Category Archives: Risk Management

Charts: Every Picture Tells a Story Don’t It? –Rolling Stones

Above is a chart of the Barrons Gold Mining Index, the oldest mining index available.

Above are chart analogs of past bear markets in gold-mining stocks. Rather than using charts to PREDICT the next “Head and Shoulders Bottom” or the next ROUNDING BOTTOM (How about I show you MY bottom?) what can charts tell you about this PARTICULAR industry?   How is that information useful? Or is it?

Note the hedged comments of the publisher of the above charts.

Charts have never shown (based on my research) to have any statistical predictive value because of the subjective nature of interpretation–there are always two sides to a chart. Buffett stopped charting when he could flip the chart over and get the same answer.   Note this article

Now onto the bull market analogs.

Bull Market Analogs Article

Notice the difference with these charts of housing and banks.

What might account for the difference in the chart patterns?  What do the charts tell you about the mining industry?  IF–god forbid–you did wish to invest in precious metals miners, how might you adapt your strategy?  What explains (mostly) the shape of the above charts?  It is perfectly rational to avoid the industry but what do the charts tell you about the structure of the industry? Whip out your competitive analysis books or and post your thoughts.



Investing might be considered decision-making under uncertainty. Therefore the following exam.

You must answer BOTH questions correctly to be hired.  You are now in the final pool of candidates to work for a big hedgie fund. Now comes

Question 1:

Imagine playing the following game,  At a casino table is a brass urn containing 100 balls, 50 red and 50 black.  You’re asked to choose a color.  Your choice is recorded but not revealed to anyone, after which the casino attendant draws a ball randomly out of the urn. If the color you chose is the same as the color of the ball, you win $10,000.  If it isn’t, you win nothing-$0.00.

You are only allowed to play once–which color would you prefer, and what is the maximum bid you would pay to play? Why?

Question 2:

Now imagine playing the same game, but with a second urn containing 100 balls in UNKNOWN proportions.  There might be 100 black balls and no red balls, or 100 red balls and no black balls or ANY proportion in between those two extremes.  Suppose we play the exact same game as game 1, but using this urn containing balls of unknown colors.

What is your bid to play this game IF you decide to play?   How does the “risk” in this game (#2) compare to game (#1)?

Take no more than a minute.   So are you hired?!

Answer posted this weekend.

ANSWER (9/10/2017)

A Reader provides a clearer distinction in Question2:

Your second problem is ill-specified for your desired effect . You write that all combinations of red/black balls within the 100 ball population ARE possible; you don’t say they are equally probable. You need to assume them to be equally probable in order for the reader to infer that the expectations are identical between problem 1 and problem 2.

The reason being is that without defined probabilities on the possible ratios the long run frequency of draws from the second bag isn’t calculable. Hence the expected value cannot be computed and therefore cannot be used in comparison to the EV of problem 1 (you need probabilities in a probability weighted average after all).

You could suggest that the offeree has a 50/50 chance of choosing the correct colour (even if the long run frequencies are not known). But this not an argument born from expected value. This is an argument of chance and it assumes the offeree has no additional information from which to make their decision (which is hardly ever the case).

There are 100 possible choices for the proportion of red/black: 100 red balls/0 black balls, 99 red balls/1 black ball etc., 98/2, 97/3     with 100%, 99%, 98%, 97% probability of choosing a black ball all the way………… to 2 black balls/98 red balls, 1/99, 0/100. Put equal weight on them since random.  When computed, the average of the expected payoffs across all these alternative realities, one got an expected value of $5,000, the same as Game 1.

The two games describesthe Ellsberg Paradox, after the example in Ellsberg’s seminal paper.  Thinking isn’t the same as feeling.  You can think the two games have equal odds, but you just don’t feel the same about them.   When there is any uncertainty about those risks, they immediately become more cautious and conservative.  Fear of the unknown is one of the most potent kinds of fear there is, and the natural reaction is to get as far away from it as possible.

So, if you said the two games were exactly similar in probabilities, then A+.  The price you would bid depends upon your margin of safety/comfort.   You would be rational to bid $4,999.99 since that is less than the expected payoff of $5,000.  But the loss of $4,999.99 might not be worth it despite the positive pay-off.  A bid of $3,000 or $1,000 might be rational for you.   The main point is to understand that the two games were similar but didn’t appear to be on the surface.

The Ellsberg paradox is a paradox in decision theory in which people’s choices violate the postulates of subjective expected utility. It is generally taken to be evidence for ambiguity aversion. The paradox was popularized by Daniel Ellsberg, although a version of it was noted considerably earlier by John Maynard Keynes.  READ his paper: ellsberg

Who was fooled?

