Thursday, May 08, 2008

Risking little

I was discussing the concept of financial risk with a friend in the finance industry last night,  and it seemed to me that our views on risk diverged somewhat.  I thought of our discussion again this morning when I read a report of the recent annual pilgrimage to the sages of Omaha, Nebraska -- Mr Warren Buffett & Charlie Munger -- whose combined wisdom struck upon this very topic.

What my friend and I were discussing was the relationship between risk and return, and how exactly one measures or quantifies risk -- which is what, as it turns out, my friend is in the business of doing.

On these two issues, my friend insists 1)that risk can be measured (one simply looks at the past volatility of an investment vehicle and extrapolates it into the future, apparently), and 2) that returns necessarily bear a direct relationship to the risk of an investment -- which is pretty much the standard patter on risk these days.  (Or as the Gnomes of Zurich have been known to say, "Worry is a sign of health: If you're not worried, then you're not risking enough." )

But why would you assume that past volatility alone is necessarily an accurate guide to future performance?  Didn't help those investors in the likes of Brierley, for example, which went from blue chip (non-volatile) to dog (highly flammable) in the blink of a share ticker's tail a few years back.

And why should risk and return necessarily be correlated?  A fairly successful friend maintains what to me seems a perfectly sensible view of risk and return, which is to seek those investments  in which the risk of loss is low and the expected return very high.  Sounds sensible to me.  Seek out opportunities in which the risk is already low, and increase you margin of safety by having a high margin of safety when things go wrong, which they do.  In other words, why not stop worrying altogether, while getting the same (or better) returns than your gnome over there with the ulcer? 

We talked some more about this, my friend and I -- my friend who is in the business of calculating risk for investors -- and I was thinking about our conversation as I read this gem from two of the world's most successful investors:

    Both men had lots of critical things to say about the so-called risk managers of our day. Risk managers, as the name implies, are supposed to ensure the safety and soundness of the investments made by financial institutions. "But too often," Buffett complained, "a risk manager is a guy who makes you feel good while you do dumb things."
   
Someone asked whether the big investment banks are too complex for even their managers to understand the risks the banks are exposed to. Buffett said: "Probably yes." He also pointed out that the managers have little incentive to worry about certain risks. His example went like this: Say there is a 1-in-50 chance of a company going out of business. If you are a 62-year-old executive planning on retiring at 65, it's not in your best interest to worry about it.
   
By contrast, the 77-year old Buffett and 84-year old Munger DO worry about risk. But they manage risk primarily by avoiding investments they don't understand. "Risk comes from not knowing what you're doing," Buffett once remarked.

And that, right there, is my answer to my friend of last night; that and the advice of Buffett's colleague Charlie Munger:

    "We like businesses that drown in cash," Charlie Munger declared during the Berkshire Hathaway shareholder meeting in Omaha, Nebraska last weekend. Warren Buffet promptly agreed.
    Throughout the meeting, Buffett and Munger repeatedly stressed the importance of investing in companies that provide ample cash flow or some other essential "margin of safety."

Sounds smart to me. You can read the whole report from the Munger and Buffet show here at Rude Awakenings.  Just scroll down to How to "Drown in Cash" by Chris Mayer.

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28 Comments:

Anonymous Falafulu Fisi said...

PC, I read that same article as well about Buffett and Munger, but it is more akin to Christians saying that Einstein believed in God, therefore God exists.

It doesn't mean that Buffett dismissed risk analysis, and therefore risk analysis and risk managers are treated the same as psychics.

The NZ ShareChat used to run an online virtual market investment game about a year ago. Each participant were allocated the same funds at the beginning, and they bet by buying & selling fake shares using the NZX real data. The guy who won the competition did use formal risk analysis and those who used other non-formal methods including Buffett were no way near making any profits at all. I think the prize was for a trip for 2 to the US.

Here are some facts.

#1) Buffett had published a few books about his (secret) methods of investments and investors around the world had bought his books and followed his methods exactly.

#2) Those followers of Buffett's methods, none had been reported to become Buffett themselves, ie, some had became so successful , they themselves had become billionaires.

#3) If you can benchmark an investor who uses the formal econometrics risk analysis and one that follows Buffett in their investment process, I can guarantee you that on average the formal risk analyst guy would outperform the Buffett guy according to whatever market index they use for benchmarking. This is fact and it has nothing to do with Mises disapproval of econometrics methods. It is something to do with reality of portfolio optimizations theory.

5/08/2008 04:27:00 pm  
Anonymous Falafulu Fisi said...

Here is an example of what risk-return optimization is:

Suppose that the risk (volatility) is denoted by a variable 'x' and expected return is denoted by variable 'y' and risk-return surface is denoted by the variable 'z'. The variable names here are arbitrary here, but it could be 'v' (volatility) , 'r' (expected return) and 'f' risk-return or whatever variable names chosen.

