Photo Credit: Dr. Wendy Longo || This horizon is distant...

Photo Credit: Dr. Wendy Longo || This horizon is distant…

I ran across two interesting articles today:

Both articles are exercises in understanding the time horizon over which you invest.  If you are older, you may not have the time to recover from market shortfalls, so advice to buy dips may sound hollow when you are nearer to drawing on your assets.

Thus the idea that volatility, presumably negative, doesn’t hurt unless you sell.  Some people don’t have much choice in the matter.  They have retired, and they have a lump sum of money that they are managing for long-term income.  No more money is going in, money is only going out.  What can you do?

You have to plan before volatility strikes.  My equity only clients had 14% cash before the recent volatility hit.  Over the past week I opportunistically brought that down to 10% in names that I would like to own even if the “crisis” deepened.  That flexibility was built into my management.  (If the market recovers enough, I will rebuild the buffer.  Around 1300 on the S&P, I would put all cash to work, and move to the alternative portfolio management strategy where I sell the most marginal ideas one at a time to raise cash and reinvest into the best ideas.)

If an older investor would be hurt by a drawdown in the stock market, he needs to invest less in stocks now, even if that means having a lower income on average over the longer-term.  With a higher level of bonds in the portfolio, he could more than proportionately draw down on bonds during a crisis, which would rebalance his portfolio.  If and when the stock market recovered, for a time, he could draw on has stock positions more than proportionately then.  That also would rebalance the portfolio.

Again, plans like that need to be made in advance.  If you have no plans for defense, you will lose most wars.

One more note: often when we talk about time horizon, it sounds like we are talking about a single future point in time.  When the time for converting assets to cash is far distant, using a single point may be a decent approximation.  When the time for converting assets to cash is near, it must be viewed as a stream of payments, and whatever scenario testing, (quasi) Monte Carlo simulations, and sensitivity analyses are done must reflect that.

Many different scenarios may have the same average rate of return, but the ones with early losses and late gains are pure poison to the person trying to manage a lump sum in retirement.  The same would apply to an early spike in inflation rates followed by deflation.

The time to plan is now for all contingencies, and please realize that this is an art and not a science, so if someone comes to you with glitzy simulation analyses, ask them to run the following scenarios: run every 30-year period back as far as the data goes.  If it doesn’t include the Great Depression, it is not realistic enough.  Run them forwards, backwards, upside-down forwards, and upside-down backwards.  (For the upside-down scenarios normalize the return levels to the right side up levels.)  The idea here is to use real volatility levels in the analyses, because reality is almost always more volatile than models using normal distributions.  History is meaner, much meaner than models, and will likely be meaner in the future… we just don’t know how it will be meaner.

You will then be surprised at how much caution the models will indicate, and hopefully those who can will save more, run safer asset allocations, and plan to withdraw less over time.  Reality is a lot more stingy than the models of most financial Dr. Feelgoods out there.

One more note: and I know how to model this, but most won’t — in the Great Depression, the returns after 1931 weren’t bad.  Trouble is, few were able to take advantage of them because they had already drawn down on their investments.  The many bankruptcies meant there was a smaller market available to invest in, so the dollar-weighted returns in the Great Depression were lower than the buy-and-hold returns.  They had to be lower, because many people could not hold their investments for the eventual recovery.  Part of that was margin loans, part of it was liquidating assets to help tide over unemployment.

It would be wonky, but simulation models would have to have an uptick in need for withdrawals at the very time that markets are low.  That’s not all that much different than some had to do in the recent financial crisis.  Now, who is willing to throw *that* into financial planning models?

The simple answer is to be more conservative.  Expect less from your investments, and maybe you will get positive surprises.  Better that than being negatively surprised when older, when flexibility is limited.

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.

 

In part 1, I went through some of the history of defined benefit [DB] pensions using a Q&A format. I’m going to continue that in part 2.

Q: What are we supposed to do about pension policy in the US then?

A: Let me start with a quotation from an old article of mine, Replacing Defined Contributions.

Pension plan reform has to face three realities.  The first is people don’t know how much to put away for retirement.  I’ll give you a hint: for almost all people, it should be over 10% of your gross pay.  The second is that people don’t know how to invest, so hand it off to advisors who will do it for them, and cheaply.  The third is silent, and leaves a lot of money on the table — most people would be better off taking an annuity from their pension plan than a third party, or trying to manage a lump sum on their own.  This is usually an option only for defined benefit [DB] plans.

It would be nice if we could give everyone a DB plan, but as I pointed out last time, the costs would be too high.  DC [Defined Contribution] plans are inexpensive enough, but they have the above three flaws.

