable risk.

Market Risk

Even if the earning power of the corporate sector and the interest rate structure remain more or less unchanged, prices of securities, equity shares in particular, tend to fluctuate.

While there can be several reasons for this fluctuation, a major cause appears to be the changing psychology of the investors.

There are periods when the investors become bullish and their investment horizons lengthen. Investor optimism, which may border on euphoria, during such periods drives share prices to great heights. The buoyancy created in the wake of this development is pervasive, affecting almost all the shares.

On the other hand, when a wave of pessimism (which often is an exaggerated response to some unfavourable political or economic development) sweeps the market, investors turn bearish and myopic. Prices of almost all equity shares regiter decline as fear and uncertainty pervade the market.

The market tends to move in cycles. As John Train says:

"You need to get deeply into your bones the sense that any market, and certainly the stock market, moves in cycles, so that you will infallibly get wonderful bargains every few years, and have a chance to sell again at ridiculously high prices a few years later."

The cycles are caused by mass psychology. As John Train explains:

"The ebb and flow of mass emotion is quite regular: Panic is followed by relief, and relief by optimism; then comes enthusiasm, then euphoria and rapture, then the bubble bursts, and public feeling slides off again into concern, desperation, and finally a new panic."

One would expect large scale participation of institutions to dampen the price fluctuations in the market. After all institutional investors have core professional expertise to do fundamental analysis and greater financial resources to act on fundamental analysis. However, nothing of ths kind has happened.

On the contrary, price fluctuations seem to have become wider after the arrival of institutional investors in larger numbers.

Why? Perhaps the institutions and their analysts have not displayed more prudence and rationality than the general investing public and have succumbed in equal measure to the temptation to speculate.

As John Maynard Keynes had argued, factors that contribute to the volatility of the market are not likely to diminish when expert professionals supposedly possessing better judgment and knowledge compete in the market place.

Why? According to Keynes, even these peope are concerned with speculation (the activity of forecasting the psychology of the market) and not enterprise (the activity of forecasting the prospective yield of assets over their whole life).

Interest Rate Risk

The changes in interest rate have a bearing on the welfare of investors. As the interest rate goes up, the market price of existing fixed income securities falls, and vice versa.

This happens because the buyer of a fixed income security would not buy it at its par value or face value if its fixed interest rate is lower than the prevailing interest rate on a similar security.

For example, a debenture that has a face value of MR 100 and a fixed rate of 12% will sell at a discount if the interest rate moves up from, say, 1% to 14%.

While the changes in interest rate have a direct bearing on the prices of fixed income securities, they affect equity prices too, albeit somewhat indirectly.

The changes in the relative yields of debentures and equity shares influence equity prices.

Business risk

As a holder of corporate securities (equity shares or debentures), you are exposed to the risk of poor business performance.

This may be caused by a variety of factors like

1. heightened competition,
2. emergence of new technologies,
3. development of substitute products,
4. shifts in consumer preferences,
5. inadequate supply of essential inputs,
6. changes in government policies and so on.

Often, of course, the principal factor may be inept and incompetent management.

The poor business performance definitely affects the interest of equity shareholders, who have a residual claim on the income and wealth of the firm.

It can also affect the interest of debenture holders if the ability of the firm to meet its interest and principal payment obligation is impaired. In such a case, debenture holders face the prospect of default risk.

Risk

You cannot talk about investment returns without talking about risk because investment decisions invariably involve a trade-off between the two.

Risk refers to the possibility that the actual outcome of an investment will differ from its expected outcome.

More specifically, most investors are concerned about the actual outcome being less than the expected outcome.

The wider the range of possible outcomes, the greater the risk.


Sources of Risk

Risk emanates from several sources. The three major ones are:

1. business risk,

http://myinvestingnotes.blogspot.com/2008/09/business-risk.html

2. interest rate risk, and

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3. market risk.

http://myinvestingnotes.blogspot.com/2008/09/market-risk.html

Types of Risk

Modern Portfolio Theory looks at risk from a different perspective. It divides total risk as follows:

Total risk = Unique risk + Market risk

http://myinvestingnotes.blogspot.com/2008/09/types-of-risk-total-risk-unique-risk.html

Return

Return is the primary motivating force that drives nvestment. It represents the reward for undertaking investment. Since the game of investing is about returns (after allowing for risk), measurement of realised (historical) returns is necessary to assess how well the investment manager has done. In addition, historical returns are often used as an important input in estimating future (prospective) returns.

