Financial Intelligence

1
Financial Intelligence Personal Finances
Investing 101

• Bob Y. Chan
• Outline for talk 6
• November 13, 2003

2
Synopsis of last talk

• Efficient markets what does it mean?
• Setting your investment objective
• Trend followers vs. contrarians

3
Outline for Talk 6

• Diversify, diversify, diversify
• Learn to earn
• How much time do your have?
• Build a consistent investment habit
• Epilogue some stories of how people got very
  rich

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A note about capital markets

• Capital markets are full of smart and hungry
  people trying to make a kill
• The result is that many information is already
  reflected in securities prices
• Should take advantage of this fact not to
  reinvent the wheel

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Wall Street vs. Main Street

• There are two investments you take
• Buying and selling securities
• Building your career
• Wall Street trick is dont marry with the
  stock
• Main Street trick is stick with your human
  capital!

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Wall Street vs. Main Street (cont.)

• Wall Street transaction cost is very low
• Stock trades round trip transaction costs are
  less than 1
• Stock prices vary 30-50 even for blue trip
  stocks
• Efficient to move in and out of stocks
• Also, can simultaneously hold many stocks!

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Wall Street vs. Main Street (cont.)

• Main Street transaction cost is very high
• To build up a business costs a fortune
• Making a wrong decision costs a fortune
• Many things that are painful to move around
• Companies are slow to move in and out of markets

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Wall Street vs. Main Street (cont.)

• Businesses are very slow moving animals!
• Executives need to tie up with their career
• Very different from financial investment
• People do not change their career often
• Once competitive advantage is built up, becomes
  barrier to entry (for businesses and executives)

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Brief Conclusion

• In your career, focus on your human capital
• Usually most money you make is here!
• Financial investment do not tie up with a
  single investment!
• Another great secret in investment is
  diversification

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Diversify, diversify, diversify

• Dont put all the eggs in the same basket
• Look for mix in your portfolio
• Different risk property
• Different time horizon
• Different geographic location
• Different sectors
• Different companies

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Diversify, diversify, diversify (cont.)

• Diversification is the most important concept in
  modern investment
• When combine different assets in the portfolio,
  part of the risk cancels out
• Parkn Shop vs. Wellcome it could be difficult
  to predict whether Parkn Shop would beat
  Wellcome in the next year, but people still need
  to buy food!

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Diversify, diversify, diversify (cont.)

• If you buy both Parkn Shop and Wellcome, dont
  need to worry who comes up better
• What you buy is the general outlook of the
  supermarket industry
• Through buying more stocks, you cancel out more
  and more risk elements
• Hence can control your risk to a level you feel
  comfortable

13
Learn to earn

• Making big profits from making short-term
  prediction is very very difficult
• Do not try to out-smart the market all the time

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Learn to earn (cont.)

• However, note
• Fashion is the great governor of this world
• Prices ultimately follows laws of economics
• Good companies in growing industries are worth a
  lot
• Human behavior moves in big swings

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Example 1 -- Currency

• Currency is the biggest capital market of all
• In the long run, exchange rate follow the law of
  economics
• Consider the U.S. dollar the U.S. is faced with
  huge fiscal deficit
• How could the U.S. deal with it?
• In the future, the U.S. dollar will likely
  depreciate against other major currencies

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Example 2 Interest Rates

• Interest rate markets are the second biggest
  market
• Global interest rates being leg by U.S. rates
• Interest rate at all time low
• When rates increase, bond prices fall, capital
  markets will be shocked
• Question can we take advantage of it?

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Example 3 study an industry

• Ask which industry(ies) would likely grow at a
  high rate?
• What are the underlying reasons of growth?
• Under such framework, which companies would
  likely do well?
• Do the homework and follow these companies

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Prices follow economics

• Predicting short term is difficult predicting
  medium term is easier
• Companies with good earnings and earnings growth
  will do good
• So, study economics, finance, and accounting
• Look especially for traps / tricks

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Companies vs. industries

• Most of the time, the best company is worth the
  most in up market and down market
• In up market, the best company will worth much
  more than the average company since most
  investors need to buy it
• Will last until a certain point (usually when the
  company / industry matures)

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Example Microsoft

• Microsoft went public in 1986 at 22 a share
• Major shareholder (Bill Gates) became richest
  person in the world as Microsoft stock went up
• In 2000 (peak), 1 share of Microsoft rose to
  (adjusted for split) 15,000
• However, 50 of rise in market value occurred
  during 1998 2000

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Prices move in big swings

• Look long enough, there is mean reversion in
  securities prices
• At some point, the price swings back
• When there is a turn, prices tend to move
  violently
• Hence, many people win many battles, but lose
  the war
• Look out for the turns!

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How much time do you have?

• Question how often do you review your portfolio
  and / or make a trade
• When people start investing, they tend to put too
  much effort on the investment and trade too often
• Ultimately, need to balance the time you have

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How much time? (cont.)

