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Alpha Theory Blog - News and Insights

44 posts categorized "External Articles"

July 19, 2011

Modern Portfolio Theory Stacked the Deck

I have often made the case to clients that diversification and volatility are portfolio management distractions. Not because they are uniformly irrelevant, but because industry dogma gives them a status well above their merit. Our industry uses diversification and volatility as yardsticks of comparison, so funds are naturally incentivized to alter their behavior to maximize their performance based on these measures. If a potential investor gauges a fund’s performance using return per unit of volatility, Value-at-Risk, Beta, tracking error, and diversification – guess what happens? You get lots of fund managers building portfolios with too many positions and avoiding volatility. Not surprising then that our industry has been increasingly dominated by high diversity / low volatility funds since the advent of Modern Portfolio Theory (average fund has 140 positions - study by Pollet and Wilson).

Scott Vincent of Green River Asset Management recently published an article titled “Is Portfolio Theory Harming Your Portfolio?” In it, he describes how Modern Portfolio Theory (Efficient Frontier – Markowitz, CAPM – Sharpe, and Efficient Market Hypothesis – Fama) has changed the shape of the investment industry from stock picking funds to super-diversified quantitative or quasi-quantitative funds. Volatility gained acceptance as the standard measure of risk for one primary reason, it was measurable (see answers to questions 2 and 10 in “Great Investor Mentality Quiz”). But being measurable doesn’t make it right. In “Is Portfolio Theory Harming Your Portfolio?”, Vincent explains:

Amazingly enough, there’s not much empirical “proof” as to why we should use variance as a measure of risk, yet it plays a critical role in almost all large financial transactions. It seems that academicians needed a way to quantify risk to fit mathematical models and they grabbed variance, not because it described risk very well, but because it was the best quantitative option available. But just because it is convenient, and it carries a certain intuitive appeal, doesn’t make it right.

If volatility is not a very good proxy for risk then are our historical judgments of active managers wrong? Yes. Do we need to change the way that we judge managers? Yes. In fact, there are half a dozen “risks” that are more important than volatility. I’m often surprised by investors that care more about volatility than leverage. I certainly believe the latter is more indicative of potential risk (i.e. Asian Financial Crisis, Mexican Financial Crisis, Russian Financial Crisis, S&L, Junk Bond, Sub-Prime Mortgage, et. al. – see article comparing Sub-prime and Junk Bond). Volatility can be tough to stomach, but potential downside loss is true risk. As Vincent says (concept described in “Eight Mistakes Money Managers Make” presentation):

Risk is often in the eye of the beholder. While “quants” (who rely heavily on MPT) might view a stock that has fallen in value by 50 percent over a short period of time as quite risky (i.e. it has a high beta), others might view the investment as extremely safe, offering an almost guaranteed return. Perhaps the stock trades well below the cash on its books and the company is likely to generate cash going forward. This latter group of investors might even view volatility as a positive; not something that they need to be paid more to accept.

Recognize that there is more than one measure of risk and that volatility is not a synonym for risk. Risk is a combination of downside potential, liquidity, time horizon, sector exposure, leverage, market correlation, and volatility (and probably several more). Just like a pilot cannot look at one gauge to fly the plane, a portfolio manager cannot look at one measure of risk to manage a portfolio.

Another major point of “Is Portfolio Theory Harming….” is that diversification is not only over-rated, but it becomes corrosive at a certain point:

The appeal to diversification, according to quantitative finance, is the idea that it allows us to enjoy the average of all the returns from the assets in a portfolio, while lowering our risk to a level below the average of the combined volatilities. But since we can’t call volatility risk and we can’t reliably predict volatilities or correlations, then how can we compile diversified portfolios and claim they are on some sort of efficient frontier? These super-diversified portfolios may be inefficient -- it may be possible to earn higher rates of return with less risk. It may be that by combining a group of securities hand-selected for their limited downside and high potential return, the skilled active manager with a relatively concentrated portfolio has greater potential to offer lower risk and higher returns than a fully diversified portfolio.

Even if we were to make volatility reduction paramount, the case for extreme diversification does not hold true. A study by Fisher and Lorie concludes that, “Roughly 40 percent of achievable reduction is obtained by holding two stocks; 80 percent, by holding eight stocks; 90 percent by holding 16 stocks.” Other studies by authors such as William F. Sharpe, Henry A. Latane' and Donald L. Tuttle make similar statements.* Needless to say, it is hard to argue that 100 positions is necessary for volatility reduction.