The Components of Return

The return of an investment consists of two components.

Current Return: The first component that often comes to mind when one is thinking about return is the periodic cash flow (income), such as dividend or interest, generated by the investment. Current return is measured as the periodic income in relation to the beginnin price of the investment.

Capital Return: The second component of return is reflected in the price change called the capital return - it is simply the price appreciation (or depreciation) divided by the beginning price of the asset. For assets like equity stocks, the capital return predominates.


Thus, the total return for any security (or for that matter any asset) is defined as:

Total Return = Current Return + Capital Return

The current return can be zero or positive, whereas the capital return can be negaive, zero, or positive.

Risk and Return - Two Sides of the Investment Coin

Investment decisions are influenced by various motives.

Some people invest in a business to acquire control and enjoy the prestige associated with it.

Some people invest in expensive yatchs and famous villas to display their wealth.

Most investors, however, are largely guided by the pecuniary motive of earning a return on their investment.

For earning returns investors have to almost invariably bear some risk.

In general, risk and return go hand in hand.

While investors like returns they abhor risk.

Investment decisions, therefore, involve a tradeoff between risk and return.

Since risk and return are central to investment decisions, we must understand what risk and return are and how they should be measured.

Estimation of Intrinsic Value

The procedure commonly employed by investment analysts to estimate the intrinsic vlaue of a share consists of the following steps:

1. Estimate the expected earnings per share
http://myinvestingnotes.blogspot.com/2008/09/estimating-expected-eps-cash-flow-per.html

2. Establish a PE ratio
http://myinvestingnotes.blogspot.com/2008/09/establishing-pe-ratio.html

3. Develop a value anchor and a value range
http://myinvestingnotes.blogspot.com/2008/09/determine-value-anchor-and-value-range.html

Determine a Value Anchor and a Value Range

1. Determine a Value Anchor

The value anchor is obtained as follows:

= Projected EPS x Appropriate PE ratio

In our illustration, the projected EPS is 5.00 and the appropriate PE multiple is 6.87. Hence the valu anchor is 34.35. However, as valuation is inherently an uncertain and imprecise exercise, it would be naive to put great faith in a single point intrinsic value estimate. Practical wisdom calls for defining an intrinsic value range around the single point estimate.

2. Determine a Value Range

For example, in the above illustration, where an intrinsic value estimate of 34.35 has been arrived at, it may be more sensible to talk of an intrinsic value range of say 30 to 38. When you define a range like this, you are essentially saying that a "there may be a bias and error in my estimate. In view of this, feel that the value range is 30 to 38." Given this value range, your decision rule may be as follows:

Market Price*** (Decision)
< 30***********(Buy)
30 to 28********(Hold)
>38************(Sell)

Estimating the Expected EPS & Cash Flow per Share

1. Estimating the Expected EPS

Based on how the company has done in the past, how it is faring currently, and how it is likely to do in future, the investment analyst estimates the future (expected ) EPS. An estimate of EPS is an educated guesses about the future profitability of the company. A good estimate is based on a careful projection of revenues and costs. Analysts listen to what customers say about the products and services of the company, talk to competitors and suppliers, and interview management to understand the evolving prospects of the company.

As an illustration, the expected EPS for Horizon Limited for the year 20x8 is developed:

20x7 (Actual)***20x8 (Projected)***Assumption
Net sales
840***924***Increase by 10%
Cost of goods sold
638***708***Increase by 11%
Gross profit
202***216
Operating expenses
74***81***Increase by 9.5%
Depreciation
30***34
S&GA expenses
44***47
Operating profit
128***135
Non-operating surplus/deficit
2***2***No change
Profit before interest and tax (PBIT)
130***137
Interest
25***24***Decrease by 4%
Profit before tax
105***113
Tax
35***38***Increase by 8.57%
Profit after tax
70***75
Number of equity shares
15 m *** 15 m
EPS
4.67***5.00

Note that the EPS forecast is based on a number of assumptions about the behaviour of revenues and costs. So the reliability of the EPS forecast hinges critically on how realistic are these assumptions.

