Archive for October, 2011

The Magic Black Box

Posted in Investing on 12, October 2011 by nathanbusch

I have recently been in the process of educating my 30-year old nephew about finances and investing.  Towards that end, I have posed the following problem, which I call the Magic Black Box Problem.

Late one night, your geeky neighbour comes banging on your door excited about his latest invention. Reluctantly, you allow him to enter and he excitedly plants himself on your living room sofa with a big smile on his face.

“Well?”, you say.

He proudly produces a small black box from his pocket and plants it on the table.

“What is that?”, you say.

He explains as follows: this is a black box.

“Yet another black box!”, you retort.

He responds as follows: not just a black box, but a magic black box. He continues as follows: you purchase this box from me; simply allow it to sit on the table for ten years; during the course of each year, it extracts particles from the air; then on each anniversary of the day that you purchased the magic black box, it produces a crisp, genuine, one-dollar bill. He finishes by stating that the box will produce precisely 10 of these one-dollar bills and will then self destruct.

The question is: how much would you pay for this box and why?

My nephew answered as follows: that he would pay no more than 92¢ for the magic black box. I then posed the question: what if this box were to be offered on the open market and multiple individuals were bidding to purchase the box? Then, I asked, what would be a reasonable price for the box on the market? He has been stumped for three-quarters of a year. So I thought that I would help him reach the answer to the question by teaching the underlying concepts and methods necessary to reach a reasonable answer.

I have become convinced that the understanding obtained by deriving the answer to this question will position one to understand how to manage just about every aspect of life.

The first step towards answering this question is to obtain some information. It will be necessary to determine the present value of monies received in the future. The present value of future revenue is the inverse problem to the future value of current revenue. That is, if we receive one dollar today, what will that dollar be worth in the future. Once one knows how to compute the future value of the dollar, one can readily compute the present value of a dollar received at some time in the future. Of course, it is still one dollar; however, the question is relative to the purchasing power of that dollar today, what will be the purchasing power of the dollar at the end of the first year. To obtain that information requires the Consumer Price Index. The official, and most reasonable, data may be obtained from the website of the bureau of labor statistics. The data may be readily loaded into a spreadsheet and analysed. The annual inflation rate may be computed as the year over year change in the consumer price index as a ratio of the start of the year. I used the monthly data starting in 1950 and determined that the average rate of inflation was 3.78% with a standard deviation of 2.93%.

It is also necessary to account for state and federal income taxes as well as long-term capital gains taxes. Since each dollar bill issued by the magic black box each year is counted as income, then it must be taxed as income. I shall leave until later the discussion of the need to account for long-term capital gains taxes. It is now time to create a spreadsheet, enter the long-term rate of inflation, the federal and state income taxes, and the federal and state long-term capital gains tax rate.

I am a Macintosh user, so my spreadsheet program is Numbers. Type the following words into the first few cells of your spreadsheet: “Inflation” into cell $a$1; “Interest” into cell $a$2; “Treasury” into cell $a$3; “Excess” into cell $a$4; and “Payment” into cell $a$5. Of course, omit the quotation marks. Also, type the following into the adjacent cells as follows: “0.0374” into cell $b$1; “0.02” into cell $b$2; “0.0314” into cell $b$3; “0.0300” into cell $b$4; and “1” into cell $b$5. Again, omit the quotation marks.

Also, enter the following in columns $d and $e: the phrase “State Tax” into $d$1; the phrase “Federal Tax” into $d$2; “0.079” into $e$1; and “0.25” into cell $e$2.

By now, your spreadsheet should look something like the following.

Inflation 3.74% State Tax 7.9%
Interest 2.00% Federal Tax 25.0%
Treasury 3.14%
Excess 3.00%
Payment $1.00

The state tax rate is fixed and I am using the income tax rate for Minnesota. The federal tax rate that you should use is not the marginal tax rate; rather, you should use the average tax rate that you pay.

The cell adjacent to the word “Payment” will contain the amount that you would be willing to pay for the “Magic Black Box.” Since this is the answer, which is currently not known, we use $1.00, as a space holder. Also, having $1.00 in cell $a$5 will allow our computations to proceed without confusing the spreadsheet program.

In the analysis of our “Magic Black Box” problem, we are going to allow for the possibility that the crisp new one-dollar bill that it issues on each anniversary of purchase is invested into some sort of a vehicle. To align with standard financial and investment concepts, let us call the crisp new one-dollar bill that the “Magic Black Box” issues on each anniversary of purchase the “dividend.”

Presume for a moment that the “Payment” had been placed into an interest bearing bank account. Of course, these days you would be luck to receive an interest of 0.015% on a standard savings account. Each month, the bank will send you a statement indicating that some interest had been paid for the month and that that interest payment had been credited to your account. I ask forgiveness from the accountants if the interest is “debited” rather than “credited.” I have never been able to remember the difference.

Nevertheless, on the following month, you will see listed the principle that you had at the beginning of the first month, the interest that you were paid at the end of that first month, and the interest that you were paid at the end of the second month. The a fraction of the interest paid during the second month is actually interest paid on the interest that was paid during the first month. Thus, at the end of the second month, you will have an amount in your bank account that can be readily computed using the following formulation:

Total = Principle x (1 + i) x (1 + i)

That formula represents accrual of compound interest.

However, in our “Magic Black Box” problem, we cannot accrue compound interest from the device until we have had a sufficient number of dividend payments, net of taxes, to slightly exceed the amount that the market is demanding for the box. In the case of shares in companies, many companies have dividend reinvestment programs, which are commonly known as “Drips”, that allow the dividend to be used to purchase fractional shares. However, with equity, it is not at all clear that the next dividend payment is made on the fractional share rather than on the integer number of shares.

