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Harry Newton's In Search of The Perfect Investment Newton's In Search Of The Perfect Investment. Technology Investor.

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8:30 AM EST Wednesday, January 30, 2008: I continue to not like stockmarkets. The little bounce we've had anticipates another Fed rate cut. I suspect that that rate cut (scheduled for today) won't be sufficient. As a matter of principle, one should never trade in front of a potential Fed rate cut, or a company earnings report. You'll be wrong far more times than you'll be right. This market and the economy remain weak.

When in doubt, stay out. Don't fell compelled to trade, as Wall Street obviously did (and probably still does). Keep reading.

Ben Stein believes traders control the stockmarket. Several readers claim they don't. I'm semi-dubious. I don't know precisely how much traders "control" the market. But I've heard figures for traders and computer trading to be as high as 70% of daily volume. And we do know (from his first book) that Cramer contacted the press and badmouthed or extolled stocks he had positions in. The era of the trader may be waning, as this piece from Bloomberg argues:

Death of VaR (Value at Risk) Evoked as Risk-Taking Vim Meets Taleb's Black Swan

The risk-taking model that emboldened Wall Street to trade with impunity is broken. Everyone from Merrill Lynch & Co. Chief Executive Officer John Thain to Morgan Stanley Chief Financial Officer Colm Kelleher is coming to the realization that no algorithm or triple-A rating can substitute for old-fashioned due diligence.

Value at risk, the measure banks use to calculate the maximum their trades can lose each day, failed to detect the scope of the U.S. subprime mortgage market's collapse as it triggered more than $130 billion of losses since June for the biggest securities firms led by Citigroup Inc., Merrill, Morgan Stanley and UBS AG.

The past six months have exposed the flaws of a financial measure based on historical prices that securities firms use idiosyncratically and that doesn't anticipate every potential disaster, such as the mistaken credit ratings on defaulted subprime debt. "Finance is an area that's dominated by rare events,'' said Nassim Taleb, a research professor at London Business School and former options trader. "The tools we have in quantitative finance do not work in what I call the 'Black Swan' domain.''

Taleb's book "The Black Swan,'' published last year by Random House, describes how people underestimate the impact of infrequent occurrences. Just as it was assumed that all swans were white until the first black species was spotted in Australia during the 17th century, historical analysis is an inadequate way to judge risk, he said.

Executives at Merrill, Morgan Stanley and UBS took steps in the past six weeks to overhaul their risk-management groups after internal models failed to foresee the first annual decline in house prices since the Great Depression that eroded five years of trading gains.

Goldman Sachs Group Inc., the firm with the highest nominal VaR, was the sole investment bank to report record earnings in the fourth quarter, while New York-based Merrill, which had the second-lowest nominal VaR of the five biggest U.S. securities firms, posted a $9.8 billion loss for the last three months of 2007, the biggest in its 94-year history.

Thain, who replaced the ousted Stan O'Neal last month at Merrill, said Jan. 17 that the largest U.S. brokerage should stop making trades that have the potential to wipe out profits. He revamped the unit overseeing trading positions and hired former Goldman executive Noel Donohoe as co-chief risk officer.

UBS CEO Marcel Rohner told employees two weeks ago that Europe's biggest bank will scale back risk taking after reporting a $15 billion writedown last year for subprime-infected investments. As part of the plan, Zurich-based UBS shut a U.S. fixed-income trading unit.

At New York-based Morgan Stanley, which disclosed a $3.56 billion fourth-quarter loss after writing down mortgage-related and other securities by $9.4 billion, the risk department will now report directly to Kelleher instead of to the trading heads. The firm said it plans to hire more risk managers.

"This loss was a result of an error in judgment that occurred on one desk in our fixed-income area and also a failure to manage that risk appropriately,'' Morgan Stanley Chief Executive Officer John Mack said on Dec. 19. "We're moving aggressively to make necessary changes.''

Stronger management might help protect firms against rogue employees. Societe Generale SA, France's second-largest bank by market value, said last week that unauthorized trades caused a $7.2 billion loss, the biggest in banking history. The trading wiped out about two years of pretax profit at the Paris-based company's investment-banking unit.

Societe Generale said the trader was Jerome Kerviel, 31, who joined the bank's trading division in 2006 after working six years in the company's back office. He had "intimate and perverse'' knowledge of the bank's controls, which enabled him to avoid detection, Co-Chief Executive Officer Philippe Citerne told reporters on Jan. 24.

"That's a whole other side of risk management,'' said Benjamin Wallace, who helps oversee $850 million at Grimes & Co. in Westborough, Massachusetts, which owns shares of Morgan Stanley and Merrill. "That's not the modeling, that's making sure that people are overseen properly.''

