Photo Credit: jessica wilson {jek in the box}

David:

It’s been a while since we last corresponded.  I hope you and your family are well.

Quick investment question. Given the sharp run-up in equities and stretched valuations, how are you positioning your portfolio?

This in a market that seemingly doesn’t go down, where the risk of being cautious is missing out on big gains.

In my portfolio, I’m carrying extra cash and moving fairly aggressively into gold. Also, on the fixed income side, I’ve been selling HY [DM: High Yield, aka “Junk”] bonds, shortening duration, and buying floating rate bank loans.

Please let me know your thoughts.

Regards

JJJ

Dear JJJ,

Good to hear from you.  It has been a long time.

Asset allocation is always a marriage between time horizon (when is the money needed for spending?) and expected returns, with some adjustment for risk.  I suspect that you are like me, and play for a longer horizon.

I’m at my lowest equity allocation in 17 years.  I am at 65% in equities.  If the market goes up another 4-5%, I am planning on peeling of 25% of that to go into high quality bonds.  Another 20% will go if the market rises 10% from here.  At present, the S&P 500 offers returns of just 3.4%/year for the next ten years unadjusted for inflation.  That’s at the 95th percentile, and reflects valuations of the dot-com bubble, should we rise that far.

The stocks that I do have are heading in three directions: safer, cyclical and foreign.  I’m at my highest level for foreign stocks, and the companies all have strong balance sheets.  A few are cyclicals, and may benefit if commodities rise.

The only thing that gives me pause regarding dropping my stock percentage is that a lot of “friends” are doing it.  That said, a lot of broad market and growth investors are making “new era” arguments.  That gives me more comfort about this.  Even if the FAANG stocks continue to do well, it does not mean that stocks as a whole will do well.  The overall productivity of risk assets is not rising.  People are looking through the rearview mirror, not the windshield, at asset returns.

I can endorse some gold, even though it does nothing.  Nothing would have been a good posture back in the dot-com bubble, or the financial crisis.  Commodities are undervalued at present.  I can also endorse long Treasuries, because I am not certain that inflation will run in this environment.  When economies are heavily indebted they tend not to inflate, except as a last resort.  (The wealthy want to protect their claims against the economy.  The Fed generally helps the wealthy.  Those on the FOMC are all wealthy.)

I also hold more cash than normal.  The three of them, gold, cash and long Treasury bonds form a good hedge together against most bad situations.

The banks are in good shape, so the coming troubles should not be as great as during the financial crisis, as long as nothing bizarre is going on in the repo markets.

That said, I would be careful about bank debt.  Be careful about the covenants on the bank debt; it is not as safe as it once was.  I don’t own any now.

Aside from that, I think you are on the right track.  The most important question is how much you have invested in risk assets.  Prudent investors should be heading lower as the market rises.  It is either not a new era, or, it is always a new era.  Build up your supply of safe assets.  That is the main idea.  Preserve capital for another day when risk assets offer better opportunities.

Thanks for writing.  If you ever make it to Charm City or Babylon, let me know, and we can have lunch together.

Sincerely,

David

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I thought this old post from RealMoney.com was lost, never to be found again.  This was the important post made on November 22, 2006 that forecast some of the troubles in the subprime residential mortgage backed securities market.  I favored the idea that there there would be a crash in residential housing prices, and the best way to play it would be to pick up the pieces after the crash, because of the difficulties of being able to be right on the timing of shorting could be problematic.  In that trade, too early would mean wrong if you had to lose out the trade because of margin issues.

With that, here is the article:

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I have tried to make the following topic simple, but what I am about to say is complex, because it deals with the derivative markets. It is doubly or triply complex, because this situation has many layers to unravel. I write about this for two reasons. First, since residential housing is a large part of the US economy, understanding what is going on beneath the surface of housing finance can be valuable. Second, anytime financial markets are highly levered, there is a higher probability that there could be a dislocation. When dislocations happen, it is unwise for investors to try to average down or up. Rather, the best strategy is to wait for the trend to overshoot, and take a contrary position.

 

There are a lot of players trotting out the bear case for residential housing and mortgages. I’m one of them, but I don’t want overstate my case, having commented a few weeks ago on derivatives in the home equity loan asset-backed securities market. This arcane-sounding market is no small potatoes; it actually comprises several billions of dollars’ worth of bets by aggressive hedge funds — the same type of big bettors who blew up so memorably earlier this year, Amaranth and Motherrock.

 

A shift of just 10% up or down in residential housing prices might touch off just such another cataclysm, so it’s worth understanding just how this “arcane-sounding” market works.

