Occam's Razor Applied to Investing

"Pluralitas non est ponenda sine neccesitate" --William of Occam (c. 1285-1349)
(Literal translation: "Plurality should not be posited without necessity.")

As investors, we have a whole smorgasbord of tempting investment entrees. Over the years, based on various motivating factors, I have invested in domestic and foreign stocks, convertible bonds, warrants, commodity-backed securities, government bonds, junk bonds, a spectrum of different mutual funds, CDs, money market instruments, income property real estate and houses. In certain cases, select investments have produced superb returns. However, generally speaking, I believe that we would all be better off keeping our portfolios as simple as possible.

There is a principle called Occam's Razor that is often used in philosophy, theology, science and medicine. It is a principle of parsimony, simplicity and economy that effectively states: "The simplest explanation is the best." (See Wikipedia for a little more background on the topic.) For example, why invoke Martians when more mundane, earthbound explanations will suffice? Or, in medicine, the most common disease that fits all of the patient's symptoms is most likely the correct diagnosis.

The way that I would apply Occam's Razor to investing and personal financial management is as follows:

1. "Perpetual" Portfolio: Strive to achieve a long-term, even perpetual, portfolio that performs well even when left unattended. One of the key reasons I favor equities over bonds is that equities have no maturity date, meaning that no reinvestment of principal is ever necessary--and no need to reinvest means no urgency to buy, too often into the wrong investment, when circumstances are not most favorable.

2. Low Turnover: Don't trade unless you are certain you will be better off after executing the trade. Some investors believe they have an "edge" and can invest profitably in the short run. The obstacles to turning a consistent short-term profit, however, are formidable: bid-offer spreads, transaction fees, taxes, time spent verifying trade details, accounting expenses, and worst of all, painfully seeing the market move against you and reluctantly admitting after the trade that your "hunch" was not correct after all. With all of the uncertainty of outcome of investments in the financial markets, I believe that trading as infrequently as possible is best.

3. No Debt: Don't borrow unnecessarily. Having no debt means never having to repay principal to anyone and never paying any interest. Also, just as with bonds, loans have a maturity date, which means that refinancing is needed, i.e., loan fees, legal expenses and administrative costs have to be paid to lenders. All of these costs can be minimized by simply borrowing only sparingly, when absolutely necessary or otherwise advantageous to do so.

4. Self-Management: Rely on your own wits to manage your own money. When a portfolio is simple, it can be managed by oneself, without the need to hire external advisors, who are more than happy to earn commissions and fees at your expense as an investor. (I spent years professionally structuring fiancial products targeting institutional investors and, not so surprisingly, always in brokering we made more money when the products we sold to "sophisticated" investors had more complex cross-market, multi-currency options embedded. The more bells and whistles, the better--for the broker but not for the investor.) Let's face it--every dollar that a broker or portfolio manager earns is one less dollar in your pocket as an investor.

5. Straightforward Tax Returns: Position your investments so that you can do your own taxes. Fewer transactions during the year and simpler investments mean simpler taxes, so simple in fact that it should be possible to do one's own taxes--without the assistance of an accountant. I find that tax software and online filing help enormously to lessen the burden of figuring out how much to pay Uncle Sam each April.

6. Adequate Income Generation: Make sure you pay yourself first. We all have living expenses. Aside from any income available through employment, investors should arrange for regular investment income through some combination of dividends (on stocks), interest payments (on bonds), and distributions of positive cash flow (on income-generating real estate). Income should be sufficient to cover all living expenses so that one's core portfolio holdings never have to be sold to cover an out-of-pocket expense.

7. No Deadlines: Avoid the stress of deadlines. Having only perpetual instruments in one's portfolio and transacting as infrequently as possible, an investor will rarely have payment deadlines to meet and hoops to to jump through.

8. Quality: Buy quality. Owning high quality assets and companies means that the chance of bankruptcy, events of default, financial distress or other early termination of an investment is minimal.