But honestly, the more damning case against super-diversification is time:

A fund manager’s job is to identify assets that are priced “inefficiently,” where the market has ostensibly made an error and a stock is available at a level that allows for relatively little risk versus expected return. But finding inefficiencies and maintaining a portfolio is difficult work and requires resources (a manager’s time and brain power, among the most important of these). Resources are not unlimited (most importantly a manager’s time). Therefore, the amount of resources devoted to each specific investment varies inversely with the amount of investments owned in the portfolio. The more positions added to the portfolio, the less likely a manager is to capture these difficult-to-find inefficiencies because he/she has less time and other resources available to do so.

I have used the concept of “mental capital” for years with clients. I ask the client how many hours a month it takes an analyst to cover an investment. For example, let’s say 10 hours. Then we’ll also assume that the analyst has other ideas that are being considered for the portfolio and for each existing investment, they spend another 5 hours working on new ideas. That works out to 15 hours for each portfolio position. If we assume each analyst works about 150 hours a month (excludes time staring at the P&L and filling out March Madness pools), that means each analyst can cover about 10 names with 10 on the watchlist. That means a fund with a team of four can reasonably cover 40 names. But a majority of funds end up with 80 positions meaning that something is being sacrificed for the sake of diversification. More than likely, the portfolio ends up with a mix of insignificant positions that take just as much time as the “core” positions, but have very little impact on the portfolio’s returns. Very rarely will the 50bps position have a large impact on portfolio returns. If it does not matter, get rid of it because it is a drain on mental capital.

All of these facts lead to the question, how do low diversity / high volatility portfolios perform? In fact, fairly well, granted that we do not have a good way to “risk adjust” portfolio returns given that we are no longer using volatility. However, Vincent highlights, “Multiple studies indicate that funds which are more actively managed, or more concentrated, outperform indexes and do so with persistence (Kacperczyk, Sialm and Zheng (2005), Cohen, Polk, Silli (2010), Bakks, Busse, and Greene (2006), Wermers (2003), and Brands, Brown, Gallagher (2003), Cremers and Petajisto (2007)). While we need to acknowledge that because we can’t measure risk, these studies, like any empirical work, need to be taken with a grain of salt. It is nonetheless interesting that if we compare the studies that focus on teasing apart the influence of more active, concentrated management, to the broad all-inclusive studies, there’s a large change in the signal received.”

Funds with the highest Active Share [most active management] outperform their benchmarks both before and after expenses, while funds with the lowest Active Share underperform after expenses …. The best performers are concentrated stock pickers ….We also find strong evidence for performance persistence for the funds with the highest Active Share, even after controlling for momentum. From an investor’s point of view, funds with the highest Active Share, smallest assets, and best one-year performance seem very attractive, outperforming their benchmarks by 6.5% per year net of fees and expenses. – Cremers and Petajisto (2007)

Basically, volatility is a distraction, diversification is a drag, and active concentrated management is a superior method of investing. That is music to the ears of Graham & Dodd’er out there. In a world where the dogma is against you, hold fast that the truth (i.e. common sense) is on your side.

Finally, I have saved my favorite quote of Mr. Vincent’s for last because it describes Alpha Theory perfectly, “The degree of concentration in a fund should reflect the confidence a manager has in the inefficiencies found, and the weight of those investments should reflect the probability of success as well as the level of asymmetry present in the prospective return profiles of the assets.” Right on Mr. Vincent, write on.


*If volatility reduction was the game, then holding 8 positions would get you almost home. But that would mean that the average position size would be 12.5%. I believe that diversification can be approached from another angle that involves downside tolerance. Start by asking, what is the maximum position size I am willing to take? Let’s say it is 6% of fund value. And if the minimum position size is 1% and position sizes are scaled linearly then a 100% gross exposure fund would have about 29 positions (6% max position size - 1% min position size = 5% / 2 = 2.5% midpoint + 1% min position size = 3.5% average position size – 100% gross exposure / 3.5% average position size ≈ 29 positions).