Hiring risk managers and giving them more power won't alter the mistake that led to last year's slump and that was Wall Street's dependence on statistics to quantify risks, Taleb said.

"We have had dismal failures in quantitative finance in measuring these risks, yet people hire quants and hire risk managers simply to back up their desire to take these risks,'' he said. "There are some probabilities that you cannot compute.''

Banks and securities firms increased the size of their trades during the past decade on interest rates, stocks, commodities and credit. Trading revenue for the five largest securities firms -- Goldman, Morgan Stanley, Merrill, Lehman Brothers Holdings Inc. and Bear Stearns Cos. -- climbed to a combined $71.1 billion by 2006 from $29.1 billion in 2002. The higher profits added to the firms' capital, enabling even bigger trading bets.

"You can scale your value at risk relative to your book value,'' said Wallace. ``It was a self-reinforcing part of the cycle.''

Goldman's average daily VaR more than tripled to $151 million in the fourth quarter from $46 million five years earlier, according to company reports. Goldman's VaR was almost twice as high as Merrill's in the third quarter.

Merrill said third-quarter daily average VaR was $76 million, compared with Goldman's $139 million, Morgan Stanley's $87 million, Lehman's $96 million and Bear Stearns's $32 million.

All the New York-based firms base their calculations at a confidence level of 95 percent, meaning they don't expect one-day drops to exceed the reported amount more than 5 percent of the time.

The amounts differ in part because every firm uses their own methodology and data. For instance, Lehman uses four years of historical data to calculate VaR, with a higher weighting given to more recent time periods, while Morgan Stanley provides VaR calculations using both four years and one year of market data.

"If you compare what peoples' values at risk are versus what their losses were in the third quarter or fourth quarter, the numbers are astounding,'' said David Einhorn, president and co-founder of hedge fund Greenlight Capital LLC in New York. "There are a lot of things that probably the value-at-risk model said would have trivial losses 95 percent of the time or 99 percent of the time but are now having a huge loss.''

Merrill's highest one-day value at risk in the third quarter was $92 million, indicating that the firm's maximum expected cost during the 63-trading day period would be $5.8 billion. In fact, the firm wrote down $8.4 billion from the value of collateralized debt obligations, subprime mortgages and leveraged finance commitments, 45 percent more than the worst- case scenario.

All of the risk-measurement tools failed to prepare Merrill for the unforeseen declines on triple-A rated securities backed by subprime mortgages, according to the company's third-quarter filing with the U.S. Securities and Exchange Commission. The firm's writedowns related to the highest-rated portions of CDOs backed by pools of home loans, which plunged in value as defaults on the underlying mortgages soared.

"VaR, stress tests and other risk measures significantly underestimated the magnitude of actual loss from the unprecedented credit market environment,'' Merrill's filing said. "In the past, these AAA ABS CDO securities had never experienced a significant loss in value.''

Securities firms developed statistical models during the early 1990s to better quantify risks as the trading of bonds, stocks, currencies and derivatives increased. J.P. Morgan & Co., now part of JPMorgan Chase & Co., helped popularize the use of value at risk as the primary measurement tool in 1994 when it published its so-called RiskMetrics system.

Four years later, two events helped demonstrate the drawbacks in using statistical analysis based on historical market movements to measure risk. Russia's bond default sent fixed-income markets into a tailspin and Long-Term Capital Management LP, the Greenwich, Connecticut-based hedge fund run by former Salomon Brothers trader John W. Meriwether, had to be bailed out after $4 billion of trading declines.

Russia's default risk was underestimated because value-at-risk computations used by investment banks depended on market events of the preceding two to three years, when nothing similar had occurred, according to Wilson Ervin, who's now chief risk officer at Zurich-based Credit Suisse Group, Switzerland's second-biggest bank after UBS.

Long-Term Capital Management, which amplified its risk by relying on borrowed money for most of its trading bets, blew up in part because it didn't anticipate that investor panic after the Russian default would cut the value of any risky debt, whether it was issued by a country, sold by a company, or backed by mortgages.

The riskiest Russian and Brazilian bonds owned by the fund plunged far more than the safer Russian and Brazilian bonds that it had bet against as a hedge, according to "When Genius Failed,'' the book written by Roger Lowenstein.

"In a market stress event, some individual sectors that previously appeared unrelated do move together, and as a result, the organization could take losses on both of them or even on positions that were previously deemed to be a hedge,'' said Ed Hida, the partner who runs the risk strategy and analytics services group at Deloitte & Touche LLP in New York.

The other risk tool commonly used by securities firms, known as stress testing or scenario analysis, also failed to prepare the industry for the plummeting value of AAA-rated securities that had previously been deemed the most creditworthy, he said.

