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LETTERS TO THE EDITOR"The Diversification Puzzie": A CommentI think the article by Meir Statman in the July/August 2004 issue is one of the best articles of thatsort I've ever read. I've spent the past 21 yearsadvising individual investors, and many of thewealthiest are real estate entrepreneurs. Some-times, they are not well-educated people, but theyhave excellent "heads for business." With that sortof investor, I almost always find myself holdingthem back from making "irrational" investmentsof too much m oney in one stock, wh ich they oftenview as similar to one building or one shoppingcenter. (I assume that method is how they haveinvested in real estate. So, if you were to includeattitude s framed by comm ercial real estate in yourstudy of investor attitudes , the lack of diversifica-tion might be even more pronounced than youfotmd.) The article was extremely helpful in indi-cating a way to help such investors make intelligentdecisions about risk and return.

An Interested Reader"Stock Options and the Lying Liars Who Don'tWant to Expense Them": A CommentIn response to the article by Clifford Asness in theJuly/August 2004 issue, I agree with Mr. Asnessthat stock options should be expensed. But I dis-agree with his rationale, which app ears to echo thatof the Financial Accounting Standards Board. TheFASB reasoning contains two flaws. The first is theassumption that employee options are a form ofequity. The second derives from the first. The FASBwants to expense the cost of employee options asthoug h the compan y were giving away free equity.

Employee options are not truly equity as under-stood in the market, so the hypothetical examplethat M r. Asness uses is misleading. He infers that ifCompany A were to buy at-the-money options inthe market and give them to employees, the cashresult would be equivalent to issuing the optionsdirectly to employees. Any comp any m anager fool-ish enough to follow Company A's example, how-ever, should be promptly fired. Traded options arenot equal in value to employee options because theemployees are restricted from spending them an d ifthe employees change jobs before their options vest,they must forfeit the options.

If Company A were to offer the employees achoice between 100 restricted e mployee o ptions orcash equal to the cost of buy ing 100 traded optionsin Company A's stock, most astute employees

would choose cash. They could pocket the cash orbuy their options in the market and receive thesame capital gains as those employees who choseto accept employee o ptions. In add ition, they cou ldcash out whenever they wanted. If employeeschose to pocket the cash now, of what value wasthe transaction to the compa ny? The compan y pa idand got nothing in return.The purpose of restricted employee options isnot to pay an employee an extra bonus for doingnothing ; it is to keep valuable employees from w an-dering off to work for competitors and to providean incentive for employees to work harder toincrease the company's share value. Therefore,employee options are not market equity instru-

ments; they are employee incentive contracts. How ,then, should employee o ptions be expensed?Consider this example: Company A has oneincentive plan that issues employee options pricedat the market when granted and vested at the endof four yea rs, at which time , they mus t be exercisedor they expire. When the options are exercised, thecompany b uys the equivalent num ber of shares inthe market. The cash cost of the options is thedifference between the option grant price and themarket price at the time shares are issued to theemployee and equivalent shares are purchased in

the market. A second incentive plan ties a cashbonus to the gain in Com pany A's share price overthe next four years. The plans result in identicalcash costs to the company and have no impact onthe number of shares outstanding.Und er current accounting rules, the expense forthe bonus plan is charged in the year the bonus ispaid but because the FASB treats employee optionsas equity instruments, the cost of the stock optionplan is expensed when the plan is initiated^basedon a probability estimate of the future value of theoptions and with no future income adjustment if the

charge doesn't match the actual expense.Either the actual cost should be charged whenincurred, as in the case of the cash bonus, or theestimated cost should be treated as a contingentliability. As a contingent liability, the estimated costcould be charged at the time the incentive plan isinitiated and th en ma rked to market as the exercisedate approached.HoUister B. Sykes

Formerly Adjunct Professor of ManagementNew York UniversityCranford, New Jersey

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Financial Analysts Journal"Stock Options and the Lying Liars Who Don'tWant to Expense Them ": Author's ResponseIn my article, I intentionally tried to stay clear of theprecise issues regarding how to account for theexpensing of stock options. Rather, I decided tofight the most important battlethat they are anexpense. This battle still has not been won, and init, Hollister Sykes and I are allies.I did not endorse any particular approach toexpensing , including tha t of the Financial Account-ing Standards Board (and the idea that options areequity is certainly not my "rationale " for expen singthem; rather, my rationale is that they ha ve value).In addition, in my notesNote 4 and especiallyNo te 7I raised the issues that concern M r. Sykesby explicitly saying that the idea that optionsshould not be expensed entirely in the year issuedis "very reasonable" without further caveat. Thus,Mr. Sykes raises interesting points, but we do notdisagree on much.I do think that, together, we have created yetanother excellent example of why importantinformationin this case, my view on multiyearexpensingshou ld n ot be relegated to a footnote.I wish the technology lobby agreed.

Clifford S. AsnessAQR Capital Management, LLCNew York City"Stock Options and the Lying Liars Who Don'tWant to Expense Them": A Comm ent1 wa s greatly surprised by the tone of the recentpiece by Clifford Asness Quly/August 2004) insuch a highly esteemed pu blication as the FinancialAnalysts Journal. Disagreement on positions ofimportance to the public and financial/investmentcommunity is common, and indeed, intellectualdebate on such issues is desirable. But to imply tha tthose who disagree with one are liars is insultingand inappropriate in fostering debate.

