Devil Shadow

The Devil's Financial Dictionary

Devil Shadow

Jason Zweig is one of the few financial journalists who writes articles and books that actually contribute an investor's success in capturing the returns that markets have to offer. His books include The Intelligent InvestorYour Money & Your BrainBenjamin GrahamThe Little Book of Safe Money and his lastest book, The Devil's Financial Dictionary.

In his new book, Zweig draws from his over 20 years of writing about Wall Street to craft a long list of witty and accurate financial term definitions that in total serve to pull back the wizard's curtain on the perceived Wizards of Wall Street. In a recent CNBC interview Zweig talked about his new book with four of such wizards who nervously laughed about the sometimes embarrassing and brutal defintions. Maybe that is why the video is no longer available on CNBC's website. Had CNBC fully grasped the true meanings and implications of these definitions, they would change their programming to be aligned with investors interest and stop tempting their viewers with market beating ideas that have no evidence of working and instead provide programming more like that of IFA.tv.

Here are a few of my favorite definitions from this hilarious and highly educational new book (the italized paragraphs after the definitions poke fun at the typical purveyors of misleading financial advice, incorporating creative and entertaining names of firms and cast of characters). The images are from IFA's Art Gallery:

Alpha (n.) Luck.

Technically, alpha is the excess return over a market index, adjusted for the risk that the portfolio manager incurred to achieve it.   Used as a synonym for skill, alpha is in fact nearly always the result of random chance:

“We bought Mongolian mortgage-backed securities when other investors had decided that the market for yurts would collapse,” said Ivana Butler, an analyst at the investment-management firm Bosch, Tosh & Mullarkey in Boston.  “But an outbreak of botulism among camels and yaks sent the yurt market higher, driving up the price of our bonds.  This is only the latest example of the alpha-generating research process that enables us to outperform.”


Index Fund (n.)

A type of MUTUAL FUND or EXCHANGE-TRADED FUND run by a machine that makes the humans who run ACTIVE funds look like monkeys.  Effectively owning all the stocks or bonds in an INDEX, the index fund doesn’t try to outsmart the market; it tries to be the market.  Unlike an active manager who assumes that tens of millions of other investors are all wrong, the index fund is built on the assumption that the market price is usually the best guess of what securities are worth.  Because index funds are extremely cheap and generate paltry trading commissions, Wall Street scorns them with the phrase “Why settle for average?” The answer: year after year, index funds outperform the majority of active funds, at far lower cost. 

“Index funds aren’t good enough for our clients,” said Robin M. Daley, chief executive officer of the brokerage firm Putnam, Woods, Greene, Bunker & Parr, at a securities-industry dinner last week.  “We feel the same way,” replied Justin Abel, president of Stoller Cash & Rector, the wealth-management firm.  “Where do you put your own money, Robin?” he asked. “You’ve got to be kidding,” replied Mr. Daley, puffing on his Cohiba cigar.  “All my money’s in index funds. “ Mr. Abel took another sip of 1982 Bordeaux and nodded: “Mine, too.”

Incubate (v.)

To test a MUTUAL FUND in private, with money only from the firm that runs the fund – giving the portfolio the unusual advantages of great flexibility and very small size.  If it works, the company will launch the fund after a year and attach swarms of new investors by promoting its one-year track record of “outperformance.”  If it fails, the firm will shut the fund down and no one will be the wiser.

Bubble (n.)

A mania; a rise in asset prices that seems irresistible at the time and irrational in retrospect; a bull market blown full of hot air until it reaches the bursting point.

The term is commonly believed to have originated around 1719-1720, when shares in the Mississippi Co. in France, the South Sea Co. in Britain, and the Dutch East India Company Co. in the Netherlands rose approximately tenfold in a matter of months and then collapsed. [Note from IFA: also see The Great Mirror of Folly]

But there is evidence that the word might be older. The earliest joint-stock firms in England – what today we would call publicly traded companies – date back to the mid-16th century. One of the first was the Muscovy Co., formed by adventurer Sebastian Cabot in 1555. By the late 16th and early 17th century, many English merchants had plunked surplus cash into shares of corporations that promised to exploit the newfound wealth of North America.

It was one of the first IPO booms in history. To give just one example, the Massachusetts Bay Company was an investment – or, more accurately, a speculation – before it turned into a colony.