9. Autopay: Use autopay whenever possible. On the expense side, setting up autopay for credit cards, utilities and all other regular payments greatly reduces the amount of time required in day-to-day financial management. (Note: Credit cards these days offer attractive rebate incentives, which provide a welcome financial kickback for those who pay down their balances monthly and never have to fork over exorbitant interest payments to the credit card companies.)

10. More Time to Enjoy Life: Sit back and enjoy. Having a simple investment portfolio means more time for all of life's activities outside of investing!

That's it. Pretty simple. Taken to the extreme it means having an investment portfolio that can be run effortlessly on remote control. Investments turn a profit and generate income that automatically goes into a bank account, from which ordinary living expenses automatically get paid--no watching the tape, no running around, no checkwriting, no worries.

Now, history tells us that William of Occam got himself into trouble with the Pope in his day by advocating a minimalist existence and idealizing a life of poverty. From his hometown of Surrey, England, he was summoned to Avignon, France, and put under house arrest by Pope John XXII for investigation of heresy for four years, during which time he fled to Munich, Bavaria (now Germany), where he died (most likely quite miserably) in a convent, possibly from the Black Death when it swept through Europe in the late 1340s, some seven centuries ago.

In our modern times, by applying similar principles of simplicity, careful investors ought to be more fortunate than William of Occam. A simpler portfolio ultimately means a richer life, with an abundance of time to enjoy all the little things and pleasures. . . .

A CD Optimization Problem

My kids opened up one-year "bump CDs" earlier this year at a local bank. These are traditional certificates of deposit with an added twist--a "bump" feature that gives the holder the one-time right during the one-year term of the CD to bump the initial interest rate higher to the current market interest rate for the same product if rates rise during the holding period. Basically, there's an option embedded in the CD that allows the holder to benefit from a rising interest rate environment. Because the holder must proactively request a rate increase, my kids (with dad's help, of course) have a decision to make: When should we exercise our right to bump the rate of the CD higher--early on, in the middle of the term, later on? Is there some optimal exercise point during the one-year term?

So far, here is how one-year bump CD rates at our bank have moved since we invested:

March 2005: 3.0% (our initial base rate)
April: 3.1%
May: 3.2%
June: 3.2%
July: 3.2% (current market rate)

Interest on our CDs has been accruing at the initial rate of 3.0% for the five months we have been invested so far. The bump feature currently gives us the right to bump the accrual rate higher to 3.2% for the remaining seven months of the one-year term, but if we do so now we forego the opportunity to benefit from any further rise in interest rates.

The 20 b.p. rise in market rates (from 3.0% to 3.2%) we have seen to date has been the result of a general rise in short-term interest rates, driven by Fed policy. If we thought that short-term rates would remain the same or fall from here, we would exercise the bump option immediately to lock in the extra 20 b.p. and start accruing interest at 3.2%. However, since Chairman Greenspan has signaled that the Fed will continue to notch short-term rates higher over the remainder of the year, our inclination is to wait a little longer before we bump. But how much longer should we wait?

We can put some math to this optimization problem to gain a little more insight (at least for those who are analytically inclined):

Let "t" represent time, ranging from t = 0 (when we opened the CDs) to t = 1 (i.e., one year out, when the CDs mature). Suppose (for simplicity) that market CD rates rise following a linear path: Initial rate + (a x t), where "a" is a constant indicating the speed of increase (e.g., 50 b.p. per year). Then, the incremental benefit we realize over the remainder of the term of our CD from exercising the bump option at time t is given by:

Benefit = (a x t) x (1 - t) [linear scenario]

We would like to maximize our benefit by selecting the best time to exercise the bump option, i.e., the value of t (between 0 and 1) that produces the highest benefit. This can be done either by inspection (using some intuition) or by applying elementary calculus: d(Benefit)/dt = a x (1 - 2t), which equals 0 when t = 0.5, i.e., half way into the one-year holding period.