June 22, 2011

Debunking Dividend Dogma

As anyone that reads my blog knows, I believe there is a general misunderstanding of dividends in our industry (Institutional Investor Article, Article with Dr. Laffer, Mauboussin Article). My basic point is that you cannot create value by paying a dividend. At best, dividends are a zero-sum equation. And if you include taxes, dividends are actually a net drag to investors. Based on this fact, I believe that companies with excess cash should repurchase shares instead of paying dividends.

Two recent articles, “Buyback or Dividends?” by Stephen Taub in Institutional Investor and “Understanding Compounding: Berkshire’s Not-So-Hidden Dividend Contrarian Secret” by my friend Arthur Clarke, give additional evidence to support buybacks over dividends. “Buyback or Dividends?” summarizes a recent S&P article by Todd Rosenbluth by stating that companies with a disciplined buyback program outperformed dividend paying companies over the past three years. I don’t put much stock in these results because of the three year time horizon and assumption that a cash distribution policy is the primary driver of returns when, in reality, returns are much more complicated (see “A Mathematician Reads the Newspaper” or “How to Lie with Statistics” for a myriad reasons why this generalization of the study is inaccurate). That being said, I believe there are some salient points, including “What counts is the amount of company’s cashflow distribution, not whether it is paid out in dividends or buybacks” and the conclusion that the net effect of share value is zero. Matter cannot be created or destroyed and there is no reason to believe that dividends and buybacks are excluded from this physical tenet.

The more profound article is “Understanding Compounding” by Arthur Clarke. Some of the logic will be familiar to frequent readers of the Alpha Theory blog because it is similar to a piece by Michael Mauboussin, but Mr. Clarke brings two very interesting analogies to bear. One, comparing dividends to the cashflow from a bond. This allows for easy compartmentalization of the dividend stream to calculate a Yield to Maturity which shows the deleterious impacts of taxes and poor reinvestment of cashflows. The second analogy is equating a dividend to a zero cost basis sell of shares. This is a great concept that brings home the impact of taxes on dividends. Both analogies contradict the fallacy that dividends are a good use of company cash.

For those of you still on the fence about dividends, I understand. Dividend dogma is powerful. Just ask the old baseball managers that roundly disregarded Billy Beane when he showed them a better way to pick players (Moneyball article). If you want to be enlightened, take some time and read these articles. Or better yet, analyze a dividend-paying company using Enterprise Value and I believe you will agree that a transfer of cash from one pocket to another does not create value.

April 12, 2011

Understanding Dividends - Michael Mouboussin Edition

As many who read my articles know, I am a big fan of Michael Mouboussin and not a big fan of dividends (more specifically, industry dogma surrounding dividends). So it was nice to read an article by Mr. Mouboussin which coherently makes the case that our industry looks at dividends through distorted lenses. From Mr. Mauboussin's recent article, "The Real Role of Dividends in Building Wealth":

"If you listen to the press or read missives from investment firms, you might conclude that dividends play a prime role in capital accumulation. In fact, well-known strategists have pointed out that dividends have accounted for 90 percent of equity returns over the past century. This statistic is potentially very misleading and warrants further examination. Here's the ending without the plot: price appreciation is the only source of investment returns that increases accumulated capital over time.

The cause of the confusion is that analysts do not distinguish between the equity rate of return and the capital accumulation rate. Depending on the choices of the shareholder, the rates can be very different. Understanding the distinction is essential for assessing past results and for thinking about satisfying future financial obligations."

My contention has always been simple, "dividends do not create value." It was my belief that for non-taxable accounts, dividends are fairly neutral, but Mr. Mauboussin makes a compelling case that dividends may even be a drag in non-taxable accounts because most of us do not actually reinvest the full dividend back into the equity. His analysis is thought provoking and definitely worth a read, The Real Role of Dividends in Building Wealth as are most of his writings which can be found on the Legg Mason website.

If you looking for some of my other articles on dividends, you can find them at:

  1. Institutional Investor
  2. Dr. Laffer Article

March 15, 2011

Will We Ever Learn?: The Scary Similarities of the Subprime Mortgage and Junk Bond Crises

I have never claimed to be a market historian, but the obvious similarities of the Subprime and Junk Bond crises are staggering even to the casual observer. Maybe it is a confluence of my recent reading of Sorkin’s “Too Big to Fail”, Lewis’s “The Big Short”, and Klarman’s “Margin of Safety” that brings the parallels into clear focus, but I am floored by our ability to have two vastly identical crises in the course of two decades.

