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Questionable Practices

In Modern Finance
And Technical Analysis
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Gregory L. Morris
• Aerospace Engineer – Univ. of Texas, 1971
• Top Gun Fighter Pilot – US Navy, 1971 - 1978
• Airline Captain – Delta Air Lines, 1978 - 2004
• Software Developer – 1979 – 1995
• N-Squared Computing
• Windows on Wall Street
• G. Morris Corporation
• Authored “Candlestick Charting Explained (1992, 1995, 2006), Complete
Guide to Market Breadth Indicators (2005), “Candlestick Charting Explained
Workbook (2012),and Investing with the Trend (2013)”
• Founder and CEO of MurphyMorris.com (1995 - 2002)
• Started MurphyMorris Money Management in 1999
• Sold MurphyMorris.com in 2002 to Stockcharts.com
• MurphyMorris Money Management acquired by PMFM in 2004
• PMFM became Stadion Money Management in 2009
• Over $5.5 Billion AUM
• Six mutual funds, separate accounts, and 401k plans
• Currently semi-retired
– Writes blog on StockCharts.com called Dancing with the Trend
– Consultant for Stadion Money Management and Chairman - Board of Trustees
– Struggling to keep golf handicap below 18
My Favorite Books

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Believable Misinformation
• George Washington cut down a cherry tree.
• Some believe water runs out of a bath tub
faster as it gets toward the end.
• Dogs sweat through their tongues.
• How many think that Dec. 21st in the
northern hemisphere is the shortest day of
the year?
• Bath water drains counter-clockwise in the
northern hemisphere.

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Question
• If you believed something that you
learned when you were young from
your parents or teachers, then…
– How many things about investing and
finance do you also believe but have never
questioned?
• That is the purpose of this
presentation.
– Market Fiction
– Market Flaws
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Believable Misinformation
• Buy and Hold is the only way to be successful in the stock
market.
• Dollar cost averaging is a good technique.
• Diversification will protect you from bear markets.
• Compounding is the Eighth wonder of the world.
• You must remain invested at all times or you will miss the
10 best days each year.
• Average returns are never better than compounded
returns.
• Probability and risk are the same thing.
• Equity asset allocation will protect you from bear markets.
• Economists are good at predicting the market.
• Chasing performance is a common technique.

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This is what Modern Finance
Uses

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Dow Industrials Drawdown
Bear Markets Can be
Expected

A 41.79% declines requires a 71.78% gain to break even!
Dow Jones Industrial Average
Feb. 17, 1885 – Dec. 31, 2013

100% - 96.27% = 3.73%
Historical Dow Jones
Industrials

Let’s play a game!

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Equivalent Returns

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Missing the 10 Best / Worst Days since
1979

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Missing 10 Best / Worst
since 1926

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Compounding is the
8th Wonder of the World
  Investment Option Investment Option
A B
Year 1 +10% +36%

Year 2 +6% +8%

Year 3 +8% -20%

Average +8% +8%

Growth of $100 $126. $117.

Compounded +8% +5.4%
Return

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What is Wrong with
Modern Portfolio Theory
• The markets are efficient.
• Investors are rational.
• Returns are random.
• Returns are normally distributed.
• Gaussian (bell-curve) statistics is appropriate for
use in finance/investing.
• Alpha and Beta are independent of correlation.
• Volatility is risk.
• Is a 60% equity/40% fixed income appropriate?
• Comparing forward (guesses) PE with long term
trailing (reported) PE.
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What MPT Forgot or Ignored
• Do people trade / invest using different
time horizons?
• Are there different views of risk among
traders / investors?
• Are there different views on where a stock’s
price will be in one week, one month, one
year, etc.?
• CAPM assumes investors AGREE on return,
risk, and correlations of all assets and
invest accordingly.
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Gaussian Statistics (Bell
Curve)

