One Day Reversal (Jesse Livermore)

A One Day Reversal occurs where the high of the day is higher than the high of the previous day, but the close of the day is below the close of the previous day, and the volume of the current day is higher than the volume of the previous day (at least 50% more than average). Continue reading...

How Instant Wealth is Created

To understand how this is done, it is necessary to think in terms of two different capital markets. The first capital market is the market for physical investment. In this market, firms and individuals make real investments in plants and equipment. The second capital market is the financial market where individuals buy financial instruments (ownership rights) without directly managing real plant and equipment. Stocks, bonds, and real estate trusts are examples of the latter; factories, stamping presses, and lathes are examples of the former.

Instant wealth arises in the process of capitalization. Consider a real investment in plant and equipment of $10 million that earns $3 million per year. Suppose that the market rate of interest or the discount rate is 10 percent. With a 10 percent discount rate, a $3 million annual income flow is worth $30 million ($3 million/.10) in the financial market. If the discount rate were 5 percent, the same investment would be worth $60 million. This is true regardless of how much it cost to make the initial investment. But in the example, the initial investor has now increased his wealth instantly from the initial $10 million to $30 million when the investment was sold. The purchaser who buys the stock for $30 million, however, has an investment that only earns the market rate of interest (10 percent). If the real investment opportunity were something that could be duplicated by the initial investor, his $10 million investment might be worth even more because of the future profits that similar investment could bring.

It is this process of capitalizing above-average returns that generates rapid fortunes. Patient savings and reinvestment have little or nothing to do with such fortunes. To become very rich one must generate or select a situation where an above-average rate of return is about to be capitalized.

If real capital markets reached equilibrium quickly, large fortunes could not be made in this process of capitalization. Once a new physical investment opportunity was discovered, real investment funds would quickly flow into the area and bring the real rates of return down to the market's average rate of return. Above-average profits would not be expected to last very long, and there would be no possibility of obtaining a monopoly on future above-average physical investment opportunities. Other people would move into the area and future physical investments would only earn the market rate of return. In this case, physical investments are only worth what they cost to build and cannot cause sudden additions to wealth.

Data on real capital markets indicate little if any tendency for the real capital markets to approach equilibrium. Substantial, persistent differences in real rates of return exist. The reasons for this fundamental disequilibrium are many and varied, but most of them spring from a basic characteristic of real investment markets. Investment resources simply do not flow quickly across firms and industries thereby equalizing real rates of return.

While the process of capitalizing disequilibrium rates of return explains instantaneous wealth, there is still the problem of how these fortunes are allocated to individuals. This brings us to what is called the random walk. Since no one can predict where these opportunities for capitalizing real disequilibrium out of existence will appear, the winners are, as in any lottery, lucky rather than smart or meritocratic.

The random walk is a process that will generate a highly skewed distribution of wealth. You cannot lose more than you have, but you can make many times what you have. Because most holders of wealth eventually diversify their portfolios, great fortunes remain even if the underlying disequilibrium in the real capital market eventually disappears. It should be emphasized that there is no equalizing principle in the random walk. Those who have had good luck are no more apt than the random individual to be subject to bad luck.

What is evidence for the random walk hypothesis? First, an examination of large financial firms (such as mutual funds) indicates that none of them is able to outperform the market averages over the long term. Professional financial managers able to make large investments in obtaining market information are not able to outperform the market average or a random drawing of stocks. Second, no one has been able to design a set of decision rules (when to buy and sell) that yields a greater than average rate of return. Third, tests indicate that stock prices quickly adjust to changes in information (announcement of stock splits, dividend increases, and so forth). Fourth, there is no serial correlation among stock prices over time. The price at any moment in time or its history cannot be used to predict future prices. When put together, all of these findings form an impressive body of evidence as to the existence of the random walk.

While many of the great fortunes represent a combination of entrepreneurial and financial investments, the same random walk process probably holds. Ability is necessary, but within a group of individuals with equal entrepreneurial talents a nonnormal random lottery occurs. There is an expected rate of return for the group as a whole, but there exists a wide dispersion in individual results around this average. Entrepreneurial talent is a necessary condition for entering the lottery, but it is not a sufficient condition for making instantaneous wealth. The entrepreneurial random walk is, however, much less subject to proof than the purely financial variant. The unsuccessful entrepreneur does not remain visible for study in the same manner as the unsuccessful stockholder.

The net result is a process that generates a highly skewed distribution of wealth. Great wealth is created in relatively short periods of time. Personal savings behaviour and one's ability to postpone future gratification have little or nothing to do with the process. Once created, large fortunes maintain themselves either because the underlying disequilibrium in real returns remains or because investments are diversified and earn the market rate of return.

