Learn Stock Investing the Hard Way

The past two weeks have been tough for me. It started from watching the movie The Big Short.

I’ll organize this post in 3 sections:

• The sad story of my investment for the past 2 weeks.
• My investing plan going forward.
• Book and movie reviews.

TL;DR

• “Be fearful when people are greedy, be greedy when people are fearful” — this sentence appears to be everywhere but it makes sense. Also keep in mind, Be Greedy here means “long or buy” not “short or sell”.
• Respect the market. Don’t ever be blinded by the illusion that you, as an individual amateur newbie investor, are smarter than the market, by watching YouTube videos for half a day. Quote from Liar’s Poker: the market was like the sea, to be respected and feared.
• Don’t trade options, if you have a full time job that is more important than trading, or you don’t have a very big heart, or you don’t have a fairly good understanding of the rhythm of the market, like some technical analysis background. At least don’t trade a significant amount.
• Have you opinion and be a long term investor. Don’t simply follow recommendations from YouTube videos or some posts from investing sites. For a majority of YouTubers, if they are always smarter than market, they won’t have time posting 3 YouTube videos a week. They should have started their own fund. Invest for longer term or value investing is better, passive investing SP500 is not the best idea, but it is better than short term speculation for most people.

Lessons Learnt

The market was melting down since the beginning of March. The market plunged 30% over a time frame of two weeks and triggered 4 times of circuit breaker.

“When there is a stock market crash, there are opportunities.”, as someone said, I started to speculate the market with very limited knowledge about the market. Technically, I have a minor in Finance when I was in college, but I didn’t even have a stock market account back then. No pain, no gains; if you don’t lose a painful amount of $$, you normally don’t learn the lesson, at least it is the case for me.

Investment & Results:

• I lost a whopping 50% in my personal investing account, so far.
• I had 30% of $$ in VIX related index, gained 30% at the beginning and lost 60% when I sold them
• I had 20% of $$ in SPXY (3x short SPY), lost ~30% when I sold it.
• I still have 50% of $$ in SPY put option (break even at 2300) and have lost 50% so far.
• I still have 50% of oil & silver stock, gained ~20%.

Note this is not my primary stock account (w/ my RSU) or 401 account, which I live on, but it accounts for a big chunk of my cash at hand.

Event timeline and my life of the past two weeks (Mar 19 — Mar 31):

• Thursday Mar 19: watched the big short the previous night, and start shorting market.
• Friday Mar 20: stock market kept crashing, gained 30% in a day.
• Monday Mar 23: Fed announced unlimited QE. Stock still plunging but VIX related indexes also dropped. I gained slightly that day
• Tuesday Mar 24: stimulus plan coming. SPY rallied quite a lot, I lost 40% in a single day. Could not have any focus for my daily work, started to read books about investment.
• Wed Mar 25: stimulus plan is getting closer. SPY rallied quite a lot, I lost another 20%.. didn’t sleep well last night and still could not focus during work.
• Thursday Mar 26: kind of stabilized. Life, getting better, still didn’t sleep well, and not 100% at work.
• Friday Mar 27: getting calmed down.
• Mar 30 — now: spent most of spare time reading investment related books and life getting back to pre-Mar19 state.

Investment Plan Going Forward

A lot of the ideas were summarized in the TL;DR section. But I will extend a bit more here.

Longer Term

• MOST IMPORTANTLY, invest in yourself and your full time job! Invest in yourself is by all means the most profitable investment. Regarding full time job, if you like your job, you should pour most of your intelligence and sweat there. If you don’t like your job, find one that you enjoy.
• 401K goes all stock. Stock market beats most of other investment for long run , without leverage. I am very unlikely to cash 401k with penalty before 65 and I’ve got my primary home, so for the next couple decades, best is to dump the cash in stock.
• Real-estate investment. Take advantage of the low mortgage interest rate and 20% down pay as the leverage. There is also a per family $500k appreciation tax exemption. Bottom line, investment in real estate beats inflation.
• Build a balanced portfolio, currently a majority of my portfolio is around MSFT, which luckily has been doing a fantastic job. However, there is no guarantee that it will rock forever. I have taken this downturn to diversify 50% of my MSFT stock into a more diversified portfolio, primarily followed Ray Dalio’s investment portfolio. Also plan to rebalance the portfolio on a quarterly basis, set some calendar reminder and be disciplined.
• Do some analysis of stocks NOT in S&P 500 on a weekly basis, focus on those unvalued based on fundamental analysis. I also subscribed Yahoo Finance premium, to help collect data points. Plan to allocate 20% of total asset investing here.
• Keep learning. I bought half a dozen finance and investment book to learn more on this area. Quote from Peter Lynch: 1) Only buy what you understand. 2) Always do your homework. 3) Invest for the long run.

