Asset Allocation – Page 19

Responding to a Bright Reader

Posted on 21 March 2011 by David Merkel

One of my readers made some good comments, and asked some good questions, so I am responding here.? From the article, Dave, What Should I Do? (3):

DM: Some of my friends want to invest with me, but I am not a total solution to anyone?s financial needs, because the only stuff I am managing is the risk capital.

Reader: Just curious, why did you choose to go this route instead of the “total solution” route.

Later in this post, you have very detailed bond fund recommendations, so why not just manage the total portfolio with the appropriate asset allocation across risk capital versus bonds?

I’m not seeing the advantage of just the risk capital approach. It seems like less AUM, and less fees, and the client still has to figure out what to do with the remainder of the investable capital.

Between your comments, and requests from clients and potential clients, that is what led me to start the fixed income strategy.? I am moving some of my family’s assets into that strategy so that I have “skin in the game.”? I always thought I would do this, but I thought it would come later.? Reality has intervened.

And, from the article, Managing Fixed Income for Equity Clients:

Given your background, I would think managing the bond portion would be almost a triviality. I would assume for bigger accounts you could do individual bonds effectively, and I understand for smaller accounts going the CEF/ETF route. I am genuinely curious why for smaller accounts you would totally avoid actively managed bond funds. This is what I currently do. I use Hussman Total Return and PIMCO Total Return for my bond allocation, but I have been thinking about further diversifying that. I?ve been thinking of adding Jeff Gundlach?s new fund now that he is on his own. My understanding is he is considered one of the top bond fund managers. I?ve also heard Dan Fuss from Loomis Sayles is really good. My thought with the bond allocation is to put it on auto-pilot as much as possible, and focus my efforts on generating alpha in the risk asset part of the portfolio.On a broader point, I think you are right about offering this, because I think most people are looking for a ?total solutions? provider. If one only manages the equity allocation, then I think you almost have to stress that to the client, and then they are still left to their own devices on what to do with the rest of the investable money. My thought is why give up that business and more importantly are you really helping that person by basically saying I only do A and you are on your own for the rest. In my view, managing the total portfolio is really win-win for both the advisor and client, and I am actually surprised at the number of advisors who only do stock-picking. My thought is they largely only do that because that is what they like.

Anyways, I hope this has been somewhat helpful, and I?d love your feedback on some of the funds I mentioned if you care to offer it.

I have respect for Dan Fuss, Jeff Gundlach, John Hussman, Vanguard and Pimco.? Pimco is misunderstood, because it is a quant shop, and uses a ton of fixed income derivatives.? Vanguard has the most durable advantage because of low expenses.

Why am I not using actively managed bond funds?? I would rather work with simple vehicles that allow me to express my macro views, and have low costs for clients.? I am the manager.? If I use actively managed funds, I am the manager of managers.? That is not what I want to be.? Eventually, if my fixed income assets get big enough, I will stop using funds and buy bonds directly.? And that will be a lot of fun, because when I managed a lot of bond assets, I was able to add a lot of value through clever trading.

And from the article Abandon All Hope All Ye Who Enter Here:

1.? What do you mean by “dual currency”?

2.? In your view, what are the investment/portfolio implications of what appears to be the inevitability of nothing meaningful getting done on fiscal policy until the crisis hits with full force.? Seems to me many, even highly intelligent people, believe we can put off adjustments for another day down the road.

http://oldprof.typepad.com/a_dash_of_insight/2011/03/constructive-postponement.html

Dual currency means that a nation has two currencies, one for domestic dealings, and one for international dealings.? I do not advocate it, but such a system can be used to favor domestic interests over international interests, or vice-versa.? It depends what the government wants to do.? Historically, there have been cases where a government under stress:

defaults on foreign obligations
defaults on domestic obligations
defaults on both

The dual currency helps with the first two options, because it allows the government to easily choose who to pay.

