An accessible introduction to the roots of the recent financial crisis (via scholarjeff).

My portfolio peaked when BSC went belly-up, but then the market staged a big recovery and things were grim for awhile. But sense (in the form of panic) has returned the last few weeks and the bears are ruling again. Now I'm almost even for the year, (even counting my losses while I was passively investing early in the year).

Yay for high unemployment and continuing housing market bust!

Here's hoping Lehman's earnings next week are awful...

Moody's is thinking about adding warning labels to its ratings. The Big Picture has a suggestion for how the label might read:

WARNING: THESE BONDS HAVE BEEN RATED AAA BY A MAJOR RATING FIRM. THESE RATING FIRMS HAVE PROVEN THEMSELVES TO BE CLUELESS, MONEY-LOSING INCOMPETENTS IN EXCESS OF A TRILLION DOLLARS IN LOSSES. THEY WERE PAID HANDSOMELY BY THE BOND UNDERWRITER, AND ARE HOPELESSLY COMPROMISED. PURCHASERS OF THESE BONDS ARE ADVISED TO IMMEDIATELY KILL THEMSELVES, THUS SPARING THEIR LOVED ONES EMBARRASSMENT IN THE FUTURE. ALSO, THESE BONDS MAY LOSE VALUE. I JUST WET MYSELF MERELY THINKING ABOUT THIS PAPER. WHILE PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RETURNS, YOU SHOULD BE AWARE THAT PAST PERFORMANCE ALSO SUCKED. DONT BLAME US IF YOU LOSE ANY MONEY, AS WE HAVE NO IDEA WHAT THE F$#@ WE ARE DOING ANYWAY. REALLY, YOU ARE ON YOUR OWN.

Arnold Kling writes:

"The point is important that the typical investor should act as if the efficient markets hypothesis is true. One of the most widespread biases in finance is hubris. I could not believe it when Mike Moffat sided with Patri Friedman's argument to use mortgage leverage to buy stocks. In an efficient market, that is just plain incorrect."

Brandon Berg gave my counterargument before I got there:

Efficient or not, isn't it generally acknowledged that an equity premium does exist? And with mortgage interest deductible at a higher rate than capital gains are taxed, the government is essentially subsidizing homeowners who arbitrage the equity premium.

The EMH simply does not apply to what I recommend (keep minimal equity in your house, put your money in the stock market instead), because it depends on the tax-advantaged nature of mortgages. That is not an inefficiency that can be arbitraged away by a hedge fund or whatever.

In these questions, please try to imagine that you are a 30-year old employed at a Bay Area technology company. Your goal is to build wealth for retirement. You are faced with several possibilities of varying risk and return.

For the first three questions, I'm assuming you must invest your entire portfolio in a single instrument. Your choices are bonds, an S&P 500 index fund, a random stock from the S&P 500, or a high P/E tech stock. I'm asking how much extra return you would need to be compensated for the riskier choices. Units are in %/year, so answering 5 to the first question means that you are indifferent between stocks and bonds if the stocks pay 5%/year more.

For the next three, I'm assuming that you have two investment options, one low-risk and one high-risk. The question is: for the given return premium, how would you split your portfolio between these investments?

Poll #890162 Diversification Poll
Open to: All, detailed results viewable to: All

How much of a premium, in %/year, would you need to be compensated for the increased risk of an S&P 500 index fund over bonds?

How much of a premium, in %/year, would you need to be compensated for the increased risk of a random S&P 500 stock over an S&P 500 index fund?

How much of a premium, in %/year, would you need to be compensated for the increased risk of a high P/E tech stock like GOOG, YHOO, AMZN, EBAY over an S&P 500 index fund?

Suppose that bonds earn 6% a year, and you can also choose an investment which earns 12%/year with the volatility of a high P/E stock. What %age of your portfolio will be in bonds?

Suppose that bonds earn 6% a year, and you can also choose an investment which earns 16%/year with the volatility of a high P/E stock. What %age of your portfolio will be in bonds?

Suppose that bonds earn 6% a year, and you can also choose an investment which earns 24%/year with the volatility of a high P/E stock. What %age of your portfolio will be in bonds?

evan linked to this story about how Google tries to protect it's newly minted millionaires from making foolish investment decisions. I'd noticed there were a lot of good seminars and sensible visitors like Malkiel, but hadn't realized it was so intentional:

As Google’s historic August 2004 IPO approached, the company’s senior vice president, Jonathan Rosenberg, realized he was about to spawn hundreds of impetuous young multimillionaires. They would, he feared, become the prey of Wall Street brokers, financial advisers, and wealth managers, all offering their own get-even-richer investment schemes. Scores of them from firms like J.P. Morgan Chase, UBS, Morgan Stanley, and Presidio Financial Partners were already circling company headquarters in Mountain View with hopes of presenting their wares to some soon-to-be-very-wealthy new clients.

Rosenberg didn’t turn the suitors away; he simply placed them in a holding pattern. Then, to protect Google’s staff, he proposed a series of in-house investment teach-ins, to be held before the investment counselors were given a green light to land. Company founders Sergey Brin and Larry Page and CEO Eric Schmidt were excited by the idea and gave it the go-ahead.

One by one, some of the most revered names in investment theory were brought in to school a class of brilliant engineers, programmers, and cybergeeks on the fine art of personal investing, something few of them had thought much about. First to arrive was Stanford University’s William (Bill) Sharpe, 1990 Nobel Laureate economist and professor emeritus of finance at the Graduate School of Business. Sharpe drew a large and enthusiastic audience, which he could have wowed with a PowerPoint presentation on his “gradient method for asset allocation optimization” or his “returns-based style analysis for evaluating the performance of investment funds.” But he spared the young geniuses all that complexity and offered a simple formula instead. “Don’t try to beat the market,” he said. Put your savings into some indexed mutual funds, which will make you just as much money (if not more) at much less cost by following the market’s natural ebb and flow, and get on with building Google.

That's awesome. Definitely a company that tries hard to take care of it's employees.

The article has lots more info about the index fund revolution and the huge scam that is the managed mutual fund industry, so read the rest of it if you're interested.