Q: How could we get people and firms to save more for retirement?

A: I’m not sure you can.  Present needs are large for many people, and they can’t imagine saving anything over 3%, much less 10%+ of pay.  Firms could do more, but it would raise costs, unless it is taken out of other benefits or wages.

Q: Why not “nudge” people to save more — create something that shows how far they are behind their most prudent peers?

A: Think about high school for a moment.  It’s a very peer conscious part of life for many people.  How well would an appeal go over asking the bulk of students to behave well, like the best-behaved students in the class?

Q: It might affect a few, but for the most part people are set in their ways.  They’ve already done their own implicit comparisons, and concluded that they are doing well enough relative to the peers they care about, given the circumstances.  They also might not like the comparison and say something like, “Fine for them, but I have different realities in my life.”

A: Right.  Effects should be small.

Q: Why not force people to save 10% of their pay then?

A: I think that treats adults like kids.  If they don’t want to save, let them be.  They might regret it later, or, they might say, “This is my lot in life.  I have to take care of what I think is important now, and when I am old, I’ll work if I have to.”  Also, people have an incredible ability to ignore reality if they need to.

Q: But isn’t there a public policy reason to encourage retirement plans and savings?

A: Most politicians think so, but retirement is a modern concept that with longer lifespans may not make sense in every situation.  The generation that fought WWII had a unique situation that allowed many of them to retire very comfortably that we don’t have now.  Productivity increases were larger, the demographics were right, global labor competition was a lot lower, and investment returns were a lot better.

You could look at my piece, Ancient and Modern: The Retirement Tripod for more on this.  As it is, it will be difficult to take care of the Baby Boomers to the same degree that their parents were taken care of — it doesn’t matter how you fund it — it is a humongous claim on GDP, and what will be left for those who are younger?

Q: So, you argue for freedom to choose in contributions, but you don’t argue for it in investing or distributions?

A: Uh, yes.  The main difference is that I think most people are capable of estimating their tradeoff of money now versus money in the future, and they are implicitly saying they don’t want to retire, regardless of what they say explicitly.

On investing, most people do not know what to do, and I would strip down most DC plans down to a small bunch of blended funds managed by professionals getting paid at low institutional rates.  There would be at most five funds, ranging from conservative to aggressive, with a default option that adjusts which fund a participant is in based on age.

On distributions, no one, not even professionals, are good at managing a lump sum of money to provide a stream of income.  Dig the ten reasons for that in this article.  People are capable of budgeting, so give them a fixed or slowly rising income to live off of, while investing their slack assets to cover future increases in costs.

Q: It seems inconsistent to me.

A: I’m just trying to be realistic about what people are capable of doing, and what their needs are.

Q: Why not have the government do the investing, or invest all pension monies in government debt?

I don’t think it is wise to entrust so much of the investing in the economy to a single entity.  Backdoor socialism is a real risk here.  Nor is it wise to fund the government via pensions.  Note how well the government did with Social Security.  It would be one thing if the government had used the money to improve infrastructure, but the money was generally spent on current consumption.

Q: The CFA Institute has put out their own plans for an Ideal Retirement System.  Wouldn’t that be a good idea?

A: When I was a kid, one of my friends would say to me, “If wishes were fishes, we’d all have a big fry.”  Like giving everyone a strong DB plan — it fails the cost test.  You could start doing this for a new group of retirees that would retire in the 2060s and beyond, but it is unrealistic for the present cohorts looking to retire sooner that have not saved enough individually or corporately.

Q: This is pretty dour.  Don’t you have anything encouraging to say here?

A: I would note that elderly people tend to be happier than younger people.  Some of it is coming to terms with life, grasping that many of the things that we aimed for when we were younger weren’t worth it, and taking some satisfaction in what good you have in the present.  It’s not all money based, but certainly money helps.  Some will look back at the past and say they did what was best for all their responsibilities.  Others may regret missed opportunities.

There may be some good that comes out of the American tendency toward voluntarism.  Who knows what elderly Baby Boomers might do when they put their mind to it?  Hopefully it won’t be voting more money for themselves from the public purse.

Q: Any final advice?

A: You are you own best guardian of your own retirement.  I encourage you to:

  • Save what you can.  This is one factor you can control.
  • Invest prudently, keeping fees low.  Don’t let yourself give into greed or fear.
  • Use immediate annuities to provide a minimum amount of income, and other assets for growth.
  • Make sure that you have younger friends to watch out for you.  Every older person needs advocates that can watch out for their best interests.

