If Beta is dead, VaR should be extinct

It is to my horror that after poring through the notes on what is VaR. It finally dawned upon me that the entire financial industry has embarked down the path of no return. In the academic world, Beta is dead and thus by inference so is VaR. I thought the industry practitioners might be better when it comes to this kind of stuffs so perhaps they might have something more advanced.

Seems like I was dead wrong, allow me to correct myself, they are even more out of touch than the academicians. Financial markets are like the real world, it is much more chaotic than what can be captured by some complex formulation and parameters. The all to familiar gaussian bell curve appeared on the 3rd page to my disgust.

Just how do you model human behaviour? Applying mediocristan laws in a world of extremistan is bound to get you into trouble. The natural tendency of human beings to swing towards extremes. Right down here we still have an entire industry worshipping something that is incorrect and I have a career that is based on bullshit.

Being politically correct emails galore

Got an email straight from a director in London to change all references of "Proprietary and Prop" to "Arbitrage" in all our reports. Well, yeah as if that is going matter at all. Now the harsh criticism on proprietary trading is coming down from the regulators and politicians. So change the wordings of the title. Presto, we are operating a different business now!!

Please do not use the acronyms PIIGS. Spell them out Portugual, Ireland, Italy, Greece and Spain correctly. Do not say you have short positions, that makes us look like short-sellers. These people gain from the misery of investors. Say you have a short exposure.

Seriously, I totally do not understand what all the fuss is about.

Practical Realities

It is the distinctive unmistakable feeling that work is starting to suck my lifeforce away. Nowadays, I spend the most of my time looking at practically meaningless data. Delta, Gamma, Vega, Theta and Rho, these Greeks are really meant make to simple things complex.

In reality, risk sensitivities are only meant for trading purposes. They represent no significance at all when it comes to real long term investments. However, trading in a bank is no difference from gambling. Investment banks are just super big glorified casinos. Why do I have to bother with all these nonsense?

Ah...I forgot, because it's my job to do so. It pays very well but I literally hate it, but this is the best I can get to move towards my goals.

Career Advice

"Would you tell me, please, which way I ought to go from here?"

"That depends a good deal on where you want to get to," said the Cat.

"I don't much care where..."said Alice.

"Then it doesn't matter which way you go," said the Cat.

-Lewis Carroll, Alice in Wonderland

Reigning in the banks

Though this might mean lower bonuses for everyone but hopefully this will reduce the amount of work I am getting! Simplify the rules and regulations as well. Lower leverage, lower risks and please...lower the amount of new trades. Banking should be boring and I would like to have it that way.

Tiger Airways IPO

"Investors have regularly poured money into the domestic airline business to finance profitless (or worse) growth. For these investors, it would have been far better if Orville had failed to get off the ground at Kitty Hawk: The more the industry has grown, the worse the disaster for owners."
-Warren Buffet

One of the worst industry ever to invest in, couple this with losses over the past few years and a negative net asset value. This may be the year of the tiger but with numerous global airlines dropping like flies, don't expect a spectacular flight for this one. Main sellers of the stocks, Ryanair. If the kings of LCCs can't turn this company around, I can't see how Temasek and SIA can.

Expectations of future profits due to the IRs is nothing but a hope at best. It might turn out well, it might not. On the otherhand, if this paper tiger were to roar, then it is sure indication that we are entering bubble territory. Caveat Emptor.

What a mess!

As much as I like the club, its finances are in a mess. Here's what I picked up from soccernet:

The bond will be used to repay the "senior secured notes". It was thought that the Glazers would be looking to finance the £175 million worth of payment-in-kind notes that are currently attracting 14.25% interest. However, this is considered personal debt and will not be refinanced through bonds.

"Manchester United today announced that it will be seeking to raise approximately £500 million aggregate principal amount from an offering of senior secured notes due 2017,'' said a United statement. "The notes, whose proceeds will be used to refinance existing debt secured against the club, will be issued by MU Finance plc.''

But the Glazers will not be selling the club and intend to use the money saved from restructuring the debt to ensure significant money is available to Sir Alex Ferguson to spend in the transfer market.

I have no idea what are in the books. However, from the surface, 14.25% worth of interest is just madness to me. No corporation can ever survive that kind of interest rates on loans. This is the kind of rate you pay for a junk bond, something with a high probability of blowing up within the next few years. Furthermore, isn't issuing new bonds to refinance existing debt a big red flag, a classic robbing Peter to pay Paul syndrome. The Glazers are destroying a great franchise from the inside.