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Reality vs. Theory

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Probabilities of an Event
Sigm Population in Range Expected Interpretation
a Frequency
Outside Range
(1 in X)
0.5 0.383 1.621 Three times a
week
1 0.683 3.151 Twice a week
1.5 0.866 7.484 Weekly
2 0.954 21.978 Every three weeks
2.5 0.988 80.520 Quarterly
3 0.997 370.398 Yearly
4 0.999 (plus one 9) 15787.193 Every 43 years
5 0.999 (plus three 9s) 1.744 x 106 Every 4,776 years
6 0.999 (plus five 9s) 5.068 x 108 Every 1.39 million
years
7 0.999 (plus eight 9s) 3.907 x 1011 Every 1.07 x 109
years
8 0.999 (plus fourteen 9s) 8.037 x 1014 Every 2.20 x 1012
years
9 0.999 (plus eighteen 9s) 4.430 x 1018 Every 1.21 x 1016
years
10 0.999 (plus twenty-eight 9s) 6.562 x 1022 Every 1.82 x 1020
years 23
12 0.999 (plus thirty-two 9s) 2.815 x 1032 Every 7.71 x 10 29
Shortcomings of Sigma
• October 19, 1987 – a 22 Sigma Event
• Twenty-two sigma as shown in previous table, based
upon Gaussian statistics, should only occur once in every
9.5 x 10103 years.
• The speed of light is approximately 186,282.21087 miles
per second, so the speed of light in miles per hours is
(186,282 x 60 x 60) = 670,615,200 miles per hour.
• Further expansion shows that the speed of light per day
is (670,615,200 x 24) = 16,094,764,800 miles per day
and so the speed of light per year is (16,094,764,800 x
365.25) = 5,878,612,843,200 miles per year.
• In scientific notation this is expressed as 5.878 x 10 12. Or
about the expected frequency of 8 Sigma.
• October 19, 1987 – a 22 Sigma Event

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Does Academic Sigma Hold
Up?

To determine average To measure the actual
daily return and sigma; returns outside +/- 3 sigma
this determines the range
for 3 sigma about the mean.

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5 Yr. Look-back – 5 Yr. Look Forward

Period Start End Date Number Avera 3 Sigma # #
Date of ge Range Days Days
Days/Ye Return + -
ars Sigm Sigma
a
Look- 10/27/19 10/20/199 1260 / 5 0.07% -2.06% to    
back 92 7 2.21%
Look- 10/20/19 10/24/200 1260 / 5   49 69
forward 97 2

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Risk vs. Uncertainty
• Is volatility risk? (here we go again)
• In the sterile laboratory of modern finance, risk is defined by
volatility as measured by standard deviation; however...
• It assumes the range of outcomes is a normal distribution (bell
curve)
• Rarely do the markets yield to normal.

• When an investor opens his/her brokerage statement
• It shows the following portfolio data for the last year:
• Standard Deviation = .65
• Loss for the Year = -35%
• Which one do you think will catch their attention? I seriously
doubt any investor is going to call their advisor and complain
about a standard deviation of .65. However, the -35% loss will
get their attention. Even investors who have no knowledge of
finance or investments know what risk is – it is the loss of capital.

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Risk vs. Uncertainty
• Risk and Uncertainty are NOT the same thing.
– Risk can be measured.
– Uncertainty cannot be measured.

• A jar contains 5 red balls and 5 blue balls. In the old
days we called it an urn instead of a jar.
– Blindly pick out a ball.
– What are the odds of picking a red ball? There are 5 red balls
and the total number of balls is 10. Therefore the odds of
picking a red ball are 5 / 10 = .5 or 50%.
– That is Risk! It can be calculated.
• Suppose you were not told the number of red or blue
balls in the jar.
– What are the odds of picking a red ball?
– That is Uncertainty!
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Risk and Uncertainty
• Risk is not volatility
• It is Drawdown (loss of capital)
• However, in the short term, volatility
is a reasonable proxy for risk
• But over the longer term, drawdown
is a much better measure of risk.
• Volatility does contribute to risk but it
also contributes to market gains.

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The Heart of MPT

Diversifiable 60% - 70% is Non-Diversifiable Risk

Non- Systematic or Market Risk
Systematic Technical Analysis

Capital Asset Pricing Model
Modern Portfolio Theory
Risk is at the
Efficient Market Hypothesis
heart of many of
Random Walk
these theories!
Option Pricing Theory

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Withdrawals and Bears!