 

I said I might expand on that post, but the need for comment and explanation of this market just got more pressing: To my surprise, one of my Googlebots dragged in a Reuters article and a blog post on the topic. I’ve seen other writeups on this as well, notably in Grant’s Interest Rate Observer (a fine publication) and The Wall Street Journal.

How a Securitization Works (Basically)

 

It’s difficult to short residential housing directly, so a market has grown up around the asset-backed securities market, in which bulls and bears can make bets on the performance of home equity loans. How do they do this?

 

First, mortgage originators originate home equity loans, Alt-A loans and subprime loans. They bring these loans to Wall Street, where the originator sells the loans to an investment bank, which dumps the loans into a trust. The investment bank then sells participation interests (“certificates”) in the trust.

 

There are different classes of certificates that have varying degrees of credit risk. The riskier classes receive higher interest rates. Typically the originator holds the juniormost class, the equity, and funds an overcollateralization account to give some security to the next most junior class.

 

Principal payments get allocated to the seniormost class. Once a class gets its full share of principal paid (or cancelled), it receives no more payments. Interest gets allocated in order of seniority. If, after paying interest to all classes, there is excess interest, that excess gets allocated to the overcollateralization account, until the account is full — that is, has reached a value equal to the value of the second most junior class of trust certificates — and then the excess goes to the equity class. If there’s not enough interest to pay all classes, they get paid in order of seniority.

 

If there are loan losses from nonpayment of the mortgages or home equity loans, the losses get funded by the overcollateralization account. If the overcollateralization account gets exhausted, losses reduce the principal balances of the juniormost certificates — those usually held by the originator — until they get exhausted, and then the next most junior gets the losses. There’s a little more to it than this (the prospectuses are often a half-inch thick on thin paper), but this is basically how a securitization works.

 

From Hedging to Speculation

 

The top class of certificates gets rated AAA, and typically the lowest class before the equity gets rated BBB-, though sometimes junk-rated certificates get issued. Most of the speculation occurs in securities rated BBB+ to BBB-.

 

The second phase of this trade involves credit default swaps (CDS). A credit default swap is an agreement where one party agrees to make a payment to another party when a default takes place, in exchange for regular compensation until the agreement terminates or a default happens. This began with corporate bonds and loans, but now has expanded to mortgage- and asset-backed securities.

 

Unlike shorting stocks, where the amount of shorting is generally limited by the float of the common stock, there can be more credit default swaps than bonds and loans. What began as a market to allow for hedging has become a market to encourage speculation.

 

With CDS on corporate debt, it took eight years for the notional size (amount to pay if everyone defaulted) of the CDS market to become 4 times the size of the corporate bond market. With CDS on home equity asset-backed securities, it took less than 18 months to get to the same point.

 

The payment received for insuring the risk is loosely related to the credit spread on the debt that is protected. Given that the CDS can serve as a hedge for the debt, one might think that the two should be equal. There are a couple reasons that isn’t so.

 

First, when a default happens, the bond that is the cheapest to deliver gets delivered. That option helps to make CDS trade cheap relative to credit spreads. But a bigger factor is who wants to do the CDS trading more. Is it those who want to receive payment in a default, or those who want to pay when a default occurs?

How It Impacts Housing

 

With CDS on asset-backed securities, the party writing protection makes a payment when losses get allocated to the tranche in question. Most protection gets written on tranches rated BBB+ to BBB-.

 

This is where shorting residential housing comes into the picture. There is more interest in shorting the residential housing market through buying protection on BBB-rated home equity asset-backed securities than there are players wanting to take on that risk at the spreads offered in the asset-backed market at present. So, those who want to short the market through CDS asset-backed securities have to pay more to do the trade than those in the cash asset-backed securities market receive as a lending spread.

 

One final layer of complexity is that there are standardized indices (ABX) for home equity loan asset-backed securities. CDS exists not only for the individual asset-backed securities deals, but also on the ABX indices as well. Those not wanting to do the credit work on a specific deal can act on a general opinion by buying or selling protection on an ABX index as a whole. The indices go down in quality from AAA to BBB-, and aggregate similar tranches of the individual deals. Those buying protection receive pro-rata payments when losses get allocated to the tranches in their index.

 

So, who’s playing this game? On the side of falling housing prices and rising default rates are predominantly multi-strategy and mortgage debt hedge funds. They are paying the other side of the trade around 2.5% per year for each dollar of home equity asset-backed securities protection bought. (Deals typically last four years or so.) The market players receiving the 2.5% per year payment are typically hedge and other investment funds running collateralized debt obligations. They keep the equity piece, which further levers up their returns. They are fairly yield-hungry, so from what I’ve heard, they’re none too picky about the risks that they take down.

