SB Thoughts

International Investments are Risky?

2007-05-06T09:59:00.000-07:00

Most Americans, and even many financial advisors, would consider international investments inherently risky. While this may come from the nature of foreign laws being unpredictable and currency fluctuations, I feel that by their very nature having exposure to these securities makes an individual less exposed to risk.
First lets examine foreign legislative risk. While I may have more confidence in the US government than say the government of France, Spain or Japan, my faith in them is not absolute. They may very well seriously damage the business climate someday, and I am fairly certain the odds are better the US will greatly screw things up than France, Spain and Japan together. If all of my assets are in the US then I am doubly hurt. My investments will take a beating as will my career and income producing abilities. If in the unlikely event things get ugly here it will be nice to have a stake in strong foreign companies.
Second lets exam the currency fluctuation situation, it is very similar to the one discussed above. Changes in the relative value of the dollar can add to volatility in the performance of your foreign securities. Consider this though, if the dollar goes up your US assets and Income from your US job will also go up, and your foreign securities will be harmed. If the dollar weakens the opposite is true. So do these holdings add to the risk of dollar fluctuations? No, they in fact hedge against any potential movements, and if you had an equal interest both abroad and at home the movements of the dollar would mean nothing.

I am not saying that foreign securities are a solution for everyone, for example a retiree living in the US may not care what the dollar does against the yen because they will only ever need dollars. For a younger investor though it is crucial that they consider investments of this nature, especially when they consider how much they already have invested in the United States and that Diversification is the only free lunch.

An Investment Opportunity of the Future

2007-02-15T21:27:00.000-08:00

For those that are not following the antics of Huge Chavez he has been making a lot of changes in Venezuela.

1. He is now ruling by decree. The opposition party boycotted the recent elections and this allowed his party to get enough of a majority to grant him decree powers. He is also discussing removing term limits so that especially talented people, like himself, would not be forced from office.

2. He has been forcing foreign companies into either selling interest in their enterprises for cut rates. He is also strong arming Verizon out of its interest in CANTV the Venezuelan telecom.

3. He is instituting price controls. We all know how wonderfully those work out.

Some might argue this is a terrible thing. Since we cannot change this lets look on the bright side, after he has completed his Populist tear through the country it will offer some ripe deals for foreign investment. Just remember when Latin American countries are in a free market nationalization streak, it is often followed by harsh populism screwing business owners.

Gambling vs Investing and why Options are like Poker

2007-01-22T20:34:00.000-08:00

They say in poker that if you cannot spot the fish at the table, then you are the fish. In poker a fish is a bad player who loses money. This is not true in just poker, but in fact in many other zero-sum games.

A zero-sum is a situation where people compete against others and the amount the winners win is exactly equal to the amount the losers lose. This is not entirely true with poker though because the house takes a cut. As long as the house takes some amount of money from the pot, then the total of all of the money that the players walk away with will be less than the total they brought to the table. This means that in a poker game where all players have equal skill they can each expect to leave with less money than they walked in with.

The "good" cards are distributed randomly, so they increase the volatility of the winnings but not the expectation of winning before the game even begins. If the house rake is known, and the distribution of cards cannot be predicted, then the only way the players can leave with more money is to be more skilled than the other players. Not only do they have to be more skilled, but they have to have enough skill to overcome the other players AND the house edge.

Options are contracts that 2 parties enter into. One party buys the right to either buy or sell a given thing at a certain price (and pays a premium) and the other party sells the right that the first party bought (and receives the buyer's premium). Put in simple terms 2, A and B, enter into a contract over an item. If the value of that item goes up A pays B, if the value goes down B pays A.

Options share the same characteristics of poker. There are 3 components that define the volatility, skill and the transactional costs. I will discuss each of these in order.

The price of the items in question are very dependent on current events and politics. These current events, which cannot usually be accurately predicted, cause volatility. For this argument I am defining just those current events that cannot be predicted as volatility. Just like in the poker game though, since no one can predict if unknown events in the future will help or hurt their position, this volatility can be largely ignored.

Not all events are completely unpredictable. By studying history, economics, past market performance or even the stars, various people believe that they can draw insight into the future movements of the market. There are arguments that this is impossible, in which case volatility would just encompass skill as well for the purpose of my argument, but if markets are not purely efficient then there will be some people who can draw insights. This makes up the skill of the investors. Like poker it isn't how skilled you are that matters, but how your skill compares to the other players at the table.

The last factor is the house edge. In the options market these are transactional costs. Every trade you make the brokers will take a cut. How much doesn't really matter, as long as there are some transactional costs then the total amount of money that both people bring to the table will be less than the total they walk away with.

Options like poker are a zero sum game, the amount that one side of the option contract makes comes directly from the loss of the other side(minus a cut for the broker). This means, just as in poker, if all players are equally skilled then they will all be slight losers due to the broker's cut. There are many great reasons to use options, such as hedging against market movements, facilitating foreign trade and protecting business interests. These are not investments though, they are essentially insurance policies that are bought to protect against some loss and there should not be the intention of appreciation. The financial landscape is populated with hedge funds, PhD's from Harvard and men like Warren Buffet. Unless you can see the fish, and are able to enter into contracts only with those fish, then you are the fish and will be eaten alive.