On the fiscal policy deadlock: the credit cycle is unpredictable in term of detailed timing.? How much more the credit cycle as applied to governments, which “never go broke.”? Things are great until they aren’t.? Who predicted that the PIIGS would erupt specifically in 2010?? Seeing the troubles is easy, naming the time is tough.

Delay merely makes the future solutions tougher, because the problem to solve is bigger.? The trouble is, we don’t know what actions our government will take.? I lean toward inflation, given the tendency of American history, but who can tell?

This is a tough time to be managing bonds, but what time isn’t?

Why it is Difficult to Improve Matters with Defined Benefit Plans

Posted on 10 March 2011 by David Merkel

A few notes before I begin for the evening.? First, I have two piles of books sitting next to me — one pile of mediocre books, and one pile of lousy books.? Should I review them, at least in summary form, or should I leave them unreviewed?? It’s ten books in all.? I never know what to do with books that are marginal at best.

Second, with the aid of one of my children, I have completed categorizing my book reviews.? All of my book reviews are ranked within their categories, with links to my reviews, and commentary on who the books might be useful to.

Onto tonight’s thoughts with an email from a reader:

I?m a big fan of your blog and have kept up with it since I started in the investment industry 3 years ago.? I was wondering if you had any advice on standing out in the Defined Benefit world as far as process and investing goes.? I?m on a team that has developed an investment style and philosophy that is highly unique to retirement planning for individuals/families, but it has become very difficult to translate that into the DB world.

I’ve been on both sides of the table here.? I’ve worked with DB plans, Trustee-directed DC plans, 401(k) and similar plans, and individuals.? Personally I would like to work with more DB plans myself, but I will share with you what I know or believe.

The first distinction with DB plans is do they retain a investment consultant or not?? If the answer is not, it means that they might not be slaves to modern portfolio theory, and might think about investment in a more businesslike way.? They would probably be more responsive to the way you do things.

If they have a consultant, then you have to approach them through the consultant.? The consultant is in a tough spot.? Most of them don’t know much about investing, but they have a wide variety of quantitative tools that have been developed by academics that allow the consultants to protect themselves while delivering little-positive-to-large-negative results for clients.

All of the statistics that the fund management consultants calculate assume a world where risk is equivalent to variation, rather than permanent loss of capital.? The consultants would rather see someone that outperforms by a tiny bit each period, than a manager that outperforms by a lot over the same set of periods, but with a lot of variability.? They are the opposite of Buffett’s phrase, “I would rather have a lumpy 15% than a smooth 12%.”

With DB plans, all they care about is investment results versus their benchmark.? They don’t care so much about winning, because they can blame and remove underperforming managers who consistently miss by a little.? What they do care about is those that miss by a lot, because that could cost them their cushy jobs.

This is one area of investing that I would purge if I could; in general, the fund manager consultants do little for the plans they serve.? Far better if the consultants actively analyzed risk, and encouraged plans to take more/less risk when circumstances favored/disfavored it.

Instead, they propagate views that are risk-neutral, as if all styles are equally valid all of the time, and all asset classes are equally valid all of the time.

Now with individuals the game is different, because there are ways to add value through tax-management, and in some cases, ethics management.? With pension plans, those issues are moot.

Now, if you have a good track record of delivering alpha with little variation versus some sector of the market, or the market as a whole, advertise that to the fund management consultants.? Get in the databases.? It’s all a performance game, and one with little tolerance for variability versus their benchmark indexes.

So, part of the reason for your difficulty stems from this: the market to serve individuals is a free market, albeit one where there are a lot of charlatans plying their trade.? The market for DB plans is a bureaucratic market for the most part, one where sponsors who don’t know investing abandon their responsibility to other who have modest math skills, but who also don’t know investing.

That is your problem, and mine as well.? More is the pity for the sponsors of DB plans.? They are the ones who get hurt in the long run.? A pity they never learn, but only terminate.

Musings on Yield

Posted on 1 March 2011 by David Merkel

When I closed my piece on Warren Buffett’s Annual Letter, I ended with an important statement tat when I read it in the morning, I thought many would find it cryptic.? Here it is:

And much as I like Buffett and Ray DeVoe, I would like my readers to internalize that there is no such thing as yield.? Yield is the decision of the company, but what you should? ask is what is the increase in value of the company.? Look for investments that increase your net worth the most.