While reading chapter 4 of “Margin of Safety” I turned to my disinterested wife after each page and proclaimed, “this junk bond thing is almost identical to the subprime crisis.” The narrative is plagiarism of the same financial horror story (see the chart below). In the search for higher yields, investors relax standards and issue debt to people (subprime) / companies (junk bond) that have no ability to pay back their obligations. Diversification and low correlation amongst low-quality borrowers was used as a justification for reducing the risk inherent in individual risky loans. Due to the demand for higher yielding assets, investment banks concentrated human and financial capital at staggering rates into packaging and selling subprime / junk bonds.

Capital available to finance these shaky deals increased with the ability to resell structured products like mortgage-backed securities and collateralized debt obligations (subprime) / collateralized bond obligations (junk bond). Retail banks and institutional investors (subprime) / thrifts and savings and loans (junk bond) created ready capital sources to soak up the buy side of any high yielding deals. CDO-focused funds (subprime) and high yield mutual funds (junk bond) added additional fuel to growing capital being given to undeserving borrowers.

An escalation of creative financing was needed to allow lower and lower quality standards including Pick-a-Pay, Alt-A, No Doc, Interest-Only (subprime) / zero-coupon and pay-in-kind (junk bond). The ratings agencies had to play dumb or be dumb to allow packaged subprime mortgages and packaged junk bonds to be magically rated investment grade. To justify these ratings they used historical models that assumed house prices could not fall (subprime) or historical junk bond default rates and no refinancing issues (junk bond). Finally, all of these lending machines were picking up speed as the empirical evidence was flying in the face of all that were willing to look as illustrated by subprime defaults growing from 2005 on and MBS, CDO, and CDS prices staying stable (subprime) / junk defaults rising in the late 80s at the same time the pace of new junk deals was accelerating.

Is our memory so short that we cannot remember the financial chaos created by the junk bond market in the 1980s? Some remembered because there were many smart investors that made the connection and made substantial bets on how the subprime story was going to end. Many issues coalesced to allow both bubbles to form and I certainly do not have the prescription to prevent it from happening again, but the first place I would focus my attention is the flawed incentive structure that paid the participants of the junk bond market to make foolish bets. The incentive to take outsized risk for short-term gain has not changed substantially in the past 20 years and has probably even become more acute with the increase of financial engineering and the repeal of Glass-Steagall in 1999. As my friend Dr. Art Laffer says, “Incentives are the key to understanding economic behavior.” Maybe we should stop paying bonuses on this year’s returns and instead pay a three or five-year rolling percentage of returns. That could discourage some of the short-termism that manifests financial crises.

We are just fortunate the Credit Default Swap market was nascent in the 80s or the Junk Bond crisis would have been compounded like the Subprime Crisis of this decade. Will we ever learn?

Similarities of the Subprime and Junk Bond Crises

Junk Bond Market (1980s)

Subprime Market (2000s)

Search for higher yielding assets

Search for higher yielding assets

Issuance of debt to companies that did not have the cash flow to pay back obligations

Issuance of debt to people that did not have the cash flow to pay back obligations

Thrifts and Savings and Loans willing to invest in junk bond backed obligations (over 1000 banks failed1)

Retail banks and institutional investors willing to invest in subprime backed obligations (230 banks have failed to date2)

Investment banks deploy substantial human and financial capital towards junk bond market

Investment banks deploy substantial human and financial capital towards subprime market

Hypothetical diversification and low correlation of underlying loans created perception of lower risk securities

Hypothetical diversification and low correlation of underlying loans created perception of lower risk securities

Structured products like collateralized bond obligations (CBO) to finance further investment

Structured products like mortgage-backed securities (MBS) and collateralized debt obligations (CDO) to finance further investment

High yield mutual funds created additional liquidity

MBS and CDO focused funds created additional liquidity

Disregard for empirical evidence: junk default rates increasing while new issuance of junk bonds accelerating

Disregard for empirical evidence: sub-prime default rates increasing but MBS, CDO, and CDS prices remaining stable

Creative financing: Zero Coupon and Pay-in-Kind

Creative financing: Pick-a-pay, Alt-A, No Doc, Interest Only, Option ARMs

Issuers paying ratings agencies for ratings on new issues

Issuers paying ratings agencies for ratings on new issues

Ratings agencies allowing junk bonds to be packaged together to create investment grade securities