As an investor when you look at an earnings forecast, examine the assumptions underlying the forecast. What assumptions has the analyst made for demand growth, market share, raw material prices, import duties, product prices, interest rates, asset turnover, and income tax rate? Based on this assessment you can decide how optimistic or pessimistic is the earnings forecast.

It is better to work with a range rather than a single number. Paint few scenarios - optimistic, pessimistic, and normal - and examine what is likely to happen to the company under these circumstances.

2. Estimating the Cash Flow per Share

In addition to the EPS, the cash flow per share which is defined as:

= (Profit After Tax + Depreciation and other non-cash charges)/Number of outstanding equity shares

is also estimated. The cash flow per share in the above illustration is (75+34)/15 = 7.27. The rationale for using the cash flow per share is that the depreciation charge in the books is merely an accounting adjustment, devoid of economic meaning. Well managed companies, it may be argued, maintain plant and equipment in excellent condition through periodic repairs, overhauling and conditioning. As the expenses relating to these are already reflected in manufacturing costs, one can ignore the book depreciation charge. (This argument, however, may not be valid for all companies. So, you must look into the specific circumstances of the company to judge what adjustments may be appropriate).

Establishing a PE Ratio

The PE ratio maybe derived from the

1. constant growth dividend model, or
2. cross-section analysis, or
3. historical analysis.

Constant Growth Dividend Model.

We derive the PE ratio for a constant growth firm from the constant growth dividend discount model.

PE Ratio
= Dividend payout ratio/ (Required return on equity - Expected growth rate in dividends)

Dividend Payout Ratio: Most companies treat their dividend commitment seriously. Consequently, once dividends are set at a certain level, they are not reduced unless there is no alternative. Further, dividends are not increased unless it is clear that a higher level of dividends can be sustained. Thanks to these policies, dividends adjust with a lag to earnings.
If the dividend payout ratio increases the above ratio increases, which has a favourable effect ont he price-earnings multiple. However, an increasein the dividend payout ratio has the effect of lowering the expected growth rate of dividends int he denomination of the above ratio which leads to a decrease in the price-earnings multiple. On the whole, in most cases, these two effects are likely to balance out.

Required Return on Equity: The required return on equity is a function of the risk-free rate of return and a risk premium. According to the capital asset pricing model, a popularly used risk-return model, the rquired return on equity is:
= Risk-free return + (Beta of equity) ( Expected market risk premium)

Expected Growth Rate in Dividends: The third variable influencing the PE ratio is the expected growth rate in dividends. The expected growth rate in dividends is equal to:
= Retention ratio x Return on Equity.

Cross-Section Analysis

You can look at the PE ratios of similar firms in the industry and take a view on what is a reasonable PE ratio for the subject company.

Alternatively, you can conduct cross-section regression analysis wherein the PE ratio is regressed on several fundamental variables. Here is an illustrative specification:

PE ratio
= a1 + a2 Growth rate in earnings + a2 Dividend payout ratio + a3 Variability of earnings + a4 Company size.

Based on the estimated coefficients of such cross-section regression analysis, the PE ratio for the subject firm may be derived.

Historical Analysis.

You can look at the historical PE ratio of the subject company and take a view on what is a reasonable PE ratio, taking into account the changes in the capital market and the evolving competition.

As an illustration, the prospective PE ratio for Horizon Limited for the past three years was

PE Ratio 20x5 9.25, 20x6 6.63, 20x7 6.23
The average PE ratio for Horizon Limited was: (9.25+6.63+6.23)/3 = 7.37
Considering the changing conditions in the capital market and the emerging competition for Horizon Limite you may say that the average PE for the past three years is applicable in the immediate future as well.


The Weighted PE Ratio

We arrived at two PE ratio estimates:
PE ratio based on the constant growth dividend discount model: 6.36
PE ratio based on historical analysis: 7.37
We can combine these two estimates by taking a simple arithmetic average of them - this means that both the estimates are accorded equal weight. Doing so, we get the weighted PE ratio of:
(6.36+7.37)/2 = 6.87

Different PE ratios

Estimated EPS is based on a number of assumptions about the behaviour of revenues and costs. The reliability of the EPS forecast hinges critically on how realistic are these assumptions.

