Investment Decisions for my Mom and More Performance Statistics

I've been reviewing the information a new manager we hired for my Mom sent me about potential investments. He has a small firm that invests in the US based in the country where she lives. We have so far given his firm about 9% of her assets. At the moment the money is all in a money market account. But now he wants to know whether after the recent small decline in the markets we want to invest in stocks. I'm going to recommend to do so but to start with $100k and then invest $8-$10k each month over the next year in the same investment. I think it is likely that the stock market will decline further this year, but I can't be sure. As I don't think stock valuations are excessive, the Fed is likely to cut interest rates, and inflation is contained, I don't think any stock market decline will be pronounced. Therefore, I'm recommending this dollar cost averaging (DCA) approach. She has plenty of cash and bonds in other accounts and only has about a 15% allocation to long-only stocks at this point. When this investment is complete she'll have about 25%. I am also recommending to invest with Aletheia Research and Management. This is the kind of manager I love - their alpha is 15% or so though the growth account also has a high beta. It isn't the kind of investment your typical pf-blogger likes as the expense ratio (paid as a "wrap fee") is rather outrageous (3% I think). The minimum investment is $100k which is why we can't just DCA all the way.

While I was reading the information on these separately managed accounts I came across an interesting performance statistic - down capture ratio and up capture ratio. These statistics are the fraction of the market gain a manager captures in months when the market rises and vice versa. It is easy to compute in an Excel spreadsheet. The Aletheia Large Cap Growth Managed Account reports an up ratio of 1.65 and a down ratio of 0.47. This is a very impressive asymmetry. According to Alexander Ineichen, asymmetric returns are the hallmark of hedge-fund like performance. So of course I computed my ratios for the last 36 months: 1.22 up and 0.71 down. Not bad. It wasn't always that way :) The asymmetry is increasing over time. In my early days of investing the asymmetry went in the opposite direction!



Following my discussion yesterday with Rich Gates and BackOfficeMonkey (love the handle!) I took another look at the correlations of my returns (since October 2002) with several other assets and managers. As I knew already, my largest correlation is with the MSCI World Index. I have a small negative correlation with the TIAA Bond Market Fund and a small positive correlation with the Australian Dollar. I estimated a regression against all these factors and only the beta on the MSCI World Index was statistically significant. If I had the data to hand I'd do a more sophisticated analysis, but the point is that the MSCI is not a bad benchmark.

Timing and Measuring Investment Performance

The chart shows how many percent you would be ahead of the MSCI World Index (Gross = total return index) today by investing with me in each of the months on the X axis. This shows the influence of timing of investments on performance. Measured from inception in October 1996 when I first started measuring investment performance you would be 10% behind the index. Investments made in late 2004, through 2005 would also be lagging in performance. But if you invested with me in any of the other periods you would be ahead by up to 47%. If, instead, one dollar cost averaged into this investment program - as I have done in practice - you would be beating the market, as investing in most months results in index-beating performance.

I think a chart of this sort would be very useful as part of every mutual and hedge fund prospectus or as a feature of websites such as Yahoo Finance.

February Report

All figures are in US Dollars unless otherwise stated. Income and Expenditure

Expenditure was $1771 - 54% of take home pay ($3,299). This is the normal background level of expenditure. 403b contributions again totaled $1,795 and Roth contributions $333.33. Non-retirement investment returns were quite strong again this month ($5,777). Retirement investment returns were also nicely positive ($3,202). The rise in the Australian Dollar contributed significantly to returns.



Net Worth Performance

Net worth rose by $US12,301 to $US389,704 and in Australian Dollars gained $A8,017 to $A493,859. This is $US7,000 more than needed to be on track for my 2007 goal of a net worth of $US470k. The Australian Dollar rose this month resulting in a relatively large gap between performance in the two currencies. Non-retirement accounts reached $US212,618 or $A269,444. Retirement accounts also saw nice gains to $US177,086.

Investment Performance
Investment return in US Dollars was 2.38% vs. a 0.49% fall in the MSCI (Gross) World Index, which I use as my overall benchmark and a 1.96% fall in the S&P 500 total return index. Non-retirement accounts gained 2.81%. Returns in Australian Dollars terms were 0.78% and 1.21%. U.S. Dollar returns also beat the indices over the last 12 months:



The contributions of the different investments and trades is as follows:



The returns on all the individual investments are net of foreign exchange movements. Foreign currency gains appear at the bottom of the table together with the sum of all other investment income and expenses - mainly margin interest. QQQQ/NQ trading again yielded very strong returns ($4,026). Apart from trading and foreign currency diversification the monthly return would have been flat. The most positive contributions from investments were from Everest Brown and Babcock - an Australian listed fund of hedge funds and hedge fund management company - and from two bond or balanced mutual funds. If all my investments were in US stocks I would have had a negative month. Diversification across currencies, asset classes, and trading vs. investing generated the positive return.

Progress on Trading Goal
Trading in my US accounts netted $3,826 a 13.9% return on trading capital. The model gained 9.4% while the NDX fell 1.7%. My goal for the year is to end up with at least as much in my three accounts - regular trading, Roth IRA, and IB - as I've put into them. The accounts in total gained a net $3,374 and I have now achieved $7,702 of the annual goal of about $19,000. Since the beginning of the year the trading capital gained 36% while the NDX was essentially flat.

Asset Allocation
At the end of the month the portfolio had a beta of 0.40. 40% of the portfolio was in stocks, 43% in bonds, 13% in cash, and loans totalled -7%. The remainder was in hedge fund type and real estate investments, futures value etc.

Half a Million

Australian Dollars. I just updated my net worth for the current date in March and I am above half a million Aussie Dollars. I might not be able to hold on to that level as some day soon I am going to reduce the carrying value for Croesus Mining. But only when it either delists or trading recommences on the Australian Stock Exchange. I expect that will be a $A10k-11k hit to net worth. US Dollar net worth is currently down on last month's strong close due to the fall in the Aussie in recent days.

It is just under a year since I passed the last Aussie Dollar milestone.. $A300k was first passed in January 2005 and $A200k in June 2004. But I first exceeded $A100k in December 1998:



Superannuation refers to all retirement accounts and medium term balance to non-retirement accounts.

Got back last night rather delayed from Florida to the snow and ice of the northeast. Today has just been catching up on everything and otherwise being lazy.

Preliminary Report

Initial figures show an almost $11k gain in net worth to $388k and well ahead of the target of $382k for this month and an investment performance of 2.05% mostly due to the gain in the Aussie Dollar as well as trading gains, my mutual funds were up just a little. There will be a full and detailed report with the final figures after we get back from Florida. Today a hedge trade went wrong when the market swooned this morning but I managed to come out with a profit on both sides of the trade.... eventually.

The main driver of the fall in the stock market seems to be the rise in the Japanese Yen. People who have borrowed or shorted low interest Yen to use the proceeds to invest elsewhere are covering their positions as the Yen rises and liquidating other investments elsewhere. The media calls this "unwinding carry trades". The fall in the Chinese market and the softening signs in the US economy also are playing a role of course.

Also, check out the latest 30s and 40s carnival.

The Day After

At this point it looks like the market is shaping up for a sideways day after the rebound in Shanghai overnight and smaller losses in European trading than Wall Street experienced yesterday. I put on a hedge trade - long 2 ES and short 2 NQ which is biased to the long side, but exited it at a loss as I had a meeting at 9:30 and it didn't seem to be doing well. It would have been in the money by now. So I guess I am just jittery after yesterday though I made plenty of money in the US market, but got slammed of course in Australia. I don't know the full extent of damage there as mutual fund prices are reported with a delay. Worst are probably the losses in resource stocks affecting my CFS Global Resources Fund which has about 10% in each of RIO, BHP, and RTP (those are the US tickers). The more hedge fund like instruments mostly responded better, though EBI.AX fell 5% and hedge fund manager EBB.AX fell 8%. I reckon I was probably slightly up yesterday overall, though I don't know how the short-term Australian Bonds in the CFS Conservative Fund (my biggest holding) responded. The Aussie Dollar fell and US bonds rose.