On the home front, I have been doing more basic financial counseling than usual, and I’ve had some say to me that it would be hard to build a buffer of 3-6 months of expenses.  If that is true of you, I would encourage you to build a smaller buffer of one month’s wages.  Why?

  • A change to good habits rarely happens immediately.  You gotta walk before you can run.
  • Psychological changes happen slowly, and there is a mental reward to achieving a smaller, interim goal.
  • The idea of living off of last month’s paycheck is a simple one.
  • Contra Aristotle, money is not sterile.  It tends to beget more money, once you pass a certain threshold.  Why?

There are discounts for upfront payment on large purchases, but the biggest reason is that once you get used to living on less than your full income, and living off of the buffer fund, there is a tendency for the buffer to grow.  You have begun to master a key concept:

Money has importance tomorrow that is more valuable than spending on purchases of trivial importance today.

I’m surprised at how money burns a hole in the pocket of so many people.  Spend down to the last dollar in the pocket and then some.  No wonder the credit card companies are so big and profitable.

I have another article coming up on this, but it is critical to basic financial management that you place importance on the ability to meet future needs with greater certainty.  Thus the need for the buffer, which implies saying “no” to low value and low priority spending.

It’s not a question of the intellect usually, but of the will.  When will you start making money your servant, rather than serving it?  Go build the buffer, even if it is small.  In time, with increased will power on your part, it will grow.

 

Dear Readers, I’m going to try a different format for this piece. If you think it is a really bad way to present matters, let me know.

Question: Why do pensions exist?

Answer: They exist as a means of incenting employees to work for a given entity.  It can be a very valuable benefit  to employees, because it is difficult to earn money in old age.

Q: How did we end up with retirement savings being predominantly associated with employment?

A: That’s mostly an accident of history.  First some innovative firms offered defined benefit [DB] plans [paying a fixed sum at retirement for life, often with benefits to surviving spouses, and pre-retirement death benefits] in order to attract employees.  After World War II, many unions insisted and won such benefits, and many non-union firms imitated them.

Q: Why didn’t many defined benefit plans persist to the present day?

A: In general, they were too expensive.

Q: If they were too expensive, why did they get created?

A: They weren’t expensive at first.  The post-WWII era was one of booming demand and excellent demographics — there was only a small cohort of oldsters to support, and a rapidly growing population of workers.  Also, the funding mechanisms allowed by the government allowed for low levels of initial funding to get them started, and they assumed that corporations would easily catch up at some later date.  Sadly, some of the funding was so low that there were some defaults in the 1960s, leaving pensioners bereft.

Q: Ouch.  What happened as a result?

A: Eventually, Congress passed the Employee Retirement Income Security Act in 1974.  That standardized pension funding methods and tightened them a little, but not enough for my taste.  It also created the Pension Benefit Guarantee Corporation to insure defined benefit plans.  It did many things to standardize and protect defined benefit pensions.  Protection comes at a cost, though, and costs went higher for DB plans.

Some firms began terminating their plans.  In the mid-1980s, some firms found that they could get a moderate profit out of terminating their plans.  That didn’t sit well with Congress, which passed legislation to inhibit the practice.  That indirectly inhibited starting plans — few people want to in the “in” door, when there is not “out” door.

Some firms began funding their plans very well, and the IRS didn’t like the loss of tax revenue, so regulations were created to stop overfunding of pension plans.  These regulations put sponsors in a box.  Given the extremely strong asset returns of the ’80s and ’90s, it would have made sense to salt a lot of assets away, but that was not to be.  Thanks, IRS.

Q: Were there any other factors aside from tax policy affecting DB plans?

A: Four factors that I can think of:

  • Falling interest rates raised the value of pension liabilities.
  • Demographics stopped being so favorable as people married less and had fewer kids.
  • Actuaries got pressured to be too aggressive on plan valuation assumptions, leading to lower contributions by corporations and municipalities to their plans.
  • By accident, the 401(k) was introduced, leading to an alternative pension plan design that was a lot cheaper.  Defined contribution plans were a lot cheaper, and easier for participants to understand.  The benefits were valued more than the technically superior DB plan benefits because you could see the balance grow over time — especially in the ’80s and ’90s!

Q: Why do you say that DB plan benefits were technically superior?

A: Seven reasons:

  • They were generally paid for entirely by the employer.
  • A lot more money was contributed by the employer.
  • It gave them a benefit that they could not outlive.
  • Average people aren’t good at investing.
  • Fees for investing were a lot lower for DB plans than for Defined Contribution [DC] plans.  (Employer provides a sum of money to each employee’s account.)
  • The institutional investors were better for DB plans than DC plans, because plan sponsors would go direct to money managers with talent, while plan participants demanded name-brand mutual funds that were famous.  (Famous means a lot of assets recently added, which means poor future performance.  Should you give your kids what they want, or what you know they need?)
  • If the companies could continue to afford the benefits, the benefits would be much larger in present value terms than the lump sum accumulated in their DC plans.