Anyone not answering correctly or NOT answering has to go on a date with my ex:

The Stock Market: Risk vs. Uncertainty

Life is risky. The future is uncertain. We’ve all heard these statements, but how well do we understand the concepts behind them? More specifically, what do risk and uncertainty imply for stock market investments? Is there any difference in these two terms?

Risk and uncertainty both relate to the same underlying concept—randomness. Risk is randomness in which events have measurable probabilities, wrote economist Frank Knight in 1921 in Meaning of Risk and Uncertainty.1 Probabilities may be attained either by deduction (using theoretical models) or induction (using the observed frequency of events). For example, we can easily deduce the probabilities of the possible outcomes of a game of dice. Similarly, economists can deduce probability distributions for stock market returns based on theoretical models of investor behavior.

On the other hand, induction allows us to calculate probabilities from past observations where theoretical models are unavailable, possibly because of a lack of knowledge about the underlying relation between cause and effect. For instance, we can induce the probability of suffering a head injury when riding a bicycle by observing how frequently it has happened in the past. In a like manner, economists estimate probability distributions for stock market returns from the history of past returns.

Whereas risk is quantifiable randomness, uncertainty isn’t. It applies to situations in which the world is not well-charted. First, our world view might be insufficient from the start. Second, the way the world operates might change so that past observations offer little guidance for the future. Once bicyclists were encouraged to wear helmets, the relation between riding the bicycle—the cause—and the probability of suffering a head injury—the effect—changed. You might simply think that the introduction of helmets would have reduced the number of head injuries. Rather, the opposite happened. The number of head injuries actually increased, possibly because helmet wearing bikers started riding in a more risky manner due to a false perception of safety.2

Typically, in situations of choice, risk and uncertainty both apply. Many situations of choice are unprecedented, and uncertainty about the underlying relation between cause and effect is often present. Given that risk is quantifiable, it is not surprising that academic literature on stock market randomness deals exclusively with stock market risk. On the other hand, ignorance of uncertainty may be hazardous to the investor’s financial health.

Stock market uncertainty relates to imperfect information about how the world behaves. First, how well do we understand the process that generated historical stock market returns? Second, even if we had perfect information about past processes, can we assume that the same relation between cause and effect will apply in the future?

The Highs and Lows of the Market

Warren Buffett, the world’s second-richest man, distinguishes between periods of comparatively high and low stock market valuation. In the early 1920s, stock market valuation was comparatively low, as measured by the inflation-adjusted present value of future dividends. The attractive valuation of stocks relative to bonds became a widely held belief after Edgar Lawrence Smith published a book in 1924 on stock market valuation, Common Stocks as Long Term Investments. Smith argued that stocks not only offer dividends, but also capital appreciation through retained earnings. The book, which was reviewed by John Maynard Keynes in 1925, gave cause to an unprecedented stock market appreciation. The inflation-adjusted annual average growth rate of a buy-and-hold investment in large-company stocks established at the end of 1925 amounted to a staggering 32.13 percent at the end of 1928.

On the other hand, over the next four years, this portfolio depreciated at an average annual rate of 17.28 percent, inflation-adjusted. Taken together, over the entire seven-year period, the inflation-adjusted average annual growth rate of this portfolio came to a meager 1.11 percent. Buy-and-hold portfolios in allegedly unattractive long-term corporate and government bonds, on the other hand, grew at inflation-adjusted average annual rates of 10.18 and 9.83 percent, respectively. This proves Buffett’s point: “What the few bought for the right reason in 1925, the many bought for the wrong reason in 1929.” One conclusion from this episode is that learning about the stock market may feed back into the market and, by changing the behavior of the market, render our “learning” useless or—if we don’t recognize the feedback effect—hazardous.
Is Tomorrow Another Day?

Risk and uncertainty are two concepts that stem from randomness. Neither is fully understood. Although risk is quantifiable, uncertainty is not. Rather, uncertainty arises from imperfect knowledge about the way the world behaves. Most importantly, uncertainty relates to the questions of how to deal with the unprecedented, and whether the world will behave tomorrow in the way as it behaved in the past.

This article was adapted from “The Stock Market: Beyond Risk Lies Uncertainty,” which was written by Frank A. Schmid and appeared in the July 2002 issue of The Regional Economist, a St. Louis Fed publication.

(Source: St Louis Federal Reserve)

A Review: The Bre-X Scandal

The Peak
It was touted by media and banks as the “richest gold deposit ever”
In December 1996, Lehman Brothers Inc. strongly recommended a buy on “the gold discovery of the century.”