And I would add “With an eye toward safety.”

When I say there is no such thing as yield, I am overstating a matter to make a point.

Will the debtor make the interest (or principal) payment?
Will the company pay the regular dividend?? Will they increase it?
Will you be able to hold the instrument so that you can realize the yield over the long haul?

During times of stress, yield has a nasty tendency to disappear, often with significant principal losses.? Thus I am skittish whenever I hear someone say that they need to get a certain yield.

Individuals and Institutions, for better, but usually for worse, often rely on getting a certain yield from fixed income investments.

If I don’t get this yield, I won’t be able to meet my monthly expenses.
If I don’t get this yield, my quarterly earnings will miss.
If I don’t get this yield, our ability to support our charitable endeavors will suffer.

Sigh.? Look, this could have been entitled “Education of a Corporate Bond Manager, Part 13,” but I didn’t because this is more broad and important.? It affects everyone.

Once there are no wages/nonfinancial profits, investors usually move into a yield-seeking mode.? I experienced this in spades for the insurance company that I helped to manage money for.

And yet, in the midst of the furor 2001-2003, we often acted against the insurer’s wishes in order to save their hide.? Particularly me; I could not bear doing the wrong thing, thinking that I would have the failure of an insurer on my conscience.

So in the midst of the nuttiness of 2002, I often did up-in-credit trades, reducing complexity trades, etc., when the market favored it.? Lose yield, gain safety, when the market is hot.? (Not when it is cold.)

I preserved the capital of the insurer, and it survived.? I even made extra money for them in the process, which they wasted on writing underpriced annuity business.

There was no level of yield that could have satisfied that client, even assuming that we could get it with safety.

But now as I start my asset management business, I deal with clients that are aiming for a certain yield.? To my surprise, even my Mom, the one who taught me the rudiments of investing is seeking for yield now.

You might or might not recall that the fourth real post at this blog was entitled Yield = Poison.? There are times to look for yield, and times not to.? The times not to are when yields and spreads are low.? At such a time, the best decision is not to reach for yield, but rather to forgo yield and preserve capital.? Buy TIPS, foreign bonds, and move up in quality and down in maturity in dollar terms.

I did this for an internal client 2004-2007, and made money for them, but it was utterly unconventional.? They could afford to deal with my idiosyncracies, because they didn’t need a current yield.

So, as I move to offer a fixed income strategy, I find myself butting heads with those that want a reliable income from bonds, and other fixed income instruments.? I’m sorry, but preserving principal is more important than getting yield.? Far better to eat into principal a little when spreads are tight, than to meet the spread target and get whacked in the bear phase of the credit cycle.

So, do I have a market for such investing in bonds, or is human nature so unchangeably mixed up that there will be few if any takers for my fixed income management?? Sadly, I think the answer is the latter.

Critical Analysis of Buffett?s Annual Report

Posted on 1 March 20111 March 2011 by David Merkel

After reviewing what I wrote Saturday night on Buffett’s Annual Letter to shareholders, I said to myself, “That wasn’t very critical.”? Now perhaps I have less to criticize him over — he isn’t boasting about risk free retroactive profits, or being a significant player in life settlements, two things I find morally dubious at best.

But today I reviewed the Annual Report and the 10-K.? The two are very similar; I will only mention one thing from the 10-K, but that one thing is big.

But let’s start with basic blocking and tackling.? Start with the income statement, balance sheet, and cash flow statements of Berky.? The balance sheet and income statements split out by division, but the cash flow statement does not.? The cash flow statement has the fine distinctions for the company in aggregate, but the income statements and balance sheet do not.

I want the best of both worlds. I want the cash flow statement segmented, and I want enterprise-wide income statements and balance sheets for Berky, with fine levels of detail.? I want those without eliminating what is being done now.? That would not be a lot of extra work, and it would only add a few pages to the 10-K — the work is probably done already; all that needs to be done is the formatting.