 

Who wins and who loses? This is tricky, but if residential real estate prices fall by more than 10%, the buyers of asset-backed securities protection will probably win. If less, the sellers of protection probably win. This may be a bit of a sideshow in our overly leveraged financial markets, but the bets being placed here exceed ten billion dollars of total exposure. Aggressive investors are on both sides of this trade. Only one set of them will end up happy.

 

But how can you win here? I believe the safest way for retail investors to make money here is to play the reaction, should a panic occur. If housing prices drop severely, and home equity loan defaults occur, and you hear of hedge fund failures resulting, don’t act immediately. Wait. Watch for momentum to bottom out, or at least slow, and then buy the equities of financially strong homebuilders and mortgage lenders, those that will certainly survive the downturn.

If housing prices rise in the short run (unlikely in my opinion), and you hear about the liquidations of bearish hedge funds, then the best way to make money is to wait. Wait and let the homebuilders and mortgage finance companies run up, and then when momentum fails, short a basket of the stocks with weak balance sheets.

Why play the bounce, rather than try to bet on the success of either side? The wait could be quite long before either side loses? Do you have enough wherewithal to stay in the trade? Most players don’t; that’s why I think that waiting for one side or the other to prevail is the right course. Because both sides are levered up, there will be an overshoot. Just be there when the momentum fails, and play the opposite side. Personally, I’ll be ready with a list of homebuilders and mortgage lenders with strong balance sheets. Though prospects are not bright today, the best will prosper once the crisis is past.

Another quarter goes by, the market rises further, and the the 10-year forward return falls again.  Here are the last eight values: 6.10%, 6.74%, 6.30%, 6.01%, 5.02%, 4.79%, and 4.30%, 3.99%.  At the end of September 2017, the figure would have been 4.49%, but the rally since the end of the quarter shaves future returns down to 3.99%.

At the end of June the figure was 4.58%.  Subtract 29 basis points for the total return, and add back 12 basis points for mean reversion, and that would leave us at 4.41%.  The result for September month-end was 4.49%, so the re-estimation of the model added 8 basis points to 10-year forward returns.

Let me explain the adjustment calculations.  In-between quarterly readings, price movements shave future returns the same as a ten-year zero coupon bond.  Thus, a +2.9% move in the total return shaves roughly 29 basis points off future returns. (Dividing by 10 is close enough for government work, but I use a geometric calculation.)

The mean-reversion calculation is a little more complex.  I use a 10-year horizon because that is the horizon the fits the data best.  It is also the one I used before I tested it.  Accidents happen.  Though I haven’t talked about it before, this model could be used to provide shorter-run estimates of the market as well — but the error bounds around the shorter estimates would be big enough to make the model useless. It is enough to remember that when a market is at high valuations that corrections can’t be predicted as to time of occurrence, but when the retreat happens, it will be calamitous, and not orderly.

Beyond 10-years, though, the model has no opinion.  It is as if it says, past mean returns will occur.  So, if we have an expectation of a 4.58% returns, we have one 4.58%/yr quarter drop of at the end of the quarter, and a 9.5% quarter added on at the end of the 10-year period. That changes the quarterly average return up by 4.92%/40, or 12.3 basis points.  That is the mean reversion effect.

Going Forward

Thus, expected inflation-unadjusted returns on the S&P 500 are roughly 3.99% over the next ten years.  That’s not a lot of compensation for risk versus investment-grade bonds.  We are at the 94th percentile of valuations.

Now could we go higher?  Sure, the momentum is with us, and the volatility trade reinforces the rise for now.  Bitcoin is an example that shows that there is too much excess cash sloshing around to push up the prices of assets generally, and especially those with no intrinsic value, like Bitcoin and other cryptocurrencies.

Beyond that, there are not a lot of glaring factors pushing speculation, leaving aside futile government efforts to stimulate an already over-leveraged economy.  It’s not as if consumer or producer behavior is perfectly clean, but the US Government is the most profligate actor of all.

And so I say, keep the rally hats on.  I will be looking to hedge around an S&P 500 level of 2900 at present.  I will be watching the FOMC, as they may try to invert the yield curve again, and crash things.  They never learn… far better to stop and wait than make things happen too fast.  But they are omnipotent fools.  Maybe Powell will show some non-economist intelligence and wait once the yield curve gets to a small positive slope.

Who can tell?   Well, let’s see how this grand experiment goes as Baby Boomers arrive at the stock market too late to save for retirement, but just in time to put in the top of the equity market.  Though I am waiting until S&P 2900 to hedge, I am still carrying 19% cash in my equity portfolios, so I am bearish here except in the short-run.

