Who’s better than you?

Much of the happiness research that I’ve read says we base a good deal of our happiness on our position relative to the others around us rather than on our absolute position.

So it matters more to our happiness for us to know that we have more food than the other guy, than that we have more food than we have ever had before.

The explanation I’ve read for this is that the best way to assure our evolutionary fitness in the past was to just be better than the people around us. The theory goes that if we were better than the people around us, then we would get chosen as a mate more often than they would and our genes would thus get passed down.

Our ancestors would then have that same inborn genetic desire to be better than the people around them thus keeping the cycle going. This I guess is the root cause of the need to “keep up with the Joneses”.

Can logic prevail?

That being said, logically we should realize that our absolute position is more important than our relative one. Logically we would be more satisfied with all the food we could eat, than with only two crusts of bread. But if we let our emotional brains make the decision, we would be more happy with the two crusts of bread, if everyone else only had one crust of bread, than with all the food we could eat, if everyone else had all the food they could eat plus a crust of bread.

So there’s a danger there that we need to watch out for. The danger of our brains tricking us into doing something that we know logically to be the wrong move, but that we can temporarily be emotionally tricked into doing. For example, we might logically know that it would be a bad idea to buy a new car, but when the neighbor comes home with his new car we feel that emotional twinge to go out and get one ourselves.

So what implication does this have for our investing?

One point is that we should try to avoid finding out if someone else is actually better off than we are. In this case ignorance really is bliss. If we don’t know if someone else is better off than us, then we won’t be tempted to make a bad decision to try to catch up with them.

So it is in our interest not to talk about our salaries because we might find out that they are not as high as the person we are talking to. As long as we don’t know the real numbers, we can imagine that we are paid more than the other person. And conversely they can imagine the same thing. But as soon as we both know the reality, then we’re both stuck comparing and then one wins and the other loses.

Don’t talk about investments

Along the same lines, it would also be a good idea not to talk about our specific investments. If we own a stock and we tell someone about that stock, then our egos are now affected by every up or down move of that stock. When we are evaluating whether or not to sell, we now have to decide what the guy we told is going to think. If we sell out now, and the stock jumps 50% he’ll know we were stupid and missed it. And if we hang on, and the stock falls 50% he’ll know we were stupid and lost all that money. So the best idea is to keep the specifics of our investments to us.

The strategies I’m advocating, No Lose Stocks and Long Shot Options, are very prone to this weakness. For most of the time, they are not going to generate returns. True, they won’t generate losses either, but people only want to tell us about the wins they make, not the losses. So we’re likely to hear lots of stories about stocks that went up large amounts, when our own investments have just seemingly languished.

But this is actually the reason these strategies work. The person on the other side of the trades, the one selling the options, is telling someone about how much money he makes each month selling options to some chump. And for most of the months that guy will be correct. Most of the time the options will expire worthless, and the seller will get to keep the money. But eventually the seller will get careless or greedy, and he’ll stretch too far. On that month or in that year, the strategy will pay off for us, and make up for all of the other losses and then some.

So if we’re following these strategies we need to realize that we are susceptible to being tricked into thinking that the strategies are not working, or that there is a better strategy out there. And we need to make sure to stay the course.

The best solution I have found is to avoid discussing specifics.

What’s another way to invest while avoiding losses?

In the last article, I briefly discussed holding your wealth in something other than dollars and said that I was planning to hold mine in No Lose Stocks and “possibly some long shot calls and puts”.

I’ve been rereading Taleb’s “The Black Swan” lately and have been formulating some ideas for a new investment strategy I’m calling Long Shot Options.

The idea in a nutshell is to find the options that have to rise or fall the smallest amount over the longest time for the smallest price, and then buy them and wait. Most often these options will expire worthless. But my hunch is that maybe once a decade or maybe even more often, they will hit. And because they are so cheap, like $0.05 per share, when I buy them, I can buy lots of them for very little money and profit exponentially if they go up.

So let’s get into the specifics of why I think this might work.

Avoiding losses

One of the things that we find difficult to take is losing money, so I plan to only buy these options with the interest earned each month on my core capital. If I use only the interest from my account each month to buy whatever options are cheap that month, then the balance of my account will never drop. Occasionally it will jump up to a new higher level when I make gains or deposits, but it will never fall.