A legend of the past

" I was taught to work as well as play, My life has been one long, happy holiday; Full of work and full of play- I dropped the worry on the way- And God was good to me everyday."
- John D. Rockefeller

Currently reading Ron Chernow's biography of John D.Rockefeller. This guy is an absolute legend. If Standard Oil were to remain as a company today. It would have consisted of ExxonMobil, Chevron and ConocoPhillips combined, which is 3 of the top 5 companies on the Fortune 500. As a percentage of United States GDP, no other American fortune amassed including those of Sam Walton and Bill Gates combined would even come close. This was probably the greatest amount of absolute wealth that any self-made person could amass by his own hands. A controversial character through and through, extremely philantrophic in terms personal life but ruthlessly efficient when it comes to business. It is not hard to imagine the critical role that he played in propelling America's ascension to supremacy as a world superpower.

Learn, unlearn and re-learn

The only function of economic forecasting is to make astrology look respectable.
-John Kenneth Galbraith

Here comes the end of 2010 and the start of a brand new decade. There were lessons learnt and re-learnt and for some unfortunately I still do not learn. Putting the past aside, its time to start anew. Going forward, what are the lessons we can learn from the past that can better guide us towards the future?

Here are my top 5 lists:

1. It ain't over till it's over

Never ever pass judgements too quickly. What might seem a wise choice then might not be so wise later. What might seem stupid then might not be stupid later. Whether you are right or wrong in terms of decisions is all time and outcome relative. You can make all the right moves and the most logical decisions but there is always the element of chance that things might not turn out as expected. There's nothing to rejoice when prices go up and nothing to panic when prices go down. If one does not need validation from the markets, then it does not matter what the market does most of the time.

2. Long-lasting competitive advantage is the driver of value

Statistics and past performances matters as much as how relevant they are as a guidepost to the future. In some cases they can be predictive, in others they are as good as a flip of coin. Value is only as good as how much you will get. If all those earnings and cashflows is going to find itself stuck in some machinery and assets, then unless the company is going to liquidate the assets, you are not going to see those cash. Understanding the economics of a business is a much better way of assessment than some esoteric calculations. Porter's 5 forces though not exhaustive is a good framework to start with.

3. The tendency of man is towards extremes.

Humans are like a pendulum that swings from one end to another. That is why we had cycles in the past, we will definitely have them in the future. However, the magnitude and duration is unknown and unforeseeable. A good business per se does not justify an astronomical price and a bad business per se might not mean it is totally worthless. (It neither works the other way round either.) Reality is not as simplistic as what many people think. Except for scientific laws of nature and history, there is no such thing as sure thing.

4. Psychological biases: Try looking into the mirror

People like to look at success stories and forget about the silent evidences of countless failures. Nothing is more inspirational than fighting and overcoming the odds to emerge victorious. However, one usually fails to notice is that to "overcome the odds", by definition means to be the exception. What makes people like to think "this time its different", for everyone else the rule applies, whereas for me, "it's the exception". Therein lies a paradox, without believing we are the exception, we wouldn't try, then there would be no success stories today. In order to be the true exception, one would have to ask himself and find out "What do you have that others don't? What are you doing that others are not?" Food for thought.

5. It's all a matter of perception

Our internal representations or experiences of any event is not precisely what happened but rather a personalized internal re-representations. People interpret things differently. The conscious mind is unable to process all the signals that are being sent to it. The brain filters and stores the information it needs and ignores the rest. The different filters in place are the reasons why two different people might view the same things differently. Those filters are made of beliefs, values, attitudes and metaprograms. Many of these filters are ingrained and stored within our emotional and cognitive system so much so that we are not aware of it. Since we do not know how things really are, but only how we represent them to ourselves, the best we can do is only to represent them in ways that helps us rather than harm us.

The Future of Finance

It seems clearer and clearer to me that the financial industry is headed for an age of rocket science. An age whereby quantitative and computational finance governed by greeks, complex alogorithms and black boxes would account for an overwhelming majority of trades on exchanges. What would be the future effects of this? Would the traditional investor be disadvantaged? Is it time that all of us should have black boxes of our own?

In this post I would attempt to share my thoughts on this:

What would the future effects of this?
It means that the market will become more and more efficient in such techniques and the profit margin in relation to risks will continue to shrink. The investor will have to on an increasingly frequent basis develop new techniques and ideas, backtest it and roll it out before some hedge fund or large bank comes into the scene. The impact of this on security prices to me is unknown but I guess that prices would become much more volatile as trades become much faster than ever before. Slight changes in economic indicators can have large impact on security prices. More and more people will have to depend on leverage. Then this means there will be counter-techniques whereby institutions with large enough capital to influence prices can front-run or harvest smaller black box players by busting their stop losses or force margin calls. Volume of stocks traded would explode and this would spell well for exchanges.