Robert A. OlsteinOlstein & Associates, L.P.Purchase, New York

"Stock Options and the Lying Liars Who Don'tWant to Expense Them ": Editor's ResponseClifford Asness's article on management stockoptions certainly triggered a respon se. As the lettersin this issue sugges t, this topic is as polarizing in thisnarrow context as the recent election. I'd like to pointout to Robert Olstein, and anyone else who wasoffended by the piece's tone, that Mr. Asness's Note2 did offer a caution that he was being deliberatelyprovocativeespecially in his chosen title! The notereads, "Before an yone gets too work ed up , I wo uld

not truly brand all who disagree with me on thisissue liars! The title is mea nt to be somew hat w him-sical . . . ." The title is a play on the title of AlFranken 's book Lies and the Lying Liars Who Tell Them.Suffice it to say, the Editor of the FA] and CFAInstitute are on record as mirroring Mr. Asness'sperspective that stock options are an expense. Nooffense was intended in our decision to publish thisarticleexcept perha ps to those who seek personalgain throu gh a refusal to expense stock options!

Robert D. Arnott"Stock Options and the Lying Liars Who Don'tWant to Expense Th em": A Comm entCliff Asness's article 0u ly/A ug us t 2004) was a sim-ply spectacular piece of analysis. He gave the argu -ments put forth by options' apologists exactly therespect they deserveand then demolished themwith d ispatch an d hum or. It ma de me sorry, for thefirst time ever, that I hadn't taken the FA} with meto the beach. Now, if only members of the U.S.Congress would read it . . .

I have one tiny quibble. Mr. Asness was toodiffident in leading off his piece by asking , "W hythis essay when the arguments in favor of expens-ing options are so clear-cut and obvious?" As thedecision on 13 October by the Financial A ccountingStandards Board to delay implementation of itsoptions expensing rules until June makes all tooclear, the lying liars who have been fighting toothand nail for more than a decade for their "right" tohide a big slug of labor costs in the footnotes to theirfinancial statements have no intention of taking"no" for an answ er. The spineless caving to politicalpressure against options expensing back in 1994 bythe accounting standard setters played no smallrole in facilitating the culture of corporate greedthat spawned the debacles at Enron Corporation,WorldCom, and others. Now we are asked tobelieve that in delaying implementation of theirnew standard to the third quarter from the first,they are merely acquiescing to the U.S. SEC requestto give companies and accountants time to adjustto truth telling about the cost of options comp ensa-tion. But make n o mistake ab out it, the SEC's kneesgot weak because it was flooded with letters fromsenators suddenly worried that their corporatepatrons are too stressed out right now from com-plying with the demands of the Sarbanes-OxleyAct of 2002 (to "tell the truth") to also fess up toshareholders about their real compensation costs.

Give me a break. T he forces of obfuscation useexceedingly clever, not to mention well-heeled,lobby ists. In July 2004, the U.S. House of Represen-tatives passed a bill (by a lopsided margin) that

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Letters to the Editor

would override the FASB on options expensing.Only the U.S. Senate's refusalled by PeterFitzgerald (R, IL) and bolstered by Banking Com-mittee Chairman Richard C. Shelby (R, AL)toallow the bill to the floor thwarted their aims. TheFASB's delay bu ys time for the forces of un trut h torevive the issue in the next Congresswhen Sena-tor Fitzgerald will have retired and the BankingCom mittee may be chaired by ano ther.The issue in this case really is as stark as Mr.Asness put it at the end of his wonderful diatribe:"If expensing op tions is ultimately not required, wewill have knowingly chosen a falsehood over truthand don e so in the most callously public fashionafter much debate, hand-wringing, and lobbying.That would be bad. Options are the canary in ourcoalmine. If the canary dies, watch out."

The canary is now on the critical list. Politicalill winds are again blowing, and Congress couldeasily veer into de claring that 2 - 2 = 22. If share-holders, bondh olders, financial analysts, and otherusers of financial statements don't find a way tolend some spine to the accounting professionwell, they'll deserve what they get: financial fiction.

Kathryn M. WellingWelling@WeedenGreenw ich, Connecticut

"Are Professional Traders Too Slow to RealizeTheir Losses?": A Comm entWith respect to the article by Ryan Garvey andAnthony Murphy (July/August 2004), I suggestthat the authors might want to explore the influence

of internal accounting systems on the results oftheir analysis. Most financial institutions todayaccount for their period-to-period profits by usingthe mark-to-market convention. If the boss hasbooked a trade's profits for any perioda day, amonth, a yearhe or she is unlikely to want torecord a loss in the next period, even if this lossrepresents simply an unrealized decline from theprevious peak. This practice may discourage fol-lowing a "let your profits ride" trading strategy,which gamblers maintain optimizes profits byholding on to win ners. The distribution curve of agam bler's trades w ill be asymm etrical, with a longright-hand tail. The trading firms' reluctance tocarry trades over the end of reporting periods cutsoff the profitable side of the tail.

M arking to market probab ly does not affect theother side of this trading dictum, which is "cut yourlosses early." The result of this "what have youdone for m e lately" syndrom e, however, may be tocut long-held w inne rs out of the set of observation savailable to Professors Garvey and Murphy.Depen ding on how they manipulated the data, theproportion of losing trades, therefore, may havebeen increased relative to what they expected.From the po int of view of the financial institu -tions that mark to market, winners and losers maybe getting mo re equal airtime than optimal tradingstrategies would suggest.

Robert F. Richards, CFAPresident

Heathbridge Capital Management Ltd.Toronto, Ontario

Th e vieios expressed in Letters to the Editor are those of the letter authors, not of CFA Institute or the Financial Analysts Journal .

ERRATA

In "Value at Risk and Expected Stock Returns" by Turan G. Bali and Nusret Cakici in theMarch/April 2004 issue of the FAJ, the definition of the preranking beta (following theequation at the top of p. 58) is incorrect. It should be" . . . P; ; + P2 ; is the preranking beta for sto ck ; ' . . . ."

We apologize to the authors for this error and regret the inconvenience to readers.A corrected version of the article ma y be found o nline at cfapu bs.org /faj/pa st.htm l.

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