6% Withdrawal
3% Inflation
adjusted quarterly)

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Linear Analysis Nonsense
• The “world of finance” is locked into
it.
• Be very careful with it or the results
are bogus.
• Basically it is taking data and
creating a straight line to represent
it.
• Whiteboard time… y = mx + b

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Academic Alpha and Beta

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FEAR of negative numbers
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60 / 40 Myth (1960-2010)

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60 / 40 by Decades

Did you want 40% in bonds here?

Did you want 60% in stocks here?

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Discounted Cash Flow Model
• Discount Rate
– Cost of Equity, in valuing equity
– Cost of Capital, in valuing the firm
• Cash Flows
– Cash Flows to Equity
– Cash Flows to Firm
• Growth (to get future cash flows)
– Growth in Equity Earnings
– Growth in Firm Earnings (Operating Income)

Hubble Telescope
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85 Year Annual Returns

What is wrong
with this?

  Small Large LT LT Govt. It T-Bills Inflatio
Caps Caps Corp. Bonds Govt. n
Bonds Bonds
Cumulat 18,366.9 3,531.23 173.08 122.13 93.00 19.58 11.81
ive 3
Annualiz 11.95% 9.85% 6.11% 5.69% 5.36 3.54% 2.97%
ed 40
Mean 16.5 11.8 6.4 6.1 5.5 3.6 3.1
Average is not very Average

Six foot Texan
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Illusion of Forecasting
• No better than guessing
• No long-term accuracy
• Cannot predict turning points
• No leading forecasters
• No forecaster was better with specific statistics
• No one ideology was better
• Consensus forecasts do not improve accuracy
• Psychological bias distorts forecasters
• Increased sophistication does not improve accuracy
• No improvement over the years.
• Kenneth Arrow Story

William Sherden, The Fortune
Sellers 42
Why do Investors like Predictions?
• If the Investor loses money, they can blame the
forecast.
• Confidence in a forecast rises with the amount of
information that goes into it.
• But the accuracy of the forecast stays the same.
• It’s that you can be a successful investor without
being a perpetual forecaster.
• Not only that, I can tell you from personal
experience that one of the most liberating
experiences you can have is to be asked to go
over your firm’s economic outlook and say, ‘We
don’t have one.’
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Sell in May and Go Away!
• Just statistics – you cannot make an
investment decision from it
• When in May do you sell?
• When in November do you buy?
• Let’s say the statistics show it works 75% of
the time.
• Not bad, right?
• If you started using this strategy, and the first
3-4 years contributed to the 25% of time it did
not work, then…
• How long would you stick with this?
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Analog Charts
What is the Correlation?

A. Closer to 1

B. Closer to 0

C. Closer to -1

D. Can’t tell

Correlation =
-1.0
How?
Correlation of Daily Returns
• The process was:
– Day 1: Series A: +1.0%, Series B -0.5%
– Day 2: Series A: -0.5%, Series B + 1.0%
• Over any period of multiple days,
both series advance, but they
do so in perfect
inverse daily
correlation.
Correlation?

+1.0

orrelation is ever and always a mathematical proces
Spurious Correlation

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This is how Technical Analysis Works

1 + 1 = 2

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Greg’s Rules
• 1. Turn off the TV and stop surfing the Internet for advice (stop the
noise).
• 2. Develop a simple process, one that you can explain to anyone
(mine is trend following).
• 3. Create a security selection process based upon momentum.
• 4. Devise a simple set of prudent and reasonable rules and
guidelines.
• 5. Follow your process with discipline; without it, you will fail.
• 6. If you do not have the discipline to do this, seek professional help
from someone who does.
• 7. Do not be upset with yourself if you do not have the discipline at
times; be proud of yourself for recognizing it.
• 8. Do not confuse luck with skill.
• 9. Listen and learn from the market – it is always right.
• 10. Read this list often.
Pot At The End of The
Rainbow?
The End

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