Bre-X’s salted samples were never checked by a third party, people wanted to believe so they never questioned the rising price of the stock. Do not ignore the warning signs.

Patience is paying off in

When is a P/E not a PE: Case Study in Indexing

A tutorial on the dangers of Indexing investing. 

Know what you are doing IF you buy index funds!  You can learn a lot by studying Horizon Kinetics.  The video provides a valuation of the index and how to think about investing or not in indexes.

Also, more on indexing here:





Hedge Fund Analyst Quiz–NG $3 The New Normal

Your boss runs into your office and slaps this report onto your desk: Don‘t Bet Against Innovation_Sub-$3 Is the New Normal

After reading the report and using your knowledge of how capital cycles work, what would you say to your boss about using the information in that report for investing?  IF you wanted to make an outstanding investment, then how might the report help you?   The video below might give you a hint.  Remember that the JP Morgan report goes to thousands of portfolio managers and analysts, so how can YOU use the information to have an edge? Or can you? Comments needed in order to keep your hedge fnd job.

Good luck!


Indexing Madness or An Indexing Bubble

A must see discussion of today’s index investing distortions   What will turn the tide for active investors. Or read commentary : Q4-2016-Commentary_Final Grant’s Conference Presentation


Q2 2016 Commentary FINAL (See section on ETFs vs. Individual Stocks)

Articles of interest:

Risk Disclosure in Plain Language; Go LT Fundamental

Written in 1998 during the Internet Riot (from Cove Capital Blog)

Risks of Investing in IPS Millennium Fund
Plain Language Risk Disclosure (Funny)

First of all, stock prices are volatile. Well, duh. If you buy shares in a stock mutual fund, any stock mutual fund, your investment value will change every day. In a recession it will go down, day after day, week after week, month after month, until you are ready to tear your hair out, unless you’ve already gone bald from worry. It will insist on this even if Ghandi, Jefferson, John Lennon, Jesus and the Apostles, Einstein, Merlin and Golda Maier all manage the thing. Stock markets show remarkably little respect for people or their reputations. Furthermore, if the fund has really been successful, you might be buying someone else’s whopping gains when you invest, on which you may have to pay taxes for returns you didn’t earn. Just try and find somewhere you don’t, though. Dismal.

While the long-term bias in stock prices is upward, stocks enter a bear market with amazing regularity, about every 3 – 4 years. It goes with the territory. Expect it. Live with it. If you can’t do that, go bury your money in a jar or put it in the bank and don’t bother us about why your investment goes south sometimes or why water runs downhill. It’s physics, man.

Aside from the mandatory boilerplate terrorizing above, there are risks that are specific to the IPS Millennium Fund you should understand better. Since most people don’t read the Prospectus (this isn’t aimed at you, of course, just all those other investors), we thought we’d try a more innovative way to scare you.

We buy scary stuff. You know, Internet stocks, small companies. These things go up and down like Pogo Sticks on steroids. We aren’t a sector tech fund, we are a growth & income fund, but right now the Internet is where we think most of the value is. While we try to moderate the consequent volatility by buying electric utility companies, Real Estate Investment Trusts, banks and other widows-and-orphans stuff with big dividend yields, it doesn’t always work. Even if we buy a lot of them. Sometimes we get killed anyway when Internet and other tech stocks take a particularly big hit. The “we” is actually a euphemism for you, got it?

We also get killed if interest rates go up, because that affects high dividend companies badly. Since rising interest rates affect everything badly, we could get killed even worse if the Fed raises rates, or the economy in general experiences higher interest rates beyond the control of those in control, or gets out of control. Whatever.

Many of the companies we buy are growing really fast. Like, 50% – 100% per year sales growth. Many of them also don’t make any money, although they may be relatively large companies. That means they have silly valuations by traditional valuation techniques. We don’t know what that means any more than you do, because we have never seen anything like the Internet before. So we might overpay for these companies, thinking we are really smart and can get away with it because they are growing so fast. It doesn’t take a whole lot for these companies to drop 50% or more, because nobody else knows what they are worth either. Received Wisdom can turn on a dime in this business, and when that happens prices fall off a cliff.

Even if we were really smart and stole these companies, if their prices run way up we are still as vulnerable as if we were really dumb and paid that high a price for them to start with. If we sell them, you will get pretty irritated with us come tax time, so we try not to do any more of that than we have to. The pole of that strategy, though, is that if we are really successful, you will have a lot of downside risk in a recession or a bear market. Bummer.