If you read the Fortune biographies that accompany their lists of the most wealthy, the winners will be described as brighter than bright, smarter than smart, quicker than quick. But look beyond the description to see if they were simply lucky or possess some unique abilities. Remember that the unsuccessful entrepreneur of equal ability will not be featured in Fortune. To what extent were they like many other people but in the right place at the right time? The real test of unique abilities is to ask how many have repeated their performance. How many have made a great fortune on one activity or investment and then managed to go on to earn another great fortune on another activity or investment? If the Fortune list is examined, it is impossible to identify anyone whose personal fortune was subject to two or more upward leaps. The typical pattern is for a man to make a great fortune and then settle down and earn the market rate of return on his existing portfolio.

What has been generated in this process is realized and unrealized gains. Realized capital gains are taxed at less than half of normal rates, and unrealized capital gains are not taxed at all. Those multibillionaires in the Fortune undoubtedly paid little or no taxes. Nor should one imagine that it is impossible to consume unrealized capital gains without paying taxes. Simply go to your friendly banker (if one is a multibillionaire, there are many friendly bankers), take out a loan using your appreciated stock as collateral, and buy whatever you like. The interest payments on the loan are even tax deductible. You can consume whatever you like and pay no taxes. At death, the principal can be repaid out of that same appreciated stock.
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Answer for the Previous Riddle

WARNING: Just in case you stumble upon the answer here first, please read the previous post before continuing.

Full answer after the jump.

The answer is that there is no such thing as a missing dime in this riddle. The reader is misled by the presumptive nature of the question. There is no reason why the amount paid by the three men, $2.70, should add up to $3.00 if you add it to the 20 cents the waiter put in his pocket. That 20 cents came out of the $2.70 they paid. So the correct calculation is that the bill of $2.50 plus the 20 cents taken by the waiter should add up to the $2.70 (3 x $0.90) that the men paid. Nothing is missing.
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An Old Riddle

Three good friends frequent their favorite restaurant and get a check that comes to a total of $2.50. Each man hands the waiter a dollar bill. On his way back with their change of 50 cents, the enterprising waiter decides that it would be needlessly difficult for the three patrons to divide up the 50 cents, so he pockets 20 cents and hands each man a dime. Now, each man paid a dollar and received back 10 cents in change. So each man really paid 90 cents. From all three, the total was $2.70. The waiter of course has 20 cents in his pocket for a total of $2.90. The riddle is that since they started with $3.00 but we have accounted only for $2.90, where is the missing dime?

I will publish the answer tomorrow at 6pm. Continue reading...

Rant about Amanah Saham 1Malaysia, again

One month ago, I published a post regarding the dividend of Amanah Saham 1Malaysia. I explained that the return of Amanah Saham 1Malaysia is not 3.7% - 4% as everyone and every single articles in all newspapers claimed. Indeed, Amanah Saham 1Malaysia is benchmarked to 5-year MGS yield which is around 3.7% to 4%. But what does that mean anyway?

The purpose of benchmarking the fund is so that PNB as the fund manager has a yardstick to measure its performance upon. Normally, a fund manager's objective is to to beat the benchmark and realize a return higher than the benchmark. 3.7% - 4% is the return for 5-year Malaysian Government Securities (MGS), it is not the return for Amanah Saham 1Malaysia.

There was another article about this silly mistake on TheStar Online. I quote:

"UOB KayHian research head Vincent Khoo said 10 billion units was a difficult target to meet given the low return for such an equity income fund.

As stated in AS 1Malaysia’s prospectus, it is noted that the fund’s returns will be benchmarked against the five-year Malaysian Government Securities (MGS). The current yield of five-year MGS is about 3.7%.

Khoo said the return was slightly higher than bank interest rates but it was not as attractive as previous Amanah Saham funds."

Again, Amanah Saham 1Malaysia's lacklustre response is attributed to the fund's low return. Fact is, this occurs because the experts and professional have been trumpeting the "low return" in all major publications. Our fellow citizens buy it and hence the low subscriptions. Nevertheless, my friend thought of another brilliant factor - our countrymen dislike the man who launched Amanah Saham 1Malaysia and thus refuse to invest in the fund. To that, I have no comment. ;)

If we have done a little more research, we would have known that Amanah Saham Malaysia (ASM) and Amanah Saham Wawasan 2020 (ASW 2020) (which consistently return an average of 6%-7%) are benchmarked to 3-month Kuala Lumpur Interbank Offered Rates (3- month KLIBOR). Guess what, KLIBOR has been hovering between 2.5% to 4% for the past few years.

Another thing that intrigued me is all these fixed-price funds by PNB (AS 1Malaysia, ASM and ASW) have up to 90% of their total portfolio invested in local equities. They are mainly equities funds. Why are they benchmarked to MGS and KLIBOR, instead of KLCI? Continue reading...

Amanah Saham 1Malaysia - Dividend NOT 3.7%-4%

In the past few days, several middle-aged women have approached and told me that they are not going to invest in the newly launched Amanah Saham 1Malaysia because its return is only about 3.7% to 4%, much lower than the usual 6%-7% return consistently achieved by Amanah Saham Malaysia (ASM) and Amanah Saham Wawasan 2020 (ASW 2020).