The last point is important, because the benefits promised were too large for the companies to fund.  Eventually, they will be too large for most states and municipalities to fund as well, but that’s another thing…

Q: So people preferred something that was easier to understand, rather than something superior, and companies used that to shed a more expensive pension system.  That’s how we got where we are today?

A: Yes, and add in the relative impermanence of most corporations and some industries.  You need a strong profit stream in order to fund DB plans.

Q: What are we supposed to do about this then?

A: Stay tuned for part two, which I will write next week.  Believe me, there are a lot of controversial ideas about this, and there are no easy solutions — after all, we got into this problem because most corporations and people did not want to save enough money for the retirement of employees and themselves, respectively.

Q: Till next time, then!

 

If you want to know what is the core problem of the average person approaching the market (though this applies more to males than females, women have more native caution on average), it is chasing a hot idea.  This can take a number of forms:

  • Getting tips from friends who have bought some stock that is currently popular in the market.
  • Doing the same thing with investors who talk or write about investing.  The best investment advice is not flashy, and does not make for good video.
  • Looking at charts and buying something that is rising rapidly, because popular media say this is “The Next Big Thing.”
  • Buying the mutual fund or other pooled vehicle of some manager who has done very well in the past, and seems to never fail.  (If you buy a mutual fund, don’t buy one that has had a lot of money pile into it recently… usually a bad sign.  Spend more time to see if the manager thinks in a businesslike way about assets that he buys.)
  • Going to a broker who is very well-dressed and confident, and talks really well, but who has no obligation to act in your best interests.  If you don’t know how he is earning his money from you, avoid him, because it usually means investments with high fees or hidden ways that you can lose, e.g. structured notes that offer a nice yield, but where possibilities to lose are more significant than you think.  At best, he will give you consensus ideas and managers that deliver him above average remuneration.
  • Buying the newsletter of some overly confident person who claims to know the secrets of the market, which he will share with you and 100,000 other close friends for a mere $299/year!  (Please read Mark Hulbert before buying a newsletter.)
  • Worse yet, giving into the fakery of those who try to bring you into a hidden opportunity.  It can be a Ponzi scheme, a promoted stock, but they suggest returns that are huge… or, like Madoff, decent but not exorbitant returns that are altogether too regular.

Many of these appeal to our desire to get something for nothing, which is endemic — we all have it to some degree, and marketers play off this regularly by offering us “free” this, and “free” that.  Earning returns from your investable assets is a business in its own right, and there are costs to doing it well.  You should not be surprised that doing well with it will take some time and effort.

You also have to avoid the impulse that there is some hidden knowledge, or group of insiders that have found an easy road to riches.  The markets aren’t rigged in any material way.  The principles of investing are well-known, but applying them takes creativity, time and effort.  There are no significant players with a new theory who make amazing money investing in secondary markets for stocks and bonds.

Most of the things that I listed above involve low-thought imitation of others.  There is little advantage in investing to mimicry.  Even if it worked for someone else, the prices are different now, and easy gains have been made.  You will do worse than the one you are trying to imitate with virtual certainty, and likely worse than average.  You need to plan to take an independent course, and learn enough such that if you do choose to use advice of any sort, that you can evaluate it rationally.  If you choose to do it yourself, you will need to learn more than that.  It takes effort, but that effort will pay off, if not in investing itself, but there are spillover effects in intelligent management of your finances, and in improving your abilities in the businesses that you serve.

In most areas of life, most things that pay off well take effort.  If people present you with easy or hidden ways to make above average money, be skeptical.  Doing it right takes discipline and effort.  (If you want the easy route while avoiding all the pitfalls see the postscript.  It is boring, but it works.)

Postscript

As an aside — you can always index, and beat most average investors over the long haul.  Buy broad funds that invest in a large fraction of all of the stocks that there are, and those that replicate the bond market as a whole.  Make sure they have low fees.  Buy them, hold them, and be done.  You will still face one hurdle: will you be able to maintain your strategy when everything is in a crisis, or when your friends tell you they are earning a lot more than you, and it is easy to do it?  Size the bond portion of your assets to the level where you can sleep soundly in all circumstances, and you will be fine.

 

Photo Credit: Dana || They charge more for "Arrest me red" too!

Photo Credit: Dana || They charge more for “Arrest me red” too!