Many of these deals ended badly. The risks — shipwreck, disease, massacres, and so forth — were enormous. Losses of nearly 100% were common. And so, presumably, was criticism of the promoters who had led many investors into such disappointment. 

... The Dutch were also familiar with the word “bubble” (which they presumably borrowed from the English), as you can see here. It was closely related to windhandel, or “dealing in wind,” the Dutch expression for trading in securities that weren’t in the speculator’s possession, as short-sellers do today – and did back then, too. (Windhandel also referred to trading in derivatives like options and futures instead of common stock or physical commodities.)

...Joseph Penso de la Vega, who in 1688 wrote what is commonly regarded as the world’s earliest book about the stock market, Confusion de Confusiones, described a stratagem used by short-sellers at the Amsterdam exchange...

From almost the very beginning of financial markets, people have understood that bubbles turn from invigorating to disastrous in the wink of an eye. In more recent times, “bubble” has been used indiscriminately by investors to describe any asset that they think is overpriced. Reliably identifying and steering clear of bubbles, however, has never been easy and probably never will be — except in hindsight.

See also HINDSIGHT BIAS.

Forecasting (n.)

The attempt to predict the unknowable by measuring the irrelevant; a task that, in one way or another, employs most people on Wall Street.

Because the human mind hates admitting the truth that the world is largely random and unpredictable, forecasters will always be in demand, regardless of their futility.  Wall Street follows what marketing professor J. Scott Armstrong has called the seer-sucker theory: “For every seer there is a sucker.”

In the real world, as with weather forecasts or predictions about who will win a sporting event, those making the projections typically estimate the likelihood that they are correct.  Wall Street forecasts, on the other hand, almost never have probabilities attached.  As decision scientist Baruch Fischhoff wrote in 1994, “When both forecaster and client exaggerate the quality of forecasts, the client will often win the race to the poorhouse.”

Fortune (n.) Wealth; also, luck.

Both meanings derive from Fortuna, the capricious and unappeasable Roman goddess of change. For most of the past two millennia, the two meanings weren’t merely interchangeable; they were one and the same. Wealth was understood to be largely the result of luck, and luck was the substrate of wealth. As a result, money was regarded as ephemeral. Your fortune was effectively on loan to you from the goddess Fortuna, who could call her property back from you at any time and without warning. The Wheel of Fortune was indistinguishable from the Circle of Life.

For centuries, Fortune was portrayed spinning a wheel and often standing on a sphere, ball, or bubble, symbolizing her own precarious balance.  Each person’s life, luck, and wealth thus played out as a tug-of-war within Fortune, who would whirl people from top to bottom and back again whenever she was bored or angry.  Artists often showed her spinning her great wheel one-quarter turn at a time toward the left (Sinistra in Latin), symbolizing the evil turn that her judgment often took. Sometimes a king tried to cling to the wheel as she cranked it.  He typically called out, “I will reign” from the ascending side of the wheel, “I reign” at the top, “I have reigned” on the way down, and “I have no reign” at the bottom.  Our modern idiom “to come full circle” is a vestige of this view of fortune. ... [see the book for the rest of the definition]

Investors who forget this lesson so deeply rooted in the historical meaning of the word fortune will have to learn it for themselves. They are most likely to learn how ephemeral fortune can be, and how much it depends upon luck, just as they are most convinced that it is permanent and that they derived it from their own skill.

Gain (v.)

To earn an imaginary profit on paper, savored temporarily before it turns into an actual loss.  In one of the primary paradoxes of finance, those who pursue gain with the greatest intensity are the least likely to achieve them; those who wait patiently for them are the most likely to receive them. 

Gold (n.)

What people think they will make piles of when they buy a shiny yellow metal that is useful primarily for melting into cuff links and charm bracelets. 

Hedge Funds (n.)

Expensive and exclusive funds numbering in the thousands, of which only about a hundred might be run by managers talented enough to beat the market with consistency and low risk.  “The rest,” says the financial journalist Morgan Housel, “charge ten times the fees of mutual funds for half the performance of index funds, pay half the income-tax rates of taxi drivers, and have triple the ego of rock stars.”

