Practical Speculation
by Victor Niederhoffer and Laurel Kenner
John Wiley and Sons, Inc, 2003, 368 pgs plus notes and index
Review score: * out of *****

The retirement plans for most companies consist of little more than a 401K investment plan. Some companies offer matching donations for the 401K, but these companies are in the minority. The shrinking number of companies that offer pension plans have used the assets in these plans as props for their balance sheets. When these balance sheet games collapse and the companies go bankrupt, the retired employees who rely on the corporate pensions usually suffer. The US governments social security plan may offer little retirement security in the future. The right wing of the Republican Party has never liked Social Security. Their plans to "privatize" social security have gone unmentioned since the stock market crash of 2000. However, the debt piled up by the George W. Bush tax cuts is designed to gut social programs, including Social Security. By piling up high levels of debt, cuts in social programs, which would normally be politically impossible, can be justified by financial need.

The bottom line is no one will take care of you if you do not invest for old age (forget retirement). An understanding of the basic risks and rewards provided by various investments is critical for long term financial survival. The retirement funds that were wiped out by the fraud at companies like Enron and the deflation of the technology bubble attest to the perils of investing and the importance of understanding risks before they become losses.

One alternative is to simply put your money in a US Treasury Bonds, which are considered a "risk free" investment vehicle. Even this choice is not as risk free as it might seem. While the chance of loss is very low, the return is also small. Inflation will eat away at the value of your assets. Without growth, there may not be enough money for old age. This means that accepting some level of risk may actually be prudent.

Successful investment is difficult, despite the claims in the SPAM e-mail I get touting the secret for realizing wealth in the stock market. The stock markets in the United States have characteristics that are similar to the mythical efficient markets that are described by academic economists. There is intense competition for stock market profits. Market information is rapidly available and inexpensive. Information about the companies whose stock is listed on these markets is rapidly disseminated. One result of these factors is that any information in the market tends to be obscured by noise.

The investor can turn to a vast literature, ranging from academic works on portfolio theory to popular books on investment for those with no previous investment knowledge. A recent addition to this sea of literature is Practical Speculation by Victor Niederhoffer and Laurel Kenner. Niederhoffer is the author of an earlier book, Education of a Speculator which he wrote when he was the manager of a top performing hedge fund (a hedge fund is an investment vehicle for wealthy people and pension funds). Before becoming famous in the investment world, Niederhoffer was known in the "racquet sport" world as a world class champion squash player in the 1970s. Niederhoffer also has a Phd from the University of Chicago (1969, in statistics and economics). After publishing Education of a Speculator the hedge fund that Niederhoffer managed lost $130 million in a single day, wiping out the assets of Niederhoffer's investors and most of his personal wealth.

In the volatile market of October 1997, Niederhoffer sold puts on the Standard & Poor's 500 in size with the expectation that the market would rebound. It eventually did, but not before dropping 7 percent on October 27. Niederhoffer's 20,000 S&P puts obliterated his fund.

CFTC Considers Niederhoffer Rule, Derivatives Strategy Magazine, March 1998

Derivatives Strategy Magazine published a comix titled The Rise and Fall of Victor Niederhoffer which summarizes some of Niederhoffer's hedge fund history and various facets of his personality.

After Niederhoffer "blew up" his hedge fund he started writing popular articles on investing and appearing on cable TV investment programs (on CNBC TV). Apparently in the last few years he has been working with journalist Laurel Kenner, the co-author of Practical Speculation.

The spectacular failure of Niederhoffer's hedge fund and his reincarnation as an investment "talking head" is not a resume that would normally encourage me to buy his book. However, Niederhoffer is a person of unusual accomplishment. A "player profile" on the Squash Talk web sites starts with the following description of Niederhoffer:

The first thing to understand about Victor Niederhoffer is that he is totally unlike any other athlete or human being you will ever meet.

Niederhoffer is possessed of the idea of excellence. He is wholly inner-directed. He is a loner, an intellectual, a champion. His desire for money and personal achievement has led him to become a PhD, an accomplish pianist, the creator of a multi-million dollar financial firm, and a speculator. His personal motto is "Create Value." For a long time he wore two different colored sneakers on court (to the total annoyance of the squash establishment in America,) sometimes with black tie, to remind himself, he says, that no two people are alike.