Avoiding losses can also be a relative gain. Consider that over the last couple months the S&P 500 has dropped 25%. Since I have been using the No Lose Stocks strategy, my own investments have returned 0% over that same period, meaning I haven’t lost any money. But compared to someone that rode the S&P 500 down to where it is, I have a relative 33% gain.

So we’re avoiding losses while still being exposed to the possibility of gains.

Overconfidence

One of the things Taleb discusses in his book is our tendency to overestimate how much we know. He talks about a psychology experiment where the participants are asked, for example, how many lovers Catherine II of Russia had. The participants are supposed to guess a range where they are 98% certain the answer is within the range.

If the participants set their ranges correctly, then only 2% of the participants should be wrong when the results are tallied. But when the answers are checked the percentages turn out to be 15% to 30% wrong. The participants are overestimating how much they know. They were given the opportunity to set the ranges as wide as they liked, and yet they still missed the mark.

What I take from this is that option sellers are doing the same experiment. The option seller is being asked to pick a range that the stock will not go to. Since the option seller is picking the range, I can then bet against that range with the knowledge that the option seller probably picked too small of a range.

So we’re able to use the option seller’s overconfidence against him.

Bad at predicting

Next consider that the option seller is predicting what the stock price will be in the future. He’s looking at the past and making predictions about how high or low the stock price will go from here and in how much time.

But he’s basing his decisions on past data and looking for occurrences that happen very infrequently. The more infrequently something happens, the worse we are at accurately predicting it. The reason being that we don’t have a large enough sample to accurately gauge the likelihood that it will happen again.

Consider if you saw something happen once in the last 30 years. You might believe that the thing happens once every 30 years. But if it then happened again the next day, the rate would be twice every 30 years or on average once every 15 years. And if it then happened again the day after that, the rate would be 3 times every 30 years or on average once every 10 years. Over a very long time, assuming the real rate stayed constant, any bunching of occurrences would eventually average out. That’s the affect of the law of large numbers.

But it means that for things with longer times between occurrences, or a low chance of happening, we are really bad at accurately predicting the real rate of the phenomena. So if we let the option seller pick what he thinks the rate is, and bet against him, he will probably underestimated the rate.

So we’re able to use the option seller’s weakness at predicting against him.

Picking on the most optimistic

The market bidding process means that when I buy my option, I’m buying it from the person that was willing to take the smallest amount of money for taking on the risk that the stock will go to that price. This means that I get to buy from the guy who is the most optimistic and thus the one who is most likely to be wrong.

So we’re able to pick the option seller most likely to be wrong in his prediction.

Income bias

We have a bias towards frequent rewards. This means we would prefer to get lots of small rewards rather than one large reward. Logically, we can reason that one large reward is better than a bunch of small rewards that don’t add up to the large reward, but psychologically we crave the constant positive feedback. So it makes it even more likely that the person selling the way out of the money options (which is a way to get constant positive income) is doing so irrationally and probably mispricing the risk he is taking in order to feed his need for a constant gain.

So we’re able to bet against the option seller’s weakness for frequent rewards.

History leaps

If we look at history we see that rather than being a smooth even progression, history often moves in leaps. A new discovery is made and then everyone quickly shuffles and readjusts to accommodate the new reality. This same thing happens in the stock market. When new information is discovered the price of the stock quickly reacts, moving either up or down depending on the information. These leaps are fundamentally unpredictable, so by looking for the longest option expiration we can get the highest chance of hitting one and profiting from it.

So we’re able to take advantage of history’s tendency to surprise us with new information.

Summary

With Long Shot Options we’re attempting to take advantage of the weaknesses of the option seller and the tendency of history to surprise us, all while avoiding losses to our core capital.

If you’d be interested in subscribing to the Long Shot Options service when it becomes available, drop me an email at contact@dividendium.com.

Who’s to blame for the “crisis”?

I see this particular question asked quite a lot lately. I also see lots of different answers depending on the political leanings of the person answering. Among the culprits I’ve heard offered up are the President, the Fed, the consumer, the banks, Wall Street, China, the Congress, OPEC, the terrorists, and so on. But I’m starting to think that who’s to blame is not the right question to ask.