This should be a relatively quick note on personal lines insurance. I’m writing this after reading the piece in this month’s Consumer Reports on Auto Insurance.  I agree with most of it.  For those that are short on time, my basic advice is this: bid out your auto, home, umbrella and other personal lines property & casualty insurance policies once every three years, or after every significant event that changes your premium significantly.

Here are a few simple facts to consider:

  • Personal lines insurance — auto, home, umbrella, rental, etc. is a very competitive business, and the companies that offer it all want an underwriting formula that would give them the best estimate of expected losses from each person insured.
  • After that, they want to know how much “wiggle room” that they would have to build in some profit.  Where might the second place bid be?  How likely are consumers to shop around?
  • Most insurers use a mix of credit scores and claim history to calculate rates.  Together, they are effective at forecasting loss costs — more effective than either one separately.
  • Read my piece On Credit Scores.  They are very important, because they measure moral tendency.  People with low scores tend to have more claims than those with high scores on average.  People with high scores tend to be more careful in life.  This is a forward-looking aspect of a person’s underwriting profile.
  • It’s fair to use “credit scores” because they are positively and significantly correlated with loss costs.  The actuaries have tested this.  Note that it is legal in almost all states to use credit scores, or something like them, but not all of them.
  • As the Consumer Reports article points out, many insurance companies take advantage of insureds that stick with them year by year, because they don’t shop around.  Easy cure: bid out your policy every three years at minimum.  If enough people do this, the insurance companies that overcharge loyal customers will stop doing it.  (Note: when I was a buy side analyst analyzing insurance stocks, one company implicitly admitted to doing this, and I was insured by them.  Guess what I did next?  It was not to sell the stock, though eventually I did when I saw that their premium increases were no longer increasing profits.)
  • Also be willing to unbundle your home and auto policies — there may be a discount, or there may not as the Consumer Reports article states.  I’ve worked it both ways, and am unbundled at present.
  • If they have that much money for amusing advertising, it implies that the market isn’t that rational.  Bid it out.
  • But — it is important to realize that insurers don’t all have the same formulas for underwriting, and those formulas are not static over time.  Bidding out your insurance makes sure you benefit from changes that positively affect you.
  • Insurers tend to get more competitive as the surplus they have to deploy gets bigger, and vice-versa when it shrinks after a large disaster.  If your premium goes up after a disaster, bid the policies out.  If it drifts up slowly when there have been no significant disasters, or claims on your part, they are taking advantage of you.  Bid it out.

Bid it out.  Bid it out.  Bid it out.  What do you have to lose?  If loyalty means something to the insurer, they will likely win the bid.  If it doesn’t, they will likely lose.  Either way you will win.  If you have an agent, they will note that you are price-sensitive.  The agent will become more of an ally, even if it doesn’t seem that way.

I went through this several times.  Most people who have read me for a while know that I have a large family — I am going to start teaching number seven to drive now.  I bid it out when kids came onto my policy.  It produced a change.  When two of my kids had accidents in short succession, my premiums rose a lot.  They would not underwrite one kid.  I got most of it back when I bid it out.  Since that time, the two have been claim-free for 2.5 years.  Guess what I am going to do next March, when I am close to the renewal where premiums would shift?  You got it; I will bid it out.

There is one more reason to bid it out: it forces you to review your insurance needs.  You may need more or less coverage than you currently have. You might realize that you need an umbrella policy for additional protection.  You may decide to self-insure more by raising your deductibles.  The exercise is a good one.

You don’t need transparency, or more regulation.  You don’t get transparency in the pricing of many items.  You do need to bid out your business every now and then.  You are your own best defender in matters like this.  Take your opportunity and bid out your policies.

Make sure that you:

  • Choose a range of insurers — Large companies, smaller local companies, stock/mutual, and any that favor a group you belong to, if the group is known to be filled with good risks.
  • Give them a standardized request for insurance, giving all of the parameters for your coverage, and data on those insured.
  • Tell them they get one shot, so submit their best bid now… there will be no second looks.
  • Some companies argue more about paying claims.  (AIG once had a reputation that way.)  Limit your bidders to those with a reputation for fairness.  State insurance departments often keep lists of complaints for companies.  Take a look in your home state.  Talk with friends.  Google the company name with a few choice words (cheated, claim denied, etc.) to see complaints, realizing that complainers aren’t always right.
  • Limit yourself to the incumbent carrier and 4-6 others.  Seven is more than enough, given the work involved.

So, what are you waiting for?  Bid out your personal insurance business.

