Financial Intelligence Personal Finances

1
Financial Intelligence Personal Finances
Investing 101

• Bob Y. Chan
• Outline for talk 5
• November 6, 2003

2
Synopsis of last talk

• A brief introduction to security analysis
• Fashion is the great governor of this world
• Firm foundations of stock value

3
Outline for Talk 5

• Efficient markets what does it mean?
• Setting your investment objective
• Trend followers vs. contrarians
• Diversify, diversify, diversify

4
What we know about capital markets

• How accurate knowledge plays depends on what
  time horizon we are looking at
• Over long period, market would follow laws of
  economics (and physics!)
• Within short period, there can be wide and
  erratic swings (because human psychology plays a
  role)

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If so, can we predict the future?

• Depends how efficient is the market
• If the market is efficient, information gets
  reflected in prices fairly quickly
• If there is any pattern in the arrival of
  information, even pattern is reflected
• Hence only new information moves prices

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Can we predict the future? (cont.)

• New information arrives randomly
• Therefore prices would follow a random walk

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Random walk

• Implications
• Prices are good indicators of value
• The past cannot predict the future
• Prices follow a random walk
• Is it true?

8
Random walk (cont.)

• In the last 30 years, thousands of studies had
  been done on this subject
• Basically the answer is mostly yes
• Especially, you cannot use the past to predict
  the future
• This is particularly true when we look at very
  short time horizon

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Random walk (cont.)

• However, over the medium to long term, prices
  tend to go back to basics (economics, accounting
  information, etc.)
• Also the property of mean reversion that
  prices tend to swing back to a long run
  equilibrium level
• With derivatives, swings in asset prices
  appears to be more frequent and wider

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Random walk (cont.)

• Conclusion even with random walk (i.e.,
  efficient capital markets), you can plan your
  investment well and go well
• Set your own rule and follow the rule consistently

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Setting investment objective

• Actually, what do you want?
• How much risk can you take?
• For how long are you investing?

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What do you want?

• Many people starts with unrealistic objectives
  and later lose interest
• Most investors cannot consistently beat the
  market
• However, you dont need to beat the market!
• Maybe just to be the market is good enough!

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What do you want? (cont.)

• Performance
• Consider the return to the total amount invested
• to get 10 is not difficult
• To get 15 is about what the stock market
  generally makes
• To get 20 is a lot (and youll be very rich if
  you can do it over and over!)

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How much risk?

• Even good companies see stock price going down
• There are all kinds of reasons why stock price
  moves up and down (and sometimes there is no
  reason at all!)
• Be prepared to take risk, and set the amount you
  can tolerate, i.e., the lower limit of return you
  can still sleep well

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How much risk? (cont.)

• Learn to cut loss -- set discipline to stop loss
  at a certain level
• Say, if stock price drops by 15, sell
• In reality, very very difficult to do!

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What is your investment horizon?

• Which analytical tool you use depends on how long
  you would hold the investment
• The longer the time period, the more important is
  economic fundamental
• In very short time frame, maybe technical
  analysis is the more effective tool

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The Life Cycle of Investing

• Note that all three issues (objective, risk, and
  time horizon) depends on your age
• 20 30 (young)
• Have little to invest
• Have nothing to fear
• Have energy to work long hours and under stress
• Can start from scratch as long as it is not
  negative
• Can take on high risk investments

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Life Cycle of Investing (cont.)

• 30 40 (still young)
• Building up career have more income
• Takes on more expenses (family, property, etc.)
• Starts to build more clear investment pattern
• Should plan to build portfolio of various asset
  types
• Should include longer term investments and
  insurance

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Life Cycle of Investing (cont.)

• 40 50 (hardly young)
• Should reach a high level of income
• Retirement is near, and should be concerned!
• Should be more experienced and focus on 1-2
  personal best investment according to
  circumstances

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Life Cycle of Investing (cont.)

• 50 60 (missing young)
• Highest level of income
• Approach stable cash flow position
• Actively planning for retirement
• Shift to financial security as main concern

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Technical analysis a brief note

• Consider the demand / supply mechanics in capital
  market
• Do not look at underlying economic fundamentals
• Look for signs or signals
• Do not try to maximize profit
• Mainly shoot for short period of time

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Technical analysis theory

• Prices set by collective behavior
• Takes time to build some trend
• When built, trend to last for some time
• Trends might be rational or irrational, so why
  bother?
• Consider the fly model of technical analysis
  look for the sign, not the fly

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The Dow Theory

• The grandfather model of technical analysis
• Look at the price charts (hence chartist)
• Consider
• More people want to buy price goes up
• More people want to sell price goes down
• Collective action / consensus make go through
  turns

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The Dow Theory (cont.)

• Individual investors do not necessarily observe
  the big picture
• Picture shown in the price chart
• Support level that the down turn is being
  tested
• Resistance level that the up trend is being
  tested

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The Dow Theory (cont.)

• The theory if the price has risen beyond the
  previous high (resistance), it would likely
  continue to rise if the price has dropped beyond
  the previous low, ir would likely continue to
  decline
• Implication the previous high and low forms the
  resistance and support or the range the shows
  collective view on price

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The Dow Theory (cont.)

• Trading strategy (one example)
• buy if the price is near the support
• if it breaks the support, sell to cut loss
• Hold until the price is near the resistance
• Buy if the resistance has been broken

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The Dow Theory (cont.)

• Since the Dow Theory, there have been many
  different versions of technical analysis
• Some are very complicated
• Some work with statistical benchmark like
  moving averages (MAs), relative strength index
  (RSI), etc.
• However, there is no study that shows any one
  works consistently in all situations

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Trend followers vs. contrarians

• Most technical analysis strategies look for
  trends
• Assumes that history would repeat in the same
  direction
• Another group of investor look for the opposite
  direction most people lose money in the casino!

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Trend followers vs. contrarians (cont.)

• Contrarians take contrary view vs. popular
  belief
• Believe that the world moves in swings
• Unpopular (i.e., likely to be against the market)
• However, if they win, might win big!
• Buy when everyone fears sell when everyone crazes

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Diversify, diversify, diversify

• Dont put all the eggs in the same basket
• Look for mix in your portfolio
• Different risk property
• Different time horizon
• Different geographic location
• Different sectors
• Different companies

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Diversify, diversify, diversify (cont.)

• Diversification is the most important concept in
  modern investment
• When combine different assets in the portfolio,
  part of the risk cancels out
• Parkn Shop vs. Wellcome it could be difficult
  to predict whether Parkn Shop would beat
  Wellcome in the next year, but people still need
  to buy food!

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Diversify, diversify, diversify (cont.)

• If you buy both Parkn Shop and Wellcome, dont
  need to worry who comes up better
• What you buy is the general outlook of the
  supermarket industry
• Through buying more stocks, you cancel out more
  and more risk elements
• Hence can control your risk to a level you feel
  confortable