PS — think of it this way: it should not have gone this high, therefore it could go higher still…

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Last week, there was an article in Barron’s describing how many mutual fund families take advantage of a provision in the law allowing them to have funds lend to one another.  Quoting from the article:

Under normal circumstances the Securities and Exchange Commission bars funds from making “affiliated transactions,” but there’s a loophole in the Investment Company Act of 1940 for funds to apply for an exemption to make such “interfund loans.” Until recently, few fund families applied for this exemption. None had before 1990. From 2006 to 2016, the SEC approved just 18 interfund lending applications. But since January 2016, the agency has approved 26. Most major fund families—BlackRock, Vanguard, Fidelity, Allianz—now can make such loans. Stiffer regulations of banks, which are now less willing to offer funds credit lines, partly explain the application surge.

I’m here tonight to suggest making a virtue out of necessity, because one day this practice will be banned after another crisis if something goes afoul.  Let the mutual fund companies that do this set up a special “crisis lending fund,” and put in place the following provisions:

  • The various funds that can borrow from the crisis lending fund must pay a commitment fee for the capital that could be lent.  Make it similar to what a bank provides on a revolving credit line.
  • When funds are not lent, it is invested in Treasury securities, or something of very high quality, in a five-year ladder.
  • When funds are lent, they receive a rate similar to rates current on single-B junk bonds.
  • The lending to other funds is secured, such that if the loans are collateralized by less than 200%, the loans must be paid down.  I.e., if the fund has $200 million of net asset value, there can be at most $100 million of loans, from all parties lending to the fund.

This would be an attractive, somewhat countercyclical asset for people to invest in.  Who wouldn’t want a fund that made additional money during a crisis, and was safe the rest of the time as well?

Just a stray thought.  As with many of my ideas, this would help create a stable private-sector solution where the government might otherwise intrude.

Picture Credit: Roadsidepictures from The Little Engine That Could By Watty Piper, Illustrated By George & Doris Hauman | That said, for every one that COULD, at least two COULDN’T

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So what do you think of the market?  Why are both actual and implied volatility so low?  Why are the moves so small, but predominantly up?  Is this the closest impression of the Chinese Water Torture that a stock market can pull off?

Why doesn’t the market care about external and internal risks?  Doesn’t it know that we have divisive, seemingly incompetent President who looks like he doesn’t know how to do much more than poke people in the eyes, figuratively?  Doesn’t it know that we have a divided, incompetent Congress that can’t get anything of significance done?

Leaving aside the possibility of a war that we blunder into (look at history), what if the inability of Washington DC to do anything is a plus?  Government on autopilot for four years, maybe eight if we decide we are better of without change — is that a plus or minus?  Just ignore the noise, Trump, other politicians, media… ahh, the quiet could be nice.

Then think about Baby Boomers showing up late for retirement, and wondering what they are going to do.  Then think about their surrogates, the few who still have defined benefit pension plans.  What are they going to do?  Say that the rate that they are targeting for investment earnings is 7%/year forever.  Even if my model for investment returns is wrong in a pessimistic way — i.e., my 4% nominal should be 6%/year nominal, you still can’t hit your funding target.  As for those with defined contribution plans, when you are way behind, even contributing more won’t do much unless investment earnings provide some oomph.

I am personally not a fan of TINA — “there is no alternative” to stocks in the market, but I recognize the power of the idea with some.  It is my opinion that more people and their agents will run above average risks in order to try to hit an unlikely target rather than lock in a loss versus what is planned.  Most will “muddle in the middle” taking some risk even with a high market, and realizing that they aren’t going to get there, but maybe a late retirement is better than none.

That’s the power of bonds returning 3% at best over the forecast horizon, unless interest rates jump, and then we have other problems, like risk assets repricing.  If you are older, almost no plan is achievable at reasonable cost if you are coming to the game now, rather than starting 15+ years ago.

And so I come to “the little market that could…” for now.  My view is that those with retirement obligations to fund are bidding up the market now.  That does two things.  Shares of risk assets (stocks) move from the hands of stronger investors to weaker investors, while cash flows the opposite direction.  In the process, prices for risk assets get bid up relative to their future free cash flows.

Unlike “the little engine that could,” the little market that could has climbed some small hills relative to the funding targets that investors need. Ready for the Himalayas?  The trouble with those targets is that regardless of what the trading price of the risk assets is, the cash flows that they produce will not support those targets.

Thought experiment: imagine that the stock market was gone and all the shares we held were of private companies that were difficult and expensive to trade.   Pension plans would estimate ability to meet targets by looking at forecasts of the underlying returns of their private investments, rather than a total return measure.

Well, guess what?  In the long run, the returns from public stock investments reflect just that — the distributable amount of earnings that they generate, regardless of what a marginal bidder is willing to pay for them at any point in time.  Stocks aren’t magic, any more than the firms that they represent ownership in.

