Thursday, May 31, 2007

Covariance


I used to be a stockpicker. I gave it up after reading A Random Walk Down Wall Street. I am utterly convinced that there is no skill in stockpicking whatsoever.

My investing advice is simple. Hold a diversified portfolio of stocks and bonds at the lowest possible cost which means investing in index funds through Vanguard or TIAA-CREF. The solution is simple, but the ideas behind the advice is profound.

Superinvestor Warren Buffett will tell you that it is OK to put all your eggs into one basket. You just have to watch that basket. This is ridiculous advice. A casual glance at Buffett's Berkshire Hathaway will show you the many baskets the man has his money in.

No one has a flawless crystal ball. In my life, there is one thing I can reliably predict. The future is mostly unpredictable. Risk is common and unending. This is why they tell you not to put your eggs in one basket.

The wisdom behind this advice comes from the risk reducing properties of negative covariance. This is opposed to positive covariance which is when everything moves together. Negative covariance is when things do not move together like in the graph above.

An example of positive covariance is when you find a forgotten twenty dollar bill beside the bed after having mindblowing sex with a gorgeous blonde. An example of negative covariance would be buying a winning lottery ticket on the day your house burns down. Positive covariance would be having the lottery ticket inside the house when it burned down.

None of this probably makes sense to you, so I'll break it down like this. Risk is simply volatility. A guy like Warren Buffett would disagree. He would say that risk is the likelihood of losing money. But losing money is a certainty of life. Warren Buffett has lost lots of money. He's losing money now on NetJets. If NetJets was a private company instead of a Berkshire subsidiary, it would be done. But Warren has other streams of income, so he is content to ride it out. In short, he is diversified.

Basically, this is how it all works. If you want to increase reward, you must concentrate your holdings. The downside is that you will increase risk. For instance, the lottery generates huge rewards for the winner, but I am willing to bet my entire net worth that you won't win the lottery in your lifetime. Ever. The risk is tremendous. That's why we work jobs. Less reward but less risk. But spending a dollar a week on the lottery is no big deal. You get to stay out of the poorhouse and also open yourself to that once in a million years jackpot.

It is impossible to have absolute return with zero risk. It also impossible to live without risk. The optimal portfolio of investments will achieve a balance between risk and return given the investor's tolerance. This means investing in a mix of stocks and bonds or going further into the various asset classes that can be sliced and diced. But I am digressing at this point. . .

Diversification is the key not only to investing but in all aspects of life. I call it the gospel of covariance. It is a good strategy. I'll apply it to certain aspects of life to show you how it works.

1. EMPLOYMENT/CAREER.

When I was in college, computer science was a hot major. It has noticeably cooled since then. Where folks were making $60K to start in this area, they now count themselves lucky to be employed. I've seen this same thing with mechanical engineering, geology, chemical engineering, etc. In all of these fields, the rewards can be very lucrative depending upon economic factors. For instance, a mechanical engineer could name his price during the defense buildup of the '80's. He was out of work when the Berlin Wall fell. (Watch Falling Down with Michael Douglas to get a taste of this.)

The result of this is that more and more people are pursuing advanced degrees. This is a mistake. The reason people with a hot major make a lot of money is because they are in high demand. But it is in the nature of markets to fill demand. The result of this specialization is that you can make a ton of cash--if you're lucky. Nowadays, a decent welder from a votech program makes more cash than a computer science grad. Why? Supply and demand.

I think people are seeing the limits of specialization. In order to make big money, you have to be lucky enough to specialize in something that is in tremendous demand. But unless this something is hard to acquire (like a medical degree), you will probably end up spending a lot of money on something with a dismal future.

I think the answer to all of this is a return to the Renaissance Ideal. In other words, it helps to know something about everything. You won't make as much as a nuclear physicist, but you'll always have a job. When the market changes, you can change with it. Have a foot in both the blue collar and the white collar worlds. Be a double major in engineering and accounting while learning a skill at the local trade school. Or learn to be a welder, a machinist, and a truck driver while pursuing your love of painting and music in your spare time. Hey, Elvis used to drive a truck. It paid the bills.

It is impossible to become great at something unless you focus on it. Pete Sampras was the greatest tennis player to play the game. He was also a high school dropout and incredibly boring. This is no accident. He focused like a laser on his sport, made some cash, and he will probably be forgotten. A bad accountant could send him to the grill at McDonald's.

By being a jack of all trades, you will be the master of none. But you will be more employable (and more interesting.)

2. PICKING UP CHICKS.

I did a personal study of players to discover their secrets. How are they able to be with so many different women? The answer was readily apparent. These cats don't have any special magic or charm over women. They are simply cocky enough to throw themselves at any and every woman they encounter. They are successful less than 10% of the time. But we only count their successes. In short, they diversify their efforts. A loser chases after one woman at a time concentrating his effort leading to sexual frustration and an evening with Penthouse. The player has his phone ringing off the hook.

I learned all of this because I wanted to know the answer to a nagging question. Why do jerks and slackers end up with the girls? Well, that's easy. Jerks have no shame, and slackers have nothing but time. The result is a lot of hook ups. If I told you that pressing a button ten times will give you a dollar bill, you'd probably quit your job to be a professional button pusher. It is no different with women. Ask out ten chicks and see what happens.

3. RELATIONSHIPS.

I have a lot of friends. That's because I network. Networking has gotten a bad rap because it seems self-serving and impersonal. But it isn't. Networking is where you go through the trouble to write down the addresses, email addresses, and phone numbers of people you know and make an effort to stay in touch with them. I never get rid of a friend. It's a lot of work trying to keep in touch with all those people, but it pays off. Never burn a bridge. Those bridges may be the ones to get you over the next troubled water you encounter.

As you can see from these examples, diversification and covariance can be applied to a lot of different areas. You will also see where others are already applying it such as with spam. Spam is annoying as hell to us but very lucrative for those sending it. It's no different than the button pusher analogy. Advertising, marketing, etc. employ the same strategy.

For me, the biggest change I made in my life was to be a bit more omnivorous in my tastes, my projects, etc. My examples in this were Aristotle and Leonardo da Vinci. Both men were geniuses, and their influence is still felt to this day. They were polymaths which means they did it all. Aristotle made important contributions in philosophy, science, politics, and literature. Leonardo did the same with painting, sculpture, anatomy, inventions, etc. Without a doubt, their reaches exceeded their grasps. You literally cannot know everything or do everything. But you can do a lot more than you think, and it is worth it. Leonardo and Aristotle diversified. We have forgotten their failures and remember only their successes.

This meme has infected all areas of my life. I accept that I will fail more often than I succeed, but diversifying my efforts saves me from being at the mercy of fate. This is the same secret behind the insurance industry. I am very enthusiastic about this strategy which may explain the eclectic nature of my blog. I just throw stuff at the wall to see what sticks.

0 comments:

Post a Comment