"Stress tests are only as good or as predictive as the scenarios used and in many cases the scenarios that played out were much more severe than people anticipated,'' Hida said. "One lesson learned is that these stress tests should be broader, should consider more scenarios.''

Kelleher, who became Morgan Stanley's CFO in October, explained the flaw in the firm's stress testing in a Dec. 19 interview, the day the company reported its first unprofitable quarter. "Our assumptions included what at the time was deemed to be a worst-case scenario,'' he said. "History has proven that the worst-case scenario was not the worst case.''

... Investment banks will continue to take unsafe risks as long as traders are rewarded for making profits, leaving shareholders, bondholders and sometimes taxpayers to shoulder the consequences, Taleb said.

Wall Street traders "make an annual bonus and get an annual review based on risks that don't show up on an annual basis,'' Taleb said. "You (as a trader) have all the incentive in the world to take these risks.''

Turn off automatic updates: From Computerworld magazine comes word that the latest Office 2003 service pack update from Microsoft won't let you open some older files, including some in Excel, Word and PowerPoint formats. This blocking of old file formats is for "security purposes," according to Microsoft. But it's a huge pain in the tushy for you and me.

My recommendation: Turn off ALL automatic updates to any programs -- Microsoft or any other vendor. Do not assume that the latest is the greatest. It often isn't. Harry's inviolate computer rule: If it works, don't mess with it. For Computerworld's article, click here.

You got to be really dumb to be in financial trouble. Regularly I get emails from organizations and "experts" telling me that "Many Americans continue to bury their heads in the sand, ignoring the fact that their credit card balances are growing, their savings account balances are diminishing, and a recession is possibly on the economic horizon." Yesterday The National Foundation for Credit Counseling (NFCC) emailed me a that my readers should take. The results will reveal whether or not they need professional help to avoid a deeper financial quagmire. Questions include:

+ I normally pay only the minimum amount due on my credit card bills.

+ My credit card balances increase each month.

+ I have begun using cash advances to meet my obligations.

+ Most of my credit cards are near the limit, so I've begun applying for new lines of credit.

Maybe I'm stupid, I can't imagine that anyone reading this column doesn't know that paying their credit cards bills in full every month is the absolute best investment around today. If you can't pay in full, spend less. What am I missing?

How the stockmarket works.
Once upon a time in a village, a man appeared and announced to the villagers that he would buy monkeys for $10 each.

The villagers seeing that there were many monkeys around, went out to the forest, and started catching them.

The man bought thousands at $10 and as supply started to diminish, the villagers stopped their effort. He further announced that he would now buy at $20. This renewed the efforts of the villagers and they started catching monkeys again.

Soon the supply diminished even further and people started going back to their farms. The offer increased to $25 each and the supply of monkeys became so little that it was an effort to even see a monkey, let alone catch it!

The man now announced that he would buy monkeys at $50 ! However, since he had to go to the city on some business, his assistant would
now buy on behalf of him.

In the absence of the man, the assistant told the villagers. "Look at all these monkeys in the big cage that the man has collected. I will sell them to you at $35 and when the man returns from the city, you can sell them to him for $50 each."

The villagers rounded up with all their savings and bought all the monkeys. Then they never saw the man nor his assistant, only monkeys everywhere!

Now you have a better understanding of how the stock market works.

Latest favorite New Yorker cartoon:

The redhead baby
After their baby was born, the panicked father went to see the Obstetrician. "Doctor," the man said, "I'm a upset because my daughter has red hair. She can't possibly be mine."

"Nonsense," the doctor said. "Even though you and your wife both have black hair, one of your ancestors may have contributed red hair to the gene pool."

"It isn't possible," the man insisted. "This can't be, our families on both sides had jet-black hair for generations."

"Well," said the doctor, "let me ask you this. How often do you and the wife have sex?"

The man seemed a bit ashamed. "I've been working very hard for the past year. We only made love every few months."

"Well, there you have it!" The doctor said confidently. "It's rust."

This column is about my personal search for the perfect investment. I don't give investment advice. For that you have to be registered with regulatory authorities, which I am not. I am a reporter and an investor. I make my daily column -- Monday through Friday -- freely available for three reasons: Writing is good for sorting things out in my brain. Second, the column is research for a book I'm writing called "In Search of the Perfect Investment." Third, I encourage my readers to send me their ideas, concerns and experiences. That way we can all learn together. My email address is . You can't click on my email address. You have to re-type it . This protects me from software scanning the Internet for email addresses to spam. I have no role in choosing the Google ads on this site. Thus I cannot endorse, though some look interesting. If you click on a link, Google may send me money. Please note I'm not suggesting you do. That money, if there is any, may help pay Michael's business school tuition. Read more about Google AdSense, click here and here.

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