What Do You Know?

in Apprenticed Investor

"Remember the wisdom of Lao Tzu: "He who knows others is wise. He who knows himself is enlightened." What do you know?"
-Paul Farrell

>

This seems to be Paull Farrell appreciation week at the Big Picture. I sense his frustration levels are increasing as he continues to rail against some of the absurdities of Wall Street.

Paul, you better watch out or you may become victim of the Cassandra Syndrome.

His latest column I wanted to reference exhorts investors to avoid the guru trap and steer clear of forecasts. Indirectly, he really suggests that individuals must take responsibility for their own investments. Incidentally, I addressed an aspect of each of these three concepts in 3 different Apprenticed Investor columns: The Folly of Forecasting, Lose the News, and Your Fault, Dear Reader.

Here's an excerpt:

"The best investing advice is simple, timeless, paradoxical -- and often ignored. Yes, ignored, because so many investors cannot make decisions. Lacking self-confidence, they rely on the random flow of breaking news. That overwhelming rush of new information, all of it short-term, drowns out the investment advice to which we should be adhering. Those timeless principles demand that we ignore breaking news and take personal responsibility, a very scary idea for investors who have lost their self-confidence.

This message has been summarized by the Chinese master Lao Tzu: "Those who know do not speak, those who speak do not know." He offered this investment advice three thousand years ago in the Tao Te Ching. Test it on any guru: Gross, Siegel, Bogle, Cramer, Bernanke, Paulson, and yes, even me. Of course, if investors took Lao Tzu's advice, Wall Street would be out of business. You'd be in command!"

Its more than the being misled by the news flow; Understand that much of what is said is merely people "talking their books." Not purposely misleading -- but that is the ultimate result.

Regardless, Farrell spoke with Paul Merriman, and identified 5 issues investors need to think about when considering forecasts and pundits and their own knowledge of "the facts" :

1. Stuff you know, that actually is true

Investors are historians not futurists. We're overloaded. Even with the best data available, like our fund profiles, you're dealing with 10,000 funds, each with 100 bits of data that's actually old news, usually at least 3-6 months old. So you oscillate between a false sense of being well-informed, and insecurity about the truth.

2. Stuff you think you know, but is wrong

Economists, securities analysts and cable's talking heads know our brains prefer positive upbeat news. Eternal optimists, they speak the good news. You know you don't know the future, so you turn to the media and press for hints, thinking maybe if you just listen to CNBC long enough, or read one more newspaper, or research one more fund, you'll figure out tomorrow. The blind are leading the blind. Your mind is rationalizing a bad idea.

3. Stuff you know you don't know, but obsess about

Every day the media talks endlessly with hundreds of market gurus, economists, CEOs. You get all the contradictions, oxymorons, dilemmas, paradoxes, a daily torrent of conflicting data about tomorrow's unknowns and unpredictables. So you obsess anxiously, trying to figure out what you can never really know until after the fact.

4. Stuff you know to be true, but deny

Our minds are masters at denying the truth, even when it's staring us in the face. In hindsight any damn fool could have predicted the dot-com collapse. But greed drove us and we denied P/E ratios mattered. You're fortunate if 25% of what you know is true. But the fact is, even when you feel you're right, you might still be dead wrong, unable to let go of even a bad idea.

5. All the stuff you don't know that you don't know

Stuff you don't see until after the fact, when it's too late! Unknowns that unpredictably crash markets: Natural disasters, deficit collapses, homeland terrorist attacks, nuclear war.

Regardless of our gaps in knowledge, the best advice remains to recognize you are on your own. "Folks, the toughest decision any investor must make is to act responsibly. But you'll never mature if you don't stop following the "experts" and take full responsibility. It's your money, your retirement, and in the end, you, not the gurus you listen to, are stuck with the gains or losses."

As one who is in the Pundit class, I've hoped to be the exception to the rule.

The Folly of Forecasting

Apprenticed Investor: The Folly of Forecasting
By Barry Ritholtz
RealMoney.com Contributor
6/7/2005 1:05 PM EDT
URL: http://www.thestreet.com/comment/barryritholtz/10226887.html

As a chartered member of the chattering class, I am all too familiar with the "perils of predictions." Anyone who works in the financial field and speaks to the press eventually gets tagged for a market forecast gone awry. It's an occupational hazard. Unfortunately, investors all too often give these "predictions" in print or on TV far more weight than they should. It's very easy for a confident-sounding analyst, fund manager or professor to say something on TV that can throw off the best laid plans of investors. I wish an SEC-mandated disclosure accompanied all pundit forecasts: "The undersigned states that he has no idea what's going to happen in the future, and hereby declares that this prediction is merely a wildly unsupported speculation." Don't hold your breath waiting for that to happen. The bottom line is that I've yet to find anyone who can accurately and consistently forecast the market behavior with any degree of accuracy, beyond short-term trend following. That inconvenient factoid never seems to dissuade the prophets -- or the press -- from their fortune-telling ways. There are a few things that investors should keep in mind when encountering these speculations. Whenever you find yourself reading (or watching) someone who tells you where a stock or the markets are going, consider these factors:

No one truly knows what tomorrow will bring. Nobody. Any and all forecasts are, at best, educated guesses.

