Investment versus Speculation

1
Investment versus Speculation

• Expected Return (value)
• The worst and the best outcomes
• The estimated probability

2
Definition of Investment

• Investment
• Speculation
• Gambling
• Game Theory Prisons dilemma Life is Beautiful
• St. Petersburg Paradox Flipping a fair coin
  until it comes up tails, and the total number of
  flips, n, determines the prize, which equals 2n.
• Pascals Wager To be or not to be
• Investment for lifetime and afterlife

3
Prisoner's Dilemma

• Tanya and Cinque have been arrested for robbing
  the Hibernia Savings Bank and placed in separate
  isolation cells.
• Both care much more about their personal freedom
  than about the welfare of their accomplice.
• A clever prosecutor makes the following offer to
  each

4

• "You may choose to confess or remain silent. If
  you confess and your accomplice remains silent I
  will drop all charges against you and use your
  testimony to ensure that your accomplice does
  serious time.
• Likewise, if your accomplice confesses while you
  remain silent, they will go free while you do the
  time.
• If you both confess I get two convictions, but
  I'll see to it that you both get early parole.
• If you both remain silent, I'll have to settle
  for token sentences on firearms possession
  charges.
• If you wish to confess, you must leave a note
  with the jailer before tomorrow morning."

5
The St. Petersburg Paradox
6
Pascals Wager

• It is possible that the God exists and it is
  possible that the God does not exist,
• If one believes in the God then if he exists then
  one receives an infinitely great reward and if he
  does not exist then one loses little or nothing,
• If one does not believe in the God then if he
  exists then one receives an infinitely great
  punishment and if he does not exist then one
  gains little or nothing,

7
The Utility in Pascals Wager

• It is better to either receive an infinitely
  great reward or lose little or nothing than it is
  to either receive an infinitely great punishment
  or gain little or nothing.
• How do you maximize your utility?
• Whats your choice?

8
Types of Traders

• Information asymmetry
• - Informed investors
• - Noise traders
• - Market makers
• Risk Characteristics
• - Speculators
• - Arbitrageurs (price-to-price or
  price-to-value)
• - Hedgers
• What else?

9
Speculative Factors

• The existence of speculative factors in
  common-stock holdings
• Whats the speculative factors?
• Unintelligent speculation
• Speculation when you think you are investing
• Speculation seriously instead of as a pastime
  when you lack proper knowledge or skill for it
• Risking more money in speculation than you can
  afford to lose

10
Beneficial Speculation

• Risk has a price Without speculation, untested
  new companies like eBay or Google would never be
  able to raise the necessary capital for
  expansion.
• Risk is exchanged but never is eliminated
  Whenever a stock is bought or sold, the buyer
  purchases the primary risk that this stock may go
  down while the seller still retains a residual
  risk, the chance that the stock he just sold may
  go up.
• Speculation induces frequent trading which, in
  turn, increases market liquidity.

11
The Myth of Stock Brokerage

• Whenever you trade, the brokers make
  moneywhether you did or did not.
• Day traders
• Marginal trades
• On-line trades
• Technical Analysts
• Stock fortune tellers

12
Factors Determining Stock Price

• Market interest rates there is no chance that
  market rates will be lower
• Expected earnings earnings are rising from the
  historical low level
• Market sentiment investors are pessimistic and
  no one would like to talk about stock markets
• Price is a function of market rates, expected
  earnings, and market sentiment.
• Whats the stock market condition in Taiwan?

13
Basic Valuation Model

• Price Function (value, market sentiment, luck)
• Function means probability
• Value
• Market sentiment is associated with mass
  psychology
• Luck is beyond humans control and is considered
  an error term

14
Return Anomalies

• Size effects
• Neglected effects
• Momentum effects
• Low price-to-earnings effect
• Low price-to-book effect
• Monday effects
• January effects

15
The Superinvestors of Graham-and-Doddsville by
Warren Buffett

• There is much inefficiency in the market
• Superinvestors exploit discrepancy between value
  and price
• Look for values with a significant margin of
  safety relative to prices
• Buying the business, not buying the stock

16
A Value-Oriented Winner

• Walter Schloss, a friend and classmate of Warren
  Buffett, has no connections or access to useful
  information.
• Practically no one in Wall Street knows him and
  he is not fed any idea.
• He looks up the numbers in the manuals and sends
  for the annual reports, and thats about it.
• Walter has diversified enormously, owning over
  100 stocks currently.
• He knows how to identify securities that sell at
  considerably less than their value to a private
  owner.
• And thats all he does.

17
Intellectual Origin

• A national coin-flopping contest by 225 million
  Americans or by 225 million orangutans
• How I turned a dollar into a million in twenty
  days working thirty seconds a morning?
• 215 egotistical orangutans with 20 straight
  winning flips
• 40 orangutans came from a particular zoo in Omaha
• Identify concentrations of unusual
  characteristics that might be casual factors

18
Possible Causes of Concentration

• Good luck
• Imitating the superior
• An enormous hereditary
• A common intellectual patriarch, Ben Graham
• Search for discrepancies between the value of a
  business and the price of small pieces of the
  business in the market with the efficient market
  theorists concern.

19
Possible Causes of Concentration

• Superinvestors do not discuss beta, the capital
  asset pricing model, covariance in returns among
  securities, or the stuff of chartists such as
  price, volume, seasonality, and size,
• but only focus on two variables,
• price and value.
• To man with a hammer, everything looks like a
  nail.

20
An Inoculation of Value Investment

• It is extraordinary to me that the idea of buying
  dollar bills for 40 cents takes immediately with
  people or it doesnt take at all.
• If it doesnt grab a person right away, I find
  that you can talk to him for years and show him
  records, and it doesnt make any difference. They
  just dont seem able to grasp the concept, simple
  as it is the discrepancy between value and
  price.
• Ive never seen anyone who became a gradual
  convert over a ten-year period to this approach.
  It doesnt seem to be a matter of IQ or academic
  training. Its instant recognition, or it is
  nothing.

21
A Herd on Wall Street and the Myth in Finance

• When the price of a stock can be influenced by a
  herd on Wall Street with prices set at the
  margin by the most emotional person, or the
  greediest person, or the most depressed person,
  it is hard to argue that the market always prices
  rationally.
• There seems to some perverse human characteristic
  that likes to make easy thing difficult.
• The academic world has actually backed away from
  the teaching of value investing over the last 30
  year.
• There will continue to be wide discrepancies
  between price and value in the market, and those
  who read their Graham Dodd will continue to
  prosper.

22
The Myth of Beta

• If a stock had declined even further to a price
  that make the valuation of 400 million instead
  of 800 million, it beta would have been greater
  given the market constant.
• To people who think beta measure risk, the
  cheaper price would have made this stock riskier.
• As a matter of fact, there is no risk in buying a
  group of such securities, that is, ten 80
  million piles for 40 million each.
• You dont try and buy business worth 83 million
  for 80 million because you cannot make a very
  close estimate about the intrinsic value and you
  should leave yourself a enormous margin of
  safety.

23
Berkshires Chairman Letter

• Berkshires annual report with the chairman
  letter written by Warren Buffett is sent to
  Berkshires shareholders every year.
• The chairman letters dated from 1977 to 2006 can
  be downloaded from the website of
  www.berkshirehathaway.com
• Berkshires chairman letters explain how Buffett
  invests and does business and reflect how Buffett
  views things in his unique approach.
• If you have two or three great ideas in your life
  and are able to effectively convert these ideas
  into actions, you would become a successful
  person.