Wednesday, December 05, 2018

The problem of Financial Pornography

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You encounter quite a bit of financial pornography once you are engaged with folks in the fund management industry. Imagine how hard it would be to peddle funds that return 7% a year. I can imagine the pressure for folks in the financial industry to tout returns north of 20%.

I do my level best to avoid engaging in financial pornography but it's not as easy as it sounds once you start to conduct some investment training of your own.

In my latest class, one of my strategies "unfortunately" backtested 21% returns with a semi-variance of 10%. In this same period if you bought every stock in Singapore in equal proportions you would have only made about 8% with a higher semi-variance of around 12%.  

If I present these numbers to the public, it is pretty reasonable to say that given that the backtest covered the recovery from 2007-2009, returns moving forward may, perhaps, not be as fantastic as the tests indicate. 

This is how, I think, a reasonable trainer should present his results. 

The problem arises when you also teach leverage in the same course.

With an equity multiplier of 2 and lending fees of 3%, you may be looking at returns of 21 x 2 - 3 or 39% a year. If you put $30,000 a year into this leverage portfolio and assume the same historical returns, you will have close half a million within 6 years. Enough for a single person to generate dividends to cover basic expenses at the end of the period.

It does not take a genius to figure out that the strategy on hindsight, could have made someone fabulously rich within a ridiculously short period of time, so I have some kind of ethical dilemma in my hands - the last thing I want is to over-excite my own students.

I don't think my solution to resolve this ethical dilemma is the best one. You can't avoid the truth once you learn a bit of simple mathematics and do some basic sums of your own.

This is how I resolve the problem :

I have to manage the expectations of my students and have them realise that money making is not as easy as just deploying a quantitative model and then leveraging it. 

Instead of using these backtested models, I get the students to focus on dividend yields. In this case, my portfolio has a forward yield estimate of  a relatively conservative 7.31%. Leveraged, it returns 7.31% x 2 - 3% or 11.62%. High but definitely not pornographic material but still plenty of good stuff to look forward to. 

Using this lower number, a consistent $30,000 contribution will still allow someone to have close to half a million within decade.

This is possibly the reason why I am so eager to invest in the portfolio my class has built. At the back of my head, once I considered all the risks, it is a pretty solid selection of counters such that even without even accounting for capital gains, I would sitting pretty on gains in the future. 

While quantitative investors do not really abide by the "margin of safety" principle, by assuming dividend yields to be the only returns for this portfolio, I am, in essence, doing my best to limit the downside of this portfolio.

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