If you want to have some fun, play poker or buy some options. If you want to hedge against some loss then options might be a good fit. If you want to invest in something with an expectation of appreciation rather than depreciation, then purchase stocks, bonds or property. These items do not operate on a zero-sum basis, and as the economy grows they have a good chance of indirectly growing with it. Focus on assets that have a history of growing in value and do not require a bet.

(Note: I am aware one person "writes" the option and receives money upfront and profits by it running out and the other has to wait for the option to be in the money, but that does not change the dynamics of a zero-sum game or the characteristics that I discussed)

How to win at Roulette, Craps and Blackjack!

2007-01-22T19:19:00.000-08:00

Yes it is true, there is a way to come out ahead at the casinos! All you have to know is the concept of utility, a little bit of statistics and like some sort of alcoholic beverage. Let us take Roulette for example.
Roulette has 18 red numbers, 18 black numbers and 2 0's. This means that there are a total of 38 numbers on the wheel. Since the house pays 1:1 for red/black bets and the true odds are 18:19 this means that 1 out of every 19 spins the house will beat us because we land on a 0 or 00. 1/19 = 5.26% this is referred to as the house edge. This means for every $100 you play the house will keep $5.26. The average roulette wheel is spun 45 times per hour and the standard minimum bet is $5. $5 x 45 spins = 225$ wagered per hour X 5.26% = $11.84 per hour to play roulette.
This is not so bad when you consider that if you spent this same hour watching a movie in a theatre with popcorn and soda would be about the same per hour, and driving around for fun(60 MPH * $.50 a mile = $30 an hour). So if we assign an equal amount of satisfaction(or utility) to these 3 activities then you can see that roulette is as much of a "win" as seeing a good movie. Plus you can drink free beer during Roulette.
Craps is an even cheaper date with a house edge of only 1.4% for an hourly cost of a $5 pass line bet being under $3. That is just about the cost of 2 premium beers, so if you drink 2 of those per hour you are breaking even.
Blackjack's probability varies depending on how close the player's betting is to the optimal strategy. Generally with decent play it will be between Craps and Roulette which means it still is a good deal.

If you use your head, make bets where the house has the smallest edge, and do not chase hunches it is very possible to use casinos as a heavily subsidized entertainment activity. Where else can you get free drinks, look at pretty girls and even rack up free comps towards meals and shows for less than $3 an hour?

On Risk/Reward Premium and Prime Bank Debentures

2007-01-22T18:36:00.000-08:00

I have a hobby of studying scams. Some of them range from the seemingly fairly obvious, such as a rich African dictator that needs MY help to hide millions, to the more sophisticated, like prime bank debentures. In the corners of the Internet there are rumors of certain investments that are only open to the very wealthy called Prime Bank Debentures. These are theoretically bonds that are issued by very secure foreign banks that you have to have $1,000,000 or so just to access, but by pooling smaller investors money together (much like a Unit Investment Trust) you can have access to these.
First lets discuss what a debenture is. Debentures are basically bonds that are not secured against specific assets. While this will make them less secure than loans against real estate or equipment, they are not as risky as completely unsecured debt such as credit cards. Since risk and reward are directly proportional along a fairly defined curve the expected return on a certain investment is fairly predictable once volatility is controlled for. This means that the interest payment on a debenture by a functioning business should probably be somewhere between risk-free debt (such as to the U.S. government) and very risky debt such as credit cards.
This gives us a range of 4.5% to about 30% for credit cards in default. This is an annual percentage. These charlatans claim they will pay 1% a day, or perhaps for the less aggressive a mean 10% a month. This means their annual rates will exceed 100%, or perhaps even a multiple of that. This leaves us with a few questions:

1. Why would a reputable foreign bank with no risk of default need to issue debt that costs them more than 3 times per year as much as a credit card holder in default?

2. If for some odd reason a prime bank did decide to issue debt like this, why would there not be vehicles like Unit Investment Trusts that openly and transparently capitalize on these great deals.

3. If the deal is really so great, why does the salesman need your money for it? If the salesman was to only have $1,000 to invest at a measly 150% interest rate, in 5 years he would have $97,000 and in 10 over $9,500,000. For that type of money I would be real quiet about the great deal and work a second shift at McDonald's to free up money to invest.

These have also supposedly been around since at least WWII. If only 1 person had put a single dollar in one of these and let it grow since 1957 his account would be worth $78,886,090,522,101,180,000.00. This is more than 100,000 times greater than the US national GDP. Even the richest Prime Bank couldn't dent this sum.

Look at this graph again, and remember it whenever anyone is pitching some exotic investment to you. Whether it is penny stocks, prime bank debentures, or High Yield Investment Programs if the returns they are promising fall outside of the 4.5%(risk free) - 30% (Very Risky) curve, then it is almost certainly too good to be true.