So, if interest rates rise linearly, the optimal exercise point is six months into our one-year term, i.e., during the next couple of months for the CDs my kids own. However, as is often the case with optimization problems, the result depends on how we choose to model the situation--more specifically, what's important in our problem is the path that interest rates follow. Beyond the simple linear path scenario, another appropriate scenario is to assume that interest rates move higher through a diffusion process typical of random walk modeling:

Benefit = b x (t ^ 0.5) x (1 - t) [diffusive scenario]

Again, differentiating to find the maximum: d(Benefit)/dt = b x [0.5 /(t ^ 0.5) - 1.5 x (t ^ 0.5)]. Setting the first derivative to zero and solving for t, we have: t = 1/3, indicating that one-third of the way into the one-year holding period is the optimal exercise point.

The actual path that market rates follow through March 2006 when the CDs mature is subject to Fed policy, general market conditions, internal decisions at the bank, international events, etc. I believe that short-term interest rates will gradually head higher on the back of Greenspan's indications. I also note that our bank appears to respond to rising interest rates in a stairstep fashion and, since the one-year bump CD rate has been stuck at 3.2% for the past three months, we are probably due for an increase soon. Consequently, I am advising my kids to wait for the next boost in the market rate of the one-year bump CD that our bank offers (possibly to 3.3%?) before exercising their bump option. This will allow them to receive more interest accrual during the latter half of their CD term--hopefully with optimal benefit over the entire one-year holding period. Of course, come next March when the CDs mature we will know whether or not we made the right decision.

Beijing Olympics 2008: A Possible Catalyst for Chinese Stocks

China today may be compared to Japan in the early 1960s--surging economy, expanding trade, optimistic sentiment, eager to put on a show for the world. The Tokyo Olympics were in 1964. Some 44 years later, in 2008, Beijing is slated to host the Summer Olympic Games. Particularly for rapidly developing economies, the Olympics are a symbol of transition, a signal to the world that the host country has entered a new era--one of international cooperation and full-fledged participation in the world economy. Along with economic growth ought to come a rising domestic stock market: Are the Beijing Olympics a bullish sign for China and a catalyst for lifting the depressed Chinese stock market?

Let's have a look at Olympic history, to see how other stock markets have fared in the years before and after their respective countries hosted the Games. Post-World War II, the chronology of locations of the Summer Olympics runs as follows:

1948: London, U.K.
1952: Helsinki, Finland
1956: Melbourne, Australia
1960: Rome, Italy
1964: Tokyo, Japan
1968: Mexico City, Mexico
1972: Munich, Germany
1976: Montreal, Canada
1980: Moscow, Russia
1984: Los Angeles, U.S.
1988: Seoul, Korea
1992: Barcelona, Spain
1996: Atlanta, U.S.
2000: Sydney, Australia
2004: Athens, Greece
[2008: Beijing, China]
[2012: London, U.K.--coming complete circle in 64 years]

Using www.globalfindata.com, I have been able to find stock market performance data for about half of the above countries (generally the ones with larger economies) around their Olympic years:

Olympic Year: City, Country: Annual Change in Local Stock Market Index
(Returns indicated are for nine consecutive years: the 4 calendar years immediately prior to the Olympic year; the Olympic year itself; and the 4 calendar years immediately following the Olympic year.)

1948: London, U.K.: 10%, 0%, 18%, -3%; -4%; -14%, 6%, 2%, -5%
1956: Melbourne, Australia: -18%, 8%, 13%, 5%; 2%; 10%, 14%, 39%, -12%
1964: Tokyo, Japan: 55%, 5%, -1%, -14%; -1%; 17%, 2%, -12%, 34%
1972: Munich, Germany: 13%, 16%, -24%, 5%; 13%; -20%, -3%, 31%, -8%
1976: Montreal, Canada: 24%, -3%, -30%, 14%; 6%; 5%, 24%, 38%, 25%
1984: Los Angeles, U.S.: 26%, -10%, 15%, 17%; 1%; 26%, 15%, 2%, 12%
1996: Atlanta, U.S.: 4%, 7%, -2%, 34%; 20%; 31%, 27%, 20%, -10%
2000: Sydney, Australia: 10%, 8%, 7%, 12%; 0%; 6%, -11%, 11%, 23%

Average Returns: 16%, 4%, 0%, 9%; 5%; 8%, 9%, 16%, 7%

(Based on the benchmark indices: U.K. Financial Times All-Share Index, Australia All Ordinaries, Japan Nikkei 225 Average, Germany CDAX Price Index, Canada TSX 300, U.S. S&P 500 Index.)

