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Measuring Returns: The Geometric vs. Arithmetic Mean

A common mistake that many people make when examining historical returns for different investments is to just look at the average return for a certain amount time.  This can be very deceiving, and has caused many people to put their money into securities that have yielded suboptimal returns.

A real-life example of how deceptive averages can be

Last year, the DJIA dropped around 32%.  This translated into about a 4,268 point drop in market value.  Investors this year, at least the few who still have their money in the DJIA, are hoping to gain this money back.  However, if the DJIA were to go back up 32% this year, it wouldn’t be anywhere close to the value of their investments from the beginning of 2008.  In fact, a 32% increase from the beginning of this year would only bring the DJIA back up about 2,808 points to 11,583.  That’s almost 12% lower than where we were before the initial 32% drop.

As you can see from the numbers, this arithmetic average return is upward-biased and can be extremely deceiving.  If I have $100,000 in the market, and I experience a 50% loss, it would take a 100% gain to get back to where I started.   Although averages clearly aren’t the best way to measure performance, there is another measure of return that we can look at for analyzing historical returns.  It’s called the geometric mean.

The geometric mean return shows the compound rate of return on an investment over time.  For example, if I had a $100,000 investment that jumped in value to $200,000, (a 100% gain) but then came back down to $100,000, (a 50% loss) the geometric mean return would be 0, whereas the arithmetic mean would be a 25% increase.  The table below displays real returns for different sectors of the stock market and further illustrates the importance of looking at geometric means vs arithmetic means.

data source: chapter 4 slides from Investments: Analysis and Behavior

While at first glance it seems that Tech Stocks are the way to go, the geometric mean is telling us that Blue Chip Dividend Stocks are far superior.

Calculating the geometric mean

While you  may not be able to find the geometric mean on every stock analysis chart, it’s not that difficult to calculate for yourself.

Mean = (a₁ × a₂ . . . a_n)^^1/n

Multiply all the numbers together and then take them to 1/nth power.

While most people won’t take the time to calculate this out themselves, it is definitely worth while if you are basing your investment decisions on histrocial data.  Trying to keep emotions and feelings aside, historical data is all we have to analyze and is our best indicator of future performance.

Short Selling: Profiting From Falling Prices

With the markets continuing their downward spiral and reaching record lows day after day, I’m sure a lot of people are trying to figure out a new way to put their money to work for them.  While short selling is not the answer to this, it is alternate method that can be used to profit in bear markets.

Short selling is a technique that an investor can use to profit from declining stock prices.  In a short sale, an investor borrows shares of a security which are immediately sold.  This is referred to as a short sale.  The investor has to return the same amount of shares that they borrowed at some point in the future.  The process of returning these borrowed shares is called covering the short.  If the price of the shares drops, the investor can buy back the shares at a lower price and return them while keeping the difference between the buy and sell price as a profit.

What if the price doesn’t go down?

No matter what, shares that are sold short must be returned.  Whether prices go up or down, the investor has to return the same amount of shares as they initially borrowed.  With regular stock purchases, investors’ risk of loss is limited to the initial investment.  The worst case scenario is that their shares will become worthless and they lose whatever they put in.  However, with short selling, the potential loss is unlimited.

Not only are the potential losses of short selling unlimited, but the potential gains are limited to the amount of the shares that are sold short.  Assuming a company that an investor has sold short goes bankrupt, the profits from that transaction are limited to the value of the shares when they are initially borrowed and sold.  Also, regular stock purchases have the potential for unlimited gains.

Now this characteristic of limited gains and unlimited potential losses alone is not grounds to say that short selling is a bad idea.  However, it is much riskier and should only be executed when an investor is very confident in their knowledge and understanding of the investment.  I would recommend that beginning and intermediate level investors stay away from these types of trades.

Using short selling information to your advantage

Many investors analyze the amount of short selling that is going on in the market to help determine the investors’ overall opinion of the where they think the market is moving.  This sentiment is measured mainly in two different ways.  The first method is called short interest, which measures the amount of shares sold short.  As this number becomes relatively high, it is safe to assume that investors are feeling fairly bearish about the market.  The other main measure is called the short interest ratio.  This takes the number of shares sold short relative to the average daily trading volume.  This can be applied to a particular stock, or the market as a whole.  When either of these measures is relatively high, it is safe to say that the overall opinion of the market is that it is going to move downward.  As you might have guessed, the short interest ratio spiked in the mid and later part of 2008.

The picture that I have painted for short selling may look a little grim, but don’t let it scare you away from considering it as a viable investment opportunity.  However, I highly recommend educating yourself properly and performing a considerable amount of research before edecuting these types of trades.

Getting Out of the Recession: What Will Work

As I’ve stated in an article written earlier this week, I do not believe that there is much the government itself can do to get us out of the recession.  So if the government can’t fix it, who can?

