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Open thread, Dec. 26, 2016 - Jan. 1, 2017

It will be nice if posts that are links (e.g. "[Link] John Ioannidis: Why Most Clinical Research Is Not Useful (2016)") can have the link in the body too rather than only in the title.

With feed readers such as feedly, one cannot directly click the link if it is in the title.

The Library of Scott Alexandria

Is there a list of Scott Alexander's short stories somewhere?

Actually existing prediction markets?

I made a couple of bets on using bitcoin. It was pretty straightforward and easy to use.

Simple investing for a complete beginner? (Just… developing world index funds?)

You imply that one should invest where economic growth is expected to be highest.

Note that it does not follow that shares in high growth companies (or countries) will lead to high returns. This is because the expected future growth may well be built into the current price.

That is, if everyone thinks something will be likely worth a lot in the future, the current price will be bid up to reflect this.

It is the uncertainty of the outcome that may arguably cause higher expected returns. If people have a distaste for uncertainty, then the price might be bid down leading to higher expected returns.

This is the idea that one must assume risk (uncertainty) to obtain excess expected returns. It is by no means ubiquitous: assuming risk may reduce expected returns. For example, people assume risk to gain exposure to negative expected returns in a casino (roulette, blackjack, &c). No doubt there are plenty of examples in financial markets where risk does not automatically yield excess expected returns.

The Rational Investor, Part I

Putting six months worth of expenses in a money-market account seems like a needless 'mental accounting' bias. You can easily and quickly liquidate a portion of your " 70% in a stock index fund and 30% in a bond fund" if you need the cash in an emergency.

The 70% stocks 30% bonds seems somewhat arbitrary. I remember reading a paper once that advocated allocating 130% equities through the use of leverage. Of course, there is always the chance that the stockmarket underperforms over the long run. But, that's the risk that you are ostensibly being compensated for.

The Rational Investor, Part I

that requires no upkeep, no worry, and good returns.

It is plausibly the "worry" (or discomfort) that is required for good expected returns. For instance, CAPM, implies you are being paid to hold undiversifiable risk. You get paid for it because of people's distaste for it.

Your expected returns for a corporate bond, for example, might be because of the worry that it defaults (the extent to which this is undiversifiable, as there is a tendency for bond defaults to co-occur in bad times.), and an illiquidity premium --- in bad times when you'd like to be able to liquidate your position, you're likely to find no one who wants to buy it from you. This is why you can expect to get a return that more than compensates you for the expected loss.

This rules out real estate entirely, and the last criterion rules out letting money sit there.

You can invest in a real estate fund, which is probably a good idea for diversification purposes

get payed back and get taxed again.

typo: payed-> paid

So I should try to minimize these charges? Exactly!

Agreed: this is key.

Someone promises me higher returns for his fees! He's lying: academic research has shown no evidence of after-fee returns beating the market in general.

A lot of money managers are probably not lying in the sense that they probably do believe they have skill even if they don't. Also: some money managers probably do have skill: you just have no good way of determining which ones they are.

Do I need anything else? According to CAPM, no.

The CAPM is great in theory, but there is little evidence that it holds in practice. Within stocks, the longterm historical data shows that riskier stocks have a tendency to have lower returns. (CAPM on the other hand says undiversifiable risk will be priced; that is, you'll get paid to hold it.). There does seem to be an equity premium over bonds though (i.e., across the asset classes, but not within). Excess returns can be earned through liquidity premia, exposure to various 'factors' such as value, momentum, low vol within stocks.

Look on Google Scholar for the works of Ilmanen, Asness, Fama, Carhart, and others to find out what works in investing.

CAPM is considered to be a clever model of a world that is not the one we live in. This is probably because people have some irrational behavioral biases, do not have the utility functions assumed by CAPM, and are exposed to principal-agent problems because money managers incentives are not directly aligned with their clients.

Owning the market through an index fund is not a bad idea. But the reason why it tends to work well is because of low costs and exposure to the equity premium over bonds. When you the own a market cap weighted fund you are getting some undesirable exposures too, such as companies that are not low vol or value. Dimensional offers low cost funds with factor exposures. AQR Capital is another one to look at.

Why is it rational to invest in retirement? I don't get it.

According to the academic literature, the opposite is true:

"Do Financial Markets Reward Buying or Selling Insurance and Lottery Tickets?" Antti Ilmanen Financial Analysts Journal, September/October 2012, Vol. 68, No. 5: 26–36.

"The empirical evidence is unambiguous: Selling insurance and selling lottery tickets have delivered positive long-run rewards in a wide range of investment contexts. Conversely, buying financial catastrophe insurance and holding speculative lottery-like investments have delivered poor longrun rewards. Thus, bearing small risks is often well rewarded, bearing large risks not."

People seem to overestimate events that are salient yet have small probability of occurring. The empirical evidence bears this out.

Investors tend to overestimate the odds of tail events, so selling insurance and lottery tickets is long-run profitable.

What Rate of Return Should You Expect?

Antti Ilmanen's "Expected Returns" is probably one of the best attempts to answer these questions. This book is however quite pricy.

From the intro: "Finance theories have changed dramatically over the past 30 years away from the restrictive theories of the single-factor CAPM, efficient markets, and constant expected returns. Current academic views are more diverse, less tidy, and more realistic. Expected returns are now commonly seen as driven by multiple factors. Some determinants are rational (risk and liquidity premia), others irrational (psychological biases such as extrapolation and overconfidence)."

It is worth mentioning that he has another book "Expected Returns on Major Asset Classes" that is a shorter version covering the central chapters of the pricy book. The kindle version is inexpensive.

What Rate of Return Should You Expect?

Surely if a certain future payoff is expected a priori to be good (because of expected favorable business climate or whatever), then the price paid will adjust accordingly. This means that expected return (a function of price paid and payoff) will be comparable to other investments with similar payoffs, rather than being good.

If, say, business climate were unfavorable, and payoff is expected to be low, price paid for the investment should adjust for this so that expected return need not be low.

If there is large degree of uncertainty associated with a payoff, then expected return may be high to reflect the low price one might get due to people's distaste for variance. (The expected return may be low though if people have a taste for variance; e.g. lottery tickets.)

The point is that expected good economic conditions per se need not be the driver of a priori expected returns. (That they are expected means that the price adjusts to reflect this, leading to mediocre returns.) Rather, the higher order moments of the (subjective) payoff probability distribution may play a more important role.

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