I came to admire Nassim Taleb, after reading his excellent book Fooled by Randomness. In this book, Taleb writes of Niederhoffer

It is worth noting that finance has its Francis Bacon in the person of Victor Niederhoffer. He was the very first to stand against the cobweb of learning of the University of Chicago and the efficient market religion of the 1960s, when it was at its worst. In contrast with the scholasticism of financial theorists, he looked at the data in search of anomalies - and found enough of them to be able to conduct a successful career in randomness and deliver an insightful book, The Education of a Speculator. Since then, an entire industry of such operators, called "statistical arbitrageurs", flourished, the major and most successful ones were initially his trainees.
(italics in the original)

Taleb writes of the influence that Niederhoffer had on him

I have to admit that for all of my intellectual disagreements with him I have been inspired by his empiricism and owe him a large share of my intellectual growth. I experienced a jump in my trading style in 1996 when Victor blurted to me that any "testable" statement should be tested (it was so obvious but I had not done it until then). His advice went straight home. A testable statement is one that can be broken down into quantitative components and subjected to statistical examination.

Nassim Taleb does not seem to be someone who distributes praise easily, so I ordered Niederhoffer's book Practical Speculation. I thought that it might be better than his earlier book The Education of a Speculator, since Niederhoffer would have learned valuable lessons from the failure of his hedge fund.

Practical Speculation is divided into two parts. In their retrospective summary of the first half of the book, which introduces the second half the Niederhoffer and Kenner write:

Part One described what is wrong with common approaches to investing. We debunked the myths and propaganda surrounding the earnings-return relation and technical analysis, presented a case study of chronic negativism, deflated the ballyhoo about value stocks, ran the media's market coverage under a whole body scan, and quantified the effects of hubris and humility on individual stocks.

In part two the authors claim to provide "a series of approaches that together can serve as a foundation for investors".

A reader might reasonably discard Practical Speculation after the first chapter, which is titled The Meme. I probably should have done so, but I could not believe that someone with Niederhoffer's reputation would write something so vacuous. I kept thinking that the book had to get better.

Chapter 1, The Meme, is a jumbled recounting of the years between 1997 and 2002. A meme is an idea, which can spread like a virus. Fashions are sometimes considered memes, as is the euphoria that underlies market bubbles and the panic of market crashes. The authors seem to be suggesting that the bubble and the demise of profitless dot-com companies was caused entirely by a meme, or psychological factors. The market was killed off by negative thinking and those who bought into the idea of "irrational exuberance". This will be a surprise to some, who would attribute the crash in 2000 to billions of dollars being invested in companies that had no business plan that would lead to profitability, massive corporate fraud and executive greed (e.g., Netscape, Webvan, Enron, WorldCom and Tyco).

The book improves somewhat after the pathetic first chapter. Chapter two is an attack on the popular idea that the price-earnings (P/E) ratio is a predictor for returns in the stock market. The corollary of this popular idea is that high P/E ratios are a sign of market bubbles. The authors claim that the idea that there is a strong relation between P/E and future returns is all propaganda, although the nefarious source of this propaganda campaign remains hidden.

Classic value investing and P/E ratios are an easy area to attack, since the foundation work in this area is based on Graham and Dodd, who based their P/E ratios on the stock market which emerging from the Great Depression. But this does not mean that the whole concept of value investing is necessarily wrong. There has been recent work which places "value investing" in a more modern context. Nor does it mean that one should accept P/Es in the 100s, as was the case for the few Internet bubble stocks that actually had earnings.

Niederhoffer and Kenner really dislike the whole value investing philosophy and include a whole (short) chapter attacking Benjamin Graham, who is considered to be one of the historical founders of value investing. They also take a few swipes at Graham's most famous student, Warren Buffett. However, it is difficult to attack Buffett, since his success has been spectacular. Perhaps they believe that Buffett's success is simply a matter of luck.

Although Niederhoffer and Kenner attack value investing, they have an almost religious belief in the stock market as a great place to invest. In fact they at one point seem to argue against portfolio diversification and for investing on margin (with borrowed money) to amplify stock market gains. What Niederhoffer and Kenner never mention is the cautionary words that preceed all reports of mutual fund performance: past performance is no indication of future performance. There are reasons to believe that stock market performance may not be as good as we have seen in the period from, say 1950 to 1995 (before the bubble). The population of the United States is aging. As those who have invested for retirement actually enter retirement they will necessarily start selling off assets to suport themselves. No one knows how large an effect the aging population will have on the stock market. But it is a simple fact that assuming that the future will be exactly like the past carries risk.

