Good reads from around the Web.

Since the world’s wealthy are happy to have their funds devoured by the locusts of high-finance – hedge funds and their 2/20% fees – then who knows, maybe they’ll be glad to have their money managed by rats, too?

Enlightenment Economics reports on a curious project to teach rats to trade:

The rats were trained to press a red or green button to give buy or sell signals, after listening to ticker tape movements represented as sounds. If they called the market right they were fed, if they called it wrong they got a small electric shock.

Male and female rats performed equally well. The second generation of rattraders, cross-bred from the best performers in the first generation, appeared to have even better performance, although this is a preliminary result, according to the text.

Marcovici’s plan, he writes, is to breed enough of them to set up a hedge fund.

If you’re thinking you want to get in early – before the best of the rat traders start to demand exorbitant amounts of cheese – you might head to the Rat Traders website to learn more.

Unfortunately you’ll discover that while the idea caught the blogosphere’s imagination this week1, the last updates from the site hail from 2009.

Perhaps the rats were blown-up in the financial crisis? Or maybe they turned to teaching or caring for the elderly or some of the other things we were told financial folk were going to do, having seen the error of their ways.

(Until about 2010, when they started making bazillions again.)

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1. Thanks to Monevator reader G. for putting me on the trail. [↩]

You probably came across the idea of diversification fairly early in your passive investing adventures.

Diversification is an age-old concept, after all.

According to The Bible, King Solomon was advising investors to spread their risks nearly 3,000 years ago:

“Invest in seven ventures, yes, in eight; you do not know what disaster may come upon the land.”

And in the 1600s the first East India companies enabled speculators backing British, Dutch and French adventurists to split their exposure across several of these prototypical limited liability companies – lessening the chances that all your worldly wealth would end up in the hold of a Barbary corsair.

Nowadays it’s easy to achieve wide diversification. Index tracking funds enable you to invest your money across markets and into different asset classes.

A simple portfolio can be created with just a handful of funds, with your precise allocations tweaked to suit your temperament and attitude to risk.

The only pirates you need to worry about are rapacious fund managers!

The theory of investing in everything

It took academia a while to pin down exactly how diversification works, but the now-famed Harry Markowitz got the game going by deconstructing how risk and reward is distributed across portfolios.

The rest is history, or rather Modern Portfolio Theory, as Sensible Investing explains in this video:

Says Art Barlow from Dimensional Fund Advisors:

“Really the cornerstone of all of what we call Modern Portfolio Theory rests on this idea of diversification. Until Harry Markwowitz gave what was almost an engineering analysis of how stock price movements interacted with each other, nobody had ever really considered it.

Even though prices don’t move in nice, let’s say, sine-wave fashion, prices do go up and down over time. So a stock will go up and down, sometimes many times over the course of a day, but certainly over longer periods of time.

And basically what he discovered was, that’s true and every stock does that, but they don’t do it at the same time, and it’s almost like if you think of two sine waves that are in opposite phase with each other, they will ultimately cancel each other out.

And even though it was not the case that these stocks were in opposite phase, as long as though they weren’t in exactly the same phase with each other, you still get some dampening effect.”

The final crucial piece of the puzzle came in the 1960s, with William Sharpe and other academics devising the Capital Asset Pricing Model.

No such a Modern Portfolio Theory now

Portfolio Theory and the Capital Asset Pricing Model now underpin most market analysis.

And latterly authors like Lars Kroijer have explained how the model implies that rather than try to pick stocks or invest in particularly skewed funds, ordinary investors are best off holding total market index trackers (something like the Vanguard World Index Fund) for the equity part of their portfolio, and vary their exposure to risk simply with cash and government bonds.

See his book Investing Demystified for more details.

Of course, not everyone agrees with the academics. Warren Buffett is one notable critic of the models.

But even he backs trackers as the best way forward for most investors.

It’s also interesting that many edge-seeking hedge funds start from the premise that markets are overwhelmingly efficient as implied by these theories, and then look for risk/reward discrepancies and mispricings.

Indeed Harry Markowitz himself co-founded one of the very first such quantitative hedge funds!

Check out the rest of the videos in this series so far.

Good reads from around the Web.

Every now and then a reader asks me to update one of the older articles on property and house prices here on Monevator.

I usually say I plan to — and usually I do plan to.

But whenever I knuckle down to it, the whole subject is too depressing.