Finally, if you haven’t already grabbed the phone and started yelling at your broker to sell our fund as fast as possible, you should understand the shifting sands of technology. It doesn’t take billions of dollars to start a high tech company, like it did U.S. Steel or Ford Motor. Anybody can do it, and everybody does. Many of our companies are small, even though they dominate their market niche. It’s much easier for a new technology to blow one of our companies out of the water than it was in the old days of canal, mining, railroad and steel companies.

Just so you know. Don’t come crying to us if we lose all your money, and you wind up a Dumpster Dude or a Basket Lady rooting for aluminum cans in your old age.

Please e-mail us if we haven’t scared you enough, and we’ll try something else.
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Fundamental investing and the long term (Go here)
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Passive investing bubble








Note: The Value Vault will be down for a few months for reorganization.   For new readers just use the search box or start at the beginning of the blog and go through the 1,200 posts.   By the end you can run Berkshire of Blackrock.

A Strategy for Resource Stocks; Investing Course

A Strategy for investing in highly volatile, cyclical stocks

Once again, gold, silver and their mining stocks are selling off for whatever reason: risk-on as money floods into the stock market, rising nominal yields, 95% certainty of a (meaningless) 0.25% interest rate hike, momentum–take your excuse. The main point is to know your companies (valuation) and wait for sales like you do at the grocery store.   This week we are having a sale on some miners.

As Sprott’s Rick Rule often says, “If you are not a contrarian in the resource sector, you are a victim.  The above video is provided to show a particular investing strategy when your quality miners are selling off to prices where you estimate a margin of safety.  However, it doesn’t mean you predict THE exact bottom.  If your holding period is three-to-five years, you can occasionally pick up cheaper merchandise. Use prices to your advantage, not disadvantage.  I also wouldn’t be surprised to see the miners sell-off further because of their highly volatile nature–huge operational and asset-based leverage–when gold or silver goes up or down, both the price of their product goes up or down and the value of their reserves.  Never expect exact timing–a fool’s game.  Also, miners are impacted by the cost of their inputs, so a rising gold/oil ratio is a positive, for example.

What about the gold price in my assumptions?   I am assuming gold is money (“All else is credit”–JP Morgan) and thus I can benchmark it against world currencies. Gold has been THE strongest money relative to all other currencies for the past 20 years, 30 years, 40 years, 50 years, 100 years.  Gold is THE only money and store of value that can’t be created out of electronic bits like FIAT MONEY.  The stability of available supple is what makes gold the premier money. Of course, due to LEGAL TENDER LAWS, gold is not a currency in the U.S., except that may be changing in some states like Arizona:

In fact, gold (originally silver) is the only Constitutional money allowed–!/articles/1/essays/42/coinage-clause

You can get a historical overview of gold’s‘ price history below. Notice a trend? Now view the miners in perspective.

P.S. Let me know if anyone wants to see a NPV case study on a miner.

Designing an analyst course

My goal is to organize a comprehensive analyst course using the best investors’ teachings and lectures. For example, Buffett, Munger, Graham, Fisher, Tweedy Browne, Walter Schloss, Klarman, and many others etc.  Why not use original sources of the best practitioners?  This is the course I wish I had twenty years ago.  It will be Buffett and Munger teaching not me.

The course would cover search, valuation, portfolio management, and you (how to improve decision-making).   There would be different modules continuing articles, case studies, videos from Columbia Business School and others. We would go from DEEP VALUE to FRANCHISE INVESTING.   Valuing assets to assessing franchises. Understanding reversion to the mean and slow reversion to the mean.  You need to understand that when a moat is breached-watch out! Note Nokia in cell phones.

I would have to make it a private web-site because of copy-right.   This would be more of like a private study place, library, and discussion area for learning.   There could be a in-person value class in some convenient location depending upon interest once folks have had a chance to go through the modules.

For example, putting ebitda into perspective might be a mini-module on a sub-set of cash-flow:   Now, if you scroll down to the last link, you can see that it was taken down.   With a private web-site, you would see this:

Let me know your thoughts because this would be a huge project to complete.  What focus do YOU want?   How would YOU design and make the course.

Have a great weekend!

A Deep-Value Canadian Grahamite Teaches His Process

Tim McElvaine explains his simple but effective process.

2016-05_conference_transcript_McElvaine Fund An excellent tutorial on Graham-like investing. Note his simple four-pronged approach.   Read more below:

Time to Index? Got Gold?

A portfolio manager who will manage the Dogs of the Dow Portfolio.