So… we can puzzle over the current moment and wonder why the market is behaving in a placid, slow-climbing manner.  Or, we can look at the likely inadequacy of asset cash flows versus future demands for those cash flows for retirement, etc.  Personally, I think they are related as I have stated above, but the second view, that asset returns will not be able to fund all planned retirement needs is far more certain, and is one mountain that “the little market that could” cannot climb.

Thus, consider the security of your own plans, and adjust accordingly.  As I commented recently, for older folks with enough assets, maybe it is time to lock in gains.  For others, figure out what adjustments and compromises will need to be made if your assets can’t deliver enough.

Tough stuff, I know.  But better to be realistic about this than to be surprised when funding targets are not reached.

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Recently I read Jonathan Clements’ piece Enough Already.  The basic idea was to encourage older investors who have made gains in the risk assets, typically stocks, though it would apply to high yield bonds and other non-guaranteed investments that are highly correlated with stocks.  His pithy way of phrasing it is:

If I have already won the game, why would I keep playing?

His inspiration for the piece stems from a another piece by William Bernstein [at the WSJ] How to Tell if Your Retirement Nest Egg Is Big Enough.  He asked a question like this (these are my words) back in early 2015, “Why keep taking risk if your performance has been good enough to let you reduce risk and live on the assets, rather than run the possibility of a fall in the market spoiling your ability to retire comfortably?”

Decent question.  If you are young enough, your time horizon is long enough that you can ignore it.  But if you are older, you might want to consider it.

Here’s the problem, though.  What do you reinvest in?  My article How to Invest Carefully for Mom took up some of the problem — if I were reducing exposure to stocks, I would invest in high quality short and long bonds, probably weighted 50/50 to 70/30 in that range.  Examples of tickers that I might consider be MINT and TLT.  Trouble is, you only get a yield of 2% on the mix.  The short bonds help if there is inflation, the long bonds help if there is deflation.  Both remove the risk of the stock market.

I’m also happier in running with my mix of international stocks and quality US value investments versus holding the S&P 500, because foreign and value have underperformed for so long, almost feels like 1999, minus the crazed atmosphere.

Now, Clements at the end of the exercise doesn’t want to make any big changes.  He still wants to play on at the ripe old age of 54.  He is concerned that his nest egg isn’t big enough.  Also, he thinks stocks will return 5-6%/year over the long haul (undefined), versus my model that says 2-6%/year over the next ten years.

What would I say?  I would say “do half.”  Whatever the amount you would cut from stocks to move to bonds if you were certain of it, do half of it.  If disaster strikes, you will pat yourself on the back for doing something.  If the market rallies further, you will be glad you didn’t do the whole thing.

What’s that, you say?  What am I doing?  At age 56, I am playing on, but 10-12% higher in the S&P 500, and I will hedge.  At levels like that future market outcomes are poor under almost every historical scenario, and even if the market doesn’t seem nuts in terms of qualitative signals, the amount you leave on the table is piddly over a 10-year horizon.  If I see more genuine nuttiness beyond certain logic-free zones in the market, I could act sooner, but for now, like Jonathan, I play on.

Full disclosure: long MINT and TLT for me and my fixed income clients

Photo Credit: Christopher || Maintaining a marriage is simple… if you do it right…

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There are at least eight reasons why taking a simple approach to investing is a wise thing to do.

  1. Understandable
  2. Explainable
  3. Reduced “Too smart for you own good risk”
  4. Clearer risk management
  5. Less trading
  6. Taxes are likely easier
  7. Not Trendy
  8. Cheap

Understandable

You have to understand your investments, even if it’s just at the highest overview level.  If you don’t have that level of understanding, then at some point you will be tempted to change your investments during a period of market duress, and it will likely be a mistake.  Panic never pays.  How to avoid panic?  Knowledge reduces panic.  Whatever the strategy is, follow it in good times and bad.  Understand how bad things can get before you start an investment program.  Make changes if needed when things are calm, not in the midst of terror.

Explainable

You should be able to explain your investment strategy at a basic level, enough that you can convey it to a friend of equal intelligence.  Only then will you know that you truly understand it.  Also, in trying to explain it you will discover whether your investments are truly simple or not.  Does your friend get it, even if he may not want to imitate what you are doing?

Take an index card and write out the strategy in outline form.  Would you feel confident talking for one minute about it from the outline?

Reduced “Too smart for your own good risk”

If you have simple investments, you will tend not to get unexpected surprises.  One reason the rating agencies did so badly in the last crisis was that they were forced to rate stuff for which they did not have good models.  The complexity level was too high, but the regulators required ratings for assets held by banks and insurers, and so the rating agencies did it, earning money for it, but also at significant reputational risk.

