Galilean moons

When I was a kid, I dreamed of seeing the four moons of Jupiter, just as Galileo did 400 years ago. I always wonder what Galileo was thinking when he looked at Jupiter's moons at night. Did he realize that he is the first one spotting some little secrets of the universe? Did he ever doubt what he found out?

But, the price of a decent telescope was kind of an astronomical number for my family and I never thought of owning one.

Last Christmas, I bought my son a telescope and my daughter a microscope. For the first time in their life, they can see the moons rotating around Jupiter and the cells underpinning the life on the Earth. To my disappointment,  they don't seem to be impressed. I hope they would remember such a moment someday.

Human brain can only intuitively understand a very narrow spectrum in terms of space and time because it's been evolved in such environment. The imagination of nature is far, far greater than the imagination of man. It is science that broadens our understanding of the universe. Scientific thinking should be a way of life for anyone living in the new millennium.

The value of Science by Richard Feynman 

I stand at the seashore, alone, and start to think.

There are the rushing waves

mountains of molecules

each stupidly minding its own business

trillions apart

yet forming white surf in unison.

Ages on ages

before any eyes could see

year after year

thunderously pounding the shore as now.

For whom, for what?

On a dead planet

with no life to entertain.

Never at rest

tortured by energy

wasted prodigiously by the sun

poured into space.

A mite makes the sea roar.

Deep in the sea

all molecules repeat

the patterns of one another

till complex new ones are formed.

They make others like themselves

and a new dance starts.

Growing in size and complexity

living things

masses of atoms

DNA, protein

dancing a pattern ever more intricate.

Out of the cradle

onto dry land

here it is

standing:

atoms with consciousness;

matter with curiosity.

Stands at the sea,

wonders at wondering: I

a universe of atoms

an atom in the universe.

Think differently

There was a big drawdown in my portfolio last month. The analytical part of my brain tells me it's fine and keep calm, but all indicators suggest that my stress level is shooting up: My shoulder muscle stiffens. Small things start to irritate me. Worst of all, I cannot help yelling at kids, the last thing I want to do in my life!

To help myself cope with stress, I devise a different way of thinking market movement.

Most investors would probably love it if time travel were possible. If we think the market movement not in terms of price but time, price fluctuation is exactly equivalent to time travel.

For example, the market bottom in March, 2009 just offers us a rare chance back to 1996. As long as we don't believe the world will be stuck in 1996 forever, we should probably buy some stocks before we're back to future again.

People often talk about 1987 Black Monday, the largest single daily loss, as a 6-sigma event. But, if we think it in terms of time travel, we're just visiting a year ago briefly. It just sent the market back to the beginning of 1987. The market ended at almost identical level at the end of 1987, which is a tremulous in term of price movement but a boring and uneventful year in the eyes of time traveller.

Most of market drops or rises just move our fortunes back and forth a few months or years. Another way to comprehend (cope with) the changes of fortune is to think, we're just as poor/rich as a few months and years ago. We probably haven't changed our lifestyle during the same periods. So, why bother to worry that much?

If we always make long term investment decisions (>10~30 yrs), our decisions to long the market a month ago should still be valid when market fluctuation move us back a few months. If the decision is truly long term and correct, we should buy more rather than feel stressed out when the market is dropping.

Anyway, the new thinking gives me a different perspective of market movement and sometime remind me of rare chances to seize lost opportunities or correct past mistakes.

A costly mistake

I haven't changed my investment strategy since May, 2009. The economic has been undergoing slow but steady recovery, and so has stock market. All serve me well so far.

However, the stock market went up too fast and too much recently, and some of my portfolio almost doubled in the past year. I became uncomfortable and extremely nervous recently. When I woke up last Thursday, somehow, I decided to sell most of my positions for the first time in more than 4 years.

The market kept going up, and I find that the opportunity loss is as real and painful for me as any investment loss. I kept asking myself, have I changed my view on long term economic outlook? is my current investment strategy fundamentally flawed? If so, what're these flaws and what're the alternatives? I couldn't give myself satisfactory answers. Another voice kept telling me to revert to status quo unless I can have new evidences and/or point out the problems in my previous strategy. After an agonizing week,  I restored my positions. This incident cost me about $60~70K, an expensive tuition! What have I learned from the mistake?

The week before last, my anxiety reached record level just as stock market is melting up. Last Tuesday, I came across a Chinese news story : A fisherman went fishing as usual and had no idea that an upstream dam was scheduled to open its gate to relieve flood pressure. The man saw the river rose slowly but took no action. When he found that he had to escape at any costs, it's already too late. He was swept away and drown immediately. My first reaction is that people tend not to see gradual change and thumb-suck till it's too late. The story was fomenting vividly in my mind ever since. I couldn't stop asking myself whether I was doing the same thing. This eventually triggers the selling of my positions. I myself was surprised that a single picture could have such an impact on my decision making.