The other half of the valuation exercise is concerned with the price-earnings ratio which reflects the price investors are willing to pay per cents of EPS. In essence, it represens the market's summary evaluation of a company's prospects

Note that different PE ratios can be calculated for the same stock at any given point in time:

PE ratio based on last year's reported earnings
PE ratio based on trailing 12 months earnings
PE ratio based on current year's expected earnings
PE ratio based on the following year's expected earnings

An example may be given to illustrate the different PE ratios. The equity stock of ABC Limited is trading on August 1, 20x5 for MR 120 and the following EPS data is available:

EPS for last year (April 1, 20x4 - March 31, 20x5): 8 sen
EPS for trailing 12 months (July1, 20x4 - June 30, 20x5): 8.5 sen
EPS expected for the current year (April 1, 20x5 - March 31, 20x6): 9 sen
EPS expected for the following year (April 1, 20x6 -March 31, 20x7): 10 sen

The different PE ratios are as follows:

PE ratio based o last year's reported earnings: 120/8 = 15.0
PE ratio based on trailing 12 months earnings: 120/8.5 = 14.1
PE ratio based on current year's expected earnings: 120/9.0 = 13.3
PE ratio based on the folowing year's expected earnings: 120/10.0 = 12.0

We will generally use the PE ratio based on current year's expected earnings.

Peter Lynch's Classification of Companies

There are different ways of classifying shares. Here is Peter Lynch's classification of companies (and by derivation, shares).

Slow growers: Large and ageing companies that are expected to grow slightly faster than the gross national product.

Stalwarts: Giant companies that are faster than slow growers but are not agile climbers.

Fast growers: Small, aggressive new enterprises that grow at 10 to 25% a year.

Cyclicals: Companies whose sales and profit rise and fall in a regular, though not completely predicatable fashion.

Turnarounds: Companies which are steeped in accumuated losses but which show signs of recovery. Turnaround companies have the potential to make up lose ground quickly.

Stock Market Classification of Equity Shares

Stock market classification of Equity Shares

Blue chip shares: Shares of large, well-established, and financially strong companies with an impressive record of earnings and dividends.

Growth shares: Shares of companies that have a fairly entrenched position in a growing market and which enjoy an above average rate of growth as well as profitability.

Income shares: Shares of companies that have fairly stable operations, relatively limited growth opportunities, and high dividend payout ratios.

Cyclical shares: Shares of companies that have a pronounced cyclicality in their operations.

Defensive shares: Shares of companies that are relatively unaffected by the ups and downs in general business conditions.

Speculative shares: Shares that tend to fluctute wdely because there is a lot of speculative trading in them.

Note that the above classification is only indicative. It should not be regarded as rigid and straightjacketed. Often you can't pigeonhole a share exclusively in a single category. In fact, many shares may fall into two (or even more) categories.

The smart way to get rich

http://articles.moneycentral.msn.com/Investing/StockInvestingTrading/TheSmartWayToGetRich.aspx

The smart way to get rich
To get big rewards, you'll need to take some risks. What's important is knowing -- based on your needs, your time frame and other factors -- just how much danger you can handle.

By Annie Logue, MSN Money
Feel like taking a risk in hopes of hitting the jackpot on a rocket stock?
Before you make the leap, you might want to get a grip on risk.

Risk is great . . . when you make money
Prices go up, prices go down, and you never know which way they're headed next. A lot of folks would say, well, that's risk. But really that's only half the picture. The other half is what you do in response.

"Nothing goes up forever"
After all, there's nothing wrong with risk itself. What's important is how you handle it. To know how to manage the risk-reward equation, you're first going to have to get a grip on what you're playing with -- and how much you can afford to lose.

