Wednesday, March 19, 2014

Accidentally Asked Questions

Once in a while people ask me questions about money. I can’t figure out why they do this, so I assume they are doing it by accident. One of the most frequently asked goes something like this:

Is now a good time to buy dollars with my shekel? Or, is it a good time to hold shekels in the Israeli stock market? 

Will Obamacare weaken the U.S. economy? What impact will the situation in the Ukraine have on the Israeli stock market?

My answer is actually very simple: I have no idea.

I am not a prophet and I cannot tell the future. In fact, even if I were a prophet I wouldn’t be able to tell the future. Prophets were primarily messengers of God who sought to encourage people to change their ways. If I were a prophet, I would probably answer this Accidentally Asked Question very simply, as: “Reading blogs will not save you! Repent from your evil ways!”

Alternatively, I may decide to use my position as prophet to improve important social issues in Israel. My prophecies would most likely sound like this:
                                                             
The spirit of the Lord descended upon me and said: “I have brought my people to a new city that has been planned. I have provided for them with roundabouts at every intersection.”

“But have my people embraced My kindness? No! They have not!"

"Go and stand in front of any gan on any morning (but especially on Friday) and say to My people, ‘Seriously!? What is wrong with you? You can’t drive an extra 50 meters and turn around at the roundabout?’”

I think you get my point. I do not know what’s going to happen in the future any more than I can understand why Israeli drivers won’t use roundabouts.

Actually, now that I think about it, maybe this is a bad analogy. We will never know why Israeli drivers won’t use roundabouts, but we can at least try to predict the future.

Why Predictions Don’t Work

Prediction is challenging because it is about things that haven’t happened yet. Although, to be fair, there are some things that we can be fairly good at predicting. Example:

Donny does not take out the garbage. He predicts that his wife will roll her eyes at him and say, “Seriously!? What is wrong with you? You can’t walk a few steps out of your way to take the garbage out on your way to the car?”

In this case, we can make a fairly good prediction because we have a long history to draw upon. However, even in a case like this, our successful rate of prediction will not be perfect. Will things turn out as predicted if Donny’s father-in-law comes by and takes out the garbage before anyone notices? No they will not. Even the easiest things to predict are only “mostly” predictable.

In the case of financial predictions, it is exceptionally difficult because many factors are involved. For example, take something “simple” like predicting the exchange rate between the dollar and the shekel. One of the most direct causes of changes in the exchange rate is changes in interest rates. The theory is that investors will move money between the dollar and shekel to achieve the highest interest rate after adjusting for credit risk.

However, even if interest rates were the only factor that impact the exchange rate (which they aren’t), to predict just them you will need to predict inflation rates and economic growth in both countries; and also, predict how each central bank will respond to these pressures.

Statistically speaking, if your prediction would require you to be right on even as few as just four different factors, and you are right on average even as high as 70% of the time, chances are only about 1 in 4 that you will be right.

Also, even if you are right, the market may already have taken your prediction into consideration. In order to profit on your prediction, you not only need to be right. You need to be right when almost everyone else is wrong.

Invest by Accident, but Allocate on Purpose

I began this blog in large part because I saw so many people making Aliyah and losing money from a declining dollar. I was lucky that when I needed shekels, the dollar had risen significantly. This experience is a classic example of a bad process leading to a good outcome. It isn’t that I was a great predictor of the future value of the dollar, it was that I was speculating on the dollar by accident and got lucky.

In managing your money, one of the biggest mistakes that you can make is relying too heavily on predictions. Instead, you should think about how to allocate your money for the long term in such a way that it will not matter if most of your predictions turn out poorly.

Your first step should be to figure out how you want to allocate your money in a “perfect world” where everything is stable and valued fairly. Once you have this set, then it would be perfectly sensible to consider small incremental adjustments based on some careful predictions.

One example of this today would be the U.S. bond market. About a month ago, I predicted that the bond market is in a bubble using careful non-expert logic. I made a small adjustment to my bond allocation by keeping it in cash instead of bonds. This is a small adjustment because the downside of being wrong in this case is a small lost opportunity. Making a large adjustment based on this prediction (for example, taking a “short position” on U.S. bonds) would be very irresponsible. My prediction is most likely either wrong or already priced into the bond market.

Accidental Answer

Should you invest more in the dollar right now? Should you take your money out of the Israel stock market?

On the one hand, at the moment, the dollar is historically cheap and the Israeli stock market is relatively high. It is always advisable to buy low and sell high. You could make a small adjustment to your investments to accommodate this.

On the other hand, if you already have allocated your investments, this will happen for you anyway. The greatest feature of an allocation plan is that every time you re-balance, it tends to lead you to sell high and buy low by accident. For example, let’s say you normally invest 60% of your money in stocks. You will find that when the stock market is high (like it was last year), you will be selling stocks in order to reset your allocation to 60%.
           
For currency, the same thing would happen if it was part of your allocation plan. Most allocation strategies tend to focus just on “stocks” and “bonds,” but for someone living in Israel, I think it is equally important (if not more so) to think about whether these “stocks” and “bonds” are in dollar or in shekel.

What’s the best way to do this?

I don’t know because I’m not an expert, but I will share my formula with you.

13 comments:

  1. I am inspired. Nuf said.

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  2. When the Israeli country bonds are ~9%, how can you go wrong and need to invest anywhere else in the world?

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  3. I found it after seeing this post. Just "Bing it"!

    http://www.israelbonds.com/home.aspx

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    1. Those are Israeli government bonds that are sold in the U.S. in dollars. If you are already holding shekel, you are probably better off buying the Israeli government bonds in shekel.

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  4. Here is an idea, I just finished reading Jpost and came up with an idea: why not invest in Argentinian bonds which are paying more than 12%, but are based on the US Dollar? A win win!!!

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    1. Interesting... the yield is high because people think that there is a high risk that the Argentinian government won't be able to pay. These are basically junk bonds that are issued by a government. (Argentina's credit rating was downgraded to Caa1 by Moody a few days ago.) If you invest in these, you should make sure to diversify enough against the risk of default.

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  5. Did you get an interview to start writing a column for the Jerusalem Post yet?

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    1. They interview their columnists? I thought you just had to know someone...

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  6. Danny - Is there any risk of war with Syria like what happened in 2006 that will affect the Israel stock market?

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    1. I think investing according to whether there will be a war with Syria is very risky because no one really knows what will happen. I think you should allocate your investments for the long wrong in way that you absorb fluctuations that will happen due to war or for any other reason.

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    2. Do you think the hint of an interest rate hike by the US federal reserve banks is good or bad for us newbie investors?

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    3. I don't know. Try to allocate your investments so it doesn't matter which way interest rates go.

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