But I'm not worried that I don't have a trade on. I don't have to have a trading position at all times. I used to think of my short-trades as hedging my long positions and felt nervous if I didn't have a short when I thought the stock market might fall. But now I think in a much more "alpha-centric" way. Alpha are returns that are not correlated with stock market returns while beta reflects returns that are correlated with the market. I divide my portfolio into three sections:

1. Hedge fund type instruments that hopefully generate alpha. Sometimes some of these seem to have a bit more beta than I was reckoning on.

2. Beta - mainly long-only mutual funds whose return is mostly correlated with market returns and may have a positive alpha. It's no big deal if their alpha is negative to a small degree (one reason I am not worried about expense ratios which tend to reduce alpha) because I can generate alpha elsewhere in my portfolio. I change my exposure to these funds over the 4 year stock cycle. At the beginning of the cycle my exposure to stocks would be much bigger. I don't have to get my market timing perfectly right. At the moment I am 50-50 in bonds and stocks reflecting the late stage of the cycle which maybe now is heading towards the bottom - assuming that we need to see a 20% correction before the cycle is over. At the beginning of the cycle I will use leveraged stock funds and margin.

3. Short-term trading - I regard this now also as a generator of alpha. The trades are in ETFs or futures and so have a +1 or -1 correlation to the market while the trades are on. But the stochastic model has a zero beta coefficient to the NASDAQ 100 index. So in the long-run the returns are all pure alpha.

And of course I am also diversifed across US and Australian Dollars.

I've arrived at this strategy after a lot of experience and seeing what works and what does not and what I can tolerate emotionally. It's much more sophisticated than the standard "buy and hold" long-only models. I know I can't tolerate the fluctuations that that leads to. It was interesting seeing the responses of some newbie investors yesterday to the drop in the markets - which in the Dow was significant for a one day drop but was really not that much of a decline off the highs yet. I wonder how many will throw the towel in when we are down 20%? I started investing and trading in 1997 and have been through the high volatility of the 1998-2002 period. I also remember very well the crash in 1987 though I wasn't invested (I did buy a little in some Israeli mutual funds before then and was an undergrad economics and geography student) and even dim memories of the 1970s. Even then I was interested in investing and would discuss things occasionally with my father who was a long-time stock and mutual fund investor though he certainly wasn't wealthy then (we were definitely lower middle class in Britain) and read the financial news.

Anyway, here is what happened in one account, my account with Interactive Brokers:



You can see the big dip a couple of weeks back and then yesterday's recovery, followed by more erratic trading. My Ameritrade account would have a similar pattern. My z-score in NQ trading (total of 209 contracts traded) is now 2.03, which means that the probability that my performance is random or actually negative is something around 2%. The Kelly ratios though for both this and my weekly results in my IB account say that I should be taking on huge amounts of leverage. The Sharpe ratio for the weekly returns on my IB account is 1.68, which is a respectable number for a hedge fund.

Recouping My Losses

Today has helped me more than recoup my losses from the last big blow up. I closed out an overnight trade in NQ like 20 points ago so my IB account isn't yet back to its all time high, but my Ameritrade accounts, which hold the core position of each trade that I hold for several days are more than making up for it. Ostensibly the cause is the 9% drop on the Chinese exchanges over night and more signs of impending recession. The ten year bonds are up 19.5 ticks at the moment. It's the only green thing on my screen apart from put options :) From a technicians perspective the bottom line is the markets were ready to fall and just waiting for the shock which is why I was net short. The rise in bonds will help balance some of my loss on long stock positions elsewhere in my investment portfolio. It's looking like being a good month unless I do something incredibly dumb tomorrow.

Suze Orman is Extremely Risk Averse

Suze Orman was interviewed today in the New York Times Magazine. I've read before about her extreme risk aversion. In the article she comments that her net worth is about $32 million allocated $7 million to owner occupied real estate, 24 million to municipal bonds (tax free), and $1 million in stocks. She says about the stocks that she put $1 million in them because if she loses it all it doesn't matter. There is no reason to be aggressive when you are as wealthy as she is. But her attitude that "you could lose it all" by putting money in stocks (you could lose 20% of it in a day based on historic precedent) is interesting and also that only 3% of her net worth is in that asset. This would make me less likely to take her advice.

But many people seem to be interpreting this comment in an exactly opposite fashion. This is also interesting. It might be related to what economists call "money illusion". Maybe talking about a million dollars not mattering is alienating to potential followers. I wouldn't like to lose $12000. But I've certainly lost more than that in a month. I even lost 3% of my net worth on a dumb trade in one day. The latter was not a pleasant experience to say the least. But in the larger scheme of things it didn't really matter. So losing a million dollars doesn't matter to Suze.

By investing in stocks to the degree I am I am setting myself up to potentially lose a very significant chunk of net worth. And that is what happened in 2002 for example. But I think it is worth taking on some risk for return.

P.S. For economics afficionados - if I feel the same way about losing 3% of my net worth as Suze does then I am assuming we must both have logarithmic utility functions. Which can't be true if she is more risk averse than I am.

Snork Maiden's Taxes

Looks like I will be doing Snork Maiden's taxes. The software she used last year won't let her file as a non-resident alien this year, even though that is clearly what she is. All foreign students count as non-resident aliens irrespective of how long they've been in the US. On the other hand I don't yet have a green card but count as a resident for tax purposes.

Back when I was a grad student I used to file a 1040-EZ even though I was a non-resident alien. For most people you pay less taxes that way. Yes, it is cheating on taxes. So we are going to file properly. The only software I use for taxes is Excel and the IRS's forms and instructions. My taxes take several hours to figure out when I get down to it. I reckon Snork Maiden's federal return will take less than half an hour. The Vermont return will be a novelty for me. I've completed Massachusetts and New York tax forms for myself before and also a California return (not my own).

Trading went pretty well today. Of my two new indicators for overbought conditions, one said to go short today and one formally said not to, but was pretty close to short. So I was short and the market went down. My overnight trade (short 2 NQ) was profitable and then I initiated another trade (short 3 NQ) in the afternoon which I held for about breakeven at the close. I also have 4 QQQQ puts and short 1200 QQQQ shares as my core trading position. So now I am effectively short the equivalent of one big NDX contract or 4000 QQQQ shares. At midday I was only short the equivalent of 1600 QQQQ shares. I'm down this month in trading but despite the big blow out my net worth performance has not been affected at all. I only have about 6-7% of my net worth allocated to trading. Good investment performance and the rise in the Australian Dollar have easily offset losing 15% of my trading capital in one day. That is the benefit of true diversification.

New Trading Rule

The big problem with my trading model has been that when the stochastic in the chart below is over 80 as it is today or under 20, I can't predict ahead of time when the market will turn and we should sell or buy. All I could do was wait for the stochastic to cross over.



So the model gave me no advantage over anyone who can read a free chart when the index was overbought or oversold. And that is a lot of the time. The model did give me a big edge when the stochastic turned around in the range between 20 and 80. I could predict that. I tended to get very jittery in these overbought and oversold zones and ended up losing most of the profits I made the rest of the time.

Today, I came up with a rule which uses one of the forecasts I was already generating from the model to give predictions for turning points in these overbought and oversold zones. I would say it works about 1/2 the time. Its performance is halfway between a trading algorithm that reverses from long to short or vice versa at the end of days when the stochastic crossed its moving average during that day and a model which shows perfect foresight and reverses position at the beginning of days that see stochastic crossovers. Let's see if it adds to my performance.