I believe that the only way to fix the current situation we’re in is to address what got us here.  Any effort by the government will not have any long-term impact unless we can change the way that things have been going and the way that business has been running.  As can be seen clearly in many of the thousands of articles that have been written lately about happenings in the financial sector, there seems to be a complete lack of fiduciary duty held by business leaders towards their customers, employees, and the general public.  If there is not a change in the way these leaders perceive their relationships towards these people, we will continue to move in the wrong direction.

I’m not saying this recession is completely the fault of these business leaders.  We are seeing millions of Americans who have leveraged themselves to the max and set themselves up in a position where even the slightest economic troubles will make their standard of living unsustainable.  It is as much the fault of the banks who have been lending money to these people as it is the fault of the people who are taking on the debt.  People must grow out of their greed and spending mentality and business leaders must evolve into a new mentality of serving rather than exploiting.

Something had to happen before people would make changes to the way things were done before, and hopefully some good will come out of the economy falling to pieces in that  it will force people to make this much needed change.  Those who don’t will surely fail in the long-run.  Seeking short-term profits now will only delay the inevitable, and those who set themselves up for success in the long-run through providing products and services with the well-being of others in mind will be the ones who survive through the recession and succeed when it recovers.

Getting Out of the Recession: What Won’t Work

With all the talk about what the best way is to fix the economy, it seems to me that no one has a sound solution.  I sure don’t have one, but I positive about a few things that will definitely NOT get us out of the mess we are in.  Unfortunately, the people who have the power to influence our situation seem to hold the opposite opinion.

What I believe won’t work

Obviously it is a common belief that the government needs to provide some sort of boost to the economy to get some money flowing and get things moving again.  While I believe something needed to be done to loosen up the credit markets, I do not think any government stimulus will be able to revive the economy.  While this has worked in the past, we are in a very different situation than we have been before when facing a recession.

The bottom line is that this is not 1931, and things have changed quite a bit since then.  Things have changed so much that expanding the public sector now will not provide the sustainable change that is necessary to revive the economy.  Looking at where we were about 75 years ago and where we are now, the government’s involvement was proportionally much smaller than it is today.  Because of how much smaller it was, they were able to beef up the public sector enough to get the economy moving again.  Now, in 2009, public investment is not nearly as viable an option.

Imagine what would happen if the government decided to use public investment as a cure-all for poor economic times.  It wouldn’t take long to get to a point where the public sector would become to large for increased investment to have less effect and the government just wouldn’t be able to afford to pay for it all.  Well, with the national debt around 13 trillion, I would say that we may have reached that point.

Obviously, the government does not agree with me here since they are in the process of executing a $789 billion dollar stimulus plan (or $3.27 trillion plan depending on how you look at it).

What I do believe needs to change is not anything that the government has much control over.  They may try to string up a few of the more miscreant offenders who helped bring us to where we are today and then try to implement some new regulations to make it look like they are making an effort fix it, but the reality is that they can’t.

Please come back tomorrow to read what I truly believe can get us out of the recession.

Bailout Delaying the Recovery of the Economy

With anxiety building as the recession hits home for most Americans, more and more people seem to be relying on the new stimulus plan as the economic panacea of everyone’s financial problems.  As more details emerge about the stimulus, people are becoming more enamored with finding out how the new stimulus is going to help them rather than focusing on how they can help themselves. This reliance on government aid has caused the exact opposite of its desired effect.

Granted, the money from the stimulus has not taken effect yet, but the only thing that I have seen the stimulus precipitate is laziness. People have decided that there is no sense in acting now, when they might be receiving money from the government in the near future.  Spending in all areas is being further suppressed in hopes that people will be able to use government money to finance upcoming projects. This seems to be delaying the very thing that can help get the economy back on track.

What happens after the stimulus takes effect?

While there’s no saying for sure whether this new flow of money will have a lasting positive impact on the economy, it is quite clear that the success of whatever efforts are made to stimulate the economy depend largely on how that money is spent.  Just as with the bank bailout, people could horde this money for themselves passing around bonuses to upper managent.  Unless there is a drastic change in the way that business leaders perceive their fiduciary duty to customers, shareholders, and society, it won’t matter how much money is spent attempting to stimulate the economy.

Try all you want to impose new regulation and pump billions into the economy, but the bottom line is that we will not get out of the hole that we’ve dug ourselves until we address what got us here in the first place.  Although there are many things people blame for the current state of the economy, the source of these problems comes from business leaders’ lack of any sense of fiduciary duty to their company and the general public.  It took us a long time to get to where we are today, and there is clearly no quick fix to get out.

Stop back soon to read and discuss what will and won’t work in getting us out of this recession.

What Is Dollar-Cost Averaging?