All prognostications are instantly stale, subject to further revision. Conditions change, new data are released, events unfold. Yesterday's prediction can be undone by tomorrow's press release.

In order to "become right," some investors will stand by their predictions despite a stock or the market going the opposite way, hoping to be proven correct. Ned Davis called this the curse of "being right rather than making money."

There are only two kinds of predictions that have some value to investors: One is probability-based, and the other is risk-based. As long as you apply the same rules -- no one knows the future, they are subject to revision and should not be taken as gospel -- then these are sometimes worth considering.

Probability assessments are typically based upon historical comparisons of prior markets with similar characteristics: The more variables that align, the higher the likelihood that a given scenario plays out in a similar fashion. They are of this variety: In the past, when X, Y and Z all happened together, then we expect that A is most likely, then B is possible, while C is the least likely.

That doesn't mean A will happen or C cannot -- only that there's a specific probability of these events occurring out of the millions of ways the future might unfold. Whether any particular scenario plays out is determined by how the countless variables interact over time.

Looking at the future in terms of various probabilities is a productive way to position assets and manage risk. Why? If your expectations for the future recognize that this is but one possible outcome, then you are more likely to consider and plan for other contingencies. It builds in an expectation that other scenarios can and will occur.

For example, one signal I use is to determine when to sell (the subject of a future column) is after a long uptrend is broken. It's not that stocks cannot go higher after breaking their trend line -- they sometimes do. However, most of the time this happens it signals a significant change in institutional behavior towards the stock. Typically, it reflects a shift from fund accumulation to distribution.

For those people who have been enjoying the ride in Google (GOOG:Nasdaq) -- especially the near vertical move since April -- this is a high probability strategy. Once that trend line gets broken, say adios muchachos, take your profits and move along.

Again, a trend break is not a guarantee that the upside is finished, but it's a fairly good probability assessment.

The second type of good prediction is the risk-based discussion. These forecasts care less about price targets -- instead, they are an assessment of danger. In other words, to buyers of stocks under the present conditions, when this, that and the other are happening, you are taking on more (or less risk) than is typical. Saying the markets contain more or less risk at given times is a very different statement than: "I think the Dow is going to go to X."

I engaged in a combination of broader market-based probability this week in Smart Money, along with future risk assessment. Given the change in character the market displayed since the April lows, I noted the high probability of a substantial rally in the second half of the year. My basis for this was part technical -- the market regaining its prior trading range -- and part anecdotal (all the hedge fund cash on the sidelines). This created a high probability of a move similar to what we saw over the summer of 2003.

But I also included a risk-based assessment based upon the age of this bull move, along with the decaying macroeconomic environment; in tandem, they set up an increasing risk environment as the year progresses. That's how a top can form, and that presents an increased risk of a market correction or even collapse.

When you stop to consider all of the unforeseen actions that might occur between now and then, however, it becomes pretty apparent that all forecasting is at best a low probability activity.

Chaos Theory

Why are the markets so difficult to predict? To borrow a phrase from the physicists, the market demonstrates "unstable aperiodic behavior in deterministic nonlinear dynamism."

This behavior is better known as Chaos Theory.

What does that mean in English? The market is called "aperiodic" because it never repeats itself precisely the same way. Weather is also aperiodic -- it may be colder in the winter than in the summer, so there is a degree of cyclicality. But the day-to-day changes are never exactly the same year after year. The same dynamic applies to the markets: There are similarities from one era to another, but it's never identical. In Mark Twain's words, "History doesn't repeat, but it rhymes."

The markets also act with a surprising degree of instability. Small forces can create disproportionately large reactions. A surprising economic report, an off-the-cuff comment by a Fed official, a small change in earnings by any one of 1,000 companies; any one of these data points can roil the market. That behavior does not occur in what the scientists call "stable" systems.

Given the complexity of both the capital markets and the physical universe, we shouldn't be that surprised that Chaos Theory is so applicable to the financial markets.

Considering how little we know about the totality of market conditions -- and how incredibly intricate and complex the system is -- it's no surprise that pundit predictions are so frequently poor.

Are Social Security Benefits Taxable?

IRS TAX TIP 2006-30

How much, if any, of your Social Security benefits are taxable depends on your total income and marital status. Generally, if Social Security benefits were your only income, your benefits are not taxable and you probably do not need to file a federal income tax return

If you received income from other sources, your benefits will not be taxed unless your modified adjusted gross income is more than the base amount for your filing status. Your taxable benefits and modified adjusted gross income are figured in a worksheet in the Form 1040A or Form 1040 Instruction Booklet.

Before you go to the instruction book, do the following quick computation to determine whether some of your benefits may be taxable:

• First, add one–half of the total Social Security you received to all your other income, including any tax exempt interest and other exclusions from income.
• Then, compare this total to the base amount for your filing status.

The 2005 base amounts are:

• $32,000 for married couples filing jointly
• $25,000 for single, head of household, qualifying widow/widower with a dependent child or married individuals filing separately who did not live with their spouses at any time during the year
• $0 for married persons filing separately who lived together during the year

For additional information on the taxability of Social Security benefits, see IRS Publication 915, Social Security and Equivalent Railroad Retirement Benefits. Publication 915 is available on the IRS Web site at IRS.gov or by calling 1-800-TAX-FORM (1-800-829-3676).