Now, once we have sufficient dividends accumulated from the “Magic Black Box” net of taxes, we can use the cash to purchase a new box. Until that happens, we should invest the dividends in an alternative vehicle that accrues some interest. There are a wide variety of possibilities. For the time being, let us presume that we have found a bank that is willing to allow us to purchase a $1.00 one-year certificate of deposit that pays an annual interest rate of 2.0%. Thus, the number in cell $b$2.

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John Bell, 11th October 2011

Posted in Exposing Corruption on 12, October 2011 by nathanbusch

Peggy, and my audience:

Thank you for bringing the latest “John Bell” missive to my attention.  I did receive a copy of the e-mail that you forwarded to me.  At times, his logic got lost in extraordinarily sloppy grammar and syntax.

I recollect that, just before pumping Jammin Java Corporation, our mysterious “John Bell” person solicited subscriptions to his “stock pick” service.  Given the response and comments that were posted on this blog, it seems that he managed to get a lot of buyers.  Since “John Bell” pulled all of his advertisement from finance.yahoo.com, I have received two of his e-mails.  I am presuming that I received the same e-mails from “John Bell” as did his subscribers.  Given the lack of guidance and support that has been forthcoming from “John Bell”,  I hope that those who did subscribe to the “John Bell” stock pick service have now been sufficiently embarrassed after giving him such a considerable amount of money for nothing useful in return.

I now turn my attention to the latest e-mail from “John Bell”.  Attached, please find the text of that e-mail:

Technical Analysis.

I must admit, I’m not a fan of using technical analysis to guide investment decisions. For those who don’t know:

Technical analysis is the art of looking at past price movements to predict the future.

On the other hand, fundamental analysis is looking at the income statement and balance sheet etc to guide decisions.

As I say, I’ve never been a big fan of technical analysis or “charting”.It all seems a little too much of a pseudo-science to me, like acupuncture.

After all, it wasn’t the chart pattern of Apple (AAPL) in 2005 that caused it to [rise from] $38 to $380.

It was the ipod, the ipad, the macbook air – All the things that are analyzed by fundamental investors and ignored by technicians.

But there is one caveat.

In the short-term, some technical analysis can help you.

You see so much of today’s trading volume is made up of short term technical trading that the chart patterns become self-fulfilling prophecies.

It’s like a financial crisis or a run on a bank.

Perception creates the reality.

As soon as people panic, however irrational the reason to panic was at first, soon enough so many people are panicking that there IS a real reason to panic!

In technical trading, when the most commonly known patterns emerge, so many traders “make the trade” that it forms the pattern they were expecting.

Here’s the only chart pattern you need to know about.

It’s very simple.

Most stocks’ trade in a range.

A $5 stock may trade for three months in the range of $4 to $6.

What has happened is the stock has created a support level at $4 and a resistance level at $6.

This means absent a rush of buying or selling the stock’ will find it hard to break $6 or fall below $4 – Thus creating a range it bounces between.

But, and here’s the important bit.

What you need to look out for is when the range is broken.

When the prices breaks past $6, as soon as it hits $6.10 or so it will usually shoot up.

It is often the start of a new, higher trading range.

Put another way, once the chart breaks a resistance level, the resistance is removed and it will continue higher.

Of course, the same occurs on the downside too.

A chart that is falling will hit support levels, once it breaches the support level it often will continue falling.

Got that?

It’s the most basic technical pattern, but pretty much every other pattern is just an abstract, unnecessarily complex form of resistance and support.

One other thing, resistance and support will get stronger the more times the chart hits the level and fails to break it.

Every time it hits $5.97, $5.98 and then retreats back to the $5.50 level it has strengthened the resistance.

This is simply because start to realize there is resistance at $6, so every time it gets near they sell (achieving the highest sale price before resistance).

As I said at the top, I’m not a big fan of technical trading. 

But if you’ve done your research and you like a companies fundamentals enough to take a position.

Then considering the technicals can help you get the best price possible.

John Bell

It seems that our mysterious “John Bell” is struggling to find a new project to bolster both his ego and bank account. From the text of his latest e-mail, we learn nothing useful about either the theory of technical analysis or the application of that theory. It is almost not even worth our while to read his e-mails any more because he has nothing of any use to say.

In short, I translate technical analysis as follows: “how to lose a lot of money really fast.”

To use technical analysis ususally involves either writing your own analysis and charting software or purchasing one of the myriad of software applications out there on the market. In short, these are a waste of time and money. Once you account for your time, transaction costs, and short-term capital gains you would be lucky to have a halfpenny in your pocket. Aside from all of that, if 10,000 people are using the same particular technical analysis software application as you are using, then your chances of being ahead of the pack is nearly zero. Thus, you will likely do no better than the average of the 10,000 people and likely do no worse than the average. If the average has only a halfpenny at the end of the day, then it seems nonsensical to be that average.

After having read Philip Fisher, Napoleon Hill, Joel Greenblatt, and most of the writings of Benjamin Graham, I have come to the following conclusion: to succeed, simply define a goal and work hard towards that goal. In the area of your finances, this involves the following: decide how much money you want to have 20 years from now; account for the short and long term capital gains taxes; periodically create a list of good companies that are selling for a cheap price; allocate your then available resources appropriately amongst the top 10 companies of that list; where appropriate, use a DRIP; and hold.

Most of all, have titanium nerves.