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URL:  http://boards.fool.com/activereinvestor-four-pillars-of-investing--21863771.aspx

Subject:  Re: Four Pillars of Investing Date:  1/5/2005  8:50 PM
Author:  JAFO31 Number:  43896 of 75340

activeREinvestor: Four Pillars of Investing, . . . keeps coming up as a must read for people getting started with investment.

As I was curious I checked out Amazon.

There is a quote from the first chapter that I wanted to raise here. Both because it is 'common wisdom' that it is correct and because it is 'professional wisdom' that it is false in some cases."

The difficulty is in knowing, with certainty, the cases.

"The book says The one thing that stands out above all else is the relationship between return and risk. Assets with higher returns invariably carry with them stomach-churning risk, while safe assets almost always have lower returns."

How can you argue with the statement.

Yet when people do study the market there are ample ways to show that risk and returns are mispriced."


For awhile.

"The simplest one was when a student studied the premium on junk bonds and discovered that the risk premium was in excess of what was needed to compensate for the actual defaults. The student went on to re-invent junk bond investing and helped to improve the efficiency of capital allocated to businesses."

And eventually Mike Milliken went to jail, too.

"Warren Buffet has discussed the same situation when he talks about re-insurance. Insurance is many times mis-priced. Re-insurance being more off the mark and therefore a prudent place for Buffet to invest given what he believes to be a superior understanding of how to price the risks. His company is the largest re-insurance company in the world by some measures."

Big re-insurance is a relatively small world with not that many players.

"A third example is how people (professionals and amateurs) mis-price long-tailed events when option prices and futures are traded. Humans by their nature are less able to deal with statically off the chart events then they are dealing with the norm."

Long-tail events, however, are different than "off the chart" events -

"They over compensate or under estimate. Explained as a good thing for survival but not the best skill when dealing with six sigma events on a bell curve."

I am a bit rusty with my statistics, but as I recall:

+/- 1 SD is roughly 68%
+/- 2 SD is roughly 95%, so single sided tail is down to 2.5%
+/- 3 SD is roughly 99.7%, so single tail is down to .15%,
+/- 4 SD is roughly 99.9% (?), so single sided tail is down to .05%
+/- 5 SD is ?
+/- 6 SD is ?

So a six-sigma event is a way, way unlikely event.

"The reaction to the recent natural disaster is an example as is the response every time there is a plane crash. Other forms of death and destruction happen around us and we do not really react. Yet when an event that is hard to believe happens we are mobilized into action or avoidance. If you were to measure the impact of one event vs another the responses are many time out of proportion to the 'impact'. Call it an emotional response. Not an efficient market response."

Yes. Plus the assumptions of EMT are never really met in real life, anyway.

"I worked for a number of investment banks and I know for a fact that the markets are not efficient or accurate in how they price everything."

I doubt that anyone truly disputes that statement.

Regards, JAFO
(The book is on my reading list, but not yet read by me)



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