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Author: activeREinvestor Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 76384  
Subject: Four Pillars of Investing Date: 1/5/2005 7:16 PM
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The books keeps coming up as a must read for people getting started with investment.

As I was curious I checked out Amazon. One nice thing about Amazon is your can browse a bit including checking out the table of contents, etc. Similar to going to the bookstore and reading a bit.

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 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. 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.

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.

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. 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. 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.

Coming back to the idea of reading the book.

As many folks are suggesting it then it is likely to be worth reading. As a teacher once explained to me. Sometimes you read for knowledge. Other times you read to figure out why people think the way they do. Hence some things are best read so you can understand the other person and not because the message being read is an accurate one.

I am sure the book will have many interesting ideas and I will learn something from it. At the same time we are trained not to believe everything we read (here or otherwise).

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. The Enron and Worldcomm shares and bonds are two examples where the actual risk was not understood and therefore the pricing was wrong. Fraud in those cases. Sometimes the issue is just because of an over reaction by the public to negative news (sales are down because consumers have cut back holiday spending). Buffet buys into companies because he values the management and the future prospects at a higher price then the market is setting for the company's shares and bonds at the time. Hence he believes that he can make better returns then the average because there is a value opportunity that the market is not recognizing. Failure to recognize and above average returns are direct proof that the markets are not efficient in all cases. What the markets will do is seek out the inefficiencies as the savvy investors move to the places of above average returns so the opportunities will not be there for ever.

Yes, it takes time and skill so you can out perform if you invest time and skill. With both you can earn above average returns while not taking proportionally higher risks.

Comments?

John

PS. Yes, I now have committed to reading the book. I will line up my order.
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