Suppose that the risk-return function 'z' is defined by the following relations. Again the equation is arbitrary here for my example, but it is almost similar to the 2 variables as it is applied in measuring risk in finance by the Markowitz portfolio theory.

Z = 0.5*X^2 + Y^2 - X*Y - 2*X - 6*Y

constraint 1 : X + Y <= 2
constraint 2 : -X + 2*Y <= 2
constraint 3 : 2*X + Y <= 3

constraint 4 : 0 <= X
constraint 5 : 0 <= Y

The symbols are :

* means multiplication
<= means less than or equal to

So, this means that in 'constraint 1', it says that the sum of the two variables risk & expected return must be no more than 2, ie, (X + Y <= 2). The other constraints 2 and 3 are interpreted the same. Constraints 4 and 5 restricts the X and Y to any number greater than or equal to zero, ie, X >= 0 or 0 <= X , whichever representation is chosen, however they mean the same.

The challenge is to find what values of X and Y, that minimizes Z while simultaneously obeying all the 5 constraints. This means whatever number for X and Y that are chosen, they must be added together and the result is no more than 2, ie (X + Y <= 2). The two values for X and Y must also obey constraints 2, constraints 3 and so forth.

The important thing here, is the notion of minimization of Z. When applied to the financial market portfolio analysis, the same thing applies, that is minimizing the portfolio risk.

What's the important of finding out the values of X and Y that minimizes Z ?

Well, once you find out the values of X and Y that minimizes Z, these are the values that the fund manager or risk manager uses to allocate funds in a portfolio. Whatever the market movement, the risk is always minimal according to whatever constraints the manager puts into the model.

Investment constraints could be formulated such as:

- no more than 15% of total funds goes into forex assets.

- Exactly 20% of total funds goes into corporate bonds.

- the amount goes to the technology sector must be twice the amount goes into transport sector and this total must not be more than 30% of total funds.

- blah, blah, blah, ...

The manager could put in as many constraints as he wishes, but the more constraints, the more intensive the algorithm in computing the values of X and Y that minimizes Z, when one is dealing with a portfolio that contains a very large number (in the thousands) of financial assets.

Herald columnist Diana Clement has a good article on asset allocation here and although she doesn't quote Markowitz (Economics Nobel Laureate), it is indeed the Markowitz portfolio theory that those services (MorningStar and the likes) are using.

Don't lose your shirt - diversify

It is the same thing that PC's friend was discussing with him last night, although I am not sure whether PC's friend quoted Markowitz to PC or not, because I think he knows that PC is hostile to anything econometric modeling.

My next post, I will tell you what values of X and Y that minimizes Z, but just give it a try.

5/08/2008 05:50:00 pm  
Blogger ZenTiger said...

So if you have buckets of money, and you understand how to absolutely minimise risk, you can take ownership of a company and make heaps of money from it without actually risking much?

This is the bit where we also have to agree, for the sake of tradition, that putting capital "at risk" is why people can be defacto owners of a company or business that relies on its workers to create the wealth.

Oh sure, they get paid a wage in exchange for a service. What's interesting is when the service rendered is actually one of creativity.

Interestingly, Ayn Rand wrote a book about it. She just didn't quite extend her thought processes beyond the obvious and immediate at the time.

Not only the state demands ownership of intellectual capital to put to its own ends. The Buffets of this world buy people and companies in the same way.

If John Galt had invented a new powered car whilst working for Ford, Ford's shareholders would have owned it. Would have effectively owned him.

What is true economic democracy and economic determinism for the individual when capital automatically owns labour, as opposed to it being a partnership?

Do you expect John Galt to rebel from shareholder interests of his productivity in the same way as sate control is seen as an anathema?

5/08/2008 11:11:00 pm  
Blogger softwareNerd said...

Risk is the possibility that things turn out worse than you expect. In an investment context, it speaks to the deviation from the most likely outcome.

Volatility is similar to deviation, and is the same as deviation if one reduces one's time horizon to a short enough span. If I intend to buy a share an hold it for (say) a month, I should be concerned as to whether this is a very volatile stock.

OTOH, if I plan to hold it for 5 years, the daily and monthly volatility is meaningless. The risk lies in the probability that the actual return will deviate from the expected return over a period of years.

Risk is not independent of the risk-taker. It depends on his time-horizon.

You're also right about the past variability not being a predictor of future variability.

Most of modern portfolio theory taught in universities is rationalistic. The funniest thing is that while the universities teach this in their classes, many of them run their huge endowment investments on a completely different basis: with very long-term time-horizons, and consequently even beat hedge funds in performance!