Would the traditional investor be disadvantaged?
It depends, very much on the whether the investor or trader relies on similar quantitative indicators to make his trades. If he does, then he will surely be outdone by these black boxes and it would be about time he revises his investment framework. Retail investors should keep away from techniques that would pit themselves in direct competition with the big boys out there.

Is it time that we should all have black boxes of our own?
I would say no as a matter of fact. These black boxes will almost wipe out the the arbitrage business of financial securities. It requires strong foundation of financial and programming skills which is not oftenly found in any normal person. However, there is one thing that black box users do not have, that is to have a long time horizon. The quant community by and large do not like to leave themselves exposed to price fluctuations for too long. The buy and hold technique might seem outmoded and dead, but I would say it would depend very much on what you buy and at what price you bought. Blindly buying the indexes, will just allow you to do average. These quant traders would come under increasing stress and pressure to find new techniques and ideas. Whilst true buy and hold investors who have perfected the art would have no such stress.

Debunking the Efficient Market Myth II

For several decades, there would come a time when the prevailing view that the world is so chaotic and so much beyond our control that even the most prudent of stock investments seemed foolhardy. Yet on hindsight these periods were all of opportunities that seemed almost incredible with the advantages of hindsight.

There were several times in these decades whereby some stocks will become darlings of the market. These were later to prove to be the most dangerous kind of trap for those who blindly followed the crowd than those who really knew what they were doing.

All these periods resembled the others in that they create opportunities whenever the financial community significantly misjudge the situation. The great waves of optimism and pessimism reflects the unfortuante tendency for humans to go towards extremes. Plus ca change, plus c'est la meme chose (the more things change, the more they stay the same). The idea that we have finally come into an era of prosperity or "Goldilocks" economy (remember Larry Kudlow), whereby severe booms and recessions are a relic of the past should be shelved in the memory as a "new era story".

Now I deem it to be appropriate to touch on the subject of Beta. This is a traditional academic measure of price fluctuations of common stocks against the market index. What bothers me is how the academic authorities equate Beta or price fluctuations whatsoever with the concept of risk. Price variation yes, risk no. Real investment risk is measured not by how much price will decline but the danger from the loss of quality and earning power through economic changes or deterioration in management. The idea of measuring investments via price fluctuations confuses the stock market's opinion and what actually happens to the owner's stake in the business. In the desperate search to quantify risk into a single statistical measure, academics have forgotten to evaluate the conceptual arguments of the theory. As Einstein said, "Make everything as simple as simple as possible but no simpler." This is one such oversimplification.

Beta in its purest form ignores all the qualitative characteristics of the company, what it produces, what is the nature of the business, what kind of people do they have for management. He might not even care what the company is called. What he treasures is the price history of the stock. Then if that is the case, then the concept of beta is of no difference to those who use technical analysis as both derive their validation from price fluctuations.

The true investor welcomes volatility for it means that there will be periods of time whereby irrationally low prices will be attached to outstanding businesses. He would be free to exploit its folly to his liking. What the price history of the company maybe is of no importance to him, he would prefer to further his understanding of the business. He does not seek validation from the markets and would not be disturbed even if nobody traded the stock for a year or two.

Real risk though cannot be judged or calculated with numbers, it can in some cases be judged with a level of accuracy that would be useful. A good framework would be to use Porter's Five forces in the evaluation and understand the nature of the business. Thereafter, would be judging the extent of accuracy these factors allow themselves to be predicted as well as the characteristics of management. Lastly, would be the price that the investor would pay for the business.

All these characteristics might strike an analyst as unbearably ambiguous since they do not come in some form of database by itself. In the parlance of law, this would be called the "reasonable man's test". If you were to unable to apply it with a degree of confidence that would be reassuring. Then, this would be a clear indication you are out of your circle of competence or the subject matter at hand does not render itself to such evaluations.

Obviously, every investor will make mistakes. But by confining oneself to a relatively few easy-to-understand cases, a reasonably intelligent, informed and dilligent person will be able to judge investment risks to a useful degree of accuracy.

Academics built arcane investment and capital allocation theories around price histories with correlations to create optimal portfolios. Laudable attempts but not very useful when the underlying concept is fundamentally flawed. Most of the greatest investors who have earned the highest compounded rate of returns all do not use any "optimal portoflio" of any kind. If a business is worth a dollar and one pays 40 cents for it something good may happen to him.

Debunking the efficient market myth I

Modern finance has very much based itself on a concept that I believe is quite fallacious. What I am referring to here, is the notion of market efficiency. The concept holds that in a semi-strong effcient market, the "efficient" prices are assumed to reflect fully and realistically all publicly available information. It holds that unless one gains material non-public information, there is no way of unearthing genuine bargains, since the favourable circumstances existing are already reflected in the price of the stock.