In an attempt to glean from the data (admittedly a very small sample) some type of "customary" (i.e., to the extent that there ever are robust patterns in stock market data!) Olympics-related stock price behavior, I take a look at simple "averages of the averages" using time windows of varying lengths just prior to and following the Olympic years:

The 4 Years Prior To vs. The 4 Years Following the Olympics: 7% vs. 10%
The 3 Years Prior To vs. The 3 Years Following the Olympics: 4% vs. 11%
The 2 Years Prior To vs. The 2 Years Following the Olympics: 4% vs. 8%
The 1 Year Prior To vs. The 1 Year Following the Olympics: 9% vs. 8%

Without trying to read too much into the data, I venture the following explanation that is at least consistent with the historicals:

1. Pre-Olympic Run-Up: In the year prior to the Olympic year, speculators buy stocks based on the Olympic story: domestic job creation from money being pumped into infrastructure, more flow of funds into the country from increased foreign investor focus on business opportunities, more international trade, growing economy, bright future, and so on. This leads to slightly better short-term performance of the stock market in the year prior to the Olympics (9%) than in the year following the Olympics (8%).

2. Olympic Year Fizzle: In the Olympic year itself, speculators close out their long positions, creating some selling pressure which leads to very mediocre returns for the market indices (5%).

3. Long-Term Growth Trend: The view over pre- vs. post-Olympics 2-year (4% vs. 8%), 3-year (4% vs. 11%) and 4-year (7% vs. 10%) time windows reveals a discernible growth trend, with stock market performance solid and improving, particularly following the Olympics.

What, then, is the implication for China with the Beijing Olympics in 2008? The historical data seem to favor strategic over-allocation to Chinese stocks beginning a year or two prior to the Olympics, i.e., during 2006 and 2007. If past stock market history surrounding Olympic years is any indication, we can expect improving returns in the years following the Olympics. With the domestic Chinese stock market having performed so dismally in four out of the past five years (Shanghai SSE Composite Index: -21% in 2001, -17% in 2002, +10% in 2003, -15% in 2004, and -18% year-to-date 2005), despite consistently strong fundamentals (economic growth at a rapid clip of 8% to 9% annually, as reported by the Chinese government), a reversion-to-the-mean theory too would point to better returns ahead.

So, yes, the Beijing Olympics in 2008 could very well be the catalyst for a bounce in Chinese stocks. Investors in 1964, the year of the Tokyo Olympics, who bought Japanese stocks and had the patience to hold during the years following the Olympics, realized double-digit gains averaging 10% for the four-year period 1965-1968, in sharp contrast to the negative Japanese stock returns in 1962 (-1%), 1963 (-14%) and 1964 (-1%). With China having entered the WTO and exhibiting more sensitivity and willingness to cooperate with international trading partners than in prior decades, I am cautiously optimistic about China's future and the impact of her giant economy and population on the rest of the world.

London Aftermath: Suggestion for Ending Terrorism

A half year ago when I began this blog, I discussed how capitalism creates a market environment allowing equities to outperform bonds and cash over the long run. Based on the premise that capitalism will continue to thrive (at least in our own lifetimes), I stated that "equity investing is the name of the game." Today I would like to touch on what I see as the key risk factor affecting long-run capitalism--the cultural chasm between wealthier "have" and poorer "have-not" countries.

The London public transit bombings of last week are a sad reminder of a weakness inherent in our interconnected global community. What we have is an ugly chain of events: 9/11 (2001), New York and Washington, D.C.; March 2004, Madrid; and now London, a day after the city was awarded the privilege of hosting the 2012 Summer Olympics. Is al-Queda responsible for all three international acts of terror? Maybe so, possibly not. In my opinion, more importantly than who set off the bombs is the question: What are the root causes of this terrorism and how do we put an end to it? (Analogy: You might have heard the comment about how the medical profession is so adept at pulling drowning people out of the river downstream and saving their lives, without ever bothering to go upstream to find out who is throwing the poor innocent souls into the water in the first place!)