5/09/2008 01:43:00 am  
Anonymous LGM said...

FF

That competition had rules which were artificial and arbitrary. It was not real. No-one was investing real money, purchasing real companies or executing a real business strategy. It was really a measure of who was the most successful gambler on the NZ stock exchange and whose system happened to work out OK.

Buffett does things for real. He does a lot more than just buy and sell some shares. He manages assets and most important, he manages people. He has commented on numerous occasions about how he spends much thought selecting managerial and supervisory people and how they are passionate and motivated (and how he sees to it that they stay that way). There is more to his approach than betting. He is not merely a passive stock trader. If you read him carefully you'll see he spends very little time trading. Most of his time is spent on other activities.

FF if all your numbers and equations equations ever perform as well as Buffett, I look forward to your fortune matching or exceeding his. You will soon be wealthy indeed. Beyond dreams. So.....

x + y = T. x is the money I have right now and y is the money you are going to send me when you become a billionaire. T will be the money I'l end up with as soon as that occurs. Now y = 0.9981 P where P = all the billions you are going to have when your modelling activities produce the optimal result (that is, you get untold wealth). Send me some money. You beauty! Now can there be anything faulty with that?

LGM

5/09/2008 06:23:00 am  
Anonymous LGM said...

Zen

If John Galt worked for Ford he would have entered into an agreement. A company representative and he would sign a document; a contract. It's a voluntary choice to agree or refuse to sign it. In Galt's case, it is reasonable to assume he would have been emplyed as an engineer or in a technical role. hence he would have been paid to develop the new engine. That would have been his job and he would have received consideration for it.

With contracts of employment at Ford what you will see is that several clauses deal with intellectual prperty matters. In summary their contract of employment states that what you do on company time with company resources belongs to the company. In return the company is required to pay you for your time, efforts, intellectual and physical labours etc. It pays you for that and you supply it. They do not own you. You do not own them or their assets (like tools, test results, literature, IP, computers, software etc. etc.). You are selling your product to them and they pay you for it*.

Now if you decided that is not an arrangement that suits your purposes, you would not enter employment with Ford or GM or whatever company under that type of agreement. You would either negotiate another type pf agreement with different terms and conditions or you would become a self-employed inventor. Good luck!

Returning to Joh Galt. Should he have worked for Ford and during his employment there he invented a new type of engine, then he would have demonstrated it to management, explained how it operated and why it was so good. Then he would have played an active part in productionising it. Likely he would have been promoted and seen some generous bonuses as well. He would not have rebelled against that which he had agreed to voluntarily in the first place.

LGM

* as someone who has worked in this industry sector, I can state with authority that the remuneration is generous for R&D and IP related positions.

5/09/2008 06:51:00 am  
Blogger Berend de Boer said...

falafulu fisi, I have to agree with PC here. You can't extrapolate the future from the past. Businesses depend on people. If the people change, the business changes. Risks don't stay the same.

It's like trusting the weather forecast model blindly instead of looking out of the window.

And there's no Buffet method. It's skill and experience, and that cannot be taught by a book.

And as LGM has said: become wealthy and we believe you :-)

5/09/2008 07:19:00 am  
Anonymous Elijah Lineberry said...

This may surprise many people, but I think with investments you should stick to Government Bonds.

For one thing there is no risk; and the returns are guaranteed.

In the last couple of decades despite two property and two sharemarket booms (and busts) 9 out of 10 investors would have made more money from 10 year Government Stock than anything else.

(Long term "investing" in real estate or shares is, of course, a vastly different activity to "trading" these things)

5/09/2008 07:50:00 am  
Blogger Rebel Radius said...

Ethics are more important to me than money.

I invest accordingly.

5/09/2008 09:57:00 am  
Blogger PC said...

Falufulu Fisi, you remind me of the sort of person who reads the footnotes in instead of the main text, then complains that you've read no argument.

Here's how you read the posts on which you comment:
Blah blah blah blah forecasting blah blah blah blah blah mathematical blah blah blah blah. [Yes, I pinched that joke from a Larson cartoon. :-) ]

You should expand your vocabulary. :-)

5/09/2008 10:43:00 am  
Anonymous Falafulu Fisi said...

Berend , PC and LGM,

I am defending academic research here. The advanced of civilization has solely been attributed to the work of academics. My post was not about myself becoming a billionaire.

My God PC. You and LGM in one minute have triumphed the superiority of Western Civilization (compared to the Muslim world) of how it got out of the darkness in the last 3 hundred years by adopting reason. On one hand, the western civilization had advanced the theory of economics/finance and you imply, that this advanced in economics/finance theoretical studies is no more different than psychics?