It seems to me that who’s to blame doesn’t change the situation. Sure it may make us feel better to be able to place blame and punish someone, and probably even just as importantly to say that it wasn’t our fault, but the problem will still exist regardless of who started it. And punishing someone now doesn’t prevent someone else from causing the problem in the future. A better solution would be to never give anyone the power to put us, the individual, in the situation again.

We can’t save the entire world from getting in this situation again, but we can take responsibility for ourselves and provide our own protection. And once we’ve made sure we’re secure, we might even be able to profit from future “crises”.

The “crisis”

I put “crisis” in quotes because it really hasn’t affected me, so I have trouble calling it a “crisis”. But then again, perhaps that’s because I’ve already done most of the things I’m about to suggest doing.

As I understand it, the problem is that our economy is stalling and people are losing faith in the economy. In response, the people are spending less, businesses are cutting back on payrolls and other expenses, banks are afraid to lend money, investors are taking their money out of the market and waiting on the sidelines, and the currency is being inflated to try to jumpstart the economy again. So in general there is less spending and the people and businesses that were depending on that spending are feeling some pain from that.

People spending less

If people cut back on their spending, then it reduces the income of the businesses that were getting that spending. But it also causes the people to get a bit grumpy about the lowering of their standard of living. People only cut back on their spending if they can’t afford to spend what they normally do. So one way to avoid this problem is to preemptively cut our own spending, and just spend less to begin with. I’ve mentioned a few times how our spending levels don’t really affect our happiness, so a lower spending level is going to leave you just as happy as you were at the higher one.

Businesses cutting back

If businesses are cutting back, it is possible that we could lose our jobs. But then it’s always possible that we could be fired or let go. A slowing economy is not the only reason that a company cuts back. So it would be prudent to always be prepared for an interruption in income. The standard suggestion of 3-6 months of expenses (not income) as an emergency fund will take care of this. And in dire situations, you could even fall back on your retirement savings. Any amount of time you take out of your retirement now will only add that time on to the end.

Banks not lending

If banks aren’t lending, then the fear is that people won’t be able to buy the things they need and businesses won’t be able to make payroll. Perhaps it’s my ignorance, but why are businesses depending on loans to make payroll? I would think a business would want to be more secure than that. Like perhaps having enough cash on hand to pay its payroll, ideally cash acquired from sales of its product. So from a business perspective, I would suggest weaning the business off of revolving credit and just paying the expenses from the income. It may make for a tight month, but after that first month, the payroll loans shouldn’t be needed any more, and all payments can be made from the income.

From a consumer perspective, I don’t see much of a problem. Perhaps a bank won’t make a loan on a house, or an education, but if that’s the case, then take the hint and wait a little bit to make that purchase. In the mean time, save up some money so you won’t have to borrow as much. If the loan is for a car, then I’ve already stated my thoughts on that. A loan is just a quicker way to get the thing that you want, while paying more for it. It’s always possible to just save up the money for the house or education and avoid the loans entirely.

Investors pulling out

If investors are pulling their money out of the market and waiting on the sidelines, that means that they expect to put that money back to work eventually. We can take the opportunity to buy the stocks at good prices with built in demand waiting on the sides for things to settle down.

My suggestions above have all been of the idea that we should take the initiative to keep our living standards as even as possible by not spending to our limits and keeping some reserves for rainy days. Not too long ago, and along the same lines, I realized I could plan a retirement that I could achieve solely through saving. Meaning I don’t need any investment gains to get there, so any investment gains I do make just get me there faster.

The effect this has had is that my investing style has become very risk averse. I’m only interested if I can severely limit my downside and have an unlimited upside. This is what I’ve been advocating with the No Lose Stocks strategy. And this is the same kind of investing that I advocate here.

As a quick example of the usefulness of this strategy, take a look back at the HNZ purchase that I mentioned a few articles ago. I bought the stock at $51.38, along with a Put option with a strike price of $60. The current price of HNZ is $41.58, a roughly 20% drop from the purchase price. And at one point on Friday, the price dropped to $38.43, a 25% drop from the purchase price. If I didn’t have the put I would have sold out by now and lost 20% to 25%, but I do have the put. So I’m able to just sit back and see what happens without any real worry.