For what it's worth the model is not formally predicting that the stochastics will cross on Friday using the rule I found to be optimal. But unless there is another strong rally it's going to be hard for them not too and there are clear sell signals in palce on the S&P 500 and Dow indices, so I'm skeptical about that strong rally. The market has, however, continued to be stronger than I expected.

Credit for Federal Telephone Excise Tax Paid

Now I know why I kept all my old telephone bills :) The standard credit for a single filer for the Federal Telephone Excise Tax Refund is $30.00. I just computed my credit using my old bills and Excel (where I set up a spreadsheet to replicate Form 8913 and do all the summations and multiplications needed). My credit comes to $111.13. $81 is not bad for half an hour's work :) Most of the credit is due to tax I paid on bundled service. So if you have those old bills give them a quick check to see if you might exceed the standard credit and if it's looking good, do the computations.

Wealth Cycle Investing

Since Millionaire Artist wrote that Loral Langemeier's "Wealth Cycle Investing" was a very foreign in approach to her, I was intrigued to take a look for myself. I got a copy and have started reading it. Basically it seems to be about levering up your balance sheet and taking more risks and for people with zero or negative net worth starting a side business to generate some cash to invest. This isn't very unusual to me. I feel Langemeier is overexaggerating how different her approach is. But it is radically different to the advice given by the usual personal finance gurus like Suze Orman.

Like many such business investment oriented "gurus" she favors direct investment in income-producing assets rather than financial assets like stocks. But she does like origination of loans to other people. I don't see any neccessary inherent advantage in direct purchase of productive assets. Take for example Warren Buffett. He does get involved directly in the insurance business - this is where Berkshire's real business knowledge is. Otherwise they are investing insurance profits and float is other people's businesses. Even when Berkshire buys whole companies as subsidiaries they retain existing management in place. In fact that is a key Berkshire principle - investing in good managers. But Loral only seems to think that investing in stocks as a way to learn about businesses (which it is too). Why not invest with good managers?

In fact, good managers could be seen as part of the investor's "team". Langemeier emphasizes continually the importance of a team to investment and business success. And it is true that networking and extensive use of specialized professionals is going to be crucial to the kind of investing she favors. Investors like me network too - but mainly online. I don't yet use any professionals for the kind of investing I do. I rely on books written by professionals. I figure out my own taxes and figure out that at this stage I don't need an "entity" (guru self-help books often overemphasize the need for "entities" - filing Schedule C as a self-proprietor has many of the same advantages - but again they are going to be much more useful for direct investors than financial traders). Well in fact Langemeier does recommend investment in private equity. Her rationale seems to be that she is more likely to have direct access to management as a private equity investor. Given the minimum usual required investment in private equity and the need to diversify over a few deals, even if you could get in on a deal as a non-accredited investor it might not be a good idea. On the other hand if you are really an active participant then it is like investing in your own business and maybe is a risk worth taking?

Otherwise, her advice seems generally solid to me and she does discuss risk, but like Kiyosaki, and others I think overstates how appropriate this path is for most people. There is no inherent advantage in my opinion in investing in any particular class of asset or starting any type of business unless you have some aptitude or edge in that investment or business. If you lack the aptitude things can instead go very wrong. If you have no edges you want to be maximally diversified (actually, to her credit, Loral likes diversification). Her best client story, is based on Jed who was managing a small chain of bike stores but had a net worth below zero. Following his first investment of just $3000, Jed quickly manages to put together complicated real estate deals. I think his management experience helped him to do this. Understanding what your edge is is I think very important to business and investment success but rather under-discussed.

Should You Rely on Trading Test Statistics?

Henry Karstens recently posted a primer on testing strategies. A key indicator is what he calls "optimal f" which is related to the Kelly Criterion. Optimal f is supposed to tell you how much you should have in your account per standard sized trade. I computed this statistic for all of my trading of NASDAQ 100 futures since I opened my IB account - a total of 98 closing trades. I standardized the gains and losses for each trade by dividing the amounts by the number of contracts bought or sold. The criterion shows that I need $4906 per contract traded in my account. It would mean I could trade up to 79 contracts with my current net worth, or $2.85 million of underlying stock.

Another statistic that Karstens presents is the z-score which is a test of whether the average gain per trade is statistically significantly greater than zero. My z-score is only 1.04. Which means there is around a 15% probability that my system, the way I am trading it, doesn't make any money at all.

The bottom line, I think, is to take all trading test statistics with a big pinch of salt. The same data that says that there is a good probability that my results are random also could be construed as saying I should be trading with 7.3 times leverage.

Uh-oh Another Blow-Up

Things were going very well this year until today. My trading was awful today and I've probably lost the profits I made this month so far and a little more. I need to use stops more and be prepared to get out of a losing position fast. Bernanke's testimony to Congress caused the market to melt-up when I was very short. The model was, in fact, pretty ambiguous on the direction today. Some signals pointing one way and some the other. I need to learn to take a small position or a hedged position in those circumstances and then really get out fast if the market is determined to go against me. If each "blow-up" gets less than the last one then I guess I am making progress.

Trading Performance Update

My results since I made this post about money management strategy have largely confirmed what I wrote there. My system mainly produces winning trades but winning and losing trades are both making or losing similar amounts of dollars. Since December 1st - when I closed the disastrous Australian Dollar trade - I have made 66 winning trades and 19 losing trades. The average win is $153 and the average loss $190 for a total of $10,156 of winning trades and $3,618 of losing trades. When I read about most trading systems and the usual advice to cut losses quickly and let winners run and that "it's more important how much you win when you win than how often you are right" I get the distinct impression that those trading signals are not much better than random and it's all in the money management.

I've almost doubled the account since then as I was down to just over $7,000 (I invested $10,000 in the account) and I have done it pretty smoothly:



Based on weekly returns the annual Sharpe Ratio is 9.7 which is just way off the scale. But based on daily data "the model" tends to have a Sharpe Ratio around 7 and extreme levels of alpha. Up till now I have only intermittently been able to trade the model correctly. I'm not convinced that I won't see erratic performance again in the future that will significantly reverse the good performance I am currently seeing. There isn't a single down week among those ten weeks since December 1st. But last July and August also looked very good too and then some sharp reversals appeared and my trading was just awful.

Penny Options Trading Gets Underway

Today was the first day on which U.S. exchange traded options (ETOs) in QQQQ the NASDAQ 100 ETF can be traded in penny increments. Up till now option bid and ask prices had to be in 5 cent increments for options priced below $3 and 10 cent increments for options priced above $3. You couldn't place a bid to buy an option for $3.03. Only $3.00 or $3.10 were acceptable prices. Market orders in options though could actually trade at any price when two orders were crossed. There are a few other stock tickers involved in this pilot program. If it is successful I suppose it will spread to trade in all ETOs.

I've been watching today and the bid-ask spread for the $47 March QQQQ put is averaging 3 cents rather than the previous 10 cents (I have two of these contracts in my Roth IRA account). The spread on QQQQ stock is typically a single penny.

I predict that the volume of options trading will accelerate as a result of this innovation. Relative to buying stock, buying options has meant immediately losing a pile of money due to the spread. The narrowing of spreads should make trading ETOs more attractive. I know I am going to be more likely to trade them in my Roth account now. Trading QQQQ stock requires more capital but still has the advantage of being able to trade pre-open and after hours if neccessary. Futures contracts require little capital, trade almost 24/5 and have narrow spreads during the main trading hours. On top of that they are taxed lower in the US. I still do some QQQQ stock trading in my regular trading account. But over time I am doing more and more of my trades in the futures market.

My First "Carnival"

Believe it or not, this is the first "carnival" I've ever participated in:

The first edition of 30s and 40s Personal Finances: Wealth Accumulation Carnival

And it's the very first edition of this carnival too!

