I had many good comments on part 1 of this series.  One was particularly good that focused on the economy as a whole, and how the promises made by the government were unlikely to be fulfilled with Social Security and Medicare.  Our government attempts to finance programs on the cheap by relying on future growth, which does not always happen.  They move up spending rapidly if growth is large, and small if growth is negative.  In either case, the government grows as a fraction of the economy.

But let me consider asset allocation projections.  It is really difficult to consider average projections of asset returns, whether in real or nominal terms.  Asset returns vary considerably, and the number of years from which average returns are calculated are few relative to the volatility of returns.

We have created an industry of asset allocators, many of which have allocated off of foolish long-term historical assumptions, as if the past were prologue.  Even if they use stochastic models, the central tendency is critical.  What do they assume they can earn over long-dated investment grade debt?  The higher that margin is, the more they lead people astray.  Stocks win in the long run, but maybe by 1-2%, not 4-6%.

Consider defined benefit pension funds — after all, it is the same problem.  What is the right long term rate to assume for asset performance?  Alas there is no good answer, and with private DB plans continuing to terminate because of underfunding, the answer is less than clear.

Scoundrels use the mechanism of discounting to their own ends — they make future obligations seem smaller than they should be, magnifying profits, and minimizing capital needs.  Cash flows are inexorable, though.  There are few ways to avoid the promises from pensions.

Investors, be aware.  Realize that long term investment assumptions are probably liberal.  Also realize that long term assets and liabilities that rely on those assumptions have liberal valuations as well.  After all, who wants to under-report income when the accounting is squishy?

Now, for my readers, what have I missed?

Thanks to all of my readers who commented on the original piece.  You were a real help to me.  Okay, what are the differences between fresh produce and financial assets?

• Time horizon — fresh produce is perishable, whereas most risky assets are long-dated, or in the case of equities, have indefinite lives.
• Ease of creation — New securities can be created easily, but farming takes time and effort.
• Excess Supply vs. Excess Demand — With a bumper crop, there is excess supply, and the supply is typically high quality.  Now to induce buyers to buy more than they usually do, the price must be low.  With financial assets, demand drives the process.  Collateralized Debt Obligations were profitable to create, and that led to a bid for risky debt instruments.  The same was true for many structured products.  The demand for yield, disregarding safety, created a lot of risky debt and derivatives.
• Low Supply vs. Low Demand — With a bad crop, there is inadequate supply, and the supply is typically low quality.  Prices are high because of scarcity.  With financial assets, low demand makes the process freeze.  What few deals are getting done are probably good ones.  Same for commercial and residential mortgage lending.  Only the best deals are getting done.

Fresh produce is what it is, a perishable commodity, where quantity and quality are positively correlated, and pricing is negatively correlated.  Financial assets don’t perish rapidly, quantity and quality are negatively correlated, and pricing is often positively correlated to the quantity of assets issued, since the demand for assets varies more than the supply.  Whereas, with fresh produce, the supply varies more than the demand.

That’s my take after your excellent comments.  Any more improvements that can be made?