Niederhoffer and Kenner seem to like easy targets. In one chapter they point out that bloated corporate egos and huge expensive corporate headquarters lead to poor stock performance (ah, lower earnings, and lower P/E don't y'know). Niederhoffer and Kenner also attack other monsters that prey on investors, including the Hydra headed monster of technical analysis (I'm not making this up, the chapter is titled The Hydra Heads of Technical Analysis).

Technical analysis, with its head, shoulders, penetration and Elliot Waves is an also as easy a target as the corporate edifice complex. There is a famous story that someone generated a graph from a random walk and showed it to a practitioner of technical analysis, who proceeded to find patterns where there were provably none. I too used to hold technical analysis entirely in contempt. However, there are market patterns which can be shown in models to have predictive value. The simplest example is that past returns are correlated with forward returns a few days out. The search for these patters is sometimes called statistical arbitrage, an area that Niederhoffer is supposed to have pioneered. After spending a chapter beating up on technical analysis, Niederhoffer describes the "VIX Indicator", a tecnical predictor based on volatility.

One of the strangest parts of the "its all lies" first half of Practical Speculation is a chapter long attack on Alan Abelson who is an editor at Barron's. Apparently Abelson is the author of a Barron's column titled "Up and Down Wall Street". Niederhoffer and Kenner cannot forgive Abelson for what they claim is his unrelenting bearish view of the stock market. Although they admit that Abelson's long tenure at Barron's has contributed to an increase in its circulation, they view his advice as toxic. Anyone, they write, who followed Abelson's fell advice would have missed out on the greatest expansion of the stock market in the twentieth century. Well, perhaps. But Abelson's readers seem to like his column. Abelson has had a well paid and successful career at Barron's. What is the problem? Why the attack? Is it personal? Or do they see Abelson as the Typhoid Mary of the Bear Market Meme?

On reaching the second half of the book, I still held out hope that it might be something more than an insult to dead trees. The second half was supposed to provide solid advice for those investors who had been mislead by hype and propaganda. And, in fact, Chapter 8, How to Avoid Spurious Correlations is worth reading, although is probably not worth the price of the book. A possible problem is that for those who have not had an exposure to basic statistics, this chapter may be a bit obscure. For a better description of linear regression and calculation of the correlation coefficient, I recommend A Cartoon Guide to Statistics by Larry Gonick and Woollcott Smith. Despite its somewhat embarrassing title, this is the best rapid introduction to statistics I've found. I have also written a web page that describes some of the basic statistical functions. This web page includes additional references.

Unfortunately it is downhill after Chapter 8. There is little solid advice for investors in the chapters that follow. For example, Chapter 10 sings the praise of Value Line as an investment tool. Value Line is widely respected and is a great resource. Value Line reports are available to E*Trade and Charles Schwab investors and I'm sure others as well. Since Value Line is so well known, this recommendation can hardly be considered earth shaking advice to investors. In finishing the chapter I was reminded of the earlier discussion on propaganda:

The Fine Art of Propaganda, a 1939 classic on the topic published by the Institute of Propaganda Analysis, outlined seven basic techniques to disseminate false information. To simplify the ideas enough for young students in public schools, the book gave each technique a catchy name: "name-calling", "glittering generality," "transfer,", "testimonial," "plain folks," "card stacking," and "bandwagon".

The chapter on Value Line ends with what could be considered a "plain folks testimonial", describing how Henry Hill, a long time Value Line subscriber turned an $80,000 investment into $48 million(!) So see, Niederhoffer and Kenner's advice really is great.

I finally put the book aside when I reached the chapter titled Market Thermodynamics. This chapter attempts to equate the laws of physics, like conservation of energy and the second law of thermodynamics to the stock market. They finish the chapter with the sentence "The application of physics to investment has great potential." If they were talking about statistical methods in physics (the basis of what is sometimes called econophysics), this would be valid. But the basic laws of modern physics describe properties of matter and energy. They have nothing to do with markets and Niederhoffer and Kenner provide nothing more than analogy. While the laws of physics provide predictive power for the physical world, they have no such power for markets.

Perhaps rather than reading Practical Speculation I should have read Niederhoffer's The Education of a Speculator. After reading Practical Speculation I am left mystified. How could the author of such pathetic book have accomplished the things that Niederhoffer has and inspired the admiration of people like Taleb? Did Niederhoffer's traumatic market melt-down lead to a loss of the ability to apply critical thinking? Who can say. I recommend avoiding this book and purchasing one or more of the books listed below:

Ian Kaplan
June 2003
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