Full disclosure: long AIZ, ALL, BRK/B, TRV for myself and clients (I know the industry well)

I’m not going to argue for any particular strategy here. My main point is this: every valid strategy is going to have some periods of underperformance.  Don’t give up on your strategy because of that; you are likely to give up near the point of maximum pain, and miss the great returns in the bull phase of the strategy.

Here are three simple bits of advice that I hand out to average people regarding asset allocation:

  1. Figure out what the maximum loss is that you are willing to take in a year, and then size your allocation to risky assets such that the likelihood of exceeding that loss level is remote.
  2. If you have any doubts on bit of advice #1, reduce the amount of risky assets a bit more.  You’d be surprised how little you give up in performance from doing so.  The loss from not allocating to risky assets that return better on average is partly mitigated by a bigger payoff from rebalancing from risky assets to safe, and back again.
  3. Use additional money slated for investing to rebalance the portfolio.  Feed your losers.

The first rule is most important, because the most important thing here is avoiding panic, leading to selling risky assets when prices are depressed.  That is the number one cause of underperformance for average investors.  The second rule is important, because it is better to earn less and be able to avoid panic than to risk losing your nerve.  Rule three just makes it easier to maintain your portfolio; it may not be applicable if you follow a momentum strategy.

Now, about momentum strategies — if you’re going to pursue strategies where you are always buying the assets that are presently behaving strong, well, keep doing it.  Don’t give up during the periods where it doesn’t seem to work, or when it occasionally blows up.  The best time for any strategy typically come after a lot of marginal players give up because losses exceed their pain point.

That brings me back to rule #1 above — even for a momentum strategy, maybe it would be nice to have some safe assets on the side to turn down the total level of risk.  It would also give you some money to toss into the strategy after the bad times.

If you want to try a new strategy, consider doing it when your present strategy has been doing well for a while, and you see new players entering the strategy who think it is magic.  No strategy is magic; none work all the time.  But if you “harvest” your strategy when it is mature, that would be the time to do it.  It would be similar to a bond manager reducing exposure to risky bonds when the additional yield over safe bonds is thin, and waiting for a better opportunity to take risk.

But if you do things like that, be disciplined in how you do it.  I’ve seen people violate their strategies, and reinvest in the hot asset when the bull phase lasts too long, just in time for the cycle to turn.  Greed got the better of them.

Markets are perverse.  They deliver surprises to all, and you can be prepared to react to volatility by having some safe assets to tone things down, or, you can roll with the volatility fully invested and hopefully not panic.  When too many unprepared people are fully invested in risky assets, there’s a nasty tendency for the market to have a significant decline.  Similarly, when people swear off investing in risky assets, markets tend to perform really well.

It all looks like a conspiracy, and so you get a variety of wags in comment streams alleging that the markets are rigged.  The markets aren’t rigged.  If you are a soldier heading off for war, you have to mentally prepare for it.  The same applies to investors, because investing isn’t perfectly easy, but a lot of players say that it is easy.

We can make investing easier by restricting the choices that you have to make to a few key ones.  Index funds.  Allocation funds that use index funds that give people a single fund to buy that are continually rebalanced.  But you would still have to exercise discipline to avoid fear and greed — and thus my three example rules above.

If you need more confirmation on this, re-read my articles on dollar-weighted returns versus time-weighted returns.  Most trading that average people do loses money versus buying and holding.  As a result, the best thing to do with any strategy is to structure it so that you never take actions out of a sense of regret for past performance.

That’s easy to say, but hard to do.  I’m subject to the same difficulties that everyone else is, but I worked to create rules to limit my behavior during times of investment pain.

Your personality, your strategy may differ from mine, but the successful meta-strategy is that you should be disciplined in your investing, and not give into greed or panic.  Pursue that, whether you invest like me or not.

This post is an experiment, and not meant to be definitive. If you have any comments to improve it, leave a comment, or email me.  Thanks.

The School of Money

Most books dealing with money tend to be too advanced for average people.  If you’ve read me long enough, you know that I am pretty conservative with my finances.  That conservatism has generally worked well for me, my family, and the church that I help lead.  It’s possible this post could lead to a series of posts; let me know what you think.

First Grade — Preparing to Work

It could be our culture.  It could be the way that public schools are organized.  My guess is that parents don’t talk about it much, and think that it will happen easily.  The transition of children learning to eventually applying their learning to work is a difficult thing in a world where there are many things to do, and not enough practicality involved in education.

Part of the problem is not having or developing an attitude of service.  There is no shame in helping others.  In one sense, compensation derives from how many people you help, times how valuable your contribution to that good or service is.