With all the volatility in the markets today, wouldn’t it be great to have a systematic method of investing that would allow investors to benefit from the volatility of the market?  Well, there actually is, and it’s called Dollar-Cost Averaging.

Dollar-Cost Averaging is an investment strategy in which an investor puts the same amount of money into a certain security in regular time intervals (i.e. two weeks, one month, etc.).  There are three parameters that the investor must decide in order to implement this strategy.  The amount of money to invest, the time interval between investments, and the time horizon of the overall investment plan in which all the investments are made.  Research has suggested that the ideal time interval between investments is somewhere between 6 and 12 months.

So why is this strategy a good one and how can it help me meet my financial goals?

By executing trades of the same amount on regular time intervals, you are able to purchase more shares when the prices are low than when prices are high.  If you were to put in a large lump sum of money at random points in time, or even following the traditional pattern of most investors, there is a good chance that you will be buying high and selling low.  Dollar-Cost Averaging (DCA) is a way to prevent this from happening and ensuring that over a long period of time, you are getting a fair price on all your shares.

Obviously this technique is suboptimal in a rising bull market because it takes longer to get your money into the market, but when the stock market is on the fall, it is a great strategy.  So if you don’t want to try to time the market, which has been proven to be a bad idea for most investors, DCA is for you.

The 4 Trading Pitfalls That Ruin Investors Part 4: The Illusion of Control

Consider the following two scenarios.

1. You are given the option of betting on a coin flip before the coin has been flipped.
2. You are given the option of betting on a coin that has already been flipped.

Which would you choose?

Studies show that most people would choose the first option because they have an illusion of control that they will be able to influence the event so that the outcome is in their favor.  The same goes for people who buy lottery tickets and select their own numbers versus being given random numbers.  The odds are the same, but everyone wants to believe that they have some control over the outcome.

Everyone has given in to the illusion on control at some point or another in their lives.  For some reason, people seem to think that they can have an influence on the outcome of events that are clearly uncontrollable, and this holds very true to investors in the stock market.

If an investor is using an online broker, they are not getting any advice on trades.  It is up to the individual investor to make decisions and execute the trades, and as people get more familiar with their online account, that illusion of control grows even bigger.  This causes investors to trade more actively and opens the door to emotional and psychological biases which lead to inferior investment returns.

How can this illusion be avoided?

Don’t make any quick decisions in your investments.  As always, staying away from speculation in the stock market and investing in index funds is definitely something an investor can do to protect themselves from this pitfall, but if you are going to buy individual stocks, you have to be willing to put in the amount of time necessary educate yourself and make smart investment decisions.  For those of you who don’t have that kind of time, or are happy being an “average” investor, myself included, index funds are the way to go.

That wraps up our discussion on the trading pitfalls of investors.  If you liked this series and would like to hear more about similar topics, please let me know in the comments!  Thanks for stopping by.

The 4 Trading Pitfalls That Ruin Investors Part 3: The Illusion of Knowledge

One of the most import things for investors to remember is that information itself does not lead to knowledge.  With the vast amount of information that is available to investors via the internet, it is easy to browse thousands of headlines and financial reports for any company traded on the major indexes.  As people are pouring over this information it is crucial to remember that just reading the headlines and numbers is not enough to obtain knowledge of what they actually mean or how to profit from them.

Thousands of investors begin their investment careers by signing up an online brokerage account, reading around Yahoo! Finance and checking out some financial information about companies they see in certain headlines, and then making their first trades based on this very small amount of information.  After reading around for a while it often feels like you are gaining knowledge, but there is a lot more to it than following a “Hot Stocks for 2009″ article. 

Everyone has fallen to this illusion of knowledge at some point or another in their lives.  Imagine something as simple as a dice roll.  If I were to roll a die three times, and all three times it landed as a 5, then it is just natural to believe that there is less than a 1/6 chance of a 5 coming up on the next roll.  That information of the three previous rolls being fives makes people believe that they have knowledge that the next roll will most likely not be a five.

It is also important to remember that even if you are reading an article that truly does have good stock trading information, you are probably the 5 millionth person to read that information and any gains that could have been made by trading on it have most likely been exploited because millions of others have already had the chance to act on it.

Good investment information is essential to making good investments, but without having the education and experience to turn that information into knowledge, it is useless.  Educate yourself, and then peruse the headlines and financial information.

As always, I am a supporter of investors becoming truly knowledgeable about investing before jumping in to any sort of stock speculation.  If you want to get into the markets, and even if you have already been in for some time, a broadly diversified, fund-based approach is the method that has statistically provided the best returns with the least amount of effort.  Remember, it’s easy to be a “B” level investor, but only a select few can become “A” level investors.

When will the Bank Bailouts Materialize More Lending?

