I may just quit my job at the plant to become a full-time stock market guy.

- Homer Simpson
 

Source: learn-wealth-creation.com

by John Allen Paulos

One big winner in the stock market can skew the average return to an impressive gain, even if most investors are losing money.

Everyone's making money except you.  Despite the recent down tick in the market, that's the dominant impression one often gets when reading about investing.  In every magazine or newspaper you pick up you're apt to read about IPOs, the initial public offerings of new companies, and the gurus who claim that by investing in them your $10,000 will grow to more than a $1,000,000 in a year's time.

In these same periodicals you also may read about all the new companies that are stillborn and naysayers' claims that most investors will lose their $10,000 as well as their shirts by investing in such volatile offerings.  What can you believe?  Both, it turns out.

Buy, Sell or Run?

Here's a scenario that helps illuminate such seemingly contradictory claims.  Hang on for the math that follows.  It's counterintuitive but not difficult.  Hundreds of IPOs come out each year.  In the first week after the stock comes out, the price is usually extremely volatile.  It's impossible to predict which direction the stock price will move, but assume that for ½ the companies' offerings the price will rise 80% during the first week and for ½ the offerings the price will fall 60% during this period.

The investing scheme is simple: buy an IPO each Monday morning and sell it the following Friday afternoon.  About half the time you'll earn 80% in a week and half the time you'll lose 60% in a week for an average gain of 10% per week - (80% - 60%)/2.  [Note to the mathematically savvy: in this instance, you are allowed to average percentages because of the 50/50 split.]

Ten percent a week is an amazing average weekly gain, and it's not difficult to determine that after a year of following this strategy, the average worth of an initial $10,000 investment would be more than $1.4 million!  Imagine the newspaper profiles of happy day traders (or week traders in this case) who sold their old cars and turned the proceeds into almost $1.5 million in a year.

But what is the most likely outcome if you adopted this scheme and the assumptions above held?  The answer is: your $10,000 would likely be worth all of $1.95 at the end of a year!  Yes, ½ of all investors adopting such a scheme would have less than $1.95 remaining of their $10,000 nest egg.

Paradox of Wealth

How can this be?

The rough answer is that a typical investor could see his investment rise by 80% for approximately 26 weeks and decline by 60% for 26 weeks.  As demonstrated below, it's not difficult to calculate that this results in $1.95 of your money remaining after one year.  The reason for the disparity between $1.4 million and $1.95?  A lucky investor will see his investment rise by 80% for considerably more than 26 weeks.  This will result in astronomical returns that drag the average up.  The investments of unlucky investors will decline by 60% for considerably more than 26 weeks (however their losses cannot exceed the original $10,000 investments).

In other words, enormous returns associated with disproportionately many weeks of 80% growth skew the average way up, yet even many weeks of 60% shrinkage can't drive the investments' value below $0.  (Incidentally, this situation is related to a classical conundrum in probability theory called the St Petersburg paradox.)  In this imagined scenario the stock gurus and the naysayers are both right: the average worth of a $10,000 investment after one year is $1.4 million, but your investment is most likely worth $1.95.  Which investors' results are the media likely to focus on?

Calculating the (Lost) Wealth

Let's first see what happens to the $10,000 in the initial two weeks.  There are four equally likely possibilities: the investment can increase both weeks, increase the first week and decrease the second, decrease the first week and increase the second, or decrease both weeks.

Quick bit of refresher math: an increase of 80% is equivalent to multiplying by 1.8.  A 60% fall is equivalent to multiplying by 0.4.  So ¼ of investors will see their investment increase by a factor of 1.8 x 1.8, or 3.24.  Having increased by 80% two weeks in a row, their $10,000 will be worth $10,000 x 1.8 x 1.8, or $32,400.  One-quarter of investors will see their investment rise by 80% the first week and decline by 60% the second week.  Their investment changes by a factor of 1.8 x 0.4, or 0.72, and will be worth $7,200 after two weeks.

Similarly, $7,200 will be the outcome for ¼ of investors who will see their investment decline the first week and rise the second week, since 0.4 x 1.8 is the same as 1.8 x 0.4.  Finally, the unlucky ¼ of investors whose investment loses 60% of its worth each of the two weeks will have 0.4 x 0.4 x $10,000, or $1,600 after two weeks.  Adding $32,400, $7,200, $7,200, and $1,600 and dividing by 4, we get $12,100 as the average worth of the investments after the first two weeks.  That's an average return of 10% weekly, since $10,000 x 1.1 x 1.1 = $12,100.