January Report

Income and Expenditure

Expenditure was $US2,515 - 76% of take home pay ($3,299). Expenditure is up this month because of paying for flights and hotels in Florida for our upcoming trip. 403b contributions now total $1,795 and Roth contributions $333.33. Non-retirement investment returns were very strong this month ($8,989) and were the most significant factor in increasing net worth by $10,941. Retirement investment returns were negative.



Net Worth Performance

Net worth rose by $US10,941 to $US377,402 and in Australian Dollars gained $A21,262 to $A485,842. This is $US3000 more than needed to be on track for my 2007 goal of a net worth of $470k. The Australian Dollar fell this month resulting in a relatively large gap between performance in the two currencies. Non-retirement accounts reached $US205,646 or $A264,735. The growth of non-retirement accounts has been very strong relative to retirement accounts recently:



The brown line shows non-retirement accounts and the green line retirement accounts. The emerging rapid acceleration in the non-retirement accounts is the reason I started maxing out my 403b. Hopefully, the strong investment and trading performance will continue but I also need to think about how to increase returns on the retirement accounts.

Investment Performance
Investment return in US Dollars was 2.28% vs. a 1.02% gain in the MSCI World Index, which I use as my overall benchmark and a 1.51% gain in the S&P 500. Non-retirement accounts gained 4.58%. Returns in Australian Dollars terms were 3.86% and 6.19%. U.S. Dollar returns also beat the indices over the last 12 months:



The contributions of the different investments and trades is as follows:



The returns on all the individual investments are net of foreign exchange movements. Foreign currency losses appears at the bottom of the table together with the sum of all other investment income and expenses - mainly margin interest. Finally QQQQ/NQ trading yielded very strong returns. The Everest Brown and Babcock entry covers returns on a listed fund of hedge funds and the management company itself which are both listed on the Australian Stock Exchange. The management company saw a large increase in share price this month. Merger candidates Powertel and Symbion also performed strongly. I also made $1170 trading Apple on the day of the evening of the earnings release. I still hold the short IYR position which is performing very badly for me.

Progress on Trading Goal
Trading in my US accounts netted $4525 a 19.7% return on trading capital. The model gained 9.1% while the NDX rose 2.0%. My goal for the year is to end up with at least as much in my three accounts - regular trading, Roth IRA, and IB - as I've put into them. The accounts in total gained $4578 which is about a quarter of the annual goal of adding $19,000. So here too, I am well ahead of my goals for this point in the year.

Asset Allocation
At the end of the month the portfolio had a beta of 0.76 56% of the portfolio was in stocks, 44% in bonds, 8% in cash, and loans totalled -18%. The remainder was in hedge fund type and real estate investments, futures value etc.

Floridian Frugality?

Posts by Cliff and Nirav about frugality and buying luxury on the cheap got me inspired to write something about "frugality" myself. Usually I don't write about this topic. I feel very comfortable with my level of spending and it isn't an area where I feel I need to improve - unlike my trading or investing - and most of the time I don't think it would be very interesting to anyone. I grew up in a pretty frugal family and the habits were instilled in me from birth. There never seemed like there was another way of living apart from being frugal, saving, and investing. My father thought me to be very spendthrift in fact. Most of my friends would say I was frugal. I rarely though buy the cheapest option, I try to get good quality stuff at a low price.

So here is an example. Moom and Snork-Maiden, Moomin's significant other, are going for a trip to Florida. There are four alternatives:

1. Don't go to Florida - invest the thousand dollars plus that the trip will cost.

2. Go to Florida and do all the cheapest things. Like buying $160 airline tickets - that arrive at 11pm in Florida and staying in a low price motel ($80 per night) on the mainland.

3. Buy tickets @ $250 that get us to Florida at 4pm. Still spend a while online finding this good deal. Moom and Snork-Maiden discussed this one quite a bit. Moom was insistent on spending the extra money, while Snork Maiden thought the cheaper ticket was better. Moom just thought that $80 extra each was a good price to pay for not arriving late at night especially if something goes wrong (flight delayed, hotel booking screwed up etc.). And if everything goes to plan we spend an extra evening in Florida visiting Snork-Maiden's friend. We also booked a hotel for the second two days of our trip on one of the barrier islands. It costs $120 per night. There are lots of much more expensive hotels surrounding it.

4. Just buy the first tickets we see that have good times and splash out on expensive hotels etc. with the best amenities right on the beach. You can spend more than $400 on a ticket and up to that a night at a hotel.

As you can see we ended up with 3. I think the extra money is worth it. But I am still doing option 3 instead of option 4.

What would you do? I am curious how frugal other PF Bloggers would really be in this situation? Would it make a difference if you had the same net worth and income as me (you could be better or worse off actually)?

Looks Like January was a Great Month

In order to keep on track for my 2007 goal of reaching a net worth of $470,000 I needed to reach $374,000 this month. It looks like I am north of $376,000 at this point. Other major milestones are exceeding a net worth in non-retirement accounts of $200,000. In Australian Dollar terms I added more than $A20,000 to net worth and sailed past $A 1/4 million in the non-retirement accounts. I made $4525 in short-term trading in the US - a rate of return for the month on capital employed of 19.69%. Yup that's more than 800% on an annual basis, so don't expect me to sustain that :) Overall investment returns were far above market indices. January is usually a month where I do very well.

Full details will be coming in a few days.

Paying for Grad School

A good article about whether to pay for a graduate degree. My usual advice is if you aren't going to do a degree in a lucrative and/or high demand professional area (business, law, medicine, physical therapy etc.) don't pay to go to grad school. Even if you are rich, if the school or some other sponsor doesn't want to pay for you then that should be a warning sign that maybe this isn't a good idea. Of course, if you really just want to do it for fun and you have the money, go ahead...

Even some of the students whose PhDs we pay for (I am director of graduate studies for my department) turn out to have been bad investments. Perhaps a quarter of them really shouldn't have done a PhD. If you count those who ended with a masters (while they planned on getting a PhD) maybe up to half of admits are a bad investment. Now maybe some people we refused funding to would have been good investments. But I like to think we do know a little when we make these decisions and that most of the people we don't fund shouldn't go to grad school.

A More Sophisticated Approach to Portfolio Construction

I don't think this article is as novel as the author and the blogger are making out. All it really says is build a balanced portfolio out of uncorrelated assets and then lever it up. Modern Portfolio Theory allows for that. But it is a more sophisticated approach to constructing an efficient portfolio than you will hear about in articles geared to the small investor that appear in the mainstream financial press. But you don't want to use very high margin lending rates to achieve this. You can achieve similar results by investing the stock portion of the portfolio in leveraged mutual funds, stock index futures etc. This means that less of your capital needs to be devoted to investing in stocks and more will be directed to real estate, bonds etc. The end result is a leveraged balanced portfolio. It will probably have lower volatility for a similar level of returns as an unlevered all stock portfolio.

This isn't far from the way my portfolio is currently constructed with a balanced mix of stocks, bonds, real estate funds etc. and then using leverage to trade stock index futures and ETFs. In the long run, I want to have a core of more hedge fund like investments for perhaps 50% of the portfolio, about 40% in funds which I will change the mix of over the 4 year stock cycle to have more stocks or more bonds and about 10% as capital for leveraged trading. Or up to 100% invested and then borrowing using low margin rates for the cash needed for trading. Currently Ameritrade are charging my account size a 10.5% margin rate which is ridiculous. CommSec in Australia are charging 8.9% (and interest rates are higher in Aus!). Interactive Brokers rate is less than 7%. The latter is economically viable.

Merger Mania

Two of my stocks are now in merger talks: Powertel - a small Aussie telecom firm - and Symbion Health - an Aussie healthcare firm (what else?). Powertel is in talks with Telecom NZ, which I really shouldn't have sold. It has gone up around 10% since I sold it! Talk is that Telecom NZ will acquire Powertel and merge it into its underperforming Aussie subsidiary, AAPT. AAPT was one of the first stocks I bought - I bought it at the IPO and sold when Telecom NZ acquired it. Symbion is one half of the former Mayne conglomerate that remained after Mayne Pharma was spun off in a demerger. Yup, Mayne Pharma was acquired too. An advantage of investing in mid and small cap stocks is that they are more likely to be acquired than mega-cap stocks are. That's one reason I made my disastrous investment in Croesus Mining. Sometimes it works out and sometimes it doesn't...