Currency inflation

If the currency is being inflated, then the dollar savings that people already have are going to be worth less in the future. Many of the people who say this “crisis” is the fault of the Fed also blame this on our lack of a gold backed or commodity backed dollar. What I realized recently is that we individuals actually have the option to back our “dollar” with whatever asset we want.

For example, if you want a gold backed dollar, all you have to do is buy gold with your dollars. Then when you want to buy something, you sell a little gold, take the dollars and buy the thing. We actually do something very similar to this when using credit cards in foreign countries. Our home currency is converted to the local currency at the time of purchase. I don’t actually see any reason that specialty credit cards couldn’t provide this service in a wide range of commodities. But even if they don’t we can implement it manually just by converting all of our dollars into whatever asset we prefer to hold our wealth in.

This is the one area where I haven’t yet taken my own advice, but I’m in the process of remedying that. And the asset I’m planning to hold the dollars in is stocks, or more specifically No Lose Stocks, and possibly some long shot calls and puts. I used to make a distinction between my savings and my investments, but now that I can invest without losing money, I don’t see any reason to continue the distinction.

Conclusion

The “crisis” may be a problem for some people, but for those people who are prepared it’s a non-event, or even a possible chance to get some new assets at distress sale prices. So be prepared for “crises” and the problems turn into opportunities.

Is the market a scam?

We are told, “the market always goes up”, but this statement ignores a few things that we might want to consider if we are going to be betting our savings on this “fact”.

First, there is the survivorship bias. This is the idea that when a company goes out of business or is purchased by another company, that company is no longer counted in the indexes. A poor company being dropped from the indexes raises the average value, so it looks like the market went up to anyone looking at the market’s history. But this understates the chances of an investor investing in a company that will later go bankrupt.

Second, it is possible that the increases in the value of the indexes are solely due to inflation. If the market was actually producing value, then the value of the market should be increasing compared to commodities.

Take gold for example. Technology makes it easier to mine gold now than it was in the past. Gold also does not decay or get used up, so the more gold that is mined the more gold there is. That means the supply of gold goes up every year. And further, there are no longer any gold backed currencies, so all the gold that used to back the currencies has also been sold to the market, further increasing the supply. Taken all together, this would imply that gold should actually be getting cheaper each year in real value terms.

Now take a look at the graph below. A dollar worth of gold in 1929 is worth $40 today. A dollar worth of the Dow Jones Industrial Average (DJIA) is worth $42 today. The values obviously haven’t moved in lock step, but they do seem to be tracking each other. But we already said that gold should be actually decreasing in value because of technology and increased supply, and that stocks should be increasing in value if they are actually producing value. What we’re seeing here is only a 5% difference, when gold should have been going down from the start, and businesses rising in value from the start.

Now think about this in terms of the companies that you’ve worked for. Have you ever seen a company that did not waste money? And who are the worst offenders, the big companies or the little ones?

In my experience, the bigger a company is the more likely someone in it is to exchange company profits for personal comfort and get away with it. The employee, manager, or CEO would rather ignore a problem and just sweep it under the rug than try to fix it.

In a smaller company these costs are harder to hide. But in a larger company the costs can be papered over and covered by some other income, like the proceeds from selling stock. And it would be prudent to point out that the indexes are really made up of the largest companies. So it’s not so far fetched now to believe that the stock market, or at least the indexes are only representing the effects of inflation and not any real added value.

When the music runs out

If this is correct, and the continuously rising market really is just a scam, then eventually the scam is going to end and reality is going to take over. Eventually the pyramid scheme will collapse.

I don’t know when this is going to happen, but inflation is probably speeding up, not slowing down, so it might be getting here faster than we expect. The $700 billion bailout bill will likely push the market higher because it will cause inflation.

I’ve been rereading Taleb’s book “The Black Swan”. In it there is a discussion about a Thanksgiving turkey. For 1000 days the turkey is fed like clockwork. Each day the turkey is fed the turkey comes to feel safer and safer. Each day brings the now regularly expected feeding. Then on day 1001, the day before Thanksgiving, the turkey gets the axe. Notice that the day the turkey felt safest was the most dangerous day.