What would happen if the Muslim world had pioneered theoretical studies in economics/finance and the Western world are playing catch up? I suspect that you would be the first one to criticize the Western scholars for not doing enough to surpass the evil world of the Muslims since they're far ahead.

Are you denying that what I have quoted, are economics/finance theoretical studies using reason or are they simply studies using psychic methods?

I wondered if you and LGM are both appointed to both become Dean and Deputy Dean of an economic/finance faculty at a hypothetical PC/LGM University. I bet that such faculty at such University, there would be no more than 5 papers being taught. They will be all Mises/AynRand/Reisman related papers and nothing else? But wasn't that of how the Muslim world slip back and the western civilization overtook in the last 300 years?

LGM, try to refute of what I stated in my last post (Markowitz theory) instead of your babbles which is trolling. I stated Markowitz (formal risk analysis) as opposed to Buffet's method. So, refute Markowitz, then back up your claim.

5/09/2008 11:44:00 am  
Anonymous Falafulu Fisi said...

SoftwareNerd said...
Risk is the possibility that things turn out worse than you expect.

Redundant statement. This definition has been known for the last 100 years or so.

In an investment context, it speaks to the deviation from the most likely outcome. Volatility is similar to deviation, and is the same as deviation if one reduces one's time horizon to a short enough span.

Redundant. SoftwareNerd, didn't you read the link to Markowitz to understand that theory? You're restating the Markowitz.

If I intend to buy a share an hold it for (say) a month, I should be concerned as to whether this is a very volatile stock.

I suggest you read a book in modern portfolio analysis.

OTOH, if I plan to hold it for 5 years, the daily and monthly volatility is meaningless.

That's why I suggest you read a book in modern portfolio analysis. There are different arguments to that.


The risk lies in the probability that the actual return will deviate from the expected return over a period of years.


But this is prior probability , isn't it? That is you require historical data to rely on calculating this probability.

Risk is not independent of the risk-taker. It depends on his time-horizon.

Redundant. This is already known. So get a book in forecasting methods & portfolio analysis and read.

You're also right about the past variability not being a predictor of future variability.

Portfolio theory already stated that. So, the statement is redundant.

Most of modern portfolio theory taught in universities is rationalistic.

How many portfolio theory do you know? I suspect that you're making up an arbitrary assertion here. Theories are based on assumptions and observations. The observations will correct (modify the theory) the assumptions if there is huge disagreement and for this reason, isn't a rational thing or it is simply irrational according to you?

The funniest thing is that while the universities teach this in their classes, many of them run their huge endowment investments on a completely different basis: with very long-term time-horizons, and consequently even beat hedge funds in performance!

Ok, back up your claim. Who are those academics who are running these hedge funds?

5/09/2008 12:06:00 pm  
Anonymous LGM said...

FF

Please state the claim you are wanting me to back up and I'll do my best to assist.

LGM

5/09/2008 02:59:00 pm  
Anonymous Falafulu Fisi said...

LGM, here are some points that PC emphasized in his post:

But why would you assume that past volatility alone is necessarily an accurate guide to future performance?

Well I replied to this (see my post above regarding the sample 5th-form quadratic equation) with a work example using the Markowitz theory. I don't need to re-invent what has been thoroughly researched. Markowitz stated in his model that past volatility is necessary for estimating projection for the future.

And why should risk and return necessarily be correlated?

Well again, this is stated in the Markowitz. You guys care to study or even read about the formulation of Markowitz instead of mocking anything equation?

Seek out opportunities in which the risk is already low, and increase you margin of safety by having a high margin of safety when things go wrong, which they do.

No, the risk is not already low. This is wrong. See the graph on the Markowitz page (risk-return graph) that I have already linked to. The risk increases as one moves to the right and correspondingly the margin of return increases along the efficient frontier curve (quadratic curve).

Buffett complained, "a risk manager is a guy who makes you feel good while you do dumb things.

PC endorses this comment. In other words, the whole business of risk analysis is bollocks. On what ground that risk analysis is bollocks? Is it simply because the successful Buffett said so, since his method is so successful that he doesn't use formal risk analysis? If it is, then this is what you call anecdotal. I had debated with a Christian person before and he quoted that Einstein endorsed the concept of a superior power (in other words God). Was this christian person 100% correct because Einstein said so, since he was the most successful theoretical Physicist ever know to man in inventing many theories?

So, try and answer those.

5/09/2008 03:43:00 pm  
Blogger softwareNerd said...

FF, Since most of your response to my post has been "read Markowitz", I just wanted to say that I've not only done so, but I studied that and more as part of my MBA. I know we aren't going to resolve this controversy in blog comments, when there are tomes written about it.