There is a global wave of mergers, acquisitions, and privatization buyouts going on that rivals the previous peak of such activity in 2000. In theory this suggests that shares are cheap as most of the acquisitions are being made with cash or borrowed money, not other shares. But I don't think the evidence is that acquirers are actually that smart and the high level of such activity could be seen as a sign of an overheated stock market instead.

P.S. Tuesday, 30 January

Telecom NZ is offering $A2.30 per share for Powertel. I paid $A1.20. The stock is trading at that level. The only issue is I bought on 6 May 2006. So I need to hold on till this 6th of May to get the long-term capital gains rate. This is worthwhile when considering the tax saving vs. interest paid in the meantime. Only question is whether I'll be able to hold on till then. The news release talks about Powertel shareholders voting on the deal in late April. If the acquisition (for cash) proceeds immediatately there is going to be no point in waiting till then - unless a better deal comes through. I'm skeptical about that, because one potential bidder already dropped out earlier saying that the price of Powertel was already too high then!

Indexing vs. Active Management Again

New research attempts to do a better job at assessing whether indexing or active management performs better for long-only mutual funds. They examine each capitalization class (small cap, mid cap, large cap etc.) for both active and passive funds. The bottom line is that there appears to be some gain to active management in the mid-cap sector. I recently blogged about the advantages of small funds. This new research also confirms that active management has some advantage in periods of market underperformance though they found that active management just underperformed less in that time period.

I would be very skeptical about buying a long-only actively managed large cap fund. I don't own any currently unless you count Colonial First State's Global Resources Fund. But actually it's not a large-cap only fund. In the past I have owned Colonial First State's Geared Share Fund. It is a large cap long-only Australian stockmarket fund that uses leverage. Of course most Australian large cap stocks would be mid-caps in the US. And the real reason to use the fund is for the built in borrowing at a very low interest rate.

I get large cap exposure in the short-term using futures and ETFs. If you want to get large cap exposure in a buy and hold fashion it probably does make sense to buy an index fund. But does it make sense to buy and hold large cap stocks anyway?

Don't Worry So Much About Saving Enough for Retirement

The NY Times discusses something I have commented on from time to time. Most people in the US end up saving enough for retirement. Poverty is concentrated in fact among families with children rather than seniors. The retirement planning tools provided by brokerages and funds management firms tend to over-exaggerate how much you need to save. As Lawrence Kotlikoff comments in this article - you could end up squandering your youth rather than your money which you will likely come to regret. My mother has a high net worth but hardly at all touches the income from these investments. She primarily lives on government and employer pensions (the employer pension from my father's employer is very low). She gets free government health care and owns her own apartment. Sometimes I try to persuade her to spend more. The main point is that the research also shows that the old spend less than the young. You only need to replace what you spend and that spending shouldn't include things like mortgage principle payments, spending on children etc....

I'll probably end up with "too much saved" (even though I had nothing in a retirement account till age 31, and a negative net worth for most of my 20s) but I am still saving rapidly now because I don't plan on retiring at 60-65 but becoming financially independent long before that. IMO my $1million goal is more than sufficient for achieving that as long as after I reach the goal I at least maintain the inflation-adjusted value of the money.

Overnight Trading Proving its Worth

I'd credit a signficant portion of the rising profits I blogged about in yesterday's post to adoption of the overnight trading tactic. And today proves the point. I closed my short position early yesterday but didn't go long till late in the day when the market had risen considerably. I bought 3 QQQQ call options in my Roth IRA account (300 QQQQ shares equivalent). This morning the market started up and then began to fall. I then bought 500 QQQQ in my Ameritrade account and after that 1 NQ contract (800 QQQQ) @ 1810.75. But the market kept falling all day... late in the day I bought another 2 NQ contracts @ 1791.75. Using the overnight trading approach I should have either dumped my 3 options contracts for about breakeven early in the session today or kept them and suffered a small loss and then gone more significantly long late in the day after prices had fallen. Trying to position myself in line with the model during the session resulted in significant losses - even though the market had already fallen when I started buying. The model is still long, which is why I bought two more contracts late in the day. They are now a little in the money but my earlier buys are underwater. I also should have put in place a hard stop at a 1-1.25% loss in the index for the day.

The overnight trading strategy does seem to work well for part-time traders who can't sit and watch the market all day. At least it works well with my psychological makeup. Today showed what happens when I deviate from it. Living and learning :)

IB Account Profit and Loss Curve

The chart shows the cumulative profit in my Interactive Brokers account since I opened it in late October 2006 trade by trade. All closed trades are shown here. Initially, things were a bit erratic and then an Aussie Dollar trade went very bad. I shorted 3 contracts and the AUD rose 1 US cent against me... that resulted in a loss of $US3000. Since then I have had a pretty smooth ride along an ascending profit curve. As I blogged, yesterday, that might make me a bit too complacent. In fact I made a new short AUD trade yesterday - but only 1 contract - and again the AUD rose against me. But this evening, on the release of the SPI report in Australia the Aussie plummeted and that trade (now closed) turned out OK.

The chart also shows the importance of cutting losses. If I just halved the size of those two big losses the track record would look very different.

I did one of these reports before for non-futures trading. It also looked pretty erratic. I am still waiting for the decisive breakthrough where my trading looks consistently profitable.

Cushion of Profits

I've managed to build my Interactive Brokers account which I use for trading futures up to $12,000. I originally put $10k into the account. After the Aussie Dollar trading debacle in early December the account had fallen to $7,000. So at this point I am achieving the first part of my second goal for 2007 by bringing one of the three accounts back to profit. As I begin to rebuild profits I start to feel less anxious about losing money in trades. This doesn't make a lot of sense economically. $2000 is about 1/2 per cent of my net worth and shouldn't make much difference to my decision making if I was really a neoclassical rational optimiser. It shouldn't matter that the $2000 is the profits in a specific account. This is a classic example of behavioral economics.

Anyway, I'm not sure if this is good or bad. On the one hand, I am likely to be less jittery and more likely to let profits run etc. On the other hand, I might start to take unreasonable risks. Need to remain dsciplined.

Small Caps and Small Funds

Following up from the discussion about mutual fund costs, Friday's WSJ had an article about top performing small cap funds (pointed out to me by Rich Gates - sorry no link as it is subscription only - I read the hardcopy at the office - I subscribe online to Barrons but not the WSJ). This showed that not only have small cap stocks outperformed large cap stocks in recent years but many of the top-performing small cap stock mutual funds are very small in terms of assets under management. TFS Capital's own analysis showed something very similar. It is well known that large mutual funds can have a hard time in getting high returns compared to small funds. This is especially likely to be true if they try to invest in smaller stocks. These small funds tend to also often have high expense ratios. 2% of $50million say is only $1million and from that you have to pay all overheads and several salaries.

The only really large cap stock I own is Berkshire Hathaway. I was thinking about making a post about the market caps of each stock and funds under management of each mutual fund I own. The biggest mutual fund that I have shares in is the Hussman Strategic Growth Fund. But the size of some of my other mutual and closed end funds could be misleading as those are in some cases products of management firms that also have other similar products. For example, Colonial First State runs very similar funds, under retail, retirement (superannuation), and wholesale labels. These are really different share classes of a single fund. They also have direct institutional mandates that may well be managed in the same fund pools. So this was just getting too hard, when I started thinking about all this!