Notes

1) Berky trades at 1.9x tangible book.? Not saying that it is fair or unfair.? It is what it is.? (When one of my kids says that, I reply, “Except when it’s not.”)

2) From page 44, Buffett made some tremendous deals during the crisis, but the lesson here is to have dry powder.? Buffett made great decisions with respect to Goldman Sachs, GE, Dow Chemical, Swiss Re, and Wrigley.

3) On page 50 there is positive prior year reserve development for the last three years.? I don’t know how far that goes back; I will have to research that.? But as I reviewed their reserving policies, I thought they were more than reasonable.? They seemed to be a good mix of methods and judgment.

4) I don’t fault Buffett on derivatives.? One can use them wisely while decrying their stupid use.

Where I have more difficulty is trying to justify the amounts on the balance sheet.? My view of level 3 assets is that those holding them should spill the calculations in detail.? We don’t have that here with Berky, though it is better than many companies.

That Berky does not have to post collateral for the most part is significant, and lends to their creditworthiness.

5) Statutory surplus had to increase at the main P&C insurance subsidiaries, because of the acquisition of Burlington Northern.? Why?? I’m not sure.? Ideas?

6) On page 60, the expected return assumption should not have risen 2009 to 2010.? 7.1% is too high as a long-term assumption — something in the 5-6% range is reasonable.

7) Berky is half an insurance company, and half and industrial/utility company.? It is neither fish nor fowl, and that is what helps make analysis difficult.

8 ) If I were made President/COO of Berky, would I centralize hiring and procurement?? No, but I would hesitate before answering.? Berky is so unstructured, that there have to be some gains from centralizing, but that said, you don’t want to negatively affect the culture of Berky, which allows acquisitions to continue as if they had not been acquired.? That might be changed cfter the death of Buffett, but who can tell?? There is a competitive strength in Berky for leaving operations alone — many sellers who love their employees like that.

9) ?We view insurance businesses as possessing two distinct operations ? underwriting and investing.? So it says on page 68.? And how beautiful, underwriting gains every year in every segment.? I have not traced the history here, though I know that Berky has been better than most companies.? I would only note that the value of float depends on how long the float exists.

10) On page 70, Buffett admits that Workers Comp and other casualty have not done well, which is rare among the lines that have done well.

11)? On page 71, he admits that terms are not generally attractive for life business.? Also oddly, there are no life premiums earned in 2008 and 2009, but losses in both years.? I don’t get this.

12) On page 74, the allocations to junk debt seems too high, though I might make that bet as well.? Where else do you go in this environment?? The high allocations to foreign debt I suspect are there to immunize Berky on foreign liabilities it has written.

13) Page 76 contains what I think is the core strategy for Berky — Inflation-protected investments in regulated industries funded by the short-term float generated from writing P&C insurance.

14) Page 78 shows how economically sensitive “other manufacturing” can be for Berky, in that profits doubled over 2009.

15) Page 79 — The change in NetJets was the decisive factor as far as changes in the profitability of Berky’s service businesses.? Score a big one for David Sokol.

16) Page 81 — the discussion on impairment of equity stakes is fascinating, but I think it would all be easier if Buffett just valued everything at market.? Who cares at what level you bought it?? The important question is for what can you sell it?

17) The Contractual Obligations exhibit on page 84 made me edgy, because total obligations are large relative to assets.? Then I took a step back and said, “But that’s the nature of liabilities, and the difference between that and the value of liabilities is not large.”? All that said, review my second risk factor at the end of this article.

18) On page 94, it reveals that Berky is mismatched short, assets versus liabilities.? That is a bet that I would take as well, but it is a bet.?? In a depressionary scenario, it would get pinched.

19) On page 97, he lists his “owner related business principles.”? I am an admirer here — the ethics are excellent, relative to the rest of our financial markets.? If I wee summarizing much of it I would say:

Ignore the accounting if it doesn?t represent the economic reality.
Act like an owner.
Lumpiness is normal for good investments.? Don’t look for smooth results.