Most institutional and individual investors will find the best way to own common stock is through an index fund that charges minimal fees. Those following this path are sure to beat the net results after fees and expenses delivered by the great majority of investment professionals. –Warren Buffett.

A minuscule 4% of funds produce market-beating after-tax results with a scant 0.6% annual margin of gain. The 96% of funds that fail to meet or beat the Vanguard 500 index Fund lose by a wealth-destroying margin of 4% per annum.  “Unless an investor has access to incredibly highly qualified professionals, they should be 100 percent indexed. That includes almost all investors and most institutional investors. –David Swensen, chief investment officer, Yale University.

“In modern markets, most institutions and almost all individuals will experience better results with index funds.” –Benjamin Graham.

Those who have knowledge, don’t predict. Thos who predict, don’t have knowledge. — Lao Tzu, 6th Century B.C.

I am reading, The Index Revolution: Why Investors Should Join It Now by Charles D. Ellis

The author presents a compelling case why most individuals should index:

  1. Indexing outperforms active investing
  2. Low Fees are an important reason to index
  3. Indexing makes it much easier to focus on your most important investment decisions
  4. Your taxes are lower when you index
  5. Indexing saves operational costs.
  6. Indexing makes most investment risks easier to live with
  7. Indexing avoids “Manager Risk”
  8. Indexing helps you avoid costly troubles with Mr. Market
  9. You have much better things to do with your time.
  10. Experts agree most investors should index

Articles proliferate such as: and research for the past few decades has shown that Index Funds Outperform.

Now lets journey into the real world:  I picked this fund family at random. Look at each of their funds’ long-term performance compared to their comparable benchmarks.   Not ONE outperforms. Not one.   Who in their right mind would invest?    As money managers become desperate to beat the index, they tend to mimic their benchmarks, so their amount of underperformance closes towards the index, but GUARANTEES underperformance due to fees and slippage of commissions and taxes.

Time to pack it in and index?   First, do not underestimate how difficult it is to “outsmart” the market.   I personally believe that the ONLY way–obviously–to do better is to be very different from the indexes.   You will either vastly UNDER-perform or OUTperform.  You have to be different and right.  So how to be right?  You must do things differently like use all available information in the financials (read footnotes and balance sheet), have a longer-term perspective such as five to seven years–at a minimum–three years to give reversion to the mean a chance to work or time for franchises to compound.   You have to pick your spots where you are confident that you are buying from mistaken, uneconomic sellers.   And when you do find a great opportunity (assuming that you can distinguish one) you heavily weight your position.  NOT EASY.


Here is what Seth Klarman recently said about current conditions (New York Times, Feb. 7th, 2017:

Most hedge funds have found themselves on the losing side of trades over the past several years, a point Mr. Klarman addressed in his letter (2016). Noting that hedge fund returns have underperformed the indexes — he mentioned that hedge funds had returned only 23 percent from 2010 to 2015, compared with 108 percent for the Standard & Poor’s index — he blamed the influx of money into the industry.

“With any asset class, when substantial new money flows in, the returns go down,” Mr. Klarman wrote. “No surprise, then, that as money poured into hedge funds, overall returns have soured.”

He continued, “To many, hedge funds have come to seem like a failed product.”

The lousy performance among hedge funds and the potential for them to go out of business or consolidate, he suggests, may become an opportunity.

Perhaps the most distinctive point he makes — at least that finance geeks will appreciate — is what he says is the irony that investors now “have gotten excited about market-hugging index funds and exchange traded funds (E.T.F.s) that mimic various market or sector indices.”

He says he sees big trouble ahead in this area — or at least the potential for investors in individual stocks to profit.

“One of the perverse effects of increased indexing and E.T.F. activity is that it will tend to ‘lock in’ today’s relative valuations between securities,” Mr. Klarman wrote.

“When money flows into an index fund or index-related E.T.F., the manager generally buys into the securities in an index in proportion to their current market capitalization (often to the capitalization of only their public float, which interestingly adds a layer of distortion, disfavoring companies with large insider, strategic, or state ownership),” he wrote. “Thus today’s high-multiple companies are likely to also be tomorrow’s, regardless of merit, with less capital in the hands of active managers to potentially correct any mispricings.”

To Mr. Klarman, “stocks outside the indices may be cast adrift, no longer attached to the valuation grid but increasingly off of it.”

“This should give long-term value investors a distinct advantage,” he wrote. “The inherent irony of the efficient market theory is that the more people believe in it and correspondingly shun active management, the more inefficient the market is likely to become.”


What do YOU think?