Five Things You Probably Don't Know About Me

I finally got tagged by Clifford with this so-called "meme" that is all over the blogosphere. So here goes:

1. I was born on the same day as my mother. 33 years apart that is.

2. I've lived on four continents - at least five years on each. I guess that leaves Africa, South America, and Antarctica to go.

3. I rode my bike from Lands End to John O'Groats - the southwestern tip of England to the northeastern tip of Scotland and from London to Nice - across France.

4. I can read the Old Testament in the original language.

5. I hate mashed potatoes.

OK, who can I pick - most personal finance bloggers seem to have done this already. Here's a new idea - please comment on this post and either volunteer yourself or nominate someone else :) Like one of those committee meetings where everyone decides to nominate the member who didn't show up :P

Blame it on the Nucleus Accumbens

My insula must be very active!

Mutual Fund Costs are not Important!

I'm fed up with hearing how people should look at the expense ratios of mutual funds when deciding which to invest in as if that was the most important factor. I just turned off a radio show I was listening to because the host was going on about this again. There is so much propaganda out there that I think a lot of people think that these costs are deducted from the reported mutual fund returns. This is not the case. Mutual fund returns are always reported after all costs. Therefore, what is of first order importance is the return not the cost. Vanguard use the line "if you don't get to keep it is it really yours" to try to get people to believe otherwise.

The argument that costs are important is based on the unproven theory that the market is totally efficient and no managers add any value. In such a world the best fund would be the one with the lowest expenses. But that isn't the world we live in. Managers can add value but most don't on average add more than their fee which is what we would expect from economic theory. However, there are some managers that do add a lot more value than their fees. On the other hand, the average individual investor won't have the neccessary insights to pick these out.

Index type funds do have an advantage of being very tax efficient relative to most actively managed funds. This is irrelevant, however, in US retirement accounts (not in Australia though where retirement account earnings are taxed at 15% at source - but a levered managed fund can end up being even more tax efficient under Australian tax rules!).

Even when choosing among index funds, the expense ratio isn't the most important thing. A fund which charges high expenses should lag the index. Looking at the reported returns is good enough. Perhaps the higher cost fund manages to offset those costs by slightly outperforming the index before costs.

Loads - the entry fees into funds are another matter. These are there in order to provide commissions for brokers. The very high rates are a throwback to the times when the cost of trading stocks were also very high (though never that high) just like trading property still costs several percent. I would try to avoid paying a load unless a fund was very interesting and there was no way around it. For example, the Australian fund manager Colonial First State charges a load of 4% on its equity funds. If you make an application direct to the firm you pay that fee and they just pocket it. If you apply through a full service broker the broker gets the fee. If you buy it through a discount broker like CommSec the broker rebates the fee to you and you pay no load! (I have accounts with both these firms).

The Croesus Mining Saga Continues

It now looks like Croesus mining shares will again be traded on the Australian Stock Exchange. A reverse split of 1 for 15 and a new capital raising is being proposed subject to approvals, though the details are a bit fuzzy to me. The Sydney Morning Herald reports:

"IN A development that has stunned the mining industry, the gold assets of collapsed Croesus Mining have been sold to a little-known UK second-board company for $71 million. Perth explorer Avoca Resources had been considered the hands-down favourite to pick up the Norseman goldmine, 50 kilometres south of the Trident mine it is developing in Western Australia. But administrators for Croesus, which collapsed due to poor hedging last year, said yesterday that an offer from Perth-based AIM-listed Davos Resources was significantly higher than two other final offers. Eight parties conducted due diligence, but the final bidders were Davos, Avoca and an overseas syndicate. Avoca shares, which had risen earlier this week on speculation the company would win the Norseman assets, fell 13.5c, or 9 per cent, to $1.355 yesterday. Croesus administrator Vincent Smith said the deal with Davos was signed a week ago but was not announced until the company lodged an $8 million deposit on Tuesday. Avoca managing director Rohan Williams said he was not informed of the winner until just before Croesus announced the deal to the stock exchange yesterday. "It was all pretty well kept under wraps," he said. "We were outbid. That's what happens in administration processes. I'm OK with that." Avoca has been tagged the "market darling" of the WA mining industry in recent months, due to its promising Trident project and expectations it would acquire the Croesus assets capable of producing about 100,000 ounces a year. "Trident is an excellent project and it's got lots of exploration upside ... but Croesus was a bonus on top of that," Hartleys analyst Andrew Muir said. "It was a bit of a shock to the market that they didn't [get Norseman]." Davos chairman David Steinepreis said his company would raise the necessary financing to complete the acquisition in London but that it intended to pursue a dual-listing on the Australian exchange in the future. Norseman mine manager Barry Cahill will be appointed the new chief executive of Davos, which might make further acquisitions. "I think there is an opportunity to rationalise the smaller goldmines in Australia," Mr Steinepreis said. Davos will re-inject money into Croesus, which will be left as a shell company with barely any assets after the Norseman sale. Croesus would then buy other exploration opportunities, offering its long-suffering shareholders the chance to recoup at least some of their funds."

Nobody Ever Went Broke by Taking a Profit, or Should you Let Your Winners Run?

Beginning (and more experienced traders too) are often confused by the conflicting advice they get from different sources. Some argue that because losses are inevitable you should let any winning trade run and close any losing trade fast so that you can generate a good ratio of the size of the profits of winning trades to the losses of losing trades. Others argue that you should take some profits if you are shown to be correct about a trade. Maybe you won't be correct for long...

I think this largely depends on the nature of the system or model you are using to trade with. Here is a nice diagram that lays out the two most important parameters: How often your trades win, and how much they win when they win relative to how much they lose when they lose. If your system is only right slightly more often than it is wrong or maybe even is right less than it is wrong, then you need to let winners run in order to be profitable. However, if most of your trades are correct the amount you win when you win versus what you lose when you lose is less important. My formal trading model is right most of the time. The winning profit/losing profit ratio though is close to one. Profitability doesn't depend on letting winners run. But if this is the case, letting winners turn into losers is very detrimental to results. Therefore, it might make sense to take some profits when we can. Does this make sense?

So far in January on my IB account I have 11 winning trades and 2 losing trades. The profit to loss ratio is more than 6. So no problems on either score here. But in December I had a couple of big losses than brought my profit to loss ratio down to 0.21! I won 24 times and lost 10 times. So cutting losses is also extremely critical. In December I let losers run and took profits too fast. Even with being right much more often than I am wrong this results in losing money.

Annual Report 2006: Part V

I promised that yesterday's post would be the last in this series, but then I came up with a new idea: the contribution of each security or fund to my annual investment result for 2006:



It's too much hassle to compute rates of return and so these are just total contributions in US Dollars. Gaining investments outweigh losing investments 4.5:1 in dollar terms. Not surprisingly the CFS Conservative Fund contributes about a quarter of the gains as it is more than half my net worth in value. Forex contributed even more. All other is the net of interest received and interest and fees paid. Interestingly investments dominate the gainers at the top of the table and trades dominate the losers at the bottom of the table. Investments that lost money are: Ansell, Telecom NZ, and Croesus. All of these are the single industrial firm stocks I wrote about yesterday. Now you can see why I'm not enthusiastic about them. On the other hand, Ansell has generated significant profits in previous years and Mayne/Symbion and Powertel made great contributions this year. But all the mutual funds, closed end funds, fund management companies, and hedge fund investments made money. These are the main patterns I can see.

As far as learning from this record in order to improve my trading in 2007, the main lesson is that avoiding the losses on my two worst trades (each is actually the sum of several trades in that security) would significantly have improved my results - adding about 1.75% to the annual return on investment. I'd like to think I can now avoid the kind of mistake that generated the losses in trading News Corp. That is the whole point of developing a trading model, though money management is a big part of it too. On the investment side the loss on Croesus was unexpected, I really believed the company was turning around, sorting out production problems, and making significant new gold discoveries. I didn't realize the size of the hedging book and how that was going to bring down the company. The lesson is to be very wary of individual stocks of companies that seem to be experiencing any kind of problem.