Terrorists are angry people, upset at their position in the world and desiring to vent their rage on the enemy around them. They are just as upset as George Bush was when he launched his War on Terror, rationalizing the invasion of Iraq and capture of Saddam Hussein through a search for weapons of mass destruction, while unsuccessfully conducting a manhunt for Osama Bin Laden in Afghanistan. With Bin Laden still on the run and the war in Iraq now in its third year, one wonders what progress has been made. . . .

Between all of the terror, bombings, fighting and war, what we fundamentally have is a conflict of cultures: Muslim vs. Judeo-Christian, religious vs. secular values, tradition vs. freedom, Allah vs. science, spiritualism vs. consumerism, social class vs. mobility, birth rights vs. money, have-nots vs. haves. Two quotes taken from history represent ways to deal with this conflict. The first is from the 18th century, when a French aristocrat (claimed by some to have been Queen Marie Antionette) showed her insensitivity towards the plight of the starving peasants when she uttered the infamous remark "Let them eat cake" (meaning a flour-and-water paste used at the time to "cake" the interior of ovens and baking pans, not the delicate, sweet variety of cake as we know it today). This type of "bad" attitude of the wealthy aristocratic class towards the impoverished peasantry has been the cause of much class tension and rebellion over the centuries.

On the other hand, an example of a "good" attitude comes from a scene in the movie "Gandhi" (1982), in which Gandhi gives advice to Nahari who is grieving over having killed a Muslim child since the Muslims killed his own son. Gandhi tells Nahari, "I know a way out of Hell. Find a child, a child whose mother and father [were] killed and raise him as your own--only be sure that he is a Muslim and that you raise him as one." Consider the resolve and determination that would be required for a non-Muslim man, whose own son had been killed by Muslims, to raise a Muslim boy as his own son, and in a Muslim way. This is the degree of compassion and love for humanity that is needed to put an end to international hate-crimes like terrorism.

So, how do we get from our fragile, conflict-prone world of today to a better, more peaceful world for tomorrow? What I suggest is that, rather than spending billions and billions of dollars on the Iraq war ($180 billion to date by one estimate) and other questionable military exercises, the U.S. and other wealthy countries should fund a comprehensive international educational exchange program. I think that U.S.-Iraqi relations would improve if, instead of continuing with its war effort, the U.S. were to send a few thousand high school students to Iraq to study each year, and in exchange host an equal number of Iraqi high school students here the U.S. Students would have their air fares, room and board, school fees and out-of-pocket expenses entirely covered by the program, with schools and host families receiving financial support as well. Participation would be through a competitive selection process, similar to how students are awarded scholarships for college. To the extent that safety is a concern, U.S. and Iraqi troops could help out as "peace officers" and bodyguards in the initial stages of the program.

My point is that only by bridging the cultural chasm between have and have-not nations will we, world citizens, ever learn to live peacefully together as one world, one humanity, without war and terrorism. By making friends with "enemy" children, our own kids here in the U.S. will acquire a broader international perspective. Extension of the educational exchange program to include many countries throughout the world will give childern further opportunities to learn from their foreign neighbor peers. Through sharing educational and cultural experiences with foreigners, our children should begin to respect not only their own country and its American-style capitalistic values but also a welcome diversity of customs and attitudes. For example, one refreshingly different view comes from the nation of Bhutan (population 2 million, located between China and India), which has an official government program promoting Gross National Happiness, a holistic alternative to the common economic focus on maximizing Gross National Product (GNP).

To the extent that the youth of our world are the future, friendship programs aimed at children give me hope that the conflict, war and terrorism we struggle with as nations will one day melt away. Friendship and education are far better weapons for fighting the long-run war against terrorism than any other form of artillery I can possibly imagine. Preventive educational measures are also a lot less expensive than guns, tanks, missiles and soldiers. Are you listening, President Bush?