Photo Credit: edkohler || Buy Now and smile!

Photo Credit: edkohler || Buy Now and smile!

One of my clients asked me what I think is a hard question: When should I deploy capital?  I’ll try to answer that here.

There are three main things to consider in using cash to buy or sell assets:

  • What is your time horizon?  When will you likely need the money for spending purposes?
  • How promising is the asset in question?  What do you think it might return vs alternatives, including holding cash?
  • How safe is the asset in question?  Will it survive to the end of your time horizon under almost all circumstances and at least preserve value while you wait?

Other questions like “Should I dollar cost average, or invest the lump?” are lesser questions, because what will make the most difference in ultimate returns comes from  the above three questions.  Putting it another way, the results of dollar cost averaging depend on returns after you put in the last dollar of the lump, as does investing the lump sum all at once.

Thinking about price momentum and mean-reversion are also lesser matters, because if your time horizon is a long one, the initial results will have a modest effect on the ultimate results.

Now, if you care about price momentum, you may as well ignore the rest of the piece, and start trading in and out with the waves of the market, assuming you can do it.  If you care about mean reversion, you can wait in cash until we get “the mother of all selloffs” and then invest.  That has its problems as well: what’s a big enough selloff?  There are a lot of bears waiting for rock bottom valuations, but the promised bargain valuations don’t materialize because others invest at higher prices than you would, and the prices never get as low as you would like.  Ask John Hussman.

Investing has to be done on a “good enough” basis.  The optimal return in hindsight is never achieved.  Thus, at least for value investors like me, we focus on what we can figure out:

  • How long can I set aside this capital?
  • Is this a promising investment at a relatively attractive price?
  • Do I have a margin of safety buying this?

Those are the same questions as the first three, just phrased differently.

Now, I’m not saying that there is never a time to sit on cash, but decisions like that are typically limited to times where valuations are utterly nuts, like 1964-5, 1968, 1972, 1999-2000 — basically parts of the go-go years and the dot-com bubble.  Those situations don’t last more than a decade, and are typically much shorter.

Beyond that, if you have the capital to spare, and the opportunity is safe and cheap, then deploy the capital.  You’ll never get it perfect.  The price may fall after you buy.  Those are the breaks.  If that really bothers you, then maybe do half of what you would ultimately do, but set a time limit for investment of the other half.  Remember, the opposite can happen, and the price could run away from you.

A better idea might show up later.  If there is enough liquidity, trade into the new idea.

Since perfection is not achievable, if you have something good enough, I recommend that you execute and deploy the capital.  Over the long haul, given relative peace, the advantage belongs to the one who is invested.

If you still wonder about this question you can read the following two articles:

In the end, there is no perfect answer, so if the situation is good enough, give it your best shot.

When to Deploy Capital, and Vice-versa was originally published on The Aleph Blog

What do we ‘know’ about investing — but can’t prove with stats?

msantoli:

image

The statistical revolutions that have overtaken sports, business and markets have bred suspicion of any observation or assertion not backed up by hard numbers.

This is a good thing in most respects. Yet experts who study these complex realms surely have ideas about how they work based on…

What do we ‘know’ about investing — but can’t prove with stats?

msantoli:

image

The statistical revolutions that have overtaken sports, business and markets have bred suspicion of any observation or assertion not backed up by hard numbers.

This is a good thing in most respects. Yet experts who study these complex realms surely have ideas about how they work based on…

What do we ‘know’ about investing — but can’t prove with stats? was originally published on The Aleph Blog

What do we ‘know’ about investing — but can’t prove with stats?

msantoli:

image

The statistical revolutions that have overtaken sports, business and markets have bred suspicion of any observation or assertion not backed up by hard numbers.

This is a good thing in most respects. Yet experts who study these complex realms surely have ideas about how they work based on…

What do we ‘know’ about investing — but can’t prove with stats? was originally published on The Aleph Blog

What do we ‘know’ about investing — but can’t prove with stats? was originally published on The Aleph Blog

Here is a letter from a reader:

Hi David,

 Long-time reader of yours.  You put out some of the best blog content on the web and I am grateful for that.