Admittedly, there is a certain element of truth in it. Very much like in a pari-mutuel betting system, the odds of a favourable gain has to be weighed against the extent of gains that is already reflected in the price. However, a half-truth doesn't serve the investor well at all.

The efficient market theory grew out of the school of random walkers. These people found out that it was difficult to identify trading strategies that worked well enough after transaction costs over along periods of time relative to the risks undertaken. These trading strategies work well some of the time and fail in others. It becomes very much like flipping a coin to decide whether to buy a stock. I don't disagree with this.

Once again, I set out disqualifiers, because there are always exceptions to the rule but not many. These include high frequnecy alogorithm traders such as Renaissance Technologies and other quantitative funds. This method is gaining alot of attention and competition from large banks and hedge funds. I believe it would become a matter of time before the market starts to arbitrage away these huge profits.

Though I know quite a bit about program trading, I do not know enough to give advices. What I am proposing here is the best method of investing not trading. One should be seeking investment opportunities with unusual prospects over the long term and avoid those that are of poor quality. This would be the central tenet to the proposal that is prescribed here.

I do not believe the markets are efficient in this approach because it is unpopular and many investors have a tendency to learn the wrong lessons. At first glance, it might seem amateurish, inexperienced and sometimes downright dumb to the untrained eye. It is safe to say to assume if you knew something was wrong, you wouldn't believe it in the first place.

Most humans, hate self-questioning and prefer to spend their time convincing themselves and others their beliefs are right. These beliefs persist, particularly when they make sense intuitively and even more so when others around agree to it. To determine the efficiency or the lack of thereof with the investment approach, the investor will have to look at whether approach are scientifically sound and relatively unpopular. The method must not be generally accepted because those that are well accepted do not produce the required results. Ironically, this reflects an unfathomable idea, "Precisely because nobody ever think is going to work, which is why it is going to work wonders."

Be particularly wary of making a decision simply because of something you know others agree with. The reasons why we hold certain false belief is because 1) They make common sense and one is typically not prone to question his common sense. 2) People around you tend to agree with you and one do not have an inclination to challenge widely held views.

By and large, those who have accepted and been influenced by the efficient market theory fall in into 2 groups. One is students, who have had a minimum exposure to practical experience. The otherm strangely enoughm is those managers of large institutional funds. The private investor by and large has paid relatively little attention to this theory.

Also, a large number of studies have shown that variation in portfolio values are 90% caused by asset allocation between the different asset classes. Implying that the greatest gains or losses are to be made by moving in and out of markets. However, it is of my viewpoint that timing the market is extremely diffiicult, simply because you have to get several things right. One will have to select the right stocks, to make sure it can withstand a severe crisis. You have to make sure that the price is right and you are not catching a falling knife. You also will have to get out at a good price with the timing right the next time you sell out.

What I am proposing here, is to choose extremely carefully the stocks you are going to buy. Buy them at a relatively fair price. Then put your hands under your butt for the next few decades, a "buy and sit on your butt" approach to investing. Then you just wait. That is all to it.

It can be easily observed that in a portfolio of a large number of stocks, be it a mutual fund or an index. Countless empirical evidences show that a "small" number of stocks actually drives a large proportion of changes of value within any portfolio. Over a couple of decades, these gains in value can become extremely substantial. The ultimate question then begets "Is it possible for investors to identify them?" My answer is "Yes, you can. However, it is not easy to find such opportunites at all."

The death of one man is a tragedy, the death of millions is a statistic

Just finished the first level of CFA exams. The questions and concepts per se are not really that difficult. What is harder is finding the time and discipline to study as well as the stamina of going through 6 hours of nerve-wrecking challenge. Whatever happens next, be it good or bad, life still goes on.

I have learnt to adopt a more philosophical attitude towards success and failure. Even if one fails, life still goes on, just pick up the pieces learn from your mistakes and move on. Disasters strike, tragedies happen almost on a daily basis to different people in different parts of the world. One is neither unique nor alone. It maybe harsh but I never gave myself (sometimes even others) much sympathy or excuses to wallow in past failures.

The corporate world has a terminology for the end result of such instances. It is commonly known as BAU (Business As Usual). No matter what happened yesterday, the world continues to revolve, markets continues to open, businesses need to be made and jobs still need to be done. Sometimes, I wonder to myself since when did I ever become such a cold-blooded creature.

