Financial engineering?

Engineers are believed to be doing very well in financial services, especially in the areas of complex derivatives using Mathematical models.

Logically, the purpose of engineering should be either to increase returns for the investors or reduce the risk on investments. In many cases, exactly opposite happens. Either the investment returns go down or the risk goes up or both. Here is another such case that promised to offer both the promise of capital safety and higher returns. Read the article to know the final outcome. Those interested in further analysis, may also like this blog post by Joshua Brown, the reformed broker.

When there is excess money in hand and when the yields are low, very often investors chase yields – something that seems to be offering (promising) higher yields than available in the market is lapped up even by ignoring the risks involved.

Investors beware. Caveat emptor. Don’t invest in something you don’t understand.

When ignorance and excess liquidity meet, the results often are interesting case studies for future generations.

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Bold, confident and wrong … on forecasting and expertise

We wrote a full chapter on forecasting and expertise. It is human tendency to seek the knowledge of the future. It is good to know what can happen, but trying to find out exactly what would happen and exactly when is nothing short of day-dreaming.

Read the following article:

Bold, Confident and WRONG: Why You Should Ignore Expert Forecasts

In the context of investing, this is the biggest game being played – prediction of the market values. It is amazing how the game continues for so long in spite of the poor record of the forecasters.

It proves the popular saying wrong – “You can fool all of the people some of the time and some of the people all of the time, but you cannot fool all of the people all of the time.” Somehow the forecasters in the markets have been able to continue the game for so long. It is amazing that the tendency to know and profit from future is so strong that we ignore the track record of the forecasters.

So what do you do if you don’t know the future? Peter Bernstein’s line in the referred article says it all.

“That’s what diversification is for. It’s an explicit recognition of ignorance.” – Peter Bernstein

That’s it. Just stay diversified. It’s the best defence available for those who understand that they are ignorant.

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Financial illiteracy and overconfidence

“Mixing a decline of financial literacy with an increase in self-confidence is a toxic combination,” said John Howe, professor and chair of the Department of Finance in the Trulaske College of Business.

Essentially, the big problems that majority of people do not understand are:

  1. Ignorance about one’s own ignorance. We are often not aware of what we do not know.
  2. Assuming that expertise is fungible. It is assumed that expertise in one area is equivalent to expertise in another area – especially “management of personal finances”

Expertise or success in one area makes one confident and sometimes overconfident. Add a dose of ignorance to that and one does not even acknowledge that one could be ignorant in management of money.

Professor Howe further continues, “This opens the door for more honest mistakes as well as fraud. It’s widely known that older adults are very common victims of financial fraud. It’s important that as we age, we find someone who has our best interests in mind when managing our finances.”

Important to recognise our own inability, our own limitation and seek professional help.

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Knowledge of your ignorance

“Knowing that you know nothing makes you the smartest of all.” Said Socrates

See the similarity Our tweet dated 15th November 2015 from the book

Feel good.

The need for diversification

Why do we need to diversify?

Well, very often, people look at the performance of a diversified portfolio and compare it to one part of it. And obviously, at any point of time, the portfolio is going to underperform at least one part of itself – if it is diversified well enough. What gets discussed in public including media and what draws everyone’s attention is the winners – be it in real life or in investment markets.

However, this knowledge is available always in hindsight – after the event is over and not before. By the time someone acts on this knowledge, the gains are gone already and one ends up buying the investment at a high cost.

Many investors know that they are not the experts and hence they seek expert advice assuming that advice is equivalent to the ability to forecast. However, it is important to remember that “there are no experts, only varying degrees of expertise.” The track record of experts even in their field is very discouraging when it comes to prediction about the future. They are not even consistently wrong, just erratic.

If that is the case, what should one do?

“That’s what diversification is for. It’s an explicit recognition of ignorance.” – Peter Bernstein

Diversification is not just a recognition of ignorance, it is also a shield against one’s ignorance and stupidity.

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Who needs diversification?

“Wide diversification is only required when investors do not understand what they are doing.” – this quote is attributed to legendary investor Warren Buffett.

However, it is important to understand that Warren Buffett knows what he knows as well as what he does not know. Most of us are not Warren. Often, we are not even aware of what we do not know. In such a case, one needs to be careful.

The study of various episodes of boom and bust suggests that in the greed to make quick bucks, investors tend to concentrate their portfolios around recent period winners (stocks, sectors or markets that have seen major outperformance in the recent past). The subsequent direction of the markets in most episodes ended up with huge negative surprises and regrets.

Diversification may be boring in good times, but would be a prudent life-time strategy for most investors.

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Leverage is not always bad, after all …

The legendary investor Warren Buffett said, “When you combine ignorance and borrowed money, the consequences can get interesting.”

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