More generally, the stock offerings rise an average of 10% each week (the average of an 80% gain and a 60% loss, remember).  Thus after 52 weeks, the average value of the investment is $10,000 x (1.10)⁵², which is $1,420,000.  However, a more likely result would be that the companies' stock offerings could rise during 26 weeks and fall during 26 weeks.  This means that a more likely worth of the investment would be $10,000 x (1.8)²⁶ x (.4)²⁶, which is only $1.95.

Of course, by varying these percentages and time frames, we get different results, but the principle holds true: the average return far outstrips the most common return.  If ½ the time your investment doubles in a week, and ½ the time it loses half its value, the most likely outcome is that you'll break even.  If your average return is 25% per week - (100% - 50%)/2, this means that your initial stake will be worth $10,000 x (1.25)⁵², or more than a billion dollars!

Professor of mathematics at Temple University, John Allen Paulos is the author of several books, including A Mathematician Reads the Newspaper and, most recently, Once Upon a Number.

Source: Special ABCNEWS.com  Who's Counting? column by John Allen Paulos which appears on the first day of every month 1 October 1999

Take Stock in Life

by Ben Stein

I recently spent most of an incredibly hot, dazzlingly humid Sunday on a 36-foot boat motoring out Florida's Intracoastal Waterway and off to a point near Key Biscayne.  I was on the boat to scatter the ashes of my main soul mate in the whole world besides my wife: a prominent English psychiatrist who was 57 when he died.

With me on the boat were the doctor's widow, his 20-year-old son, his 14-year-old daughter and a few friends from his life.  His children were more or less twisted like corkscrews with anguish.  The wife tried to be cheerful and remember old times in their 33-year relationship, but her lovely face was flushed with strain, and her blue eyes endlessly pink.

As for me, I just plain cried and thought of how bitterly I missed him and our endless conversations.  We talked about everything - women, George W Bush, the Civil War, the 1960s, Bob Dylan - but probably as much about the stock market as about anything else.

The good doctor, probably as smart a man as I have known, was tormented by the stock market.  He had studied economics and finance at Cambridge.  He had briefly been a merchant banker in London.  He had inherited money and invested it brilliantly in property.  But he was endlessly frustrated and maddened by the stock market's turns.  He wanted to be a successful speculator like the ones he read about in magazines, but he always went the wrong way.

For sound reasons, he thought the market had been overvalued for decades.  He totally missed the boom of the 1990s and especially was crazed by the tech bubble, which he thought was a bubble all along, but never had the enthusiasm to sell into.  He missed it long on the way up and short on the way down.  It tortured him.

Tormented

The market kept him up nights, filled him with self-loathing, was a part of what led him to attempt suicide at the end of 1999 after reading about the huge gains so many investors had made in tech, but which had eluded him.  When the tech sector tanked after March 2000, the doctor was filled with rage at himself for his failure to sell short, to the point that he stocked up on barbiturates to kill himself.  Now he has done it.  He took the drugs, and he died.  There were other big factors in his suicide, but his perceived failures as an investor and speculator were an immense factor in putting him into a suicidal depression.

I loved the doctor like a brother.  I know his anguish about the market, despite the fact that he left a very large estate and was never anything but affluent.  The tragic fact is that I know a lot of people who have felt that anguish.  I had two great uncles who went from rich to poor in 1929 and committed suicide.  I have known many a man who felt broken, ruined, worthless by losses or forgone gains in the market.  I have been there myself.

The Error of our Ways

But this is a titanic mistake.  If the market does not go our way, that's its nature.  It says nothing about who we are as human beings.  If the greatest minds in finance, the managers of hedge funds, the managers of the most immense mutual funds, the portfolio gurus at the (once) hottest mutual funds can make mistakes - and they most certainly do, all of the time - so can the rest of us.  That's just life and markets.

But, more: we are not how much money we make.  We are fathers, mothers, spouses, children, friends, lovers.  We are people to whom other people look for love and care and a smile and laughter and a shoulder.  At all of these, the doctor did amazingly well.

We are colleagues and partners, advocates and caregivers.  Our money is a very small part of us.  How much of it we made on the market is an even smaller part.  Few obituaries talk about the investments the loved one made or how they did.  No eulogist talks about whether the decedent got into Microsoft early or sold GE too soon.  The market is meant to serve us, not to own us body and soul.  If we do not keep it in its box, it can grow to devour us and leave our children twisted like corkscrews with grief on a boat off Key Biscayne.

Think about it.  Take the market seriously, but not too seriously.  It's just a little of what makes a life.