After some thought, I could trace the rationalization back to an event couple of years ago. It was the day of Tsunami on 2004, whereby almost 300,000 people killed with the highest number of casualties coming from Indonesia. From a perspective of a normal human being, it was an unprecedented disaster. However, what surprised me even more, was that the JKSE index unflinchingly rose instead, marching unstoppably forward. That very moment, impounded within me a icy-chilling sense of reality that till today still continue to send shivers down my spine.

Compare and contrast this with the events of the September 11 tragedy, whereby 3000 people died and stock markets worldwide fell sharply. Though both are tragic events, but the relative costs in terms of human lives couldn't be more apparent. One is a hundred times more than the other and yet responses by markets couldn't be more inconsistent.

Capitalism has implicitly placed a price on human lives. What the markets are telling us, despite how unsightly it is, is that the world can't be bothered by people whose lives don't matter. As the saying goes, the death of one man is a tragedy, the death of millions is a statistic. It seems Joseph Stalin knows a little more about human nature than we do.

Dubai Bond Default

More problems at work because of Dubai bond's default. Not because of direct exposure to their bonds and CDS but rather more because of HSBC pulling the HSI down. We are experiencing pretty big VaR moves all over the place due to panic selling. Whether there are more trouble than meets the eye? We still do not know. However, many of my colleagues are keeping their fingers crossed. Apparent from the comments, "Now is already the month of December, I don't want this thing affecting my bonuses!"

My opinion is that the default per se is not a big issue $80-90Billion may be large but not insurmountable. What I think is more important is the health of US consumers who are still in a balance sheet recession. Most probably they are taking the opportunity to stock up hugely on necessities during this Black Friday. The financial media as usual might again want to distort this as a sign of financial strength.

Lucky for me, sold out on my Capitamall Asia positions just before markets closed on Thursday, made some coffee money. Kudos to discipline of not leaving speculative positions over weekends. Experience has taught me that market sentiments can change at the snap of a finger. Didn't expect this Dubai issue to pop out immediately out of nowhere though.

Buying opportunity? Well, depends on the extent of correction that happens later. Given how US and Europe reacted, doubt there will be anything more than a small 3-5% move. As they say, bonuses coming up, thus window dressing season is in, doubt traders will be in the mood to rock the boat now.

Fortune's Formula

Bought it over at HarbourFront PageOne bookshop. Haven't been able to put it down ever since. Though it's a little pricey for a paperback and probably a book you can get over at the library. However, I still never regretted owning it. That for itself, my friend, speaks volumes.

Relooking History with a new perspective

I was doing some financial research and came across an interesting phenomena. Unfortunately, I have no rational economic explanations for it. Therefore, it might one of those predictors that performs excellently in backtesting but to fail miserably going forward. Nonetheless, it might lead to something though.

This experiment was conducted under the scenario that if one were to buy the S&P500 and hold it there for the next ten years without selling. How well would the investor fare through companies' earnings and dividends without considering capital appreciation of the stock itself? Earnings risk premium tends to overstate performance (upper bound), whereas dividends risk premium usually understates performance (lower bound). The real performance usually lies in between the two.

It would be interesting to note that backward earnings premium is highly correlated to forward dividends risk premium. It has a correlationship of almost 90%. An astonishing predictor considering the fact that forward dividend risk premium are figures made with hindsight hence impossible to produce at that point in time. However, backward earnings premium is another different story altogether.

The results have shown that ever since 1977, investing has become a lot more harder than ever. Earnings risk premiums and dividend risk premiums have virtually collapsed, sometimes even negative. This runs against the prevailing notion that if one had bought stocks in the long bull market of 1990s and they would have earned quite substantially. In fact, most of the time, these people would be much better off if they had bought 10 year treasury bonds instead. This showed that most stocks between the late 1970s till the recent crisis were just plain overvalued.

Good news is that according to this indicator, stocks are fairly cheap even at current prices. This is in direct contrast of my qualitative analytical work. In a way, it could also be a defining moment, for the outcome would allow me to place more weightage on qualitative or quantitative factors in the future.

Human Psychology

In this post, I shall deviate a little from my normal course of subjects and delve into area of human psychology. I highlight the importance of this is because it is necessary to take note that our biological decision making process which has served us so well in our natural daily lives would become fatal most of the time when it comes to financial markets.

I would first and foremost iterate that when it comes to theology, I remain an agnostic. In other words, when it comes to the supernatural, spiritual or other forms of metaphysical claims, I simply do not know the truth. I believe that such things are simply unknowable and one cannot reach a conclusion without the leap of blind faith.

However, allow me to start with a general observation that helps explain what follows. First of all humans are social primates. It does not matter whether or not evolution is true or not, the fact that we share about 95% of our DNA with chimpanzees is not subject to debate. Therefore, many of our body features and basic drives mirror the behavior those of our hairy cousins.