Ratings agencies allowing subprime to be packaged together to create investment grade securities

Ratings agencies used historical models without a scenario for weak economy, no refinancing, and default rates higher than historical levels

Ratings agencies used historical models without a scenario of declining house prices

1 Many of the bank failures of the 80s and 90s were due to bad commercial and real estate loans, not just junk bonds

2 The full impact of commercial loan losses have not been realized at this point

February 1, 2011

Nice Surprises – The View from the Blue Ridge

We recently had a portfolio manager, whom we had originally spoken to a few years prior about our offering, call and sign up for Alpha Theory. The manager had recently read a Berkshire-Hathaway investor letter and it reminded him of the core tenets of Alpha Theory and how some of the issues his fund experienced could be resolved by using a discipline like Alpha Theory. Of course we are honored that Buffett's philosophy would make a manager think of Alpha Theory, but after reading the letter, I definitely see the connection. The manager, Chris Pavese of Broyhill Affinity Fund, writes a regular blog called "The View from the Blue Ridge". This particular post of Chris's revolved around Buffett's 1966 letter to investors (the letter can be read on Chris's blog) which spent a great deal of time discussing the lack of importance of diversity. Or better said, diversification assumes finding good ideas is easy and it is not. It is worth a read and so is Chris's blog. In addition, there are many studies that show that diversification benefits decline dramatically at a very low number of positions (see Upson study). Another good reason to avoid the diversification trap.

November 16, 2010

Untangling Skill and Luck – Mauboussin

"Separating skill and luck encourages better thinking about outcomes and allows for sharply improved decision making." – Michael Mauboussin, Legg Mason

Michael Mauboussin, a personal hero of mine, was kind enough to reach out to me after reading my blog, "The Investor's Serenity Prayer." Many of the ideas for the blog post were inspired by Mr. Mauboussin's book, "Think Twice." Mauboussin has expanded on some of the topics touched on in "Think Twice" with a new article titled "Untangling Skill and Luck" which can be found in the differentiated thinking portion of Legg Mason's website.

The article goes through numerous examples of how different professions/games (baseball, football, chess, business, investing, etc.) are part skill and part luck, each with varying degrees. To see the proofs, please read "Untangling Skill and Luck". For me, one example that stood out was that in major league baseball the worst team will beat the best team in a best-of-five series about 15 percent of the time. That is more frequent than flipping a coin and landing on heads three times in a row. For teams where skill is even closer, the percentage goes up dramatically. As a point of comparison, if a great chess player played a mediocre chess player 1,000 times, the great chess player would probably win all 1,000. So next time your favorite sports team is a 3-to-1 favorite and they lose, do not shoot the coach. Ask if the opponent just flipped a coin and got heads a couple of times (25% chance or same as 3-to-1 odds).

When thinking of investing positions on the skill/luck continuum, I'm reminded of a conversation with my office-mate from my first job at CIBC Oppenheimer. He told me that investing frustrates him because unlike many other professions he cannot just work harder and make more money. The guy mowing lawns can work more hours, mow more lawns, and make more money. The salesperson can make more cold calls, land more customers, and make more money. Both professions have a high correlation between effort and reward. But the investor can work 24/7 and potentially not make any more money. Clearly there is the chance that working harder will improve returns, but the correlation between effort and success is not nearly as high as a driven person like him would have liked. I believe this fact is another proof of investing's skew towards the luck side of the skill/luck continuum.

So understanding that luck plays a part is goal number one and then trying to understand how much luck is goal number two. Based on Mauboussin's estimates, investing is larger part luck than skill. This is discouraging for us that devote our life to honing our investing skill, but we should not despair that our efforts are in vain. The fact that investing is not pure luck means that skill matters! But as Mauboussin says, "The key is to focus feedback on improving skill. This is a very difficult task in activities where luck plays a big role. For example, this means that in evaluating an analyst or portfolio manager, it is much less important to see how she has done recently (whether her picks did well or her portfolio beat the benchmark) than it is to assess the process by which she did her job. Embracing and implementing this point of view is demanding. And make no mistake about it: the reason to emphasize process is that a good process provides the best chance for agreeable long-term outcomes."