As for your question about the university endowments, I'm sorry I don't have a reference to the article, but it was either in Barrons or WSJ. While the article spoke mainly about David Swensen's career at the Yale endowment, it also compared a group of endowments to a group of hedge funds and to the S&P.

You spoke of a TV or mag contest, and anyone who thinks he can win a TV contst with an approach that judges the value of a business is deluded. The counter example to your example is: Long Term Capital management, with its great rationalistic Nobel prize winner. The very definition of rationalism: "if we assume that counter party risk is minimal, then..."; but, the truth -- the inductions -- are in such assumptions.

Further, it's important to point out that even if Buffett et al are totally and completely wrong, that does not make Markowitz et al right. Indeed, it is a problem in the broader field of financial theory and economics, that some academics, when faced with the wordiness and inexactness of the more classical approaches, attempt to reduce things to equations, but end up doing so in a rationalistic way.

I invite any layperson who wants to research this to take the following apporach: use morningstar to find funds that have done well not over the last few years, not even 5 years, but that have done well over at least 10 years, and hopefully 15 (i.e. a fund with a 10-year history should be treated as a few percent below an fund with a 15 year history).

Select funds based on only the single parameter of 10 years final returns (after expenses), as adjusted above.

Then, take the top ten of these funds and find their web-sites. Read the last couple of quarterly letters of the fund-managers, wiht the following question: "what is their approach to investing?" That way you will be able to find what makes for success. Some of this success may be blind luck, but if you find some themes that are consistent, there's probably something to those.

Finally, none of this means that people who try to emulate these managers will do well. More often than not, people who emulate these managers simply buy stocks that are cheap for a very good reason, ending up with a little trash that wipes out any sensible purchases. Despite telling themselves that they will not pick up "cigar-butts", that is what ends up happening.

5/10/2008 01:40:00 am  
Anonymous NotYourBusiness said...

Fascinating topic, risk management.

Risk aversion negatively affects everything in our lives - finance, career,our personal lives, emotions. Too many scaredy-cats unwilling to take a chance.

PC, your appetite for risk would not extend much past a ticket in a chook raffle darlin'.

5/10/2008 08:28:00 am  
Anonymous LGM said...

FF

You'll need to do better than that. State the specific claim I made and then ask me about it.

At this point the position is analogous to my being asked to back up Aquinas claims regarding angels, even though I have never made claims regaring the existence of angels in the first instance.

---

As far as all this number cruching and modelling goes, put it like this. Buffett built himself the second largest personal fortune in the World. Those who sat back and tried to build mathematical models, regarding what he did, failed to build such a fortune. Nowhere close did they get (despite fatuous claims to the contrary). I doubt any of those clowns got within an order of magnitude of Buffett. Know why? Because they never had a clue about what he was actually doing, EVEN WHEN HE TOLD THEM. That's right, those modellers and analysts are so far up their won arses they can't hear. They are so stuck in their little imaginary world of perfect numbers that when of the world's most successful businessmen actually tells them exactly what he is doing, they don't listen and they don't learn from him. They just plug away at those overheated computer terminals punching keys. Meanwhile Buffett makes another tem, twenty or one hundred million.

Now read this part really, really, really carefully. If you are passionately motivated by the same sorts of business activities that Warren Buffett is, then you should do exactly as follows. If you are not, then you should go find something that excites your passions and interests and do that instead.

Buffett started out as a young junior with a strong interest in business. At one point he was employed in a brokerage. He started to wonder what and how the numbers on the ticker related to the underlying businesses concerned and the assets they controlled and the activities they were engeaged in. He decided that all the models he was using to pick stocks were absolutely and utterly worthless to him because they did nothing to convey, analyse, deal with or take into account the real entities of which he was trading ownership portions (stocks and the likes). And so, long before anyone else was doing it, Buffett started to visit these companies, interview the management, look closely at the books, seek out information from competitors, staff members, customers, retailers, suppliers and purchasers- anyone who had a realtionship with the organisation of interest. In short, he ignored the sterility of the models and learnt about reality. He ended up knowing more about potential targets for acquisition than did anyone else, including the management themselves. Then he started to make his moves. Most of these are well documented and written up in the general record, so you can read exactly how they were executed. What you will not see is the long process of diligence that preceeded each and every one. Nor will you read of the lessons gained in each case. For that you need to listen to the man himself or a member of his satff that may choose communicate with you.

Over the long haul Buffett came to understand many of the same things that guys like Brierly learnt (e.g. book value of assets can be much less than the market value of those same assets AND the books only give a snapshot of the company at one frozen instance in time) but he also learned something far more important than that. He came to understand that the people running a company were the most important thing he needed to gain certain knowledge about. To this day Buffett's preferred acqusitions are companies that are or were family run. Always he prefers and likes companies that have tight, motivated, loyal groups of management and employees at the helm. Not only does he take great pains to understand a company's culture and who is running it, he also spends at least as long working out how he can keep things that way after acquisition.