I was dumbfounded. How did they know about its return when 70%-90% of the fund's total portfolio is going to be invested in equities and the rest in fixed incomes? Amanah Saham 1Malaysia, like the ASM and ASW 2020, is mainly an equity fund. And equities, as we know, had gone through a roller coaster ride in the past one year. Shanghai Composite Index, for example, after reaching a high of nearly 6000 at the end of 2007, had plunged to low of 1700 before staging a tremendous recovery to 3400 lately.

To find the answer, I checked the website of Amanah Saham Nasional Berhad and downloaded the prospectus for Amanah Saham 1Malaysia.

From page 12 of the prospectus:

5.3 PERFORMANCE BENCHMARK

The performance of the Fund is benchmarked against the performance of other instruments that have similar features with that of the Fund. Being a fixed price fund, the return to unitholders of the Fund will mainly be in the form of the Fund’s income distribution yield. The return will be benchmarked against the average of 5-year MGS yield which can be obtained at Bank Negara Malaysia’s (BNM) website and Bloomberg.

Well, the current average of 5-year Malaysia Government Securities (MGS) yield is about 3.7% - 4%. They must have misinterpreted what they read in the newspaper, I thought. So I spent some time explaining to them, that Amanah Saham 1Malaysia is benchmarked to 5-year MGS yield which is around 3.7% to 4%, and that is not the return of Amanah Saham 1Malaysia. We will not know the return of Amanah Saham 1Malaysia, as it is largely depended on the performance of its portfolios.

Then, this morning I read the following excerpt from Nanyang Siang Pau:

理财界人士指出，一个大马基金的年利率介于3.7%至4%之间，不比之前推介的利息至少6%高，因此都掀不起太大购兴。

I nearly fell from my chair.

Clearly, the public has been misguided. I can understand when the typical person can't fully apprehend the prospectus as they don't study finance, but the people who say this are professionals, they are the experts. What are they doing?!

From the master prospectus that I downloaded:

ASB, ASW 2020, ASM and ASD
Being fixed-price Funds, the performance of these Funds are expressed in terms of the respective Fund’s Annual Income Distribution Yield, benchmarked against the 3-month Kuala Lumpur Interbank Offered Rates (3- month KLIBOR), which is obtainable at any commercial bank.

You can obtain the 3-month KLIBOR here.

Do I need to say more?
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How Banks Create Money

Yes. You heard that right! Banks create money. No, they don't have smoke-filled basement rooms in which counterfeiters work vigorously. Banks don't make currency as in notes and coins, what they create is deposits, and they do so by making loans.

Now banks are not magicians either. They can't create money out of thin air. In order to create money, they need a raw material - money. This money comes from customers' deposits. It is the money we deposit into the banks.

Armed with these deposits as reserves, banks can now make loans. Note that banks don't have $100 of reserves for every $100 that customers have deposited with them. If banks behave this way, they wouldn't earn any profit. Banks loan out more money than the reserves they possess, thus in the process, banks create new money that did not exist before.


Bank's required reserve ratio determines the maximum amount of loans that banks can make. Banks are required to hold a level of reserves that does not fall below a specified percentage of total deposits. This percentage is the required reserve ratio.

The required reserve ratio is a bank regulation set by the central bank. It normally ranges from 3-10%. A 3% reserve ratio means that the banks must keep $3 for every $100 deposits, and can loan the remaining $97. A 10% reserve ratio means the banks have reserves of $10 for every $100 while the rest $90 can be loaned out. These reserve levels, albeit low, are adequate for ordinary business needs.

To illustrate this, let's assume the required reserve ratio is 10%.

One day, Roger deposits $100,000 into a certificate of deposit at Citibank. Now Citibank can use this money to create loans. With a required reserve ratio of 10%, Citibank can loan out a maximum amount of $90,000 and keep only $10,000 as reserves. On the second day, Andy approaches Citibank for a loan of $90,000. The bank manager approves the loan and opens an account for him with a credit balance of $90,000.

The story does not end there. According to Citibank's balance sheet, the $90,000 loan to Andy is also a $90,000 asset for the bank. Andy has to repay the $90,000 (plus interest) to Citibank at a future date. As you can see here, Citibank has effectively created $90,000 out of nothing.

Since Citibank has now an additional $90,000 asset, it can make another loan based on this asset. Hence, a second $81,000 loan is created.

This process will keep on repeating itself. Loan #3 is $72,900, loan #4 $65,610 and so on and so forth. A initial deposit of $100,000 will eventually create $1,000,000 of money (the original $100,000 deposit and another $900,000 loan).

Now you should see that banks only have tiny amount of reserves, reserves that are needed to meet depositors' demand for currency and to make payments to its creditors. When confidence towards a bank falters, a bank run occurs. And this is what happened to many US banks in the current crisis - Huge bets on CDO and other derivatives turned sour, confidence eroded, followed by large withdrawals from their depositors. The banks failed when they couldn't repay all their creditors and depositors at once.
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