Even though the heart of the article was the in-depth studies of skill versus luck, my favorite part was Mauboussin's thoughts on portfolio management:

"Finding gaps between fundamentals and expectations is only part of the analytical task. The second challenge is to properly build portfolios to take advantage of the opportunities. There are two common mistakes in sizing positions within a portfolio. One is a failure to adjust position sizes for the attractiveness of the opportunity. In theory, the positions in more attractive probability-weighted opportunities should be more prominent in the portfolio than less attractive opportunities. In some activities, mathematical formulas can help work out precisely how much you should bet given your perceived edge. While this is difficult in practice for most money managers, the main idea remains: the best ideas deserve the most capital. The weighting in many portfolios fails to distinguish sufficiently between the quality of the ideas. The analytical part of a good process requires both disciplined unearthing of edge and intelligent position sizing aimed at maximizing long-term probability-weighted return." (By the way, the second mistake mentioned was overbetting through leverage.)

This is Alpha Theory in a nutshell, so it clearly warms my heart to see Mauboussin spell it out so explicitly.

September 13, 2010

Institutional Investor | 8 Mistakes Series – Final Installment Released Today

The last installment of the "8 Mistakes Money Managers Make" series on Institutional Investor (www.InstitutionalInvestor.com) was released today. The series has been highlighted in their weekly electronic newsletter and posted on their homepage. The articles focus on poor position sizing's effect on portfolio risk and return. The root cause being a basic misunderstanding of an asset's impact on the portfolio and how it should be used to determine position size.

A link to the entire series can be found here or by visiting www.InstitutionalInvestor.com and clicking on the "8 Mistakes Money Managers Make" link under the "Asset Management" section.


September 2, 2010

Institutional Investor Article Series: 8 Mistakes Money Managers Make

Institutional Investor (www.institutionalinvestor.com) will feature a daily article series I authored beginning today. The series, “The 8 Mistakes Money Managers Make,” was highlighted in their weekly electronic newsletter today and posted on their homepage. The articles focus on poor position sizing's effect on portfolio risk and return. The root cause being a basic misunderstanding of an asset’s impact on the portfolio and how it should be used to determine position size.

The initial article, “Mistake #1: Discounting the Downside” is located under the “Asset Management” portion of the website and can be found here. Be sure to visit www.InstitutionalInvestor.com tomorrow for the solution to Mistake #2: The Good Stock Paradox.

August 4, 2010

Probably is not a Probability

If I tell you that I believe something is likely to happen, what probability would you give my usage of "likely"? How do you know it is the same as my estimate of "likely"? We all use probability expressions in our conversations to express differentiated levels of uncertainty. The problem is that my expression may not match your interpretation. The further the gap between the two, the more flawed the decisions that come from the conversation will be.

I've often been asked by portfolio managers, why I think it is important to force analysts to come up with a discrete probability. Closing the gap between my meaning of "likely", "probably", "possibly", "almost certainly", "maybe", "slim chance", etc. and your interpretation is a critical reason.

There are numerous studies that find that one person's intentions generally (look, another probability expression) don't match their interpretation. These studies show that many times the gaps are so vast to make the words meaningless.

As a portfolio manager, the most important goal is to accurately capture the economic impact of an asset in your portfolio and size the position based on that impact. Without an accurate assessment of probability, that task is rendered ineffective.

There is a considerable amount of literature on the subject and I've chosen a few that prove my point. There are studies that show that certain probability expressions on average have similar meaning. However, the variance between individuals was great and we are talking about interpersonal relationships where the expression of probability can have a huge impact.

Check out the studies for proof that Probably is not a Probability.

"How probable is probable? A numerical translation of verbal probability expressions", Ruth Beyth-Marom, March 1982

"Adolescents' and adults' understanding of probability expressions", Michael Biehl, May 2000

July 19, 2010

Dividend Policy Article with Dr. Laffer

I recently published an article with Dr. Art Laffer concerning dividend policy. I have strong feelings about companies that pay dividends and investors that care too much about them. Dr. Laffer also concludes there is little rationale for paying dividends and enhances the argument by explaining how dividend policy will change with the pending dividend tax rate increase scheduled for January 1st, 2011.

Read the full article at: http://www.alphatheory.com/pdf/ImplicationsOfDividendTaxIncrease.pdf.