In conclusion, Buffett is a people man. He even explains it in several speaches. He knows that the analysts spend untold time comparing asset values to stock values. He knows that analysts use huge software schemes to determine the future and what their next deal should be. He knows most of Wall St have sophisticated tea-leaf reading means to try to devine the future (the Romans used to sacrifice goats and read the entrails befire a battle to determine the outcome, so he likely wouldn't be surprised to discover they serve goat at various Manhattan restaurants). Buffett continues to plod the course of doing extremely painstaking diligence and making acquistions based on evidence and information deliberately and painfully acquired.

---

Ok then. That's not to say Buffett is omniscient. He clearly isn't. He makes errors and so do some of those who work for him. What is does say is that following some model is not going to yield result such as his. that's because Buffett deals with reality directly while modellers so not. "Man is not a number."


---

Now go back to my maths model.

x + y = T.

It's perfect isn't it. What could be wrong with that?

LGM

5/10/2008 09:15:00 am  
Anonymous Falafulu Fisi said...

SoftwareNerd
Since most of your response to my post has been "read Markowitz", I just wanted to say that I've not only done so, but I studied that and more as part of my MBA.

Yes, you did MBA, but you couldn't recognize the simplified Markowitz (non-matrix) quadratic type-equation that I posted in my second message (right at the top) of this this very thread, let alone that you understand the topic of this very thread on risk minimization using optimization theory which is the bedrock of Markowitz. The reason I simplified the Markowitz formula into a fifth form level so that readers here at NOT PC could follow the example of minimization. If I had to post the Markowitz in matrix form using matrix algebra (see above), then no one could understand the very topic of debate about minimizing risk.

Z = 0.5*X^2 + Y^2 - X*Y - 2*X - 6*Y

Your MBA program must have been a thorough course, heh?

BTW, if you haven't thought out the values of X and Y that minimizes the function Z (risk-return) where these values must also satisfy the 5 constraints quoted in my previous message, then here is the answer.

X = 0.6667
Y = 1.3333

which gives the minimal (least):
Z = -8.2222

You can try a few different combinations of X and Y, which is potentially infinite, but none of those will give a value for Z that is smaller than -8.2222 ;

See, guys who are nerds in software are suppose to know these algorithms, right?

I know we aren't going to resolve this controversy in blog comments, when there are tomes written about it.

Why not? We're not going to resolve it in peer review publications either since I don't publish articles. I read what other authors publish and if I find anything interesting for software implementation, then I implement their algorithms. There are other development that had been built on the work of Markowitz and Sharpe, such as the Black-Litterman model first developed at Goldman Sachs plus more. I am currently implementing the following model which is a dynamic portfolio management as opposed to the static Markowitz management. The risk is updated as new information is developed in the market. If you're a nerd that you would have no problem following the algorithm described below.

Arbitrage pricing theory-based Gaussian temporal factor analysis for adaptive portfolio management

BTW, I am well read in certain economics/finance literatures , the ones that involve algorithm model derivations which are vital for my software development, such as Journal of Computational Finance, Journal of Computational Economics , JOURNAL OF ECONOMIC DYNAMICS AND CONTROL and a few others. There are other non-traditional economics/finance peer publications that published related economics/finance articles in journals from Physics, Artificial Intelligence, Signal Processing, Optimizations, Feedback Control Theory, Statistics, Data mining, etc. So anything that you can bring up here for discussion, I am ready to debate with you on those.

You spoke of a TV or mag contest, and anyone who thinks he can win a TV contst with an approach that judges the value of a business is deluded.

No, I just pointed that out as an example, so that anyone who has no clue to risk analysis (portfolio management) can understand the difference between formal risk analysis and non-risk analysis. Hey I can pull up the literature with peer review study which shows that risk analysis outperforms non-risk analysis if benchmark using one of the popular methods as Sharpe ratio, Omega ratio, Sortino ratio,
Kappa ratio, or Upside ratio, but I am not going to do that job for you. If you want those evidence, you can dig up the literature yourself, you know you are the MBA boy. A good site for you to start with is the freely downlodable papers from RePEC (Research Papers in Economics).

Further, it's important to point out that even if Buffett et al are totally and completely wrong, that does not make Markowitz et al right

I didn't say that Buffet is wrong and Markowitz et al, is right. What I pointed out is the derision of formal risk analysis (you know, the thorough research work in economics) by those who champion reason. So, much for thorough research work and theoretical studies which adopts reason to be ridiculed, but for guess work is being elevated & championed as the way to go. Aren't those who championing the adoption of reason contradicting themselves. I have no problem with Buffet's method, I do have a problem with those who are self contradicting, and that is my issue here.

