Wine as a long term investment

Buying high-quality wine actually can be a very good long-term investment. See the article at An academic paper discussing this (serving as the basis of the above article) is available for free download through SSRN. High-grade wines have a great return with relatively low volatility. The returns are also not very correlated with the stock market, so wine would be a great way to diversify.

The problem? Storing the wines requires good conditions (such as a good, cool, dry cellar or a wine cooler). Also, selling the wines would rack up huge commissions when they are auctioned off. And if you do not have a large collection it would be hard to sell the wine.

This is a perfect type of investment for a mutual fund or ETF. There is one hedge fund that deals with wines, but its minimum investment is high (100k euros) and its fees are steep as well.

Of course, the other way to invest in wines is to buy them and drink them and consider that in an investment in happiness! Yesterday I opened up a bottle of 2005 Morgon (a good, fruity red Beaujolais with some complexity and terroir).  My return on investment was immeasurably large.

Disclosure: I like wine and I make it as well. My disclosure policy likes wine as well.

Why Inexperienced Investors Do Not Learn

Why Inexperienced Investors Do Not Learn: They Don’t Know Their Past Portfolio Performance

Glaser and Weber just released a paper with the above title on SSRN. I urge you to download and read it. They examine the performance of 215 online investors over the past 4 years and find that the investors have no clue whatsoever as to how much money they made or lost. At the extreme, one investor who thought he had lost 50% per year had actually gained 2% per year. Another who thought she had gained 120% per year had lost 3% per year.

There was literally no correlation between the returns investors thought they had made and the returns they actually made. There was a tendency for those with better performance to be more accurate in assessing their past performance (they were better calibrated). This is a logical outcome–those investors who know how they did were more likely to allocate money to strategies that worked. So if they knew that they tended to lose money speculating in tech stocks, they would know to switch to something safer (index funds or blue chip stocks). That is why you should know your performance.

I am the poster boy for the importance of tracking performance. Since I started seriously investing in 2005 I have done all sorts of things–day trading, options, shorting stocks, speculating in gold, quantitative investing, value investing, and raw speculation. I know after tracking my performance in detail on Icarra that most of these things were not worthwhile. While I made a lot of money in gold I did not know what I was doing, so it made sense to get out. I lost money in day trading and got out with minuscule losses after only a week. I have made money shorting stocks. I have broken even on my options trading, mostly because I have gotten fairly good at shorting stocks and I used puts on a few stocks this summer that I could not borrow the shares to short. I have lost a lot of money in various stock speculation. When I have focused on finding and understanding good value stocks I have on the whole made money, doing slightly better than the market. My quantitative investing performance has been pretty darn spectacular.

So now that I know how I have performed, what will I do about it? I have forbidden myself from rank speculation in stocks or options. I have increased my short activity. I have limited the number of individual stock positions I pick for my value investing portfolio, increasing the size of each position, so that I can focus on better understanding each company. I have also drastically increased the portion of my portfolio that I allocate to quantitative strategies, both long and short.

So take a look at your performance. If it is okay, you may want to allocate more money to those strategies that are more profitable and less to those that are less profitable. If your performance is dismal, you may want to just stick all your investments in index funds. Remember, if you index, you can expect to outperform 80% of all investors, while spending a lot less time thinking about your investments.

Feel like timing the market?

It may not be such a good idea. A perfect market timer could have, over the last 80 years, turned $1 into $670 million. A perfectly inept market timer would have turned $100 million into $1,000. A market timer would have to be right about 70% of the time just to equal the return of a buy and hold index fund. Do you think you are that good? See the study here

Uncorrelated assets now correlated

One of the reasons for recommending diversification of asset classes (stocks, bonds, real estate, commodities, etc) is that since different asset classes are imperfectly correlated this will reduce volatility and risk. A recent report from Merrill Lynch shows that the correlation between different asset classes have increased over the last year. Your best bet for diversification? Short-term bonds with maturities of a 2 to 5 years. My bet is on treasuries, particularly TIPS. For my personal portfolio, I lend money on the P2P lending site and I expect to earn an 8.5% annual return with little effort.

Article here (PDF):

The Kelly Criterion

The Kelly Criterion is a formula for choosing how large a bet to make on each trade/investment/gamble. It works for the stock market, though it was originally developed for gambling. The formula is simple: bet the proportion of your investment as defined by the ratio of expected return divided by maximum return. Expected return is what you expect in the long run.

So, the formula is: P_invest = E(r) / M(r)
Proportion of portfolio to invest = P_invest
Expected return= E(r)
Maximum return = M(r)

Now, a couple of examples:

1. If you flip fair coin and win $1 if heads and lose $1 if tails, the expected return is $0 (.5 x $1 + .5 x -1). The maximum return is $1 (if heads). Therefore, the Kelly criterion suggests you bet no money ($0/$1). This makes sense, because you should not invest money where you expect to only break even.

2. You want to short Apple (AAPL) because you think there is an 80% chance the stock will go down in the next month. You think if that happens, the stock will go down 10%. You figure that there is a 20% chance that the stock will go up 5%. The expected return is 7% (.8 x 10% + .2 x -5%). The maximum gain is 10%. The Kelly formula suggests that you invest at most 70% (7/10) of your portfolio.

3. Same thing, shorting AAPL. You like the odds, so you increase your leverage by buying put options. You buy just out of the money options. Now, there is a 70% chance that your options expire worthless (-100% return) and a 30% chance that you make 300%. The expected return is +20% (.7 x -100 + .3 x 300). The maximum gain is 300%. The Kelly formula says that you should bet less than 1/15 (about 6.5%) of your portfolio (20/300).

One thing to consider is that the Kelly formula seeks only to maximize gains. If you wish to minimize portfolio variability as well, you should invest significantly less than the maximum allowed by the Kelly formula. Also, keep in mind that the formula is only as good as your guesses of probability.

I recommend a Legg Mason article on the Kelly Criterion, or this paper by Edward Thorp (who used it to great effect).

Visit Cisiova’s website for their advanced online Kelly Criterion calculator, which allows you to enter a large number of possible outcomes.

If you liked this post you may want to check out William Poundstone’s book Fortune’s Formula.

Disclosure: I own no Apple stock, long or short. Unfortunately, I did once lose money shorting AAPL. My disclosure policy never loses me money.

My Investments

I track all my easily trackable on the website I make my portfolios available to the public. Below are links to all my portfolios:

All my investments (the total of all portfolios below) loan portfolio 

Mutual Funds and ETFs

Stockpicking portfolio

Quantitative Portfolio

In addition, I have my favorite mutual funds and ETFs in separate paper portfolios. I actually own many of these.

I will rarely if ever discuss stocks in my quantitative portfolio because those are chosen by secret methods and I do little in depth due diligence on these stocks.