Annual Report 2006: Part IV

This is the final part of the annual report where I review my current investment allocation and strategy:



This is a screen shot of part of the allocation spreasheet I set up each month to keep tabs on my investment strategy. 2/3 of my net assets are in Australian Dollar related investments. Australian based international investments that aren't hedged into the Australian Dollar are listed in the "Other" column. Yes, over half my net worth is in the CFS Conservative Fund - this fund is 30% invested in equities with the remainder in bonds and cash. I've listed it under Australian Bonds even though it also includes foreign bonds and equities and Australian shares. I have 1-2% of net worth allocated to any individual stock investment. Larger shares can be allocated to closed end funds or trading positions (e.g. 15% allocated to a SPY trade). Unlike the majority of PF Bloggers I don't have any index funds as investments. I use ETFs as trading vehicles.

Here is a different view of the portfolio:



My strategy is to invest 100% of my net worth and borrow against this to fund trading. At the end of 2006 my net trading position was long. The beta exposure column shows how much each category adds to the portfolio's beta (which measures its sensitivity to the S&P 500 index). The investment portfolio contributes a beta of 0.45. My trading positions added a beta of 0.553. So currently I have a very conservative investment portfolio. The overall portfolio's beta can range from 0.9 when I have long trading positions to -0.1 when I have short trading positions. IMO this is a much better approach to market timing than trying to swing an entire portfolio for and against the market. I developed this philosophy from Soros' approach as described in "The Alchemy of Finance".

The overall investment portfolio is conservative at the moment because the yield curve is inverted and there is a strong risk of a recession. Bonds do well in economic slow downs and recessions when the Fed cuts interest rates. So I do adjust the investment portfolio but over the course of years, trying to only incur long-term capital gains taxes. When I am bullish on the economy the beta of the investment portfolio will be above 1.

Breaking down the investment portfolio I have the following kinds of investments:

Core Investments (22%): Loftus Capital, Clime, EBB, EBI, Challenger Infrastructure, Berkshire Hathaway, HCBK, TFS Market Neutral Fund, Hussman Strategic Growth Fund, TIAA Real Estate, Newcastle, Platinum Capital. I don't intend to change these investments with changes in the economy. The investments are a mix of hedge funds, real estate funds, and investment management companies. I would like to have more of this type of investment.

Market Related Mutual Funds (71%): The four Colonial First State Funds, and CREF Bond Market Fund. In fact I have never adjusted the CFS Global Resources Fund since I bought it many years ago, but often wonder if I should. So maybe that too is a core investment. I hold onto positions in the CFS Future Leaders and Developing Company Funds because they are closed to new investors. In order to expand my holdings in the future I need to remain in them. I used to hold a much higher percentage in these funds. My holdings in these funds will change dramatically when I get bullish on the economy.

Industrial Stocks (9%): Ansell, Croesus, Symbion, Powertel, Telecom NZ. Croesus is probably worth nothing in fact (but has not been delisted). I have subsequently sold Telecom NZ. Ansell and Symbion are in the health related field and so I think will not be affected much by recession. Powertel is a small Australian telecom that has done very well and recently reached profitability. I will sell these when I think future gains don't look promising. I may buy new single stock investments when I see opportunities.

Weak Economy, Low Inflation, Record Low Bond Yields?

John Mauldin forwarded his subscribers (subscription is free) an interesting article by Hoisington and Hunt today. They point to low inflation and low growth this year rather than an outright recession but also what they describe as "record low bond yields". A continuing fall in interest rates has been one of my themes for a long time and the reason I hold so many bonds (in mutual funds). Falling interest rates mean rising bond values. Periods like this are when bonds perform well and tend to outperform stocks if the reason for falling rates is economic weakness.

Annual Report 2006: Part III

The following table compares my rates of return on investment to the MSCI World Index and the S&P 500 Total Return Index:



Both those indices include reinvested dividends and in the former case tax credits too. The MSCI World Index covers all countries indexed by MSCI is expressed in US Dollars. I consider the MSCI index the benchmark I measure my performance against. This post has a chart comparing my USD Total Asset Return to the MSCI World Index.

Anyway, getting back to the table - it is divided into four sections:

The first two columns of figures only cover non-retirement assets. I give the return in Australian Dollar and US Dollar terms. The latter look a lot better due to the rise in the Australian dollar from 2001. The returns are the total gain over the relevant period - not annualized rates of return.

The next two columns also include retirement accounts. In the long-term these returns are a lot better with a 123% gain over ten years but are poorer for 2006 itself. Recently, my retirement accounts have been invested more conservatively than non-retirement accounts. In earlier years this wasn't the case and I chose some very successful funds including Colonial First State's Geared Share Fund.

Columns 5 and 6 present the same data for the two stock indices. Over 1, 2, 3, and 5 years the MSCI has outperformed the S&P 500. I have just about matched the S&P 500 over 10 years and outperformed it on all the shorter horizons. I outperformed the MSCI over 3, 5, and 10 years but not over 1 or 2 years. My 2005 rate of return was particularly low.

The final three columns give the same information in terms of annual rates of return. This shows that my rates of return have been extremely strong over 3 and 5 years. The S&P 500 performed poorly over the 5 year horizon. The fall in the US Dollar is one reason that both I and the MSCI outperformed the S&P 500 - foreign stock markets have also performed better in terms of local currencies during this period. So are my returns just luck? I could have moved all my non-retirement assets to the US in 2002 when I moved here from Australia. I deliberately chose not to do so. I also chose to invest most of my Australian retirement account in Australian shares rather than other alternatives. These were deliberate choices based on my view of the value of the currencies. I now see the Euro, Pound, and Aussie Dollar as fully valued and so will focus on accumulating US Dollars. Only time will tell if I am right.

Sold Telecom NZ

I sold all my shares in Telecom NZ. I've owned this stock since 2000 when they took over AAPT - an Australian telecom start-up which I bought at the IPO. I've bought in and out over time, so this final sale registered a loss for tax purposes. The stock fell sharply in mid-2006 after the New Zealand government tightened the regulatory regime to encourage more competition. The stock price has recovered since then, but the high dividend yield has been cut and the company is struggling to gain traction IMO. Neither the company nor analysts are forecasting any earnings growth. The five analysts who track the company each have a different opinion ranging from strong buy to strong sell! The bottom line was I asked myself if this investment will return more than the margin loan interest I am paying to maintain it and my answer was no. I hold very few individual stocks of non-financial companies. After selling this, my remaining such investments are: Powertel, Ansell, Symbion, and Croesus Mining. I don't believe I have any edge in choosing these investments. But, occasionally there are situations which look favorable to me and turn out well and sometimes very badly.

Annual Report 2006: Part II

A focus of many who seek financial independence is building passive income. Payments that come without you having to do any work for them. My passive income in dividends, interest, and mutual fund distributions was about $13,000. Short-term capital gains from trading - which isn't passive income - generated about $6,000, but I spent about $4,000 on investment interest (mostly margin interest). If I wanted to maxmimize capital appreciation I could gear up a lot more and have the cash-flow to cover the interest payments. I've really been very conservative in this regard, though the vast majority of investors in the stock market do not borrow to invest at all. On the other hand, margin loan rates I am paying are actually very expensive relative to other sources of leverage (futures, options, levered mutual funds). Taxwise, in the US it is optimal to not exceed the sum of short-term capital gains, interest, and US non-qualified dividends in margin interest payments. For example, if tax is with-held on foreign dividends you can't claim it as a foreign tax credit and simultaneously deduct margin interest against the income. The built-in interest component of futures, options, and levered mutual funds is at a much lower rate - close to the risk-free rate - than most brokers lend at to small accounts.