Our main differences lies in only three millimeters of convoluted gray matter, called the cerebral cortex. That is we are biological machines that operates 95% on a similar basis with only 5% differences. This 5% might be what accounts for our consciousness or self-awareness which has bestowed us with higher order thinking and sparked entire civilizations.

Thus, there are basic human psychological tendencies that we have to be aware of, for these applies to the human species in general.

The first is Pavlovian conditioning, this is quite apparent for one can observe how incentives and disincentives work in the real world. Perhaps the most important rule in management is about "Getting the incentives right". Get them wrong and you will start to witness dysfunctional behaviors that games the system.

However, there is a consequent effect that receives less attention than it warrants, known as the "incentive-caused bias". A pretty decent fellow can be driven both consciously and unconsciously by incentives, into irrational behavior that alters his own reality.

This person gets into a rationalization pattern that vindicates this behavior. The cognitive drift is present in every human being and it can cause incredulity in a perfectly normal human being. Thus the principle "What a man wishes, that also will he believe".

The mis-influence can obviously be seen on televisions, whereby tearful mothers, with heartfelt convictions, declare before national television the innocence of their obviously guilty sons. I have experienced this same psychological self-denial, that such a sane person as myself could not accept the unfortunate death of a dear friend long time ago.

That being said, there is another form of warping one's own self-reality. Coming from an accounting background, there is an old saying in the accounting world, "Whose bread I eat, his song I sing." When corporate management of established institutions ask the accountants to jump, the reply was "How high?" The natural results of incentive caused bias is well-developed in economics. Also well-known as the "Agency Problem".

Although money is the main driver amongst rewards, it is not the only reward that works. People also alter their realities and cognition to avoid pain or to gain identity, friendship, companionship, advancement in status and many other non-monetary items. It is important to recognize one's self incentive-caused bias taking place sub-consciously, for it is the cause that has led to many imprudent behaviors.

The second is a hating/disliking tendency. All humans need at least an object of hate within a group, which is also part of the "us against them" mentality. Whereby people bond together through a commonality of enemies. Consider the fact that the world's most successful religions have successfully garnered irrational hatred towards evils such as "demons or devils". It is usually way easier for a person to blame something for his shortcomings, misfortune or some feelings of guilt, than to take responsibility for them.

The triggering of such a tendency is the feeling of loss. A man ordinarily reacts irrational intensity over a small loss or threatened loss of property, love , friendship, dominated territory, opportunity, status or any other valued tangibles or intangibles. As a natural result, infighting in corporate settings over dominated territories often cause immense damage to an institution as a whole.

This also protects ideological or religious views by the feelings of dislike and hatred directed towards vocal non-believers. This happens in part, because the idea of nonbelievers if they spread will diminish the influence of views that are supported by a comfortable environment including a strong self-belief maintenance system.

This ideology-based group think rejects all conflicting inputs. When the vocal critic is a former believer, hostility is often boosted with a concept of betrayal that triggers hatred because a colleague is lost and fears that conflicting views will have extra persuasive power when they come form a former colleague. The result in history is the accusation of heresy which justified much killing of heretics, frequently over torture or burning the victims alive.

It is almost everywhere the case that extremes of ideology are maintained with great intensity and with great anitpathy to non-believers, causing extremes of cognitive dysfunction. This happens when other psychology tendencies are acting concurrently.

The third is doubt-avoidance tendency. The brain of man is programmed with a tendency to quickly remove doubt by reaching some decision. This doubt-avoidance tendency is well hard-wired into our survival instincts. After all, the one thing that is surely counter-productive for a prey animal is to take a long time in deciding what to do.

So pronounced is this tendency that it is logical to believe that at least some leaps of religious faith are greatly boosted in order to remove self-doubt. Even if one is satisfied that his own faith comes from revelation, one must still account for the inconsistent faith of others. This results in the aggressive evangelism activities to convert others.

What usually triggers doubt-avoidance tendency is some puzzlement and stress. Such as what is the meaning of life? Why do we exist? As we shall see later, this tendency usually works in tandem with social proof tendency and stress influence tendency. Many of these factors, naturally occur when facing religious issues. Thus, the natural state of most men is some form of religion. And this is what we observe.

The fourth is the congruence principle also known as the "status-quo bias". The brain of man conserves programming space by being reluctant to change which is a form of avoiding inconsistency. Anything that is inconsistent, causes a phenomenon known as cognitive dissonance. Cognitive dissonance is an uncomfortable feeling caused by holding two contradictory ideas simultaneously and trust me it is not a pleasant experience at all. The desire to avoid such unpleasant feelings to make a person feel better are what leads to confirmation bias, the denial of evidences that point out to the contradictory or other ego boosting mechanisms.