20) I appreciate the humility that Buffett displays on point 9 of his principles. He didn’t phrase it right, and now he has corrected it.

But now for what should be at the top of what Warren writes:

The Two Real Risks for Berky

From the 10-K on page 19:

Insurance subsidiaries? investments are unusually concentrated and fair values are subject to loss in value.

Compared to other insurers, our insurance subsidiaries invest an unusually high percentage of their assets in common stocks and diversify their portfolios far less than is conventional. A significant decline in the general stock market or in the price of major investments may produce a large decrease in our consolidated shareholders? equity and under certain circumstances may require the recognition of losses in the statement of earnings. Decreases in values of equity investments can have a material adverse effect on our consolidated book value per share.

If I were Buffett, I would put this on page one of his shareholder letter, because this is the biggest risk.? No other insurance company in the US takes as much equity risk as Berky.? Buffett is a great investor, but in a Great Depression scenario, Berky could be a zonk.

The second risk is more quiet and insidious.? Debt has grown where the Berky parent company is on the hook, whether directly, or by guarantee, as at the finance subsidiary.? This was AIG ten to fifteen years ago.? The initial increase in debt was innocuous, but it led to more increases in debt.? After 20 years, AIG was overindebted both in cash terms and synthetically.

What I am saying is that once the discipline against debt is breached, it becomes easy to justify more debt.? I think we are seeing that now, and Buffett is compromising his principles.

Hey, Greenberg eschewed debt for two decades, and then piled it on for two decades.? Is Buffett doing the same thing?? Personally, I think he is, though I don’t think he has thought it through.? Warren, if you are reading me, pull back on the debt.? It killed Hank.

Problems with Constant Compound Interest (5)

Posted on 23 February 2011 by David Merkel

This is a continuation of an irregular series which you can find here.? Maybe if I were more scientific, I would have called it “All Exponential Growth Processes Run Into Constraints and Threats,” or if I were more poetic, “Nothing Lasts Forever — Nothing Grows to the Sky.”

Regardless, simple modeling is the bane of long-duration financial calculations.? I remember talking with some friends who served on a charitable board with me, about some investment grade long bonds (11-30 years) that I had purchased for a life insurance client that yielded 7-9% in late 1999.? They said to me that it was foolish to lock up money for so long in bonds, when you could earn so much more in stocks.? My three comments to them were:

Prohibitive for life insurers to hold equities
At current levels of the market, the yield of these bonds more than compensates for the possibility of capital growth in equities (valuations are stretched)
The risk in the bonds is a lot lower.

And, I said we ought to shift shift our charity’s asset allocation to more bonds, as we were invested past the maximum of our guidelines in equities.? They looked in the rearview mirror and said that we were doing fabulous.? Why change success?

I was outvoted; I was a one-man minority.? There are a lot of people who would have loved to make that change in hindsight, but done is done.? I ended up leaving the board a year later over a related issue.

Now, don’t think that I am advising the same in 2011.? We may be headed for significant inflation or deflation; it is difficult to tell which.? Bonds offer little competition to equities here.? Commodities and cash may be better, but I am reluctant to be too dogmatic.? If the economy turns down again, long Treasuries would be best.

Here’s the difficulty: most people have been trained to think at least one of a few things that are wrong:

That we can use simple models to forecast future outcomes.
That average people are capable of avoiding fear and greed when it comes to investing.
That financial markets are random in the sense that last period’s return has no effect on the returns of future periods.
Over long periods of time, average investors can beat long Treasuries by more than 2%/year.? (Corollary to the idea that the equity premium is 4-6% versus 0-2%/year over high quality bonds.)
That financial markets are expressions of what is going on in the real economy.
That the real economy tends toward stability
That government actions make the real economy more stable

I’m prompted to write this because of two articles that I ran across in the last day: Retiring Boomers Find 401(k) Plans Fall Short, and Stay Out of the ROOM (registration required).