Again, I need to at least double the combination of passive income and short-term active trading gains. The cash flow would then cover my expenses and price appreciation (this year around $20,000) would more than cover the effects of inflation in eroding the value of my taxable accounts. Given that my retirement accounts would continue to grow undisturbed, running down the value of the taxable accounts a little wouldn't really be a problem, but it is better to have rising rather than falling income!

Annual Report 2006: Part I

This is my first annual report. I covered some basics a few days ago. Here are the more or less final numbers for income, expenditure, and saving:



The format is the same as my usual monthly reports. Current income is actual cash received from salary, tax refunds, and other sources including inheritance. Retirement other income is total employer and employee retirement contributions to my 403(b). I note the transfer of money from current savings to my Roth IRA account separately. Total retirement contributions were, therefore, $15,432. Total income and realized and unrealized investment gains summed to $53,429. About 2/3 of the gains were in non-retirement accounts which have been more aggressively invested on the whole. About a quarter of the US Dollar gain was due to the rise in the Australian Dollar ($12,092).

It is exciting to see investment gains begin to rival income from employment and exceed saving from current other income and retirement contributions that totalled $42,430. Current investment income ($34,728) exceeded spending ($25,676). There is no guarantee that this will continue in the future. But as assets increase the chances are higher that it will. Investment returns on current accounts for this year are close to long-run expectations based on an alpha-beta analysis. I would like to double this income stream - so that it would be close to my current pre-tax salary - before quitting my current job and looking to make a living from trading and investing. If I can achieve the same rate of return this year I would yield $50k in current investment income.

Net worth grew by $94,675 with about 2/3 of the gain in non-retirement accounts. This imbalance is an additional factor that lead me to start maxing-out my 403(b) contributions.

Changing Distribution Method

I've decided to stop reinvesting the distributions from my non-retirement Australian mutual funds managed by Colonial First State and receive cash distributions instead. These funds constitute 35% of my net worth. The reasons for this decision are as follows:

1. After maxing out my 403(b) contributions investable cash flow from salary is much reduced. Last year these funds distributed $A13,200 (USD 10,400). This cash will largely replace the funds now diverted to my 403(b). Cash is needed to take advantage of emerging investment opportunities and from 2008 onwards I will probably need cash to make tax payments - up till now salary with-holding has been sufficient. This year I will exhaust carried forward capital losses.

2. Tax is payable whether a cash payout is received or not. So using this money to invest in new investments is more tax efficient than selling existing investments.

3. There is no discount for reinvesting the distributions and no load for new fund investments so no actual costs to this choice.

4. The Australian Dollar is currently strong and the US Dollar weak. I want to increase US Dollar investments. I can easily transfer this money back to the US for investment. In fact, that is what I plan to do. Up till now I have been using Australian dividends received to reduce my margin loan with Commonwealth Securities.

I need to send my request in writing. The next distribution is at the end of March - some funds have quarterly and some half-yearly distributions. I am still reinvesting my dividends from Telecom New Zealand and distributions from Everest Brown and Babcock, the TFS Market Neutral Fund and the Hussman Strategic Growth Fund. My other Australian investments do not allow dividend reinvestment by foreign investors. I'm not planning on changing these instructions at the moment.

December Report

Got back Friday from a long trip to Vermont and am getting up to speed - the coming week will be spent mainly on preparations for teaching the next semester. Good news is that Thursday I got an e-mail from my lawyer that she has received the documents to go to the next stage in my green card application - the actual application for the visa itself. The process started in 2003 and looks like being finally concluded this year. With a green card I will have much more freedom of employment and location than I do now as an H1-B holder.

Income and Expenditure



The monthly report for February explained the basic layout of these monthly statements. This month there is a new line for "tax credits". The current (non-retirement) investment returns are reported on a pre-tax basis. Part of the total return on investment includes foreign (mainly Australian taxes) paid on dividends. I get to claim these back on my annual US tax return. The "current other income" includes my net tax refunds (this category is mainly salary). If it wasn't for these credits my reported "other income" would be lower as my tax bill would be higher. Up till now I have been doing a kind of double-counting on these reports and slightly exaggerating my actual saving and income. For the moment I've chosen to compute saving by deducting both expenditure and tax credits from total income. I guess I should report all income on a pre-tax basis and then include a line for taxes. This would mean changing my accounting systems to actually record gross income monthly and then include stuff like health insurance in spending. At the moment my reported salary figures are take home pay after all deductions. So my expenditure is also somewhat under-reported too I guess...

Anyway, getting to this months results:

Expenditure was $US2,092 - $500 more than last month partly due to travel and spending on my trip to visit my girlfriend in Vermont - 64% of take home pay ($3,290) which is much reduced due to maxing out my 403(b) contributions from this month forward. Only one of my two new higher retirement contributions posted to my account and so expect to see retirement contributions ($1,180) higher next month. Non-retirement invesment returns were very strong this month ($6,564) and were the most significant factor in increasing net worth by $10,149.

Net Worth Performance

Net worth rose by $US10,149 to $US364,714 and in Australian Dollars gained $A13,322 to $A462,366. A net worth of half a million Aussie Dollars is now clearly in sight but one never knows what fluctuations could occur on the way there...

Investment Performance
Investment return in US Dollars was 2.21% vs. a 2.26% gain in the MSCI World Index, which I use as my overall benchmark and a 1.40% gain in the S&P 500. Non-retirement accounts gained 3.51%. The contributions of the different investments and trades is as follows:



The returns on all the individual investments are net of foreign exchange movements. Foreign currency losses appears at the bottom of the table together with the sum of all other investment income and expenses - mainly margin interest. Powertel again had one of the best percentage gains. The Everest Brown and Babcock entry covers returns on a listed fund of hedge funds and the management company itself which are both listed on the Australian Stock Exchange.

Asset Allocation
At the end of the month the portfolio had a beta of 0.90. 58% of the portfolio was in stocks, 45% in bonds, 7% in cash, and loans totalled -21%. The remainder was in the hedge fund type and real estate investments, futures value etc.

Accounts Restatement

As I am tidying up my accounting spreadsheets for the end of 2006 I am also fixing some issues from the last several years. The major issue was loans I made to friends in 2002-3 which I then cancelled in July 2004. I have now restated the loan payments to those friends as consumption expenditure for those periods. This results in lower net worth and higher expenditure in the 2002-4 period but also higher estimated investment returns as a given investment return is now attributed to a smaller capital base. I've gone back and updated all my NetWorthIQ entries. The following chart shows the MSCI World Index vs. an equivalent index for my own investment portfolio over the last decade:



Initially I was conservative and underperformed the index and then in recent years have generally outperformed the index - catching up to the MSCI index and then tracking it more or less. This pattern is also shown in the next chart which displays estimates of the alpha and beta of my portfolio over the last several years:



Each alpha and beta pair is estimated on 3 years of monthly returns data. Generally, my alpha - my excess risk-adjusted return - has tracked upwards. In earlier years I subtracted value while in recent years I have added 10-24% return above the market rate of return while taking relative risk into account. The linear regression line tracks this learning curve.

The final picture shows rolling twelve month totals for earning (salary etc. plus all investment returns on non-retirement and retirement accounts) and spending for the last 17 years:



The main feature is the lack of correlation between my earning and spending. I don't spend a lot more now than I did when I was a graduate student in 1990-93. And, these data are NOT adjusted for inflation. I spent much more than I earned in that period. The two big bumps in the spending profile are the periods when I moved to Australia from the US (1996) and then back to the US (2002). From October 2001 to August 2002 I was dependent on investment returns which at first were positive and then very negative. This combined with rising expenditure - including two round the world trips in three months in January and March 2002 resulted in the big fall in net worth in that period.

Missing Retirement Contribution

My missing retirement contribution is now showing up on TIAA-CREF's website. But it's been parked in a money market fund despite my instructions in the application forms. Well, I'll move it and change the instructions online for future contributions. Just a reminder to make sure that your instructions are carried out as requested.