Obviously a bubble?

Quite often I meet young value-minded investors for whom London property in particular is clearly in a crazy bubble.

They are appalled that I don’t agree that an imminent crash is a slam dunk certainty.

I say that I might if I was standing in their shoes. My problem is London house prices first looked to me like a crazy bubble in 2004.

Besides, far more often I meet people who say “you can’t go wrong with London property”, including members of my own friends and family.

One is weighing up leaving London, or else using the six-figure deposit she’s saved hard over her ten years in work — together with the highest mortgage she can get with her (latterly) £70,000 a year job — to buy a two-bed flat in Zone 3 in the East End.

Madness.

But will it ever end?

Everything in me that’s a value investor says yes — including my awareness that my reticence to voice that London property is in bubble territory, after being wrong for (most of) the past ten years, is probably in itself a sign of a bubble.

But the animal in me is fearful. It sniffs the air, sulks, and returns to its den.

Numbers of the beast

Some useful stats on all this in The Telegraph today, in an article that asks if the average working life is no longer enough to pay for a house:

Official figures suggest there are about 400,000 over-65s still with mortgages, a figure that is growing by about 10% per year. And as Telegraph Money reported recently, European figures show that one in five of British 65 to 69-year-olds is still working, a far higher proportion than in Germany, France, Ireland, Italy or Spain.

Why? To pay off their mortgage, of course, or scrape a bit more towards a pension, or both.

The article is a rarity, in that it combines the plight of older home almost-owners with that of the young.

It also gives lie to the nonsense that it has always been this hard for the latter:

The ratio between property prices and wages has shifted so enormously that house buying today is as difficult for buyers with two wages as it was 35 years ago for a single borrower on just their own income.

Today’s first-time buyer – putting down an average £30,000 – would need to borrow 3.4 times a single wage, compared with a borrower 35 years ago needing 1.4 times his wage, to purchase the equivalent property.

As for London:

Say you’re a hugely lucky buyer with a 20% deposit (£100,000) to put down.

Assume the average rate you’ll pay over 25 years is 5% – a generous assumption, given rates over the past 25 years have averaged higher.

You’d still pay around £2,340 per month and just over £700,000 in total.

It’s generally said mortgage costs shouldn’t exceed half of a household’s after-tax income. But for £2,340 to equate to less than one half of post-tax income, an individual would have to earn £87,000 in today’s tax regime (£4,800 per month after tax).

And that’s the average property in the capital – not the comfortable family home that an averagely paid accountant or doctor might have afforded in London in the Eighties, but which today would cost £2m or £3m.

Generation wars revisited

The most depressing takeaway from all this?

The suggestion that 60-somethings with mortgages should use the new pension freedoms to release cash to pay off their debts.

It’s probably good advice, as no doubt the poorer among them will eventually be able to pass means-tests for pension top-ups or similar, which I’d bet will look at incomes and investments, but not at personal places of residence.1

But as a sustainable solution for the nation, I think this is ridiculous.

The correct thing for older people living in big houses they haven’t paid off to do is to sell-up, move somewhere smaller, and put anything leftover into their pension.

And to free up a house for a young family at the same time.

I once had a bitter, bitter argument in an online forum that I eventually had to leave about this sort of thing, when I said I had no sympathy for 65-year olds rattling around in 5-bed houses who were struggling to meet their heating and council tax bills.

Sell! Move!

Apparently I was utterly uncaring and heartless. Because I saw a bigger picture of need, not a micro-hardship.

Well that was a decade ago, and things have only gotten more crazy.

I’ve discovered in unrelated discussions that even most Monevator readers disagree with me that inheritance tax should be, say, 95% over the first £100,000.2

So I suspect that equally few among the phew-we-made-it middle-classes will be on my side when it comes to my call for mass-downsizing.

An Englishman or woman’s home is a castle. And once they’re in it, they’re jolly well entitled to pull up the drawbridge, right?

Even if they can’t afford it, and even if it is turning the next generation into peasants.

I so wish the whole caboodle would crash, before it gets even uglier.

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1. I am speculating about the future here, not talking about the specifics now or yesterday. [↩]
2. Whereas incomes I’d tax at a flat rate of perhaps 25%, after raising the personal allowance for lower earners. Earn more while you work, contribute, start businesses or invest. Get much much less because dad died. [↩]