Notes
1 One of the best books ever written about risk is Peter L. Bernstein's Against the Gods: The Remarkable Story of Risk (New York: John Wiley & Sons, 1998). It is highly recommended reading.
2 And, of course, luck. But Lady Luck always favors the bold.
3 If you could invest $1 million and compound it at 50 percent per year for 10 years tax free, your money would grow to $134,000,000. Venture capital profits aren't tax free, of course, but they are tax deferred (profits are generated many years after the investments are made) and almost always receive long-term capital gains treatment.
4 As discussed in Chapter 2, Andrew W. Mellon was probably the first American venture capitalist in the modern sense of the term. Mellon and his family and family bank provided the seed capital for such ventures as Alcoa, Koppers, Gulf Oil, and many other firms, as well, of course, as Mellon Bank itself (founded by Andrew's father, Thomas).
5 For this reason, purchases of extremely large blocks of a particular stock will often occur not on a stock exchange but in a negotiated transaction. In such a transaction the buyer(s) will often get a bargain, a true “quantity discount” relative to the price at which the stock is selling on the exchange. On the other hand, the seller will also get a bargain, because the discount he will give the buyer will be lower than the discounted price likely to result from the market impact of such a huge sale.
6 Even more extreme events are also characteristic of capital markets behavior, as I discuss later.
7 The only exceptions to this iron law of investment risk have to do with manager talent: A very few extremely talented managers appear to be able to generate excess upside price volatility (that is, excess positive rates of return) without concomitant downside price volatility. This trick seems to be easier to achieve in extremely inefficient sectors of the markets and where the manager is able both to buy stocks long and sell them short. But as we will see, it is extraordinarily difficult to identify these managers in advance. Moreover, adherents to the “strong” version of efficient market theory would argue that most “talented” managers are really just lucky managers. If you flip hundreds of thousands of pennies, a very few, very “talented” pennies will come up heads 20 times in a row!
8 Several Nobel Prizes have been awarded for work in the field of behavior finance, including the 2002 award in economics, which went to Daniel Kahneman.
9 Special thanks to my partner, Jim Foster, for his contributions to this portion of the chapter, which originally appeared, in slightly different form, in my blog at www.Summitas.com.
10 As reported in Forbes magazine. See “The Average Investor Is His Own Worst Enemy,” by David K. Randall (June 28, 2010).
11 Terrence Odean, Brad Barber, Yi-Tsung Lee, and Yu-Jane Liu, “Just How Much Do Investors Lose from Trade?” Review of Financial Studies 22, no.2 (2009): 609–632.
12 Behavioral Finance and Investor Types (New York: John Wiley & Sons, forthcoming, 2012). Pompian simplifies the complex world of behavioral investing so that investors and their advisors can get their arms around this large subject. He also provides clear guidance for how to avoid the behavioral traps that stand between investors and their financial goals.
13 Chamfort's actual remark was, “Swallow a toad in the morning and you will encounter nothing more disgusting the rest of the day.”
14 John C. Bogle, Don't Count On It! The Perils of Numeracy, keynote address before the Landmines in Finance Forum of the Center for Economic Policy Studies at Princeton University, October 18, 2002.
15 Dr. Hardin is probably best known for his environmental parable, “The Tragedy of the Commons,” Science 162 (1968): 1243–1248.
16 “An Ecolate View of the Human Predicament.” This article appeared in McRostie (ed.), Global Resources: Perspectives and Alternatives (University Park Press, 1985). The essay was expanded into Hardin's book, Filters against Folly (New York: Penguin Press, 1985).
17 That is to say, I have applied the Bogle total return rates to a different set of dollars, just to make it more interesting.
18 Bogle, Don't Count On It! 5, note 2.
19 For another take on the important issue of variance drain, see Chapter 5.
20 Variance drain costs Edith 128 basis points of annual compound return, bringing her effective return (for net wealth purposes) down from 11.3 percent to 10.02 percent.
21 In adjusting our final wealth calculations for the variability of the returns, we have used the simple approximation: C = R − σ2/2, where R is the mean return and σ is the variance in the return. See Tom Messmore, “Variance Drain,” Journal of Portfolio Management (Summer 1995): 106.
22 Bogle, Don't Count On It! 6, note 2.
23 Market impact refers to the fact that, because money managers tend to be huge investors, the mere fact that they are attempting to buy a stock will force the price of that stock up, substantially increasing the cost of the transaction. An identical problem occurs when the manager tries to sell a stock: The large sell order will cause the stock price to decline, reducing the sales proceeds. The combination of buying higher and selling lower has a huge impact on managers' abilities to produce competitive returns.
24 Bogle, Don't Count On It! 6, note 2.
25 Bogle, Don't Count On It! 6, note 2.
26 Private foundations pay a small excise tax on their investment income.
27 Bogle, Don't Count On It! 6, note 2.
28 Bogle, Don't Count On It! 7, note 2.
29 An entire branch of modern portfolio theory—behavioral finance—is devoted to studying the counterproductive actions people take when investing capital. In 2002 the Nobel Prize in economics was awarded to Daniel Kahneman for his pioneering work in “having integrated insights from psychological research into economic science, especially concerning human judgment and decision making under uncertainty,” as the Royal Swedish Academy of Science said in its public announcement of the award. Much of Kahneman's work was done in partnership with Amos Tversky who, having died, was ineligible for the prize.
30 Thomas Malthus wrote his famous paper, “An Essay on the Principle of Population,” in 1768.
31 Thomas Hobbes, Leviathan (1660). “No arts; no letters; no society; and which is worst of all, continual fear and danger of violent death; and the life of man, solitary, poor, nasty, brutish, and short.”