Historically, hedge funds were highly secretive, seldom disclosing what they owned and barely deigning to describe their overall strategy.  That mystique made them especially attractive to a sophisticated investor-much the way nearly everyone prefers to receive presents covered in opaque wrapping paper.

Hedge funds date back at least to the 1920s, when they were called “hedged” after the ancient practice of planting hedges around a property to deter outside threats.  

The term “to hedge” or “to be hedged in” has been commonly used in English since at least the seventeenth century to describe the act of making an offsetting bet to compensate for possible loss on a speculation.

The origins of the word have other implications for investors.  The use of hedge in English to mean a fence or defensive barrier dates back approximately a millennium. As a verb, the word has had a variety of related meanings: By the mid-1500s, to hedge in meant “to enclose, to prevent escape or free movement” and “to shut out or exclude”; in the seventeenth century, it also meant “to monopolize, to restrict for one’s own use” and to increase the likelihood of being repaid on a debt by folding it into a larger obligation that was better secured.... [see the book for the rest of the definition]

Day-Trader (n.)

See IDIOT.

Diversify (v.)

To own a variety of investments with countervailing risk and returns, making your portfolio safer; most investors, however, di-worse-ify instead, making their portfolios more dangerous by buying lots of whatever has been going up lately.  If all your holdings go up together, they have high CORRELATION and will also go down together.  The world “diversify” comes from the Latin diversificare, to make different; to be diversified, you must own assets that sometimes make you feel good and sometimes make you feel bad. 

Long Term (adj.)

On Wall Street, a phrase used to describe a period that begins approximately thirty seconds from now and ends, at most, a few weeks from now.

“Google was a long-term holding for us,” said Hugo Bailyn, a portfolio manager at Grimm, Rieper, Knight & Harkness, an investment-management firm in Opa-Locka, Florida, in an interview on June 13.  “We bought it in May.”

Market Timing (n.)

The attempt to avoid losing money in bear markets; the most common result, however, is to avoid making money in bull markets.

Newsletter (n.)

A publication that contains no news but many letters.  When the letters are formed into words claiming to predict the returns on financial assets, subscribers will usually get their money’s worth, and then some.  Those who paid $199 for a subscription will end up at least $199 poorer, those who paid $500 will end up at least $500 poorer, and so on. 

Outlook (n.) A guess.

A session at the Ouija board by financial pundits; like all Wall Street forecasts, an outlook is an aftercast, based not on what is likely to happen but rather on what has been happening.  If markets have been doing well lately, then the outlook will be positive; if they’ve been doing poorly, then the outlook will be negative. 

An informal survey of market strategists by the Wall Street Journal in December 2006 found that nearly all had a positive outlook for 2007, without a trace of worry that a financial crisis would be on the horizon.  On March 3, 2009 – six days before the US stock market bottomed – the same group’s forecast was abysmally pessimistic.    

Portfolio Turnover (n.)

The buying and selling of stocks, bonds, or other securities by anyone trying to buy good investments (or those that are still cheap) and sell the bad ones (or those that are no longer cheap).  In theory, the portfolio manager, investor, or trader continually removes investments with low potential and replaces them with those that have high potential.  In practice, most investors tend to hang onto their loser too long and sell their winner too soon (see disposition effect).

Turnover is costly.  Investment Technology Group estimates that it costs professional fund managers – or, rather, the clients of fund managers- nearly 0.5 percent to buy or sell the average US stock.  A fund manager selling every stock one year after buying it is thus subtracting, on average, almost a full percentage point from the fund’s annual return. (Small stocks are even more expensive; there, a fund selling its typical stock one year after buying it subtracts about 2.2 percentage points a year in trading costs.)  Turnover also turns unrealized profits into realized capital gains, accelerating tax bills from the future into the present. ... [see the book for the rest of the definition]

Turnover often results when a portfolio manager worries that clients will wonder what they are paying him for if he just sits on their assets all year long.  As Fred Schwed Jr. wrote in his class book Where are the Customer’s Yachts? In 1940: “Your average Wall Streeter, faced with nothing profitable to do, does nothing for only a brief time.  Then, suddenly and hysterically, he does something which turns out to be extremely unprofitable. He is not a lazy man.”