My theory is, the part of brain responsible for logic thinking and reasoning can often see the opposite arguments from both sides and result in analysis paralysis. Most of our everyday actions are actually executed sub-conscientiously by fight-or-flight mechanism and they are usually driven by emotion. This part of brain directly responds to the raw inputs and makes rule-of-thumb quick decisions. It's very quick and decisive but usually lack of deep analysis.

Evolution selects two seemingly conflicting mechanisms because we need both to survive. I think we need to primarily rely on the analytical part to guide our investment decisions because investment is inherently long term and non-linear.  Our long term investment strategy shouldn't be controlled by emotion.

To overcome the bias, I decide to slow down my decision making. Though I shall continuously take new data and facts into considerations, I shall not change my overall strategy lightly. The strategy change must be driven only by business cycle or my lifestyle change. It shouldn't happen more often than once in a decade.

I shall not make portfolio changes more often than once in a year. When I do decide to trade, I must be able to elaborate pros and cons of the transaction. I shall write it down and tell my wife, and then put it aside for a few weeks before execution. A good investment decision shall not be easily swayed by my own mood, refuted by my wife, or affected by events in the next few weeks or months.

Beat the market

                   大智若愚 -- The great wisdom may seem dumb.

                   大道至简 -- The ultimate sophistication is simplicity.

When investing, people tend to think of buying and selling. For each trade, they have to answer at least 3 questions correctly in order to make profit:

1. What to buy?
2. When to buy?
3. When to sell?

They have to repeat the process for their lifetime to become very successful investors. Most of so-called value investors are mainly focused on the first questions, and market timers/speculators may develop lots of theories to address the 2nd and 3rd questions.

Such trading mentality could be harmful to investing. I would argue that the most important investing decision is actually "How long should I hold my investment?" Once the issue gets resolved, the rest of investment questions become secondary and can be answered easily.

To see why, let's look at the Probability Density Function (PDF) of S&P 500 daily returns for the holding period of one trading day:

The probability distribution of returns seem pretty random. People may say the market's efficient because it's very hard for anyone to consistently pick positive days and avoid negative days. If we increase holding periods (in trading days), the expected normalized daily returns (geometric mean) don't change too much but the shapes of the corresponding PDFs change significantly:

If we put all PDFs across all holding periods (delta T) together, we get a return surface showing how normalized daily return's distributed: it spreads over a wide range of positive and negative values when holding periods are short, and the distribution becomes very concentrated when holding periods are long. If holding periods are longer than 10 years, you're almost certain to get non-negative returns.

An average investor has10,000~15,000 (trading) days to act. If we represent it by a line of 10,000~15,000 day long, what investors do in their lifetime is to break the line into small pieces and  place them onto the return surface. A successful life-long investment is to put more pieces on the positive side than negative side. At the first glance of equity return surface, it should be immediately obvious why long term indexing makes sense. No modern financial theories or complex arguments are required to see the insight.

It's hard to identify good stocks, and it's even harder to time the market. I don't believe that I have any inherent advantages over other market participants. I doubt my ability to identify good investments and make profitable trades consistently. I know my mind will degrade due to aging and my experience may become less relevant due to unforeseeable paradigm shifts. In a word, the more investment decisions I have to make, the more likely the distribution of my investments will spread on the return surface randomly.

Therefore, my investment strategy shall NOT depend on my ability of being an outliner. To ensure all my investments stay on the positive side on the return surface is to make as few decisions as possible. The single most important investment decision I'll make is to decide the holding periods of my investments. If my holding periods are very long (forever), it almost guarantees that my investments will always yield positively, actually historical data suggests close to 100% if holding periods are > 20 yrs.

If returns are always positive, leverage will magnify them in my favor. It's just simple math, no complex concepts or fancy theories. So, the second investment decision I'll make is the leverage.

Once I decide that I should hold my investment forever (forever ~= lifetime), I can settle the 3 trading questions once for all:

1. What to buy? -> The Market - Because it's the only investment vehicle that may last for my lifetime. 
2. When to buy? -> Whenever I have cash available for investing.
3. When to sell? -> Never.

The decision on holding periods also gives me different perspective. I no longer value my investment in dollars but in the shares of total market. The fluctuation of the dollar denominated value of my portfolio no longer bothers me because I'm gonna to hold them forever and the real goal of my investment is to increase its shares relative to total market value not to worry its daily movements in terms of dollar denominated value.