BTW, why did you bother to study MBA if for so much of your course content that now you think they're bollocks? Just ask LGM and PC about MBAs, I wouldn't be surprised if they say that MBAs are bollocks.

5/10/2008 04:27:00 pm  
Anonymous NotYourBusiness said...

A fairly successful friend maintains what to me seems a perfectly sensible view of risk and return, which is to seek those investments in which the risk of loss is low and the expected return very high.

Which has been oil companies for a few years...otherwise there is no one who is a truly wealthy self-made man who has not taken a lot of risk.

If your 'friend' tells you otherwise they are making shit up - or dealing in 'commodities' which are not part of the legit tradeable market.

If you get my drift.

5/10/2008 05:05:00 pm  
Anonymous LGM said...

The wealthiest man I know once told me he never took a risk in his business. He never experienced any of the stresses that many risk takers complain about, get sick from and die from. I discussed his business activities with him at great length over a dinner a little while ago. He said that what he did was decide what he was good at, spent all his time working at it and then money came in. In short, he bet 100% on himself. Every day he started working at 6 in the morning. Had 15 minutes for breakfast at 8. Worked on until lunch (at 11) when he took one hour break. Worked on again 'til around 2 or 3 when he had a coffee (this one at his work place- not in the lunchroom or kitchen). Stopped working at 6. Then he went home and had dinner with the family. Watched the news and had an hour for a nap. Back to the workshop he went by 8:30pm. Worked through until 11pm or so and then went off home to sleep. Sometimes he even worked in the morning hours. Believe me he got rich and very, very quickly indeed. No risk involved he says. Just consistant work for several years. He knew he could not fail. 100% certain. He even told me the secret why and how he knew that.

You guys are spending a whole heap of time dribbling on about theory and muck while some of the best opportunities to build untold wealth are passing you all by. How bad is that!

LGM

5/11/2008 07:02:00 am  
Anonymous LGM said...

FF

I made a good sinecure teaching the IP component of an MBA at an Australian university.

My opinion regarding the MBA is that the worth of an MBA depends on exactly what information is presented during the course and who the student meets while undertaking the course. If you really must do the course, the best thing to do is choose an MBA where you know you will be making really important contacts for your future.

Having said that, I have to admit that most MBA courses are worth jack shit when it comes to learning how to operate a business. You can pick up some important leads and some important contacts but the rest is up to you. Best of luck.

And as for $40,000 in fees- you'd have to have to be really, really, really certain that you couldn't find something better to do with that cash. Maybe Kiwisaver. Better yet, give it to me, I'll give half back and you'll be $20,000 better off than if you'd done the degree.

LGM

5/11/2008 07:11:00 am  
Anonymous LGM said...

BTW for the same load of cash you could do a Masters of Law and Legal Practice in Finance or IP at night classes in Sydney. It'd take four years and you'd have a far more valuable qualification as well as gainful employment during and after the course. Yes, that's right. They'll place you in a good role during the course and guide you during the early stages of your post study career.

Why do some other generalist non-vocational qualification instead?

LGM

5/11/2008 07:15:00 am  
Anonymous Falafulu Fisi said...

You guys are spending a whole heap of time dribbling on about theory and muck while some of the best opportunities to build untold wealth are passing you all by.

That is why I talked about it a lot, since I realize that there is opportunity there for adopting the theory in commercial applications. So, I am chasing after it, is that a bad thing? I think not.

No risk involved he says.

Yeah, right. This is the most bizarre and absurd claim I've ever heard in a long long time, especially from someone like you who had been teaching MBA courses.

LGM, here is your favorite phrase here at Not PC.

The onus is on the one who is making the claim to prove it.

Can you prove your claim? It is a fact of life that risk is everywhere no matter how small it is but it is still there, that is it exists. So much for your emphasizing to prove it challenge at Not PC, that you went as far to use an anecdotal evidence to claim that a businessman never took a risk in his business. Here is your answer. The man didn't understand what the term risk is and if you want a bet, just tell me what his business is and I can dig similar markets to his business and find the risk in superior products or services from his competitors, risk in government regulation over his business, risk of price war with his competitors and so forth. I can guarantee you that I can find some risk in your rich friend's business.

BTW, the risk that is on discussion on this thread (investment risk using Markowitz) is different from the risk that you're talking about of how to run a business. These are completely 2 different types of risks. It seems to me that you jump into this thread to participate without fully understanding of what the topic of discussion is about. It is about financial market investment risk.

5/11/2008 11:35:00 am  
Anonymous NotYourBusiness said...