I’ve written about this before in many places, including Ancient and Modern: The Retirement Tripod.? And yet, when I wrote about these issues 20 years ago, one of the things that I tried to point out was that as the demographic bulge retired, it would be difficult for homes and asset markets to throw off the returns necessary, because there would not be enough buyers for the assets/homes.? If a large portion of the population wants to convert assets into a stream of income — guess what?? They are forced sellers, and yields that they will get will be compressed as a result.

In a situation like that, those that are better off, and can delay turning all of their assets into an earnings stream should be disproportionately better off.? As with corporations, so with individuals/families: those with slack assets and flexibility are able to deal with volatility better than those for whom the environment must be stable/favorable for the plan to succeed.

Now, the Wall Street Journal article points at the problems of 401(k) plans.? What they say is true, but the same is true of other types of defined contribution and defined benefit plans.? When assets underperform, and/or investors make bad choices, guess what?? The pain has to be compensated for somehow:

401(k): They will work longer, maybe all of the rest of their lives, and cut back on expenses and dreams.
Non-contributory DC: maybe the employer will ask them to kick in voluntarily, or he might give more.? Also same as 401(k)…
Private sector DB plans: employers may contribute more, or they may terminate them.
Public sector DB plans: Taxes may rise, spending cuts enacted, forced contributions to retiree plans negotiated, plans terminated for a 457 plan, partial plan termination, job cuts, funny accounting practices (worse than the private sphere), brinksmanship over debts, etc.

Note that one of the answers is not “take more risk.”? First, risk and return are virtually uncorrelated in practice.? Only when enough people realize that might risk and return become positively correlated.? Second, there are times to increase and decrease risk exposure.? Typical people won’t want to do that, because of euphoria (the example of my friends above) and panic.? The time to add to high risk assets is when no one wants to touch a high yield bond.? More broadly, always look for asset classes that throw off the best cash flow yields, conservatively estimated, over the next ten-plus years.? Be sure and factor in the likelihood for economic regime changes and capital loss, inflation, deflation, etc.

Good asset allocation marries the time horizon of an investor to the forecasts for future returns, conservatively stated, and considers what could go wrong.? At present, investment opportunities are average-ish.? I would be wary of stretching for yield here, or raising my risk exposure in equities.? Stick with high quality.

And, for those that are retired, I would be wary of taking too much into income.? I have a simple formula for how much one could take from an endowment at maximum:

10 Year Treasury Yield
Plus a credit spread — 2% if spreads are sky-high, 1% if they are good, 0.5% if they are tight.
less losses and fees of 0.5% — higher if investment expenses are over 0.25%.

Not very scientific, but I think it is realistic.? At a 3.5% 10-yr T-note yield, that puts me at a 4% maximum withdrawal rate, given a 1% credit spread.? This attempts to marry withdrawals to alternative uses for capital in the market.? You may withdraw more when opportunities are high, and less when they are low.? (But who can be flexible enough to have a maximum spending policy that varies over time?)

Now some of the advanced models that calculate odds of retiring successfully are a step in the right direction, but they also need to reflect demographics, time-correlation of returns, regime-shifting returns/economics, etc.? Things don’t move randomly in markets; that doesn’t mean I know which way things are going, but it does mean I should be cautious unless the market is offering me a fat pitch to hit.

These statements apply to governments as well, and their financial security programs.? In aggregate, investments can’t outgrow growth in GDP by much, unless labor takes a progressively lower share of national income.? (And who knows, but that the pressure on union DB plans to earn high returns might lead to takeovers/layoffs in private firms…)? The real economy and the financial economy are one over the long haul, but can drift apart considerably in the intermediate-term.

In summary, any long promise/analysis/plan made must reflect the realities that I mention here.? We’ve spent years on the illusions generated by assuming high returns off of financial assets.? Now with the first Baby Boomers trying to retire, the reality has arrived — sorry, not everyone in a large birth cohort can retire comfortably.? Wish it could be otherwise, but the economy as a whole can’t generate enough to make that