Medium Term ( ~ 1 year)

• Maintain 30% or 1/3 of asset in cash, bond.
• Stock market is more bearish than fast recovery, for medium term. There is too big a debt than GDP (120%), the virus and 16 million unemployed population are too big a big burden in the economy. It is unlikely to have an immediate recovery in the next 2 months.
• Maintain the short position in my personal investment account, for hedging.
• Even though Fed has done everything it could (best ever from history) to save the market, it is much more likely to hit another round of bottom (~2100 points SP 500) than rally back to 3000 points. Quote from Fortune Apr edition: “If valuations, measured by the Shiller benchmark (CAPE), return to the normal by 2021, the S&P would fall an additional 22% to 2150. Reversion to the mean is a powerful force in the markets — and it usually prevails.”

Movies and Books reviews

I devoured quite some movies and books for the past 2 weeks, summary here.

Movie: The Big Short 4.5/5

Some background quick hitters first.

Understand Subprime Mortgage Crisis in easy-to-understand-words

Terminologies:

MBS: mortgage-backed securities. You get a mortgage of $1M for your house with 5% interest rate from a commercial bank like Bank of America, later BoA sell your mortgage to an investment bank like Goldman Sachs. GS collects many mortgages from commercial banks and form a specialized entity — Special Purpose Entity Corp. that owns all these mortgage. Now this company would securitize the mortgage and issue securities around it, for example, 1M shares of that 1B mortgage. The issued securities backed by mortgage is called MBS.

Why would banks want MBS? For BOA, if it just loaned 1B to customers, it lost 1B dollars liquidation that it could invest elsewhere. Now it sells the 1B to GS, it gets a non-trivial service fee, and another $1B from GS to do other investment.

CDO: collateralized debt obligations. Some investors are risk tolerant and some are risk adverse, so naturally, we want MBS with different risk & reward levels. CDO comes into the picture by collecting a pool of bonds with different risk levels. CDO is sliced into many “tranches”, with 3 different levels of risks: Senior, Mezzanine and Equity. Senior is composed of AAA, Mezz from A to AA, Equity is B or below. When mortgage defaults happen (overall CDO loss), Equity tranche will be obliged to suffer, then Mezz, and Senior the safest.

This is not the end story of CDO, but the beginning of it :) Greedy folks from Wall Street came up with “synthetic CDOs”, which means: they create CDOs from other CDOs. For example, a CDO X is rated as AAA since it has 30% of AAA bonds, and a CDO Y is rated as AA since it has 20% of AAA bonds and 20% of AA bonds. CDO Z is rated as B since it only has 10% of AA or plus bonds. What about we merge X, Y, Z into another CDO? That is a synthetic CDO. How to rate it? It “should” depends on the quality, however, back in 2008, it depends on the market demand. So a synthetic CDO composed with X, Y, Z is most likely rated as AAA since it has a big chunk of AAA CDO. Now the synthesized CDO is AAA, it could be used to synthesize other CDOs. In the end, a AAA rated CDO might contain at most 5% AAA bonds, all the rest are crap.

CDS: credit default swaps. Think about a Poker game, this is a side game non-players bet against each other. Poker player A is playing a $10M poker tournament final table heads up. On the side, institution B is betting $1B A to win the game, institution C is betting A to lose the game, so B & C will reach a deal of $1B. In financial market, think about a CDO or a bond M that is A rated, a pension fund X is required to only buy AAA rated CDOs, but M is only A, so it can’t buy that. Fund X could make a deal with an insurance company Y to enter into a CDS. Y will insure M to be AAA, if it defaults, Y will pay for bill. In return, X will pay Y some premium as insurance fees. AIG is the Y here during the crisis.

The subprime mortgage crisis started with a booming housing market due to some housing stimulus policies. The demand for mortgage increased to an insane level of confidence of the housing market. Everyone believes the housing market will bully forever. Banks offer 0% downpayment mortgage with close to 0 background check. In the meantime, rigged rating organizations like SP, Moody and Fitch, they give AAA to every CDO and there was an insane amount of demand for more CDOs. This leads to an excess housing inventory that is far beyond demand. Once the housing prices declines, the bubble starts to burst. The interest of MBS evaporates. People with lower credit start can no longer pay the mortgage and default. CDOs start to burst and companies who own a bunch of CDOs start to suffer from capital depletion as those CDO becomes much less worthy. Government or investors require the hedge funds or institutions to a fixed amount of collateral, since the CDOs’ sharp drop in value, the hedge funds have to sell those CDOs to avoid future collapsing of the market to meet the liability requirements. This cascading effect brings more and more CDO selloff.

Besides institutions who bought tons of CDO suffered, the lightly regulated CDS market also suffered badly. AIG authored CDS for $440 billion of MBS, there is no way for AIG to pay off $440 B defaults and it went out of business till government bailout.