I’ve got a question I’d hope you consider answering in the blog.  I’m almost embarrassed to ask it, for fear of appearing facile, but here goes:

Our economy is struggling with a lack of aggregate demand, low monetary velocity, and a whiff of deflation.  QE does not seem to be transmitting its monetary effects to the real economy, just helping to inflate asset prices instead.  So why wouldn’t we consider sending direct stimulus to households, similar to what we did in 2008-09, only on a much bigger scale?  Say there are 120MM households.  Send each one a $5k check, and if I’ve got the zeroes right, that’s a “mere” $600B we’re borrowing to disburse – about 60% of what the Fed is doing annually with QE.  Most of the money would recycle and multiply quickly to the economy (net of what gets allocated to debt paydown, and what gets banked by the well-off).  And due to some current one-times in the Federal budget, we’ve actually got a better balance sheet in the moment to do something with added borrowing/spending. 

Crazy thought, but these are uncommon times.  Curious what you think. 

Dear friend, I think about this in two ways: ethics and metaphysics.  The metaphysics are easy — yeah, let the Fed remit all of its seigniorage to the people rather than to the Treasury.  Far better than letting the government spend it.

But the ethics are touchy.  How do we define ethical taxation systems?  My view is that people should be taxed according to their increase in net worth, and at a flat rate, but with no ability to defer income from taxation.  Most wealthy people don’t care about tax rates because they can find ways to defer/reduce taxable income.  This is a major reason why you should distrust the Democrats, because their desire to raise tax rates would do little.  This is also a reason to distrust the GOP, because there is no decent reason to decrease tax rates.

We need to tighten up the definition of income in the US, and no longer allow citizens and businesses to defer income.  If we taxed all economic activity as it occurred we would have balanced budgets.

The rich aren’t paying enough in the US, not because of tax rates, but because they can hide their income.  That is the way that policy should proceed, to make the wealthy pay according to their increase in net worth.

I’ll write about this more later, but the main idea is to tax people proportionate to their increase in wealth.  That is the Bible’s solution for how people should give.

 

 

Sometimes I think regulators are in over their heads.  They aren’t talented enough to run a company, but they think they can control the excesses of financial companies.  Then there’s the Fed.  They think they can control an entire economy through the weak policy lever of affecting the views of people have for calculating what interest rates they should use to capitalize the values of assets.

Think of assets as a stream of future cash flows.  But what are those cash flows worth today, to buy or sell them?  The interest rate that makes the price and the cash flows equal is the capitalization rate, or, “cap rate.”

For years, at least in the Greenspan era, lowering the cap rate via Fed funds was the rule when times were weak.  He was the anti-Martin, bringing back the punchbowl rapidly when the party was getting a little dull.  Because of that, the economy grew more aggressively for a time, but at a price of growing unproductive debts.

The Problem

You can lower the interest rates as low as you want, but it doesn’t change the underlying productivity of the economy.  You might push asset or goods prices higher — it depends whether saving or spending is more important.  At present, actions of the Fed push asset prices higher, which doesn’t do much for the economy as a whole.  Rising asset prices do not stimulate the economy much.  Though it would be dishonest to do it, it would stimulate the economy more if Ben would rev up the “Helicopter of Happiness” and rain dollars from “Heaven.”

The Fed created the housing bubble with their policies 2001-2007.  They did that to stimulate the economy.  You can only use strong sectors of the economy to transmit monetary policy, because they can absorb more debt.

That’s true when not in a liquidity trap. We are in such a trap now, given the profligate prior Fed policy.  They did not let recessions destroy bad debts leading to a reduction in the marginal productivity of capital.  That value is so low now, that companies pay higher dividends and buy back shares.  Relatively little goes into growth via new investment.

My point is that monetary policy has some potency if central bankers are willing to inflict pain in the bear phase of the credit cycle.  With Greenspan and Bernanke, that was absent.  As such, we suffer in a liquidity trap, and one that current Fed policy will not remedy.  Far better to raise short-term interest rates and let some bad businesses fail, and grow from there.

One of the great things about the US is that people give their time and effort for things that benefit society.  It is a secular offshoot of the Puritan idea of creating a Holy Commonwealth.  We are out to save the World from itself, but now, without anything like Yahweh/Jesus telling us to do it.

I must admit that I serve in both spheres — I am an elder in my Bible-believing Presbyterian congregation.  I also serve on the Baltimore CFA society’s board, and may become a part of the board that oversees the pension plans for Howard County, should the county executive so choose me.  (As an aside, I applied for similar posts at the Maryland State level, but I fear that I am either too controversial, or too qualified.  I suspect that they don’t want people who really know the business.)