It is easy to see that a quickly reached conclusion triggered by the doubt avoidance tendency when combined with a tendency to resist any change in that conclusion will naturally cause alot of errors in cognition for the modern man. As it works out in an observable manner, we deal with many people whom we diagnose as imprisoned in poor conclusions that they will rather carry to their graves. So bad is the problem that, radically new ideas are seldom accepted by the old guard. Such events can be recognized by Galileo's persecution by the church. Instead, much progress is made by subsequent new generations who comes along and are less brain-blocked by previous generations.

One corollary of this tendency us that a person who has just made an investment or sacrifice in the course of assuming a new identity will intensify his devotion to the new identity. Afterall, it would be inconsistent behavior to make a large sacrifice for something that was no good. And thus, civilisation has invented many tough and solemn initiation ceremonies, often public in nature that instensify new commitments made. Examples that usually come to mind includes, baptism, blood oaths, pledges and even marriage solemnization.

The human mind works a lot like a human egg, there's an automatic shut-off device that bars any other sperm from getting in.

This tendency will often make humans into a subject of manipulative practitioners that gain advantage from triggering this tendency. So strong is the tendency that it can be manipulated to lead people into behaving horribly as a result. Two famous studies in psychology the Stanford prison experiment and the Milgram experiment are done to prove the existence of such a tendency in perfectly normal human beings. We do not know the horrible acts that we humans are capable of.

Though there are still many others, the last tendency that I will discuss here is the social proof tendency. Also known as the monkey-see monkey-do tendency. It has been proven that social animals possess a mirror gene expression. It is triggered in the puzzlement or stress, and particularly when both exist. Since so many others are doing it and I do not know any better, I must be right in doing it as well.

This social proof tendency interacts in a perverse way with the envy and hatred tendencies. A common expression is when people fight over a single man or woman when they are surrounded by an entire forest of better ones. Political versions becomes dead serious as the Middle East threatens nuclear war just because of some land that can easily be divided arbitrarily.

The important takeaway here is that several powerful psychologies work in tandem that causes us to do what we do. Although in several circumstances, it serves us well. In others, it can be extremely faulty especially when it comes to financial markets or religious beliefs. We may think we are above all these because we are rational humans which think for themselves. Though occasionally logic and reason can be used to determine a course of action, men and women including myself are more persuasively motivated by emotions which are also our psychological tendencies. Often, we simply use our intellects to rationalize those emotional actions after the fact.

How Stock Market Operates (Part II)

When for a long period of time a particular stock has been selling in a certain price range, say from a low of 25 to a high of 30, there is almost an irresistible tendency to attribute true value to this price range. Giving in to this urge can be very costly. This is because the genuinely worthwhile profits in stock investing come from holding the surprisingly large number of stocks that have gone up many times from its original costs. The only true test of whether a stock is "cheap" or "expensive" is not its current price in relation to some former price, but whether future cashflows realized are significantly more or less favorable than the current appraisal of that stock.

Taking from a Graham parable, the market is not a weighing machine on which the value of each issue is recorded by an exact and impersonal mechanism, in accordance with its specific qualities. Rather it is more like a voting machine, whereon countless individuals register their choices which are the product partly of reason and partly of emotion.

This is an important principle because despite the laws and regulations in place today, pools of manipulation of shares still exist. The methods of all these pools are fundamentally similar. The members would sell stocks back and forth amongst themselves at gradually rising or constant prices. All this activity on the stock price would attract attention of others who would then start buying shares and take a portion of the shares off these pools' hands at still higher prices. These highly skilled manipulators were quite experienced and able practitioners of this rather questionable art.

The conservative investor must be aware of the nature of the current appraisal by the financial community of any industry he is interested in. Determining whether at that moment the price of a stock is attractive, unattractive or somewhere in between depends on most part how far off these appraisals deviate from reality. However, to the extent that the general level of stock prices affects the total picture, it also depends somewhat on correctly estimating coming changes in purely financial factors, of which interest rates are by far the most important.

Allow me to close this chapter with a simple summary, prices have only one significant meaning for the investor. They provide him with an opportunity to buy wisely when prices fall sharply below its calculated intrinsic value. Throughout the investment process, he will be better off ignoring market prices and pay attention to his calculated range of future cashflows lest he gets anchored by some misleading price conditioned into his mental memory.

How the stock market operates? (Part I)

Every significant price move of any individual common stock occurs because of a changed appraisals of that stock by the financial community. It should never be forgotten that an appraisal is a subjective matter. It has nothing necessarily to do with what is going on in the real world around us. Rather, it results from what the person doing the appraising believes is going on, no matter how far from the actual facts such a judgment may be.