Why did the investment banks get into trouble during the financial crisis?  They didn’t keep things simple.  They held a wide variety of complex, illiquid investments on their balance sheets, financed with short-term lending.  When there was doubt about the value of those assets, their lenders refused to roll over their debts, and so they foundered, and most died, or were forced into mergers.

I try to keep things simple.  Stocks that possess a margin of safety and high quality bonds are good investments.  Stocks have enough risk, and high quality bonds are one of the few assets that truly diversify, along with cash.  That makes sense from a structural standpoint, because fixed claims on future cash are different than participating in current profits, and the change in expectations for future profits.

Clearer risk management

When assets are relatively simple, risk management gets simple as well.  Assets should succeed for the reasons that you thought they would in advance of purchase.  Risk assets should primarily generate capital gains over a full market cycle.  fixed Income assets help provide a floor, and limit downside, so long as inflation remains in check.

With simple asset allocations, you don’t tend to get negative surprises.  Does an income portfolio fall apart when the stock market does?  It probably was not high quality enough.  Does you asset allocation give large negative surprises close to retirement?  Maybe there were too many risk assets in the portfolio after a long bull run.

Cash and commodities (in small amounts) can help as well.  Those don’t have yield, and don’t typically provide capital gains, but they would help if inflation returned.

Less trading

Simplicity in asset allocation means you can sleep at night.  You’ve already determined how much you are willing to lose over the bear portion of a market cycle, so you aren’t looking to complicate your life through trying to time the market.  Few people have the disposition to sell near near top, and few have the disposition to buy near near the bottom.  Almost no one can do both.  (I’m better at bottoms…)

Pick a day of the year — maybe use your half-birthday (as some of my kids would say — it is six months after your birthday).  Look at your portfolio, and adjust back to target percentages, if you need to do that.  Then put the portfolio away.  If you have set your asset allocation conservatively, you won’t feel the need to make radical changes, and over time, your assets should grow at a reasonable rate.  Remember, the more conservative asset allocation that you can live with permanently is far better than the less conservative one that you will panic over at the wrong time.

Taxes are likely easier

Not that many people have taxable accounts, though half the assets that I manage are taxable, but if you don’t trade a lot, taxes from your accounts are relatively easy.  Unrealized capital gains compound untaxed over time, and there is the option to donate appreciated stock if you want to get a write-off and eliminate taxes at the same time.

Not Trendy

You won’t get caught in fads that eventually blow up if you keep things simple.  You may be pleasantly surprised that you buy low more frequently than your trendy neighbors.  Remember, people always brag about their wins, but they never tell you about the losses, particularly the worst ones.  Those who don’t lose much, and take moderate risks typically win in the end.

Cheap

Simple investment strategies tend to have lower management fees, and fewer “soft” costs because they don’t trade as much.  That can be a help over the long run.

That’s all for this piece.  For most investors, simplicity pays off — it is that simple.

I was pleasantly surprised to be invited to contribute a chapter to this book.  I am going to encourage you to buy this book, but let me give some of the reasons not to buy this book:

  • Don’t buy it to give me something.  I don’t get anything from sales of this book.  Neither does Mebane Faber, who is giving all of the profits to charity.
  • Don’t buy it to read my article.  You can read it for free here.  Better, you can read the updated version of the article, which I publish quarterly, here.  (Those reading this at Amazon, there are links at my blog.  Google “Alephblog The Best Investment Writing” to find them.)
  • Don’t buy it to get current ideas.  There are none here.  The weakness of the book is that the articles are dated by 9-21 months or so, BUT… that doesn’t keep the book from being relevant.
  • Don’t buy it if you want one consistent theme.  It’s like reading RealMoney.com, except with a broader array of authors.  There is no “house view.”
  • Don’t buy it for the graphics in the book.  The grayscale images in the book are good for black & white, but some are hard to read.  The graphs for my article are far better at my blog.

The book is a good one because there is something for everyone here.  Do you want quantitative finance?  There is a good selection here. Do you want good basic articles about how to think about investing?  There are a good number of those as well, particularly from well-known financial journalists, and some of the most well-regarded bloggers.  Do you want a few unusual articles that might cause you consider some asset sub-classes or techniques that you haven’t considered before?  They are here too.

The writers fall into four buckets — journalists, asset managers, pundits/authors, and those who sell information at their websites.  I will tell you that my personal favorites from this volume are Tom Tresidder, Mebane Faber, Chris Meredith, Ben Carlson (how was he the only one with two articles in the book?), Jason Hsu & John West, and Cullen Roche.

