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The Top Ten Greatest Investment Books of All Time

December 16, 2016 By Murray Williams Leave a Comment

Here is my personal ranking of the greatest investment books of all time. Investors cannot go wrong with any of these titles.

1. The Intelligent Investor by Benjamin Graham

This is hands down the greatest investment book ever written. Warren Buffett considers it his investment bible. Enough said. Mr. Graham’s explanation of stock quotations being more like a popularity contest than a fair valuation of a business is right on. His analogy of Mr. Market and how the price he quotes can be either rational or irrational is exceptionally poignant. The chapters on Market Fluctuations and Margin of Safety are the absolute gems of this work and should be read by every student of finance and investor who puts money in the markets.

2. Security Analysis by Benjamin Graham and David Dodd

A more comprehensive volume of the same topics and points made in the Intelligent Investor, which is simply a more condensed version of this book. This work is ambitious and covers in more detail bonds as well as other instruments such as warrants and convertibles. Financial analysts should read as much of this book as they possibly can.

3. Margin of Safety by Seth Klarman

Quite frankly I think this book is in many ways even better than the Intelligent Investor and I would have put it number one if not for the fact that it is out of print and copies are so difficult to find. This is the most logical and informative investment work ever written. If you are fortunate enough to come across a copy of this rare treasure you will agree with me.

4. One Up on Wall Street by Peter Lynch

Quite possibly the best pure stock picking book ever written. Mr. Lynch transformed Fidelity’s Magellan fund into a juggernaut using the principles contained in this work. His insight on using common sense to identify businesses in your area of expertise and how anyone can use their own knowledge and competence to find great investment opportunities was solid gold. His chapter on finding the tenbagger was the crown jewel of this work, which was the first time the term was ever coined.

5. Market Wizards by Jack Schwager

More of a trading book than an investment book, this unique volume has unparalleled insights into managing risk, particularly in finding deals where the trader has a favorable risk to reward ratio. If you always enter trades where your downside is limited and upside unlimited, you cannot go wrong in the long run. Mr. Schwager’s interviews with Ed Seykota and Larry Hite were some of the best commentaries on trading, investing, and risk I’ve ever come across. Every investor should read at least those two chapters. They are absolute gems.

6. A Random Walk Down Wall Street by Burton Malkiel

This book quite simply launched the index fund revolution. A contemporary classic, this work contains many insights on the Efficient Market Hypothesis (EMS). If you want to engage in the argument for or against buying stock index funds, you should definitely read this cover to cover. The randomness of stock prices is a subject that should be studied by every student of finance.

7. Common Stock and Uncommon Profits by Philip Fisher

A true investment classic in the sense of the word, this book’s greatest contribution to investment literature is how to evaluate the management of a company. Leadership at the top of a company can make or break it, even if it commands a strategic advantage over its competitors. History has shown that a leadership change at the top of a troubled company can completely change its fortunes in a short period of time.

8. How to Make Money in Stocks by William O’Neill

Different from the other investing books on this list, this book covers how to invest in growth companies, which is something that value investors such as Benjamin Graham just haven’t effectively addressed. The fact is, the most successful companies hardly ever trade at a discount to book value or sub working capital, but that doesn’t mean they should be avoided. This book contains ideas that every investor should consider and contemplate upon.

9. Reminiscences of a Stock Operator by Edwin Lefevre

By far the most entertaining read on this list. This is definitely not an investment book, but an abridged autobiography of the greatest speculator of all time, Jesse Livermore. Named the Great Bear of Wall Street, Mr. Livermore shorted the stock market in 1929 and made an estimated $100 million doing so. In today’s dollars, that is a few billion. Every novice and seasoned trader should read this and even non-speculator types will find it valuable especially when it comes to getting good executions on trades. The boy plunger was definitely the greatest speculator who ever lived. He made and lost millions.

10. Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay

Before the term behavioral finance was coined, there was this book. First published in 1841, yes that’s not a typo, this book contains the complete histories of the greatest speculative bubbles up until that time, including the South Sea bubble and Tulipmania. Sir Isaac Newton lost a fortune speculating in the South Sea company, which he alluded to frequently in his writings. Tulipmania was a phenomenon in Holland where people paid ungodly sums of money for rare tulip bulbs. Prices eventually crashed. This book is a primer on the greater fool theory, which every sensible investor should be versed on. Identifying and avoiding speculative manias will save many an investor their fortunes.

Don’t agree with this list? Let me know.

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Stock Fund Folly: Debunking the Efficient Market Hypothesis

August 26, 2016 By Murray Williams Leave a Comment

MUTUAL_FUNDs1

The Efficient Market Hypothesis (EMH) has been around for more than 50 years. Academics and investors alike have differed on its merits, and many financial organizations have built their businesses based solely on this theory. Index fund and ETF companies in particular have profited handsomely over the years from the proliferation of this idea. But does indexing really benefit investors?

For those unfamiliar, the EMH claims that since markets are efficient, share prices will always reflect underlying value accurately. In other words, it is no use making any value judgments of equities since the current price is already reflecting all information about the company and discounting its future earnings. It claims that fundamental and technical analysis of equities is useless and that investors would be better off if they just bought a fund that mirrored an index since its transaction costs are less. It concludes that active stock investing is no more effective than picking stocks at random.

Do stock funds as a whole beat the market averages? The answer is no they don’t. But this may not necessarily be an indictment of active versus passive investing, but more a problem with the stock fund paradigm itself. Stock mutual funds and exchange traded funds tend to be broadly diversified and I will postulate that this is more of a detriment than a benefit. When the entire stock fund universe is compared with the market averages the return is a few percentage points less. This slight under-performance is most likely due to increased transaction costs rather than poor stock picking skills. It does not prove that random stock selection is better than judgment based selection. This is where their reasoning falls apart. Proponents incorrectly assume that the slight under-performance of actively managed stock funds points to the superiority of passive index investing over any other approach. But the reality is that this anomaly exposes the mediocrity of both index funds and actively managed stock funds. It simply proves that too much diversification causes average results. The reason why actively managed stock funds seldom beat the averages is because of over-diversification and because they must buy high and sell low.

Think about it. The more a stock fund diversifies its holdings the more its results will mirror the averages. Broad diversification also eliminates any advantage a skilled manager brings to the table. A minimum amount of diversification is both necessary and wise to reduce risk, but too much is a recipe for mediocrity. There comes a point of diminishing returns whereby superior performance becomes merely average.

The question we should be asking is can managers who invest in multiple asset classes of their own choosing beat the stock market averages? The answer is a resounding yes. We know this because it has been done. The fact remains that many managers including Warren Buffett, Ray Dalio, Seth Klarman and others have indeed performed this feat. Proponents of efficient markets argue that these managers are simply outliers and that the general theory is sound. I would argue that the EMH only applies to stock fund managers. In other words, efficient market theorists are correct when they claim managed mutual funds will be at a slight disadvantage to index funds, but they are incorrect when they assume that index fund investing achieves better results than concentrated stock portfolios or multiple asset class managers. Balanced investors can not only beat the market averages, but the odds are significantly in their favor.

This has more to do with the constraints placed on stock fund managers rather than their investing acumen. New money coming into the fund has to be invested in equities. The manager has no choice, even at the height of a bull market when stocks are trading at high valuations. Likewise, at the bottom of a bear market when there are a lot of redemption requests, he has to sell to meet the withdrawal demand. He has no choice. By nature of the beast he has to buy high and sell low. This is magnified even further during times of extreme euphoria or despair. This explains why stock funds tend to mirror the market averages.

Stock fund managers also have concentration constraints. In many cases they cannot have more than 2% of their assets in any one company. Even if they come across an opportunity where an excellent company is available at an attractive price, they won’t be able to take advantage of it if they are fully invested.

On the other hand, the balanced fund manager who can buy any asset class he chooses has a lot more leeway. At the height of a bull market he doesn’t have to put new money into stocks, he can buy bonds or just park it in cash. Likewise, at the bottom of a bear market with a lot of redemptions pending he doesn’t have to sell stocks. He can liquidate a portion of his bond portfolio instead. The balanced fund manager can really buy low and sell high.