Mistakes happen, and important events and new information can change the underlying values of assets.  But, in general, investors who sell something soon after they bought it are probably doing something wrong.  The great value investor Philp Carret liked to say that ”turnover is almost indistinguishable from error.”  Warrant Buffett’s reluctance to sell is so extreme that he describes his investment style as “lethargy bordering on sloth.” And as the mathematician and philosopher Blaise Pascal (1623-1662) wrote in his Pensées: “All the misfortunes of men comes from only one thing: not knowing how to remain at rest in a room.”

Prudent-man Rule (n.)

The legal principles of good judgment under which money should be managed for other people, essentially unchanged since the early nineteenth century – although prudent men and women seem to be harder to find now than they were then.  See OTHER PEOPLE’S MONEY.

Massachusetts Supreme Court justice Samuel Putnam wrote in 1830 that someone investing on another’s behalf should “observe how men of prudence, discretion and intelligence manage their own affairs… considering the probable income, as well as the probable safety of the capital to be invested.”  Judge Putnam was ruling in a case alleging that the managers of a trust had recklessly invested in manufacturing and insurance stocks rather than such “safe” securities as bank stocks or government bonds.  “It has been argued,” he wrote, “that manufacturing and insurance stocks are not safe, because the principal is at hazard.  But this objection applies to bank shares, as well…. Do what you will, the capital is at hazard.”

His central point: investing is intrinsically risky.  The task of the prudent man or woman is to avoid unnecessary and unrewarding risk, not all risk entirely.  Prudence is the exercise of good judgment on the basis of historical evidence and careful analysis.  It isn’t the pursuit of safety at all cost.

Rebalancing (n.)

Automatically buying some of whatever has gone down and selling some of whatever has gone up.  All investors say they want to buy low and sell high, which rebalancing does mechanically and unemotionally.  Most investors fail to rebalance when they should, however.  Buying high and selling low is much more exciting. 

Representativness (n.)

The intuition that a small sample of data is a good representation of the population from which it is drawn, leading people to extrapolate long-term expectations from nothing more than short-term randomness. 

Take H to be stand for “heads,” T for “tails.”  If you flip a coin six times, most people believe you are more likely to flip HTTHTH or THHTHT than HHHTTT or TTTHHH, although each of the four sequences is equally likely.  And if your tosses produce HHHHHH or TTTTTT, onlookers will be amazed, although even longer streaks than that are common in a random process.  The proper question to ask whenever an investment or money manager is on a hot streak is not how long it has lasted, but rather how representative the results are of the probabilities of success in the long run.  Short-term performance is almost never a good predictor of long-term results.  Given the importance of luck, it can take fifty years or more to determine statistically whether investment performance is the product of skill or random chance.  By then you- and people who produced the performance-might no longer even be alive. 

Stock-Picker’s Market (n.)

An imaginary set of circumstances in which shrewd and skillful investors stop competing against each other and are able to trade exclusively with an unlimited supply of morons. 

The justification for this belief is weak, even by Wall Street’s featherweight standards of reasoning. 

The vast majority of trading volume in the stock market comes from professional money managers, or “stock-pickers.”  So a moment’s reflection should tell anyone that the term “a stock-picker’s market” makes no sense.  The more the market is dominated by highly paid, expertly trained, electronically equipped stock-pickers, the harder it becomes for any of them to beat the average performance of all of them. 

Nevertheless, financial pundits will declare several times a year: “It’s a stock-picker’s market now.” However, approximately two–thirds of all professional stock-pickers underperform in the typical year, regardless of how many “experts” have declared it to be a stock-picker’s market.

For every stock-picker who was right to buy one stock, there must be another who was wrong to sell it; one manager’s gain is always a different manager’s loss.  That’s true whether the market is going up or down, whether some stocks are moving out of sync with other (see correlation), or whether money is moving in or out of index funds.  Not only is it not a stock-picker’s market now, but it’s never a stock picker’s market.  A rare, few stock-pickers will do well in some markets, but it’s impossible for most to do well at the same time.

When someone tells you “it’s a stock-picker’s market now,” they should be strapped down with duct tape and forced to watch financial television on endless replay.  After a few days of escalating mental anguish, such wretches will realize the error of their ways, although they might need behavioral-cognitive therapy before they can appear again in polite company. 

Source: The Devil’s Financial Dictionary