Don’t get me wrong, I like almost all of the authors in this volume, and am proud to be featured among them.  For a number of them, though, I would have picked other things they have written in 2016 that had more punch, and offered more of a difference in perspective.

Why buy this?  After you read this, you will be a smarter, more well-rounded investor.  In my calculations, that’s  pretty good — 32 articles that will take you 4 hours to read.  Got seven minutes?  Read an article; it just might help you a great deal.

Quibbles

Already stated, though if you don’t like statistics, one-third of the articles may not appeal to you.  Also, a few articles veer into political commentary (not that I would ever do that 😉 ).

Summary / Who Would Benefit from this Book

Though almost anyone could benefit from this book, it is geared toward investors with intermediate-to-higher levels of knowledge and experience.  If you want to buy it, you can buy it here: The Best Investment Writing: Selected writing from leading investors and authors.

Full disclosure: I received two free copies of the book for contributing the article.  That’s all, unless someone buys the book through the link above.

If you enter Amazon through my site, and you buy anything, including books, I get a small commission. This is my main source of blog revenue. I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip. Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book. Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website. Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites. Whether you buy at Amazon directly or enter via my site, your prices don’t change.

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Just a note before I begin. My piece called “Where Money Goes to Die” was an abnormal piece for me, and it received abnormal attention.  The responses came in many languages aside from English, including Spanish, Turkish and Russian.  It was interesting to note the level of distortion of my positions among those writing articles.  That was less true of writing responses here.

My main point is this: if something either has no value or can’t be valued, it can’t be an investment.  Speculations that have strong upward price momentum, like penny stocks during a promotion, are dangerous to speculate in.  Howard Marks, Jamie Dimon and Ray Dalio seem to agree with that.  That’s all.

Now for Q&A:

Greetings and salutations.  🙂

Hope all is well with you and the family!

Just have what I believe is a quick question. I already know [my husband’s] answer to this (Vanguard index funds – it his default answer to all things investment), but this is for my Mom, so it is important that she get it right (no wiggle room for losing money in an unstable market), hence my asking you. My Mom inherited money and doesn’t know what to do with it. a quarter of it was already in index funds/mutual funds and she kept it there. The rest came from the sale of real estate in the form of a check. That is the part that she doesn’t know what she should do with. She wanted to stick it in a CD until she saw how low the interest rates are. She works intermittently (handyman kind of work – it is demand-dependent), but doesn’t have any money saved in a retirement account or anything like that, so she needs this money get her though the rest of her life (she is almost 60). What would you recommend? What would you tell [name of my wife] to do if she were in this position? BTW, it is approx $ZZZ, if that makes a difference. Any advice you can give would be very much appreciated!

Vanguard funds are almost always a good choice.  The question here is which Vanguard funds?  To answer that, we have to think about asset allocation.  My thoughts on asset allocation is that it is a marriage of two concepts:

  • When will you need to spend the money? and
  • Where is there the opportunity for good returns?

Your mom is the same age as my wife.  A major difference between the two of them is that your mom doesn’t have a lot of investable assets, and my wife does.  We have to be more careful with your mom.  If your mom is only going to draw on these assets in retirement, say at age 67, and will draw them down over the rest of her life, say until age 87, then the horizon she is investing over is long, and should have stocks and longer-term bonds for investments.

But there is a problem here.  Drawing on an earlier article of mine, investors today face a big problem:

The biggest problem for investors is low future returns.  Bonds have low rates of returns, and equities have high valuations.  You’ll see more about equity valuations in my next post.

This is a real problem for those wanting to fund retirements.  Stocks are priced to return around 4%/year over the next ten years, and investment-grade longer bonds are around 3%.  There are some pockets of better opportunity and so I suggest the following:

  • Invest more in foreign and emerging market stocks.  The rest of the world is cheaper than the US.  Particularly in an era where the US is trying to decouple from the rest of the world, foreign stocks may provide better returns than US stocks for a while.
  • Invest your US stocks in a traditional “value” style.  Admittedly, this is not popular now, as value has underperformed for a record eight years versus growth investing.  The value/growth cycle will turn, as it did back in 2000, and it will give your mom better returns over the next ten years.
  • Split your bond allocation into two components: long US high-quality bonds (Treasuries and Investment Grade corporates), and very short bonds or a money market fund.  The long bonds are there as a deflation hedge, and the short bonds are there for liquidity.  If the market falls precipitously, the liquidity is there for future investments.

I would split the investments 25%, 35%, 20%, 20% in the order that I listed them, or something near that.  Try to sell your mom on the idea of setting the asset allocation, and not sweating the short-term results.  Revisit the strategy every three years or so, and rebalance annually.  If assets are needed prematurely, liquidate the assets that have done relatively well, and are above their target weights.