So, rather than “following your bliss,” the best work comes from enabling the bliss of others.  It is rare that anyone will pay you for doing what you enjoy, and only that.  Most work involves some things that are disagreeable.  It’s important to look for the good that you can do in the midst of difficulty.  Sometimes that greatest value comes from finding a new way to deal with difficulties, and making processes more productive as a result.

Somewhere around age 15, young people need to see what areas in the economy need talent, and what sort of skills are needed.  In addition to specific skills, remember that in much of life mathematical reasoning, verbal skills, and genuine curiosity for solving problems will apply to a wide number of situations.  Remember, the economy will be different 20 years from now in ways that we do not presently fathom.  Being able to think creatively and critically, and being able to express it well in oral and written ways will never go out of fashion. (As an aside, that is one of the criticisms I hear in the local money management community.  Young people come out of college, but cannot express themselves well in writing.)

Informational interviewing at younger ages could be useful.  Even at older ages, when you get the chance to ask business owners or managers questions, ask them what are the biggest problems that they face, what keep them up at night, etc.  If nothing else, you’ll get a better perspective on what it is like to be in charge, and the headaches thereof.

Software may eliminate many jobs where analytical processes can be easily replicated by code.  Analyze any career for the threat posed by software, or, employ the software yourself to enable you to do more and better work.

You’ll need to consider whether you want to take more risk and run your own business, or less risk and work at a set of skills for someone else.  That said, you can never eliminate risk.  Most of the firms that I once worked for are out of business today, or doing business in such a way that I might not be employed by them now.  There are advantages to trying to control your own destiny, even if you fail a few times in the process.  The skills you will might come in useful if you do choose to work for someone else later.  But if you succeed, you could end up with a valuable business that helps many people — customers, employees, vendors, and of course you.  High rewards go to those who lead and structure the work of others successfully.

College is needed for many high level jobs, and sometimes a master degree or a doctorate.  In other cases, additional training at a special school or a junior college may be enough.  Even after graduation, a plethora of certification situations may present themselves.  Before entering any education situation, try to analyze whether it will genuinely pay off for you or not.  Remember, even nonprofit colleges and universities rely on students to come and pay tuition so that the schools can survive.  This is why it pays to have a range of ideas in mind of what you might like to do before going for higher education.  There is nothing worse than taking on a load of debt that is not dischargeable in bankruptcy, and having no good way to pay it off.  (Note: consider income-based repayment plans if debt is high, and income low.)

Also note that you may not find what you want to do on the first try, in addition to job obsolescence.  Sometimes the path may involve retraining.  If so, count the opportunity cost of the time and money spent.  Sometimes the best path may be indirect — get a lesser job at a firm that you might want to work for and then try to interact with those in the area that is your greater interest.  In this day and age, many employers don’t advertise positions — the only way to find out about them within a firm, or by word of mouth.  If you can show a degree of talent and diligence, greater opportunities may open up for you.

In the end, remember that your work is a means to an end of helping others, while personally benefiting in the process.  Look to the needs of others, and find a way to serve well.  In most cases, the rewards should follow.

Critical Questions

  • What human needs are not getting met?
  • Do you have an idea for a business that meets those needs?
  • Have I talked with enough different people, or read enough, to get a view of what is in demand, growing, etc.
  • What jobs pay well that don’t require college?
  • What sorts of jobs and people getting work visas for at present?
  • What education or skills do I need?  How might that change?
  • Do I have good basic reasoning skills in math, science, reading, writing, general reasoning and logic, etc?

One of the constants in investing is that average investors show up late to the party or to the crisis.  Unlike many gatherings where it may be cool to be fashionably late, in investing it tends to mean you earn less and lose more, which is definitely not cool.

One reason why this happens is that information gets distributed in lumps.  We don’t notice things in real time, partly because we’re not paying attention to the small changes that are happening.  But after enough time passes, a few people notice a trend.  After a while longer, still more people notice the trend, and it might get mentioned in some special purpose publications, blogs, etc.  More time elapses and it becomes a topic of conversation, and articles make it into the broad financial press.  The final phase is when general interest magazines put it onto the cover, and get rich quick articles and books point at how great fortunes have been made, and you can do it too!

That slow dissemination and gathering of information is paralleled by a similar flow of money, and just as the audience gets wider, the flow of money gets bigger.  As the flow of money in or out gets bigger, prices tend to overshoot fair value, leaving those who arrived last with subpar returns.

There is another aspect to this, and that stems from the way that people commonly evaluate managers.  We use past returns as a prologue to what is assumed to be still greater returns in the future.  This not only applies to retail investors but also many institutional investors.  Somme institutional investors will balk at this conclusion, but my experience in talking with institutional investors has been that though they look at many of the right forward looking indicators of manager quality, almost none of them will hire a manager that has the right people, process, etc., and has below average returns relative to peers or indexes.  (This also happens with hedge funds… there is nothing special in fund analysis there.)