Just a few short months have passed since the initial $700B bailout plan was passed by the U.S. Government, but already people are concerned that the plan is not working as quickly or effectively as was hoped. Consumer spending is at record-breaking low levels, and banks’ lack of lending is being blamed. Panic continues to be the tone in Washington D.C. as policy-makers scramble to come up with a new plan (to spend more money) to ‘save the American Economy.’ The truth of the matter is it takes time for economic policies to materialize into an actual change in the economy. No one can say for sure whether the bailout money is working or not, but there are some possible explanations as to why the financial industry isn’t just handing out loans off the back of a truck yet.

There are growing concerns that the added capital banks are receiving through the Troubled Asset Relief Program is not resulting in more credit extended to consumers. This is a real problem, since the main purpose for lending banks the capital was to strengthen their balance sheet (extra capital means more liquid assets to make up for the troubled assets on their balance sheets) and to give them additional reserves to make loans to cash-strapped consumers and businesses. Since consumer spending is partially what drives the economy, until banks start lending more money, this injured economy stands little chance at recovering any time soon!

So why then aren’t banks lending money? To be fair, this statement cannot be made as a blanket statement regarding all banks across the country. Believe it or not there are still healthy banks out there that are willing to lend money to qualified individuals in need of a loan. Unfortunately, at a time like this when unemployment levels are high, the people that are the most in need of a loan are not approved based on the sheer fact that they lack a source of repayment. The same principle goes for companies who need financing for basic working capital needs; if they don’t generate adequate cash flow banks are reluctant to lend the money. That said, if you really need the money, you probably can’t get it.

Another reason why the bailout money hasn’t translated into increased lending can be explained using the inverse relationship between risk and reward. When a bank decides to lend money to an individual or company, they are taking on risk. The risk of lending is high right now. There is no guaranty that the bank will recover all of the money they lend, especially given a struggling economy. For example, a seemingly strong company could suffer an unexpected loss or financially sound individual could lose their job, rendering them unable to make payments. Obviously the borrower still has some obligation to pay, however many foreclosures or bankruptcies result in at least a partial loss for the bank. The reward a bank earns on the loan is directly related to the interest rate. Currently, the reward for lending money is low. Plummeting interest rates have really put a damper on banks margin over the past year. This high risk-low reward environment for banks is not conducive to extensive lending on banks behalves.

There’s no arguing that the economy is struggling, but what is up for debate is the way to go about fixing it. Given the lagging nature of the economic cycle, it would seem that policy-makers and politicians would be more patient when waiting for the results of the enacted monetary and fiscal policy to come into play. However, policy-makers are already focusing on the next course of action, before the first one has had any time to work its way through the economy. It took a long time for the U.S. economy to find its way into this mess, it’s going to take at least that long to get out.

The 4 Trading Pitfalls That Ruin Investors Part 2: Online Brokerages and Trading Activity

lWith the ever increasing popularity of online brokerages, an investor who calls his broker and asks them to make a trade on their behalf would be considered pretty old school.  With the ease of making internet trades it makes sense why E*TRADE is opening “1,000 new accounts a day.”  But is this rise of online trading really a good thing for investors?

Without having to make that phone call to make a trade, there is no 2nd opinion from a broker (who should have their clients’ best interest in mind) about the transaction.  This removal of the stockbroker as a gatekeeper to the stock market causes many investors to increase their trading activity, and the number of mistakes that they make.

Without a doubt, online trading influences investors’ psychological biases.

A study by Brad Barber and Terrance Odean observed the trading behavior of 1,607 investors who switched over from phone-based to online trading accounts.  They found that, on average, investors who made the transition to online accounts increased their trading activity by 71% during the first and second year of being online.  After the second year, the increase dropped down to about a 28% increase from the average trading activity for these investors when trading on the phone-based system.

Not only did the number of trades go up, but the performance of their portfolios vs the market went down.  Before transitioning to the internet trading account, these investors were earning about 2.35% more than the general stock market, but after going online, these same investors underperformed the market by 3.5% per year!

Why the increase in trading activity and decrease in success for these investors? There are two main reason.

1. The low commission costs of trading online make internet trades seem relatively cheap.  This makes investors feel more comfortable making trades since there is a lower cost for carrying out the transactions.
2. The huge amount of information that is available to investors on the internet allows people to search around the web and find loads of information giving them the illusion that they possess some great knowledge that others do not.  It is easy to learn very specific information about a company or the market in general, but people fail to realize that they are probably the 5 millionth person to read that same information.  This illusion of knowledge stimulates trading.

Please be aware, I by no means dislike or discourage online trading.  However, I do encourage a long-term approach and broad diversification.  Personally, I shoot to match market averages rather than beat them, and speculation is a very small part of my investment strategy.  I use internet trading accounts, but I don’t make many trades, and very rarely in individual companies.  Sites like E*TRADE are great, but they must be used carefully.

Please stop back soon to catch the rest of the this series on the trading pitfalls that ruin investors.