So the S&P 500 just completed three consecutive days of closes over the old all-time high from March 2000. And you are sitting with a pile of uninvested money. What to do ???
I had a finance class at MIT Sloan School around 1980 with Fischer Black, who was one of the great financial market experts of the 20th Century. He taught us about "time diversification" on one day in his famous course.
Time Diversification:
One can mathematically prove that under fairly broad assumptions about the market and its distribution of returns that by making partial investments over time you will reduce your risk considerably while not reducing your expected returns. Once considered, it's almost obvious, being a form of the well-known statistics result that the variance of an average of multiple samples is less the variance of a single sample. The "sample" is your return on investment over a long period of time.
This investing theorem extends the concept of diversification to the time dimension, compared to the well known, and famous "free lunch" of diversification of investing across a portfolio of many stocks. In simple terms, you reduce your risk of investment by breaking your total investment dollars into several pools and spreading out the TIME when you make those investments. In more exotic terms, this theorem is analogous to part of Einstein's famous relativity theory that merged time & space into one four vector - here investment time and the space of stocks are merged into a single investment tactic.
You need to diversify across BOTH the space of stocks AND time to obtain the lowest risk for your return on investment.
So here is the answer of "What to do???"
Break your investment dollars into a few parts- perhaps three.
1. Invest one part (1/3 of the total) NOW.
2. Invest the next part on the earlier of a significant pullback (after the dust settles) or in a few months.
3. Then invest the last part in the late fall.
You're thinking, "why don't I just wait for the "significant pullback ?"
Because it might NOT happen for a long time, or when it does happen, the news that might have created it will then scare you into not investing even then. For example, if you were that smart, why didn't you invest everything in early March on THAT pullback? It was too scary then, that's why. But if you are putting only 1/3 to work, you might be able to pull the trigger on a pullback.
And your thinking, "Bunkerman, if you're so smart, why aren't you doing your Einsteinian time diversification ??"
D'uh, I'm smart enough to know I'm not perfect. I DID and AM doing this NOW. In late November, 2006, I had a large pile of new money to invest. I put 1/3 to work at once, even though the market was "extended" in the eyes of some gurus. And in March, I gave Mrs. B 1/3 to start her "Sky Fund" - I posted that. And on Monday morning, I'm giving Mrs. B the last 1/3 for her Sky Fund to invest immediately. We are now in the Elysian Fields of investing, the "Blue Sky" area when all prior resistance levels have been taken out and all known overhead supply is gone.
It's a bull market until something changes. The trend is your friend.
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7 comments:
I hope you challenged Professor Black on his Black-Scholes Theory, bunkerman....that "theory" may work well in a finance laboratory but is utter nonsense in the real world...
That was 1980 mfl59. I didn't know anything about options then. But we did discuss the normal distribution assumption & the insider trading & the outsized moves (he had some name for those, I forget).
I'm no options expert, but aren't all the volatility & Greeks & the entire language that I read about re options using it as a framework? And doesn't the Street still use it as a base case for understanding options pricing? Options traders seem to use it's terminolgy as a "lingua franca".
He spent quite a bit of time teaching us about the limitations, such as the fallacy of the Normal distribution, etc.
Since he went from MIT to Goldman Sachs until he died in the mid 1990s, and was well-regarded there as I know from people who knew first hand, I guess they didn't think his ideas were "nonsense".
From my understanding, "limited" is a better characterization of Black Scholes. He would not have disagreed with that. Classical physics works pretty well for may phenomna, but breaks down miserably for others. It's not nonsense, just limited. The same applies for its successor, non-relativisitic quantum mechanics, when relativistic effects are important.
He definitely would not have made the errors the LTCM guys did. He really talked a lot about the limitations & outlier events.
Yes perhaps nonsense a bit too harsh...but limited is a good description....yes as we all know returns are not distrubuted normally, volatility is not a constant (perhaps the biggest limitation of the theory), and there are taxes and transaction costs to doing business...
Why didn't Fischer Black participate in LTCM? His buddy Myron Scholes was one of the main strategists there, from what I recall...I wonder if he and Scholes had some differences of opinions....I just started reading the biography of Scholes...pretty interesting...
Black died in 1995 before LTCM. Anyway, he was very, very risk averse personally. He had four daughters at the time. He only invested in Treasuries in 1980. It was a little humorous (for him, too) - having all these financial ideas but only wanting to buy Treasuries.
Very sad him dying so young. His class was very memorable and useful for me later in finance working on the "Street"
I had another finance class with Robert Merton, the other LTCM guy with Scholes. He was at MIT in 1980. He was a super teacher, too. His class ideas were very helpful later, too.
Actually I still think about some of the concepts & thinking of both in my current investing situation. Just as reminders of effects, etc.
Their personalities were very different.
Wow I didn't know he passed away...guess that answers my question....very interesting information bunkerman...it must have been a great experience to study under one of the founding fathers of modern finance....
Yes, it was a great experience.
That's one thing about those schools. I had physics under several of the greats at Harvard, too.
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