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Don't-miss reads for investors

It's not too late to make some summer reading recommendations, and a quick review of my bookcase turned up some titles I think would be valuable for any investor. These books cover topics ranging from a detailed explanation of how the markets really work to the basic benefits of financial planning and some of the common behavioral errors investors make. Each book holds many helpful insights, and each is well worth the investment.

"Market Sense and Nonsense"

While not a book for novice investors, Jack Schwager's "Market Sense and Nonsense: How the Markets Really Work (and How They Don't)" is still an accessible read for investors interested in learning the truth behind the way many people think the markets work.

Schwager, who breaks his book into 21 short chapters, provides an education on many important facts and myths about the investment management business. He does so in a concise and entertaining way. The sections on measuring risk, understanding correlation (an often misunderstood topic) and how the use of leverage affects risk and return are particularly good.

Among the points Schwager makes are:

  • So-called expert opinion isn't more reliable than the proverbial dart-throwing chimp.
  • High volatility does not necessarily imply high risk.
  • Investments shouldn't be viewed in isolation, but by how their addition affects the risks and returns of the entire portfolio.
  • While markets are pretty efficient, making them difficult to beat, they aren't perfectly efficient.
  • Market prices aren't normally distributed.
  • The best time to start a long-term investment in stocks is after an extended period of poor performance, just when many investors have thrown in the towel.
  • Concentrating on funds with the strongest record of returns isn't a sound strategy.
  • Past returns are not reliable indicators of future performance, and many track records conceal hidden risks.
  • Superior performance doesn't necessarily imply manager skill.

Schwager provides valuable insights on portfolio management, assessing risk, hedge funds and much more. Because he's from the world of active investing, perhaps it will come as a surprise to readers that he recognizes the market is difficult to beat. What that means for many investors (and probably you) is that the best choice might also be the traditional academic advice: Invest in index funds so you can at least match the market.

"Strategic Financial Planning Over the Lifecycle"

Unfortunately, when it comes to financial planning -- let alone investing -- our education system has failed the public miserably. Despite the fact that money may be the third-most-important thing in our lives (well, not money itself, but what money provides) after our family and our health, most individuals are totally unprepared to do proper financial planning.

Having a well-developed investment plan is the necessary prescription for investment success. Narat Charupat, Huaxiong Huang and Moshe Milevsky in "Strategic Financial Planning Over the Lifecycle: A Conceptual Approach to Personal Risk Management" provide some important insights that most books on investing miss.

For example, the authors focus on your personal balance sheet and human capital. As a result, they convey the importance of considering your labor capital, how it correlates with the risks of your equities when deciding on your equity allocation and how it changes over time. It's unfortunate that not only most individuals miss this very important issue, but so do most professional financial advisors I've come across.

The book also focuses on the important concept of "consumption smoothing" and how to determine the optimal savings rate. Other parts address integrating mortgage and other debt financing into decisions, the buy-a-home versus rent-a-home decision, income tax issues (such as whether taxable or tax-advantaged vehicles are best for holding your stocks and your bonds), integrating risk management and insurance (such as disability, life, liability and longevity) into a financial plan, asset allocation and effective diversification, and retirement planning.

If you're interested in learning about how to do true financial planning, this book provides an antidote to financial ignorance. While the math can get a bit heavy, the book's key messages can be extracted without understanding the formulas involved.

"Behavioral Finance: Insights into Irrational Minds and Markets"

As the subtitle of James Montier's "Behavioral Finance: Insights into Irrational Minds and Markets" suggests, the book provides a summary of the findings from the field of behavioral finance. Montier, previously a global equity strategist at Dresdner Kleinworth Wasserstein, is now with investment management firm GMO, where he brings insights from the "real world."

The book's first chapter is a survey of behavioral errors we make as investors. Among those discussed:

  • Persistent overoptimism.
  • Being fooled by randomness.
  • Believing we're in control of a situation far more often than we really are.
  • Attributing good outcomes to skill and bad ones to bad luck. Keep doing that, and you're the genius who's never wrong, just unlucky sometimes. Remember the adage, "Don't confuse brains with a bull market."
  • Overconfidence combined with optimism causes investors to overestimate their ability to analyze risks, to understate those risks and to exaggerate their ability to control the situation. It also leads to excessive trading.
  • Men are more overconfident than women, trade more and thus produce worse results. But men do make their brokers happy.
  • Cognitive dissonance is the mental conflict we experience when presented with evidence saying our beliefs are wrong. When we indulge in self-denial, we tend to "jump through mental hoops" to reduce or avoid mental inconsistencies.
  • We tend to seek information that agrees with our views and ignore all other information. This is known as confirmation bias. We also tend to tenaciously cling to our beliefs and forecasts.
  • We're subject to the availability bias, defined as the degree of ease with which we can recall past events. This leads to overinvestment in whatever is "hot" in the financial media.
  • We tend to underweight unlikely events, treating the unlikely as impossible and the likely as certain.
  • We overpay to obtain the small likelihood of a large profit, or what we can call the lottery effect. This leads to overvaluation of small growth stocks, IPOs, penny stocks and the stocks of companies in bankruptcy
  • We make the mistake of thinking we're "playing with the house's money." We become aggressive after making winning "bets."

One of this book's more interesting sections is devoted to using quantitative screens to gain an advantage in the market. Among the screens Montier discusses using are liquidity, amount of accounting accruals, changes in leverage, margins, return on assets and cash flow. He also points out at least one of the problems with these strategies is that they can lead to highly concentrated portfolios. Montier believes that style rotation is the key to maximizing returns.

Another interesting insight from the book is that -- because of asymmetric information (corporate officers have more insight into the company's prospects than do investors) -- you should be very skeptical about investing in IPOs, SEOs (seasoned equity offerings), convertible bonds and stock-financed mergers and acquisitions.

The evidence suggests that the insiders know the stock is "too highly" valued given the estimated prospects. Thus, they seek to raise capital when their capital costs are low, and your expected returns are low as well. As he does throughout the book, Montier presents historical evidence to support his views.

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