My reflection after the past two weeks from the movie:

Very exciting movie! It portraits Michael Burry, an eccentric hedge fund manager, who profited billions of dollars by shorting the housing market during the 2008 subprime crisis. Interestingly, he also pointed out there is a huge bubble in index fund due to too much passive investment end of 2019. This movie, joint with the big debt crisis book, gave me courage and led me to short the current market as well. But, I am at the brink of mental collapse and I didn’t pick the right short strategy either — I bought VIX index, which I didn’t understand when I bought it, and I bought the put option which expires in a quarter timeframe with super high risk.

You won’t understand the frustration from the movie when Michael bet against the market with a strong conviction, but the market was fraud and went against you. It is a painstakingly long effort to bet against the market and “American House Dream”. When you short the overall market, you are betting against the Federal Reserve and the U.S government. Think about it, Fed could print trillions of dollars to beat you up. Back to 2006, many people discovered the housing market bubble before the 2008 crisis, around 2006, but very few sustained the continuous housing bull market the coming 2 years.

I realized I don’t have the conviction, knowledge, time and fortune to bet against the U.S government. A strategy I would take is to hold a higher percentage of cash/bond when there is a possible crash after my own research, and invest when it crashes.

Movie: Too Big To Fail (2.5/5)

This movie also pictures the 2008 subprime mortgage crisis and focuses on the actions of U.S. Treasury Secretary Henry Paulson. The movie is so-so, I don’t feel very engaged in this movie. It talked about how Henry who united (pressured) all major big banks to save the market.

Book: Big Debt Crisis (4.5/5)

Written by renown founder of Bridgewater Hedge Fund Ray Dalio, this series of books (a set of 3 books), summarized the financial crisis over the past 2 centuries into an archetype. It goes through the different phases of each debt cycle, and comments the actions taken by the government and central bank.

The first book is a short one with only 64 pages, but very insightful. I’m not intending to further summarize here, but quoting a few interesting points here.

3 monetary policy to push the string (aka what Fed & Gov could do)

• Interest-rate driven monetary policy is the most effective one.
• Quantitative easing as it is now called (printing money and buying financial assets)
• Helicopter money: put money directly into the hands of spenders

It says in 2008, Fed and government has learnt the lesson from 1929 depression and acted in a timely manner thus the economy managed to recover in 2 years. This led to my understanding to current Fed operation: unlimited QE, cut interest rate to 0 directly, helicopter money. The Fed has taken all necessary steps to stabilize the market and infiltrate confidence into the market to avoid selloffs, and I think it has achieved quite some results.

Why can’t government stop printing money during hyper-inflation?

This has been a puzzle I never spent much time thinking, but happens all the time like in Zimbabwe. The book used the post WWI Germany debt crisis as an example.

“Stop printing means in a short time the entire public could no longer pay merchants, employees, or workers. All national and economic life would be stopped.”

Book: Modern Value Investing (3/5)

I saw this book recommended by some YouTubers and the author Sven Carlin seems to be a smart guy. Sven is a fanboy of Seth Klarman and quoted him here and there in his book.

This book introduces what is value investing and redefined what is risk at the beginning of the book.

Market is irrational, perfect market doesn’t exist. We should differentiate between intrinsic value and market created, illusionary pricing.

My note: understand the intrinsic value of a company from disclosed reports like financial reports, balance sheet, is a research topic.

“The intelligent investor is a realist who seels to optimists and buys from pessimists” — Benjamin Graham. Value investing beats growth investing.

What is risk? Author: how much can you lose with a certain investment. Evaluate risk according according to fundamentals.

Later, it moves to talk about 25 tools to value invest the market with a “margin of safety”, in a few categories:

• Evaluate the value of a business from its indicators like NPV, Liquidation value, Stock price, Takeover price, CAPE ratio.
• Invest with a Margin of Safety (take 20% or 25% cut from your estimate)
• Understand the sustainability of a business. Even if a company is undervalued, it needs some catalyst to be reevaluated. Balance sheet offers a good insight into this.

Book: Money Walks(会走路的钱) 2.5/5

This book is a quick read, rating 3/5. The investment strategy is around 3 areas:

• Real estate. The author also believes more in real estate in emerging market — China and bought a slew of houses in China, as well as bay area during 2009.
• Bitcoin. The author invested a good amount of money in Bitcoin.

His recommendations of amateur investors are:

• if you have a full time job you enjoy and want to be a passive investor, invest in index funds in stock.
• If you just want a 9–5 job, and interested in spending more time in investment, use leverage in housing market to profit.
• Don’t put money in 401K.

The fundamental philosophy of the author’s investment strategy is: whether the value of a merchandise will appreciate or depreciate doesn’t depend on its intrinsic value, but depends on the wealth of the merchandise’s owners. Especially depends on the wealth of people who must purchase them in the future, whether they will be richer or poorer.

I think the content of the book is relatively shallow but I like his philosophy. It explains why his investment in real estate in China, and it makes sense.

Other books I’m reading:

• Liar’s Poker
• Money: Master the Game
• Security Analysis
• Wealth of Nations