In summary, my investment is guided by Principle of Least Actions:-) minimize the number of decisions I have to make for my lifetime. The only trick I will use to beat the market is leverage, nothing else. To translate the principle into everyday practice, I will:

1. Keep buying broad-based index ETFs/funds tracking productive assets such as S&P 500 and hold them forever. 
2. Control one and only one parameter, leverage ratio. Roughly speaking, 2~3x when I'm young  and ~1 when my salary no longer matters. I may go beyond the range under extreme market conditions, e.g. market crashes or melt-ups. But, extreme conditions don't happen often and I shall make no more than 2~3 leverage change decisions for my whole lifetime. I already made one in May 2009, so I have at most 2 major leverage decisions left.
3. Live modestly relative to my net worth. For example, consume no more than 1~2% of my investment (~ dividends of S&P 500). Find a job to cover the cost and/or lower my living expense if the returns on investment are not enough to sustain my current lifestyle. Retire when my W2 no longer makes difference.

Based on historical S&P data, people born around 1930s, e.g. Warren Buffet, only need to correctly adjust leverage ratios 2 or 3 times to beat Warren Buffet. In another word, if we have 8 monkeys and instruct them to toss a fair coin to adjust leverages once every 10~20 years, there will be one monkey who can beat or match Warren Buffet and his Superinvestors of Graham-and-Doddsville. If the monkeys don't bother to become legendary investors, they just need to maintain a constant leverage and easily beat the market for doing nothing*.

S&P 500 Relatively Returns

S&P 500 Accumulative Returns (1950 == 1)

* A monkey's born in the same year as Warren Buffet can outperform the market for each and every day since 1950 if he maintains a constant leverage. 

* Rule #3 is key to survive downturns like 1975, 1987, 2001, and 2009.

The empirical data and simple math may be assuring to someone, but there simply aren't enough historical data to prove anything+. Therefore, the hardest part to implement this strategy is the capacity to do nothing: I have to resist the temptation to react to day-to-day events.  I have to live in a world full of fear, doubt, and uncertainty, and commit to something long before I can see the final result.

* Maintaining a constant leverage ratio could be viewed as an extension of Kelly Criterion, a strategy trying to maximize accumulated return while avoiding gambler's ruin. The following book gives a detailed discussion on the relevant theories and practices:

https://www.amazon.com/KELLY-CAPITAL-GROWTH-INVESTMENT-CRITERION/dp/9814383139

Fear and uncertainty

Doubt is not a pleasant condition, but certainty is absurd. -- Voltaire

There are lots of talks about euro debt crisis and double-dip recession recently. I can sense the growing fear and uncertainty in the market. It may be the worst year since 2008~2009. 

I think, most of time, investment is to deal with fear and uncertainty. If you're used to uncertainty and this may be a good time to invest. I did try to increase long positions, but I kind of run out of money and hit the upper limit of leverage I can tolerate.

I try to spend all of my time with family and kids. I should focus on living and enjoying my everyday life and  and don't pay too much attention to the market. However, the overall economic and market can still drag my mind out of my daily activities. Perhaps, a good investor is always someone like a Zen master.

There is an old Chinese saying: 无欲则刚, meaning you become tough when you no longer have earthy desire. It may be a paradox for investors because investors have inherent earthy desires: maximizing their returns :-)

一塊紅布

It's been 20 years since 1989 Tiananmen Square Protest. I still vividly remembered sounds and images on CCTV during those days and nights. Even today, I cannot describe my feeling and its impact on me in words.

Scary time

Our family often eat at Souplantation at Cupertino during weekends.  It used to be a crowded place on Friday night, but it has only a couple of guests today.

People seem really really scared!

The world is rapidly de-leveraging.  Millions have lost their jobs and more layoffs are expected. People are comparing this crash with Great Depression. Both our house and savings in 401k account lost about half their values. President Obama came out and tried to assure American public, but the market kept going down. Mass media are indulged in downward feeding frenzy. It looks like we're seeing the end of capitalism and western civilization.

However, I think my employer (a major tech company) should survive this crash and my job should be safe. Major tech companies may emerge from the downturn better than others because the recession should weed out their relatively weak competitors. I hope my job is safe. A stable income covering everyday living expense is probably the biggest asset I have for now.

I think I should put all of my money into stock market and leverage as much as possible.  I couldn't sell my house because it's barely above water, and no one would buy it anyway. The only good thing is, I still have a Line Of Credit opened before the crash. I think I should take it out, move all money to stock, and leverage as much as possible. I think I'm screwed if Bank of America goes bankrupt and withdraws the LOC.

But, I have been thumb-sucking for a couple of weeks and I'm too petrified to take action. “Be Fearful When Others Are Greedy and Greedy When Others Are Fearful” -- It's easier to be said than to be done.

I'm just 35 and I don't mind of working for another 20~30 years. But, if I'm wrong, I'll commit my family to huge loss and hardship. They will have to suffer together with me because of my decision. The fear and potential guilty is almost unbearable.

Somehow, I think I have to act. When people say "It's once-in-a-lifetime crisis", it also implies "It's once-in-a-lifetime opportunity" for someone who can foresee the future and seize the moment. I don't know how much worse it has to go before it becomes better. But, as long as I believe the earth will keep spinning, the sun will keep coming out. I don't know how long it will take to recover, but I just need to believe it will.