I know you love your mom, but the amount of assets isn’t that big.  It will be a help to her, but it ultimately will be a supplement to Social Security for her.  Her children, including you and your dear husband may ultimately prove to be a greater help for her than the assets, especially if the markets don’t do well.  The asset allocation I gave you is a balance of offense and defense in an otherwise poor environment.  The above advice also mirrors what I am doing for my own assets, and the assets of my clients, though I am not using Vanguard.

Photo Credit: Fabio Tinelli Roncalli || Alas, there were so many signs that the avalanche was coming…

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Ten years ago, things were mostly quiet.  The crisis was staring us in the face, with a little more than a year before the effects of growing leverage and sloppy credit underwriting would hit in full.  But when there is a boom, almost no one wants to spoil the party.  Yes a few bears and financial writers may do so, but they get ignored by the broader media, the politicians, the regulators, the bulls, etc.

It’s not as if there weren’t some hints before this.  There were losses from subprime mortgages at HSBC.  New Century was bankrupt.  Two hedge funds at Bear Stearns, filled with some of the worst exposures to CDOs and subprime lending were wiped out.

And, for those watching the subprime lending markets the losses had been rising since late 2006.  I was following it for a firm that was considering doing the “big short” but could not figure out an effective way to do it in a way consistent with the culture and personnel of the firm.  We had discussions with a number of investment banks, and it seemed obvious that those on the short side of the trade would eventually win.  I even wrote an article on it at RealMoney in November 2006, but it is lost in the bowels of theStreet.com’s file system.

Some of the building blocks of the crisis were evident then:

  • European banks in search of any AAA-rated structured product bonds that had spreads over LIBOR.  They were even engaged in a variety of leverage schemes including leveraged AAA CMBS, and CPDOs.  When you don’t have to put up any capital against AAA assets, it is astounding the lengths that market players will go through to create and swallow such assets.  The European bank yield hogs were a main facilitator of the crisis that was to come, followed by the investment banks, and bullish mortgage hedge funds.  As Gary Gorton would later point out, real disasters happen when safe assets fail.
  • Speculation was rampant almost everywhere. (not just subprime)
  • Regulators were unwilling to clamp down on bad underwriting, and they had the power to do so, but were unwilling, as banks could choose their regulators, and the Fed didn’t care, and may have actively inhibited scrutiny.
  • Not only were subprime loans low in credit quality, but they had a second embedded risk in them, as they had a reset date where the interest rate would rise dramatically, that made the loans far shorter than the houses that they financed, meaning that the loans would disproportionately default near their reset dates.
  • The illiquidity of the securitized Subprime Residential Mortgage ABS highlighted the slowness of pricing signals, as matrix pricing was slow to pick up the decay in value, given the sparseness of trades.
  • By August 2007, it was obvious that residential real estate prices were falling across the US.  (I flagged the peak at RealMoney in October 2005, but this also is lost…)
  • Amid all of this, the “big short” was not a sure thing as those that entered into it had to feed the trade before it succeeded.  For many, if the crisis had delayed one more year, many taking on the “big short” would have lost.
  • A variety of levered market-neutral equity hedge funds were running into trouble in August 2007 as they all pursued similar Value plus Momentum strategies, and as some fund liquidated, a self reinforcing panic ensued.
  • Fannie and Freddie were too levered, and could not survive a continued fall in housing prices.  Same for AIG, and most investment banks.
  • Jumbo lending, Alt-A lending and traditional mortgage lending had the same problems as subprime, just in a smaller way — but there was so much more of them.
  • Oh, and don’t forget hidden leverage at the banks through ABCP conduits that were off balance sheet.
  • Dare we mention the Fed inverting the yield curve?

So by the time that BNP Paribas announced that three of their funds that bought Subprime Residential Mortgage ABS had pricing issues, and briefly closed off redemptions, and Countrywide announced that it had to “shore up its funding,” there were many things in play that would eventually lead to the crisis that happened.

Some of us saw it in part, and hoped that things would be better.  Fewer of us saw a lot of it, and took modest actions for protection.  I was in that bucket; I never thought it would be as large as it turned out.  Almost no one saw the whole thing coming, and those that did could not dream of the response of the central banks that would take much of the losses out of the pockets of savers, leaving bad lending institutions intact.

All in all, the crisis had a lot of red lights flashing in advance of its occurrence.  Though many things have been repaired, there are a lot of people whose lives were practically ruined by their own greed, and the greed of others.  It’s a sad story, but one that will hopefully make us more careful in the future when private leverage rises, creating an asset bubble.

But if I know mankind, the lesson will not be learned.

PS — this is what I wrote one decade ago.  You can see what I knew at the time — a lot of the above, but could not see how bad it would be.