The key point to note is this, any individual stock does not rise or fall at any particular moment in time because of what is actually happening or will happen to that company. It rises or falls according to the current consensus of the financial community as to what is happening and will happen regardless of how far off this consensus may be from what is really occuring or will occur.

Because of a financial community appraisal that is at variance with the facts, a stock might well sell for a considerable period for much more or much less than it is intrinsically worth. Furthermore, many segments of the financial community of a habit of playing "following the leader", particularly when that leader is one of the larger New York City banks.

This sometimes means that when an unrealitic appraisal of a stock is already causing it to sell well above what a proper recognition of the facts would justify, the stock may stay at this too high level for a long period of time. Actually, from this already too high a price, it may go even higher. These wide variations between the financial community's appraisal of the stock and the true set of conditions affecting it may last for several years.

However, there will come a time when the bubble bursts. When a stock has been selling too high because of unrealistic expectations, sooner or later a growing number of stockholders grow tired of waiting. Their selling soon more than exhausts the buying power of the small number of additional buyers who still have faith in the old appraisal. The stock then comes tumbling down. Sometimes, the new appraisal is quite realistic. However, this re-examination is frequently evolved under the emotional pressure of falling prices, the negative is over-emphasized, leading to under valuation. It may take quite some time for a more favorable image to supplant the existing one.

It is important to note that in several instances what has shifted was the emphasis not the facts. Though, the facts too can change. A clearer picture develops when an investor ascribes price and intrinsic value to 2 different dimensions. The former is based on perceptions and the latter is based on reality.

For the purposes of clarity, I would define intrinsic value to be the amount that is justified by current facts. The reason I did not choose the absolute future cashflows is because there will be circumstances by which are not even reasonably foreseeable even by the extremely skilled investor.

Under such defintions, both price and instrinsic values are dynamic in nature. Though both are not the equivalent of each other, both can influence each other in several profound and important ways. The characteristics of a business intrinsic value will very much depend on the nature of the underlying business itself. Whereas for the price, much more will be due to behavioral traits of shareholders. With this picture in mind, the investor will have a clearer idea of how the stock market operates.

Thus, from here, arises an old Graham key principle.You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right. This principle effectively shows why regressing historical prices against an index does not produce any meaningful results. It is in direct conflict of the the traditional Capital Asset Pricing Model (CAPM).

This can be quite interesting philosophically, because if a huge amount of people is willing to pay $2 for a $1 bill for an extended period of time, does it make that $1 bill to be worth $2? Fuzzy logic but an important thought to hold.

Interesting al-ARM

In order to enhance cognition, it would be good practice for one to consider all the merits of potential weakness in a belief that one holds. Here, I would like to discuss the effects of the second phase of the mortgage crisis which I personally believe will derive from Option-ARMs, Alt-A and commercial real estate. Counter-arguments include:

1. There is an increasing belief that given how low-interest rates have fallen, it would nullify the effects of recasts.

My view on this point is that low rates will mitigate the effects but not so much because the main problems will be coming instead from negative home equity and the repayment of principal. Interest is just one small portion of the whole payment mechanics.

2. The second and more credible argument is that many of Option ARM homeowners will have defaulted long before the recasts. Payments reset occur after 5 years or when the debt grows to a preset amount typically 110 to 120 percent of the original principal. It is believed that almost 40% of these homeowners are already delinquent and many will start missing payments beforehand.

This is valid point and deserves some attention. If 40% of these homeowners are already delinquent, there's still 60% out there which have yet to go. It would also mean that the heavy blow up is sooner than we think it would be. Perhaps more towards a single peak rather than a double wave. Thus the peak would more probably happen in 2010 rather than 2011.

3. Alt-A comprises of people with better credit rating.

These are very much liar loans and just another nicer name for subprime in any case. These loans were made during a time when people are incentivised to lie about their credit score, have houses as proof of social status and when everyone else is doing the same thing. Nothing much you can argue about that.

4. US Government's effort to rework mortgages.

This is not going to have as much impact as many believe it to have. It is slow, inefficient, bureaucratic and mis-incentivised. In other words, you are not going to have a lot of bang for your buck in this programme.

5. These exotic loans are locality specific with a disproportionate amount coming from California

What these means is that not the entire banking industry and not all consumers will be dramatically affected. A dispropotionate few will be dramatically affected much more than others. This is where it gets scary, if the effects were to be spread out and the pain shared throughout an entire industry or country, it is still not so bad. However, if the effects were to be concentrated on one single area then we might actually see some interesting things.