Graphic: How risky is it?
It's pretty hard to talk about investment risk without falling into a lot of clichés about roller coasters and bungee jumping and being able to sleep at night. That imagery is entertaining but maybe not terribly helpful. Instead, let's start with the basics. We don't want to lose money, right?
"Obviously, negative return is risk," says Lee Schultheis, the CEO and chief investment strategist at AIP Mutual Funds in White Plains, N.Y.
Pros such as Schultheis use some pretty powerful computer-driven tools in their analysis of risk. Here are just a few of the concepts that are important to them:
Standard deviation, much beloved of finance professors, measures how much the results of a process tend to vary. The higher the standard deviation, the more unpredictable the results.
Correlation, used by those managing diversified portfolios, tells you how much two assets move together to reinforce -- or offset -- performance.
Value at risk, often used by hedge funds, measures the likelihood that you will lose all of your money in any time period.
All three are mathematical concepts and require some comfort with statistics to calculate -- but not to understand. Each translates the uncertainties of risk into mathematical estimates of likelihood that offer a good basis for planning.

Math won't help everything
If you have an investment with a high standard deviation, close correlation to other investments or a high value at risk, you're taking on significantly more risk. If more than one of those factors is involved, watch out.
Let's say you're thinking about doubling up an investment in technology stocks. Results in that sector are going to be erratic to begin with. But because the new investment correlates positively with stuff you already own, the risk to you is much greater.
Normally, riskier investments hold the promise of greater returns over the long run. But that may not help you sleep at night.

What are acceptable losses?
Professionals will use concepts like standard deviation and correlation to balance risks in ways that can get pretty complicated. The average investor isn't equipped for that sort of thing. Fortunately, there are approaches that are a lot simpler to manage while still offering an approach that is fundamentally sound.
Edward Gjertsen, a certified financial planner with Mack Investment Securities in Glenview, Ill., encourages his clients to think about risk in a more personal way. He tries to focus their attention on their own fundamental needs.

How safe is your job?
He offers clients what he calls his seven-day cash challenge. Clients are asked to withdraw as much cash as they think they will need for all of their expenses -- coffee, groceries, whatever -- during one week. Then he asks them to report back on when the money runs out.
Very few folks make it through all seven days without a trip to the ATM.
"The ones who do it find it's eye-opening," Gjertsen says.
That's because most of us have a lot of expenses that we don't think about: birthday presents, a manicure before a party, prescription refills and the like.
"Every time somebody swipes a card, somebody's making money somewhere," Gjertsen says. "You don't necessarily realize this money is whipping through your hands."
The cash challenge helps Gjertsen's clients understand where they should draw the line on risk. Most of us do not want to gamble away the money we need to pay basic expenses and buy an occasional birthday present. But if we can take care of our basic needs, plan for college for the kids and fund a reasonable retirement, say, and still have a bit of money left over, that's different. There, maybe a bit of additional risk makes sense.
"Your portfolio should reflect whatever your underlying risk preferences are," says Leo Harmon, a senior director at Fiduciary Management Associates in Chicago.
To handle risk intelligently, you first need to make sure you can afford it. Then make sure it fits well into our overall investment strategy. Diversify. Don't bet the farm on a single sector. And recognize that it's not just how much money you'll need, it's when you'll need it.
For instance: A technology sector that sees a lot of ups and downs may be the worst possible investment for an individual who is planning to retire next year. But for the person with a 10- or 20-year time horizon, the same sector might make a lot of sense.
In the right situation, the addition of some well-managed risk makes sense and should have a positive effect on a portfolio. To profit from additional risk, though, you have to be comfortable enough to ride out the short-term fluctuations. Be prepared for some volatility, and understand that the ups and downs tend to get more extreme as the risks go up.

How competing economies help you
Meanwhile: Bear in mind that all investments carry risks of one sort or another. Just because a security has low volatility doesn't mean that there's no potential for loss. A steady loser is a lot worse than an investment that goes down a lot but then goes up by even more.
"It might not feel bad along the way because it only goes down a little bit at a time," AIP Mutual Funds' Schultheis says of the steady losers. In the end, though, a loss is still a loss.
If you think it through, risk can work in your favor. And you can still sleep at night.