• Do not leave your positions unattended
• If you do not have time, dont do day-trade!
• Make sure you have time to understand market
  movement and make appropriate actions
• If not, relax and take a longer-term view on the
  investment

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Build a consistent investment habit

• Remember you cant make all the profit in the
  market
• Point is to consistently make investments
• Review investment performance regularly

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How do people get very rich?

• Intelligence
• Persistence
• Do the right thing at right time
• Hire the right people
• Learn from other peoples mistakes
• Market power
• Luck

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Peter Lynch and the Magellan Fund

• Lynch was a Wall Street Legend who ran the
  Magellan Fund from 1977 through 1990
• During this time the total return was 2,700
  (i.e., average 29 over 13-years)
• Fund size grew from US 18 million to 14 billion

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Peter Lynch (cont.)

• Joined Fidelity as an analyst in textile
• 1970s low recession in the U.S., fund
  investment declined steadily
• 1976 Fidelity merged the 6 million Magellan
  Fund with the 12 million Essex Fund

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Peter Lynch (cont.)

• Both funds had been fallen stars
• For 4 years no one bought from the fund, and the
  Magellan was reopened in 1981

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Peter Lynch (cont.)

• In early years, the challenge was to slow
  investors from redeeming
• There was basically no focus, and bought anything
  that Lynch thought would make a profit
• Lynch did lots of homework and study the industry
  and the management of the companies

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Peter Lynch (cont.)

• Lynch tried to discover companies when they
  were ignored by the market
• When the value was generally realized, the fund
  made big profits
• gambles got bigger and bigger, and the Magellan
  Fund gained recognition from the market

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Peter Lynch (cont.)

• Built into market power whenever Lynch is
  buying, everyone tries to follow

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Bill Gates and Microsoft

• Bill Gates went to Harvard but quit and ran to
  Silicon Valley to run a computer company in the
  1970s
• In the early days, software was written by
  computer hobbyist and was distributed for free
• Later, more specialized software was put into
  machines for certain purpose

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Bill Gates (cont.)

• 1972 a mathematician Gary Kildall started to
  write codes on Intel chips to control the basic
  functions, called Operating System
• Kildall called the program CP/M (Control Program
  for Microcomputers)
• The microcomputer was starting to evolve from a
  toy to parallel the mainframe

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Bill Gates (cont.)

• Within a short time the CP/M ran 500,000
  machines, and Kildall made a lot of money
• 1975 Gates and Paul Allen co-founded Microsoft
  to write codes in BASIC and resell accessories.
  Their business had nothing to do with disk
  operating system

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Bill Gates (cont.)

• 1980 IBM (HQ in New York) was convinced that
  the mainframe computer would come to a dead-end,
  and decided to move aggressively to
  microcomputers, later called personal computers
• Needed a DOS to run the PCs, so desperately that
  they were determined to acquired one

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Bill Gates (cont.)

• The IBM guys flew to CA, and went to Gates shop
• Gates sent them to the owner of CP/M
• However (as history / myth said), Kildall went
  flying in his own plane
• IBM turned back to Gates, and Gates sold IBM a
  software, later called MS-DOS

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Bill Gates (cont.)

• However, Gates didnt have the software
• His partner Allen knew of a guy named Tim
  Paterson who wrote a CP/M imitation called Q-DOS
• Microsoft bought the Q-Dos for 75,000 (at one
  time Gates was worth 100 billion!)

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Bill Gates (cont.)

• Also, Gates reached a license agreement with IBM
  each IBM and IBM compatible computer that
  uses the MS-DOS would pay 40 as license fee
• It turned out that IBMs strategy was open
  architecture it opened up the IBM PC to
  everyone so as to gain the market in the shortest
  time

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Bill Gates (cont.)

• Many IBM clones was produced Compaq alone sold
  500 million IBM clones in the first year
• Microsoft made 500 million from the MS-DOS
  license before Windows was launched

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Bill Gates (cont.)

• Windows was not invented by Microsoft
• It was learned from Apple
• Apple learned it from Xeroxs PARC
• object oriented programming or more commonly
  called Graphic User Interface or GUI

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Bill Gates (cont.)

• Apple was founded by Steve Jobs and Steve Wozniak
• Apple launched the Macintosh in 1984 with the GUI
  technology
• In 1983, the Apple board brought a professional
  manager John Sculley from PepsiCo
• Soon Jobs was kicked out from Apple

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Bill Gates (cont.)

• With Apple in a mess, Microsoft took over and
  launched MS-Windows
• With the huge market power, Microsoft bundled
  some imitations into a software package named
  Office
• WORD word processor
• EXCEL spread sheet
• Powerpoint acquired in the 1990s

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CONCLUSION

• Talk series attempts to build sense of managing
  your finances and interest in investing
• Your invest in two areas
• Human capital
• Financial
• Try to make good balance between the two

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CONCLUSION (cont.)

• Control expenses and have some to invest
• Most powerful thing is compound interest
• Consistent investment pays off
• Market is efficient and difficult to beat
• However, sensible investment still works
• Luck matters, but luck will not knock at the
  unprepared!

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CONCLUSION (cont.)

• GOOD LUCK!