Broadly diversified stock funds generally do no worse or better than the market averages. Over time they will more than likely mirror the averages minus transaction costs of course. I feel a little sorry for stock fund managers whose performance is constantly scrutinized and compared with the market averages. If they have a bad year they will be replaced even though their stock picks were sound for the most part.

Another incorrect assumption promoted by the efficient market theory is that fundamental analysis is of no value whatsoever and that everyone should just buy an index fund and go on vacation. I challenge this notion. Again, the theory postulates that managers who pick stocks using research and judgment can do no better than stocks picked at random or a chimpanzee who just throws darts at the financial pages. This is flagrantly false.

Let’s take a hypothetical example. Suppose you have two companies who engage in the same business. A commodity wholesaler for instance. They sell the same commodity to the same geographic market. But one company has a 90% debt to equity ratio and the other has only a 10% debt to equity ratio. Which company will fare better over time? All things being equal, the company with less debt will do better. Of course in practice all things are not equal, but you get the idea. Fundamental analysis can make a difference especially when there are glaring and obvious discrepancies.

Indexing itself may not be the miracle investing strategy that its proponents claim. Maybe at first it was, especially in the 1970s when few people were doing it. But like other investing schemes of the past, the more people who engage in it the less effective it becomes. Take the S&P 500 for example. It is the most indexed group of stocks in the entire world. People who buy into an index fund that mirrors the S&P 500 live and die by the stocks in that index. A company that gets promoted by Standard & Poors into the index will get an immediate bump in their share price. All the index funds in existence will suddenly buy this stock. Therefore, the more index funds there are in relation to other stock funds, the more overvalued the index tends to be. Likewise, if a stock gets demoted from the index it will take a hit, and the more it is indexed the bigger the hit will be.

At the height of a bull market S&P 500 stocks tend to be more overvalued than lower-cap stocks. This is primarily due to the proliferation of indexing. Mere membership in the S&P 500 can artificially prop up share prices despite underlying business conditions. That may be fine and dandy during a bull market, but when the next bear market strikes, heavily indexed companies will get hammered even harder than lower-cap issues.

Index funds and actively managed stock funds are basically the same animal as far as results go. Equity fund investing by itself, either active or passive, is no match for the multi-asset class manager with sound judgment who can competently assess value. Investors should look more into balanced fund managers and compare their results to the market averages before investing solely in stock funds.

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Is There a Holy Grail to Investment Success?

July 9, 2015 By Murray Williams Leave a Comment

The Holy Grail

The Holy Grail is described in mythology as the cup that Christ drank from during the Last Supper, and is described as having mystical and miraculous powers. It is the stuff of medieval and Arthurian legend. It is also metaphorically described as something magical and elusive that may or may not exist. For investment professionals, the Holy Grail would be a formula for trading the financial markets that generates superior results. But to determine whether The Holy Grail exists or not we first have to define our terms. What results would classify a trading or investment formula as the Holy Grail? Would it be a strategy that simply beat the stock market averages or beat it by a lot?

Some theorists believe there is no investment Holy Grail, just as some believe there is no secret to financial success. But throughout human history there have always been people who succeeded financially and those who did not. Is there a key that separates the successful from the unsuccessful? There must be otherwise it would not be happening, the same way it has happened for thousands of years.

The proponents of the Efficient Market Hypothesis (EMH) and Modern Portfolio Theory (MPT) would have you believe that it is not possible to beat the market averages and that everyone should just buy an index fund and be done with it. But if that were true there wouldn’t be managers such as Warren Buffett and George Soros and numerous others who have beaten the averages consistently for many years. If the odds were against them, then they would have lost money or their results would have mirrored the averages. It is obvious they are doing something different from the norm. The question is, what is it?

Proponents of EMH argue the averages cannot be bested because they take the performance results of the equity mutual fund industry as a whole and compare it to the market averages. The problem with this reasoning is they fail to make the connection that equity mutual funds as a whole ARE the market. Of course their results will not significantly differ from the averages. That is like saying someone who bets on every horse in a race cannot lose. Of course they can’t.