Published April 11, 2008

Investing: When to bet the farm

http://articles.moneycentral.msn.com/Investing/StockInvestingTrading/InvestingWhenToBetTheFarm.aspx#pageTopAnchor


Investing: When to bet the farm

Big payoffs often require big risks. Bet wrong, and you could lose everything. Do you have what it takes? And how do you assess whether a dicey investment is worth it?

By Annie Logue, MSN Money
You want a big return? How big a risk do you want to take to get it? Gauging the risks associated with really promising investments, and handling those risks appropriately, can change your life.
"It's never safe to take a risk, by definition," says Carl Luft, an associate professor of finance at DePaul University in Chicago.
Yet successful investors take major risks all the time. They succeed because they do their research, can afford to lose the money they invest in high-risk schemes and are able to make up any losses they incur with other investments, which frequently involve complementary or counterbalancing risks.Whether considering an investment in a stock, a privately held startup or a hedge fund -- all high-risk propositions -- investors should start by digging through the details of the business case to figure out how the return on investment is likely to be generated. How big a payoff might the investment produce? And how likely is success?
Successful investors look hard at the downside as well. What would the price of failure be? And how likely is that?

Just jump in and take a risk
And what about all the outcomes in between?
Luft emphasizes that successful investors tend to have a broad view, taking the downside into account with the upside. They plan on an outcome somewhere in the middle of the range of possibilities. That is their "expected return."
"An expected return is an average," Luft says. "It's the probability of all of the outcomes."
Risk assessment gets pretty sophisticated at risk-oriented hedge funds. These funds combine and counterbalance risks to put together exotic investment strategies that increase an investor's upside while controlling the downside -- all for a price. But the basics are just common sense.
Russell Lundeberg, the chief investment officer for Barrett Capital Management in Richmond, Va., spends his days researching investments both risky and safe for the wealthy families in the firm's client base. He researches basic business practices as well as the big-picture business opportunity.
"The No. 1 most overlooked aspect of hedge fund due diligence is on the operational side," he says. "The things that can be potential risks and pitfalls are not always easy to spot."
Among the not-so-obvious business risks, Lundberg mentions high employee turnover, sloppy accounting and computers that aren't backed up. A mistake in the office can wipe out an investment's potential return even in the most promising environment, Lundeberg says.
Our own personalities add complexity to high-risk situations.
Bill Gurtin of Gurtin Fixed Income Management in San Diego points out the risks associated with overly emotional reactions.
"What you don't want to happen is for people to get emotional with the market," he says.
The more emotional we get, the more likely it is we will make a mistake, Gurtin explains.
A company's business prospects can be measured and evaluated statistically, but there is no easy measure for mood swings. Before making any moves, people contemplating high-risk investments should come to grips with their emotional makeup and know how they are likely to react.

Graphic: Three ways to analyze a company (Quantitative, Qualitative and Technical Analysis)
Where risk is high, the investor needs to analyze his or her life situation.

Is financial risk really risky?
"There are times in your life when it's appropriate to take different levels of risk," Gurtin says.
Age is a big factor. Age changes us in a lot of ways. We gain emotional maturity. At the same time, the nature of our financial obligations changes, and the time horizon for risk gets tighter.
"Let's say you're young, in your mid-20s," Luft says. "If you take a big risk and something goes wrong, you have time to recover." On the other hand, the middle-aged homeowner probably needs a bigger safety net, especially if there are kids who need braces or there are college costs to consider.
Even a high-risk investment can be a very positive part of a portfolio when it's appropriate to a person's situation and is well-managed.
"In investing and in life, you have to look at everything on a risk-and-reward basis," says Manny Weintraub, the president of Integre Advisors, a New York firm that manages equities for long-term growth. "Volatility is not the end of the world."

Risk lesson from the OTB
Weintraub is a good example. He left the investment firm of Neuberger Berman in 2003 to start his own firm. He knew most new businesses fail, but he had a lot of confidence in his own investment skills. If the business went under, he reasoned, he could always get a job with another firm.
"Careers are actually the easiest place to take risks, as long as you don't burn your bridges," Weintraub says.
Luft suggests younger investors, particularly, should be ready to gamble with their careers. But in the same breath he cautions as professional investors often do: Risk only as much as you can afford to lose, he says.

Published Aug. 28, 2008