Just to hark back to the traditional loser response to FF:

become wealthy and we believe you :-)

All those traders who use technical analysis in dealing rooms on a daily basis are increasing bank's profitability. Their jobs depend on it. If it didn't work they would be shown the door. People like John Spencer would not hire dealers versed in TA to manage his money if it didn't get results and minimise his risk.

Plenty of people are rich and continue to make money using mathematical modelling.

I do suspect the politics of envy are at work here "I'm a small player and can't make money in the market - so why should you?"

5/11/2008 03:34:00 pm  
Anonymous LGM said...

FF

The claim is his. I've repeated what he said to me me. So what's your problem with that?

That guy is a very wealthy man. I've asked him how he managed it and he's explained what he did. I accept what he's said on the basis that he is extremely wealthy indeed. He probably knows what he's on about.

The important point to realise is that he didn't spend time theorising or modelling or talking. He planned and then he acted. He didn't talk about it, he just went off and did it.

His advice was to figure out what you are good at, choose your area where you will do better than everyone else, plan your work and go right ahead. Oh, and he said one other thing. He told me that most people are lazy. They like the "quick and easy way". He reckons if you work harder, more consistently and in a more directed fashion then they, you can't lose. He says there was no risk of failure. No risk, right from the outset. Once he started he knew exactly where he was headed. The evidence was clear to see. As evidence I could see his cars, house, launch (bigger and faster than the one you know about) and all sorts of other stuff (like his personal library amd paintings).

FF on the basis of who he is and what wealth he's generated I'm inclined to believe him. For him there was no risk. All he needed to do was stick to his plan and put in a lot of effort for several years.

He says, "No talkee. Doeee."

BTW, there is no risk for you to invent for him. He's there. He's done what he planned and he's continuing to do it presently.

---

As far as an MBA goes, my advice is that if you MUST do one, diligence the hell out of the course BEFORE you enroll and put your money down. Make sure you do one that is going to benefit you with useful knowledge that you couldn't get anywhere else (for free) and with contacts (that you couldn't approach in a more economic fashion). NZ$40k is a lot of tax paid cash. So we are talking about ~NZ$60k to you. Compound that out over 30 years at, say, 9% and see what it's worth. Now you must be absolutely certain that what you are doing is the best way to employ it. If it's an MBA that you reckon is best, then you should go right ahead. If not, don't. Be careful with your choice.

---

What do you reckon about that model x + y = T ?


LGM

5/12/2008 06:11:00 am  
Anonymous LGM said...

notyourbusiness

In reality the traditional loser response is from someone who is NOT wealthy, NOT a successful businessman, telling other people all about how to do business. Talk is cheap.

Condseder, a functionary is just a functionary no matter how impressive his title or how pretty his tie.

BTW I am not referring to FF.

LGM

LGM

5/12/2008 06:22:00 am  
Anonymous Falafulu Fisi said...

The important point to realise is that he didn't spend time theorising or modeling or talking.

So as Sam Morgan (Trade Me), Geoff Ross (42 below), Peter Maire (Navman), Annette Presley (Slingshot/Callplus), Rod Drury (Xero Software), Brian Peace (Peace Software), Sharon Hunter (PC Direct ) and so many local NZ entrepreneurs had made millions by hard working. You read their stories about how they worked up to 60 hours a week when they were trying to first establish themselves in the market. Oh, and by the way, they never used modeling either since that is irrelevant to running their businesses. So, there is nothing new to working hard and figuring out your market so that you become competitive. These entrepreneurs concentrated on good marketing and developing new products to be competitive, which is what they should be concentrating on. You don't need Markowitz risk-minimization modeling to run your everyday business, which is the very topic of discussion & debating on this thread.

But what is new (or unknown) is the risk-minimization that majority of investors (including PC) don't know about its advantage and that is exactly what Herald Columnist Diana Clement described in her article (Don't lose your shirt - diversify ). Even seasonal investors (many many years of experience in investing in the market) haven't known about such method.

What do you reckon about that model x + y = T ?

Your model has no solution. In the language of linear algebra, it is an Indeterminate System (ie, a set/s of linear equation/s that either has infinite solutions or no solutions, but no define solutions). You have one equation with 3 variables and it is unsolvable, because there are more variables than equation.

This must be the type of model that your rich business friend must have been using (ie, indeterminate).

5/12/2008 01:36:00 pm  
Anonymous LGM said...

FF

Yup. Work in a directed, intelligent fashion and it pays off.

x + y = T is not indeterminate. The model is based on defintes. Each algebraic symbol was defined already. x is how much money I got already. y is how much you are to give me (and is defined according to P) and T is what I end up with. It's perfectly clear and it's a good model. What's so wrong with it? It a good model. Best one around in a long time!


LGM

5/12/2008 05:58:00 pm  

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