When I came to Baltimore, my boss had a number of things to teach me:

  • When someone asks you for help finding work, give him help.
  • Break off time to aid the broader interests of your industry, in this case, the CFA Society.
  • Where you have the opportunity, favor the local financial community if it doesn’t cost a lot to do so.
  • Help students and young professionals where you can.

I have made an effort to do this.  I aid people who are looking for opportunities, and I advise them.  I may not be the best, but I have been around the block a few times.  I really enjoy aiding people to find jobs in investing.  I love spending time with students, and encouraging them to think broadly about how investing works.  It is not a simple formula.

Thus I find my time pulled many different directions, and my dear wife wonders at how I do it.  The truth is, I don’t do it.  I have as many hours as all those who are alive.  It is just a question of the distractions that you block out in an internet era.

Thanks for reading me, and as Program Chair for Baltimore CFA, if you have any great speaker ideas for me, please send them to me. Thanks.

Why are TIPS yields negative out to 20+ years?  People are willing to lock in a loss versus CPI inflation in order to avoid a possibly larger loss.

Why do some people continue to invest in money market funds, bank deposits, savings accounts, when inflation is running at 2%+/year?  They are willing to lock in a loss versus inflation in order to avoid a possibly larger loss.

When the Fed adopts aggressive strategies, people will have two responses:

  1. “Yields on safe investments are too low.  I need more income.  I guess I have to take more risk.”
  2. “Policy is abnormal, and I am scared.  I know I am going to lose here, but I want to lose as little as possible.  TIPS, bank deposits, and money market funds make sense here.  Maybe some gold as well.”

The Fed is counting on response #1, but response #2 is much more common than they would like.  Now, response #1 is nothing all that great — the Fed is trying to extract value out of economic actors by making them undervalue risks, whether those risks are duration, convexity, credit, etc.  When they encourage more risk, they are trying to extract economic wherewithal out of those that invest there.  Who is the one that buys when things are hot, before they are not?  That is the target.

So be wary amid the efforts to “stimulate” the economy.  When an economy is heavily indebted, stimulus does not work.  Far better to invest your money in areas where stimulus does not play a role.  Look for healthy places in the economy that do not rely closely on the government.

Finally, don’t take minor changes by the Fed too seriously.  They are utterly convinced of their “super powers,” and do not appreciate how little control they have.  Every action of the Fed in their “stimulus” has produced progressively less response.

The Fed does not control the US economy.  They are codependent with it, and they do not act, they react.  The FOMC is hopelessly lost, with a cast of C+ students running the show — people who can’t think more broadly than the failed ideas of neoclassical economics.  As I have said before, the FOMC needs more historians, and no neoclassical economists.  Bring in the Austrians, they might solve things.  You might get a depression in the short-run, but afterwards, things would be normal.

That’s why some would rather lock in a smaller loss; this situation is volatile enough that many will want to do so.  As for me, I will try to buy undervalued companies, and make money there.

For fun, I decided to try running a test on the constant we call Pi in binary form [note headline].  Pi is the ratio of a circle’s circumference to its diameter.  It is many more things as well.  It is a unique number in mathematics.  As Linus said to Charlie Brown after meeting the kid named “Five,” “How about the name 3.14159?”  Charlie Brown says, “I think there are a lot of kids who would be named 3.14159.” (From memory, I could have botched it.)

I found on the web the first 2^15th power (32,768) binary digits for the “fractional” part of Pi. In decimal terms, it means Pi to a little more than 10,000 decimal places.

Pi is an irrational number.  That means it can’t be expressed as a fraction of two integers.  As such, in binary form, since the series does not terminate, the pattern of ones and zeroes should be random.  As such, we can do a “runs test” to see whether the number of runs is abnormal.  Too few runs: zeroes and ones alternate too frequently.  Too many runs: zeroes and ones do not alternate enough.

My expectation was that neither abnormality would occur.  But I had to follow the data to the conclusion.  As it the first 32,768 digits of Pi, it had too many runs, such that the probability of it being random was 1.26%.

I don’t know what to do with this, but my next experiment will be on the number e, 2.71828…

I’m good with math, but not great with it.  Advice is welcome…