If the situation you’re in is safe, then each day should confirm for you that you are safe and that your safety will probably last even longer. If the situation you’re in is not safe, then each day should tell you that you’ve pushed your luck just a little farther and it might give out all that much sooner.

The problem is it’s difficult to tell the difference when you’re in the situation. But one way to figure it out is to look for things that don’t follow physics or human nature. The turkey should have suspected something was wrong when he started getting “free lunches”. We should be thinking the same about the “free lunch” of a rising market and start looking for ways to protect our necks.

Exploit the loophole

With inflation and the markets, government has created a loophole. When a loophole exists you can temporarily get more than you would otherwise be able to. But the more the loophole is exploited, the faster it will close. So the longer and more extensive that government inflates the money supply, the closer we get to the loophole closing. The closer we get to “Thanksgiving” and the “axe”.

My opinion on this is that we should look to benefit from the loophole, but make sure we don’t end up paying later for the freebies that we got from the loophole. So taking a look at the chart above of gold and the DJIA crossing over each other tells me that I should be setup to take advantage of the rising prices of the DJIA, but also avoid losing the value I gained when the price of the DJIA falls back down. Personally, I do this with the No Lose Stocks strategy, so my profits climb with the stock, but don’t fall because of the Put.

A further way to exploit this loophole and/or protect yourself from the eventual fall is to short the dollar. I’m not saying to buy other currencies because I think they are all basically linked to each other. My advice is to buy the companies that are capital efficient as I explained in the last article.

Another protection would be to not lend value. Any time that you hold dollars you are lending the value of those dollars to someone else. Someone else is borrowing the thing you would have purchased with the dollars. But if inflation destroys the value of the dollars before you get to buy that thing, then you will have lost that value. So don’t hold dollars, don’t lend money (hold dollar denominated debt like CDs or bonds or personal loans), don’t sell Call options, and don’t sell cash covered Put options.

Selling Call options limits your upside. Basically you are letting someone else borrow your dollars to buy a stock. If inflation takes the stock to the moon, then your dollars will be worthless. Selling cash covered Put options is very similar because you are lending your dollars to someone else. You can’t put the dollars to work buying some commodity or stock, and again if inflation takes prices to the moon, your dollars will be worthless.

(I realize not selling call options goes against the Inflatable Dividends strategy, but this is my honest opinion. However I also realize that I can’t know everything and the strategy of using inflation to continue our economy may last for a lot longer, during which time the Inflatable Dividends strategy would be racking up profits.)

On the flipside, taking the opposite approach to these tactics would be good ideas in anticipation of high inflation. If you can buy commodities or stocks with your dollars, borrow money to invest, buy call options, or buy put options on stocks you own, then these would all be in line with profiting from inflation.

For a while I had an article up on how to use 0% credit cards to get cash advances and then deposit those in a high yield savings account. This is a nice way to generate some small “free” income. But from the perspective of inflation, it would be a better idea to take that same 0% loan and buy a No Lose Stock, or take the interest from the high yield bank account and buy a call option. I’m not advocating risking any of the money that was actually borrowed since you have to pay all of that back. I’m only advocating getting some one-way exposure to the effects of inflation.

Lastly, if you wanted to you could just buy gold or silver bullion coins and then buy gold and silver puts on those to protect the dollar value. There would be a cost (unlike with NLS where the stock’s dividend pays for the put option), but you might consider it like paying for insurance.

I’m just saying that we should be even more cautious now that we have pushed our luck as far as we have. The free lunches might soon be at an end.

Pay only for profits

After writing the post on HNZ the other day I started thinking about the idea of stop losses. Many of the gurus that I’ve read advocate using a stop loss. They advocate any where from 8% to 25%. The HNZ position that I have on has to rise 17% before I see a profit. But I only lose that 17% if I first gained it. If I was maintaining the same position with a 17% stop loss, I would stand the chance of losing the 17% even if I didn’t make any gains. I much prefer the idea of paying only for my profits and never paying for my losses.