For the retail crowd it is worse, because most investors look at past returns when evaluating managers.  Much as Morningstar is trying to do the right thing, and have forward looking analyst ratings (gold, silver, bronze, neutral and negative), yet much of the investing public will not touch a fund unless it has four or five stars from Morningstar, which is a backward looking rating.  This not only applies to individuals, but also committees that choose funds for defined contribution plans.  If they don’t choose the funds with four or five stars, they get complaints, or participants don’t use the funds.

Another Exercise in Dollar-Weighted Returns

One of the ways this investing shortfall gets expressed is looking at the difference between time-weighted (buy-and-hold) and dollar-weighted (weighted geometric average/IRR) returns.  The first reveals what an investor who bought and held from the beginning earned, versus what the average dollar invested earned.  Since money tends to come after good returns have been achieved, and money tends to leave after bad returns have been realized, the time-weighted returns are typically higher then the dollar-weighted returns.  Generally, the more volatile the performance of the investment vehicle the larger the difference between time- and dollar-weighted returns gets.  The greed and fear cycle is bigger when there is more volatility, and people buy and sell at the wrong times to a greater degree.

(An aside: much as some pooh-pooh buy-and-hold investing, it generally beats those who trade.  There may be intelligent ways to trade, but they are always a minority among market actors.)

HSGFX Dollar Weighted Returns

HSGFX Dollar and Time Weighted Returns

That brings me to tonight’s fund for analysis: Hussman Strategic Growth [HSGFX]. John Hussman, a very bright guy, has been trying to do something very difficult — time the markets.  The results started out promising, attracting assets in the process, and then didn’t do so well, and assets have slowly left.  For my calculation this evening, I run the calculation on his fund with the longest track record from inception to 30 June 2014.  The fund’s fiscal years end on June 30th, and so I assume cash flows occur at mid-year as a simplifying assumption.  At the end of the scenario, 30 June 2014, I assume that all of the funds remaining get paid out.

To run this calculation, I do what I have always done, gone to the SEC EDGAR website and look at the annual reports, particularly the section called “Statements of Changes in Net Assets.”  The cash flow for each fiscal year is equal to the net increase in net assets from capital share transactions plus the net decrease in net assets from distributions to shareholders.  Once I have the amount of money moving in or out of the fund in each fiscal year, I can then run an internal rate of return calculation to get the dollar-weighted rate of return.

In my table, the cash flows into/(out of) the fund are in millions of dollars, and the column titled Accumulated PV is the accumulated present value calculated at an annualized rate of -2.56% per year, which is the dollar-weighted rate of return.  The zero figure at the top shows that a discount rate -2.56% makes the cash inflows and outflows net to zero.

From the beginning of the Annual Report for the fiscal year ended in June 2014, they helpfully provide the buy-and-hold return since inception, which was +3.68%.  That gives a difference of 6.24% of how much average investors earned less than the buy-and-hold investors.  This is not meant to be a criticism of Hussman’s performance or methods, but simply a demonstration that a lot of people invested money after the fund’s good years, and then removed money after years of underperformance.  They timed their investment in a market-timing fund poorly.

Now, Hussman’s fund may do better when the boom/bust cycle turns if his system makes the right move somewhere near the bottom of the cycle.  That didn’t happen in 2009, and thus the present state of affairs.  I am reluctant to criticize, though, because I tried running a strategy like this for some of my own clients and did not do well at it.  But when I realized that I did not have the personal ability/willingness to buy when valuations were high even though the model said to do so because of momentum, rather than compound an error, I shut down the product, and refunded some fees.

One thing I can say with reasonable confidence, though: the low returns of the past by themselves are not a reason to not invest in Mr. Hussman’s funds.  Past returns by themselves tell you almost nothing about future returns.  The hard questions with a fund like this are: when will the cycle turn from bullish to bearish?  (So that you can decide how long you are willing to sit on the sidelines), and when the cycle turns from bearish to bullish, will Mr. Hussman make the right decision then?

Those questions are impossible to answer with any precision, but at least those are the right questions to ask.  What, you’d rather have the answer to a simple question like how did it return in the past, that has no bearing on how the fund will do in the future?  Sadly, that is the answer that propels more investment decisions than any other, and it is what leads to bad overall investment returns on average.

PS — In future articles in this irregular series, I will apply this to the Financial Sector Spider [XLF], and perhaps some fund of Kenneth Heebner’s.  Till then.