Ben Stein is a writer, actor and host of Comedy Central's Turn Ben Stein On and Win Ben Stein's Money.  He also is a member of USA Today's board of contributors.

Source: USA Today Wednesday 11 July 2001

The Casino Economy

Using other people's money to become a millionaire

by Brian Easton

Use $20,000 as a deposit on a $100,000 house, borrow $80,000 from the bank.  Get a friendly valuer to say that the house is wrth $200,000.  Get the bank to lend you another $80,000 against the value of the house (so you have a mortgage of $160,000).  With the $80,000 cash that the bank has just given you, buy another four $100,000 houses and borrow another $80,000 on each house.  Get your pet valuer to double the price of the four new houses, so your houses are now worth $1,000,000.  You can borrow an extra $320,000.  Repeat.

After the third round of this magic, you will own $10.6 million of buildings, have debt of $8.48 million and equity of $2.12 million.  You are a millionaire, and you only started with $20,000!  If the reader is a little lost trying to follow the sums, don't worry.  Some who worked the system candidly admit that they lost track of their finances, too.

It is not quite as simple as that.  You will have to pay your helpful valuer, various bank fees, interest charges, and so on.  But it illustrates how by revaluing assets and raising debt on the new value, the business can obtain cash for repeating the miracle.

Hire a public relations specialist, who will convince the financial journalists that you are a terribly clever fellow, with a knack for spotting commercial opportunities.  The lenders will be impressed and come beating at your door.  Do another round.  (You will have to diversify into property and shares.)

Now you have $46.2 million of assets, with $34.08 million debt and $8.52 million equity.  Your picture is on the financial pages.  You are asked for advice on things you know nothing about, such as the economy.  (Your PR adviser says, "Praise free enterprise.")

People clamour to have a share of your wizardry, so reluctantly (of course) you agree to float on the sharemarket a portion of your private company.  Suppose you sell off half the shares at a 50% premium.  (And, again, for simplicity ignore the costs of PR, merchant bank, sharebroker and financial journalists.  The journalists get free trips to your meetings, dinner and wine, but usually not cash like the others.)

Immediately after the float, you have $6.39 million in cash and shares worth $6.39 million that retain a controlling interest in your company.  The day after the float, the share price leaps another 50%, the stags who bought the shares sell them at a tidy profit, and happy share punters find thenselves owning shares in a company at more than twice the net (already grossly inflated) value of its assets.

The story keeps going, but, eventually, it comes out that your business is a fraud, the share price dives and the company becomes worthless.  The banks foreclose.  The assets are still there, but their true value is about half of what it was in the company books, there is no equity left.  Just a lot of debt.  Still, you have the $6.39 million from the float. Invest it wisely.

Grimy details aside, the point is that the $6.39 million cash return from the original $20,000 comes from other people's savings.  (The banks have made a loss, too, which does not affect their depositors, but the shareholders in the banks take a loss.)

I tell this fable because I continually meet people who expect to make fabulous returns on their investments, but who never ask what is the underlying process that generates the return.  Where does the cash come from?

During an asset (property or equity) boom, revaluation gives fictitious profits, which only become real when the asset is sold and turned into cash.  Now the overvalued asset is owned by some other investor who has given up the cash, but hopes to do the same.  It can be like passing a parcel that contains a bomb.

Of course, there are some genuinely high-returning investments, but they are few in number.  The typical investment gives a return of 3% above the rate of inflation.  By a bit of tweaking you might get it a little higher, or avoid paying tax.  Promises of easy 20% annual returns, say, in the current low-inflation climate are - well - problematic.

You may be cleverer than the average investor, or luckier.  Then again you are more likely to be below average (because the return is skewed).  High investment returns are often at the expense of ordinary investors, who find their savings consumed by other investors.  Keynes once described the sharemarket as a casino.  Casinos randomly redistribute people's savings, less a margin for the dealer.

Source: Listener 5 December 1998

Also see:

Why Microsoft Scares Me (the next page in this section) - So there you have it.  $3.1 billion from a tax loophole, $1.3 billion from its employees, and $0.7 billion from put warrants combine to give Microsoft over $5 billion from its own stock in fiscal 1999.  And it avoided paying $9 billion in wages.  All that from a company that only had $7.8 billion in net income!  And as long as the stock keeps going up, they can keep doing that ad infinitum...

For more articles relating to Money, Politics and Law including globalisation, tax avoidance, consumerism, credit cards, spending, contracts, trust, stocks, fraud, eugenics and more click the "Up" button below to take you to the Table of Contents for this section.