After years of experience and extensive research I’ve come to the conclusion that the Efficient Market Hypothesis, while valid, only applies to equity exclusive investors with broadly diversified stock portfolios. In other words, it applies to individual investors who only buy stocks, as well as equity fund managers. For example, if you are a stock fund manager with a required minimum of 100 stocks in your portfolio, then you will be at a disadvantage. Over time, your results will not significantly differ from the averages, and transaction costs will leave your results below that of the averages.

Mathematically speaking, there are two ways to beat the stock market averages:

  1. Have a concentrated equity portfolio
  2. Own multiple asset classes and rebalance regularly

Leveraging a portfolio will not beat the market averages, as I will explain later.

For example, let’s say we have a DeLorean and went back in time to the year 1990. For argument’s sake, let’s say you wanted to invest in equities but could only buy 5 stocks. You decided to buy Microsoft, Intel, Apple, Starbucks, and Walmart. How would your portfolio have fared? We all know the answer to that. A portfolio of these winners would have left the market averages in the dust. Of course hindsight is always 20/20, but this example demonstrates the power of a concentrated portfolio with superior performers. The trouble is, no one could have predicted that result let alone had the wherewithal to stay with those positions.

The other way to beat the averages is to own multiple asset classes. Different asset classes such as bonds, precious metals, real estate, and cash can not only reduce the overall risk of your portfolio, but also make it more profitable. By holding different asset classes and re-balancing them regularly, investors will be profiting from market fluctuations. This differs from the margin speculator who is betting on the direction of the market. He will always lose in the long run to the balanced investor.

The purely mathematical reason for this is because big losses hurt you more than big gains help you. Let’s say you start with $1000 and enter an investment that combines a 9 percent gain with a 9 percent loss. You would end up with $992. In contrast, let’s say a speculator entered the same position but instead used 10 times the leverage. He would end up with $190 at the end. Roughly an 80 percent net loss! This is astonishing when you think about it, especially the number of traders out there who are holding naked margin positions. When you ask most speculators about the potential risks of their trading systems they think simplistically that a 90 percent gain combined with a 90 percent loss will be a wash with no net gain. This is incorrect because they aren’t grasping the concept of the arithmetic versus the geometric mean.

With the arithmetic mean or simple average, you add up all the outcomes and divide by the number of outcomes. Whereas the geometric mean multiplies the outcomes and takes the root of the number of outcomes. For example, let’s take 3 numbers: 1, 7, and 13. The arithmetic mean or simple average would be 7, whereas the geometric mean would be 4.5.

(1 + 7 + 13) / 3 = 7 Simple Average

³? (1 * 7 * 13) = 4.5 Geometric Average

The geometric mean is calculated by multiplying the three numbers and taking the cube root of the product. Compound return is the geometric average, not the simple average. Leverage always lowers the geometric mean of outcomes over time because once again, big losses hurt you more than big gains help you. Every consistently winning manager emphasizes and follows this rule. Large losses destroy a portfolio, and reducing or eliminating leverage is the first step to increasing absolute return. Investors should always choose the game with the highest geometric mean of returns. This is the Holy Grail.

However, if you define the Holy Grail as an investment system with all gains and zero losses, not even in the short term, then I would agree there is no Holy Grail. But a system that significantly beats the market averages over time could be classified as such.

In 1962 a mathematician by the name of Edward O. Thorp published Beat The Dealer, which presented the first popular mathematical system for beating the game of blackjack. The card counter was born. Contrary to popular opinion, the card counter was not immune to losses. He could lose half his bankroll during a losing streak. But if the counter kept playing, he would beat the casino significantly. It was just a matter of time. The odds were on his side.

Dr. Thorp discovered the Holy Grail of beating the game of blackjack. It was a probability puzzle and he figured out how to skew the odds in his favor. The financial markets are nothing more than one giant probability puzzle. If others have beaten it, it is entirely possible that you can too.

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