A rogue trader working for a bank has managed to lose a record $7 billion making unauthorized trades. The trader, Jérôme Kerviel, worked at the bank Société Générale in France. He lost the money trading in the European stock index futures market. Stock index futures are essentially side bets between two parties on whether the stock market will go up or down. This rogue trader made about $40 billion in bets that the stock market would go up, and as we have seen over the last week, those bets didn’t work out very well. When the bank discovered the huge bets, they sold them off quickly and ultimately lost $7 billion in the process. There have been many stories about rogue traders over the years. One thing all the stories have in common is huge losses. Don’t these rogue traders ever get lucky and make money? My guess is that many of them do make money, at least for a while. What would bank management do if they discovered a rogue trader who risked billions, but had made a bill...

In my previous post I showed how over time an investment with a given expected return is likely to have a lower actual return due to volatility. The more volatile an investment is, the bigger the difference between the expected return and the actual returns you get. This explains the inconsistency among various reports of average stock market returns . One way to reduce volatility and increase the actual return from investments is diversification. To diversify means to spread your money among multiple investments. This is the “don’t put all your eggs in one basket” advice that we often hear. Let’s go back to the example in the previous post where we have an investment that each month either doubles or loses 60% with equal probability. This kind of extreme case is unrealistic, but makes it easier to understand how diversification helps. We saw before that the most likely outcome was that this investment would lose almost everything over 3 years, even though the average outcome is ...

In a previous post , I showed how the average real return in the US stock market from 1926 to 2000 is 9.3%, but that this translated into a compounded real return of only 7.4%. The reason for this difference is the volatility of the returns. Let’s go for a better understanding of the cost of volatility without any advanced math. A Simple Example Suppose that you have $10,000 invested for two years. In the first year you lose 10%, and the next year you make 10%. It might seem at first that you have your $10,000 back, but that isn’t exactly right. After the first year you were down to $9000, and then in the second year you earned 10% on that $9000 to get a total of $9900. In the end you lost 1% of your money. However, the annual returns were -10% and +10% for an average return of 0%. The lost 1% over the two years is not due to a negative expected return; it is due to the volatility of the returns. The average return is 0%, but the compounded return is about -0.5% per year. Anoth...

I know I promised a discussion of risk and volatility, but that will have to wait. The stock market is crashing! Shouldn’t we be doing something? Yesterday morning the newspapers and online news sources were nearly unanimous: stocks are headed down and it’s going to be ugly. It can be tempting to sell everything at times like this, and many investors will sell. But if you do sell, when will you jump back in? Maybe you’ll buy once the market rises consistently for a week or two to show that the carnage is over. But this amounts to selling low and buying high. This is the opposite of what you want to do to make money. Any attempt to time the trading of stocks to make more money is called market timing. It can be tempting to try market timing, but be aware that there are others out there who are trying to beat you at this game. Collectively, market timers can’t make more money than those who simply buy and hold their stocks. In fact, on average they have worse results because they...

I intend to review the book Worry-Free Investing by Zvi Bodie and Michael Clowes, but for now I want to discuss one part of the book that reports historical U.S. stock market returns that are higher than I was expecting. In Chapter 6, the authors discuss U.S. stock returns from 1926 to 2000. They actually give real returns, which means the returns after inflation is subtracted out. Based on the historical data, they calculate the average yearly real return on stocks to be 9.3%. But, others say that the long-term real return on US stocks is 7%. This may not look like a big difference, but if you play around with one of the many free retirement calculators available online, you’ll find that an extra percent or two of return on your investments each year makes a big difference over the long term. So, which one is the correct historical average return? It turns out that they are both right because they are talking about different things. The 9.3% figure comes from taking the returns...

Graham McWaters and Gary Ford work for financial institutions and are writers and public speakers on financial matters. This is a review of their book, “The Canadian Guide to Protecting Yourself from Identity Theft and Other Fraud,” published by Insomniac Press. Although there is some focus on Canada, much of the material is relevant in the US as well. This book is a useful guide to the different types of fraud that people need to understand and avoid. The authors do a good job of personalizing the material with victim stories. Some types of fraud covered are debit and credit-card fraud, gathering personal information from computers on the internet, real-estate fraud, investment scams, and telephone-based scams. A frequent problem with personal finance and investment books (and self-help books in general) is repetitiveness. It’s not unusual for a book to have only 20 pages of real content repeated in multiple ways to produce a 200-page book. This book is better than most, but is ...

One of the arguments for using financial advisors is that they provide a steady hand that helps keep you from making rash investment decisions that will hurt your returns. The study by Bullard, Friesen, and Sapp released in December 2007 casts doubt on this argument. As discussed in this post , the study showed that mutual fund investors actually get lower returns than the funds’ reported returns because of poor market timing. You would think that working with a financial advisor would keep investors from making such mistakes, but apparently not. Another aspect of the study was to examine how investors working with a financial advisor fared compared to other investors. The study’s authors summarize: “We find that investors who transact through investment professionals using conventional distribution arrangements experience substantially poorer timing performance than investors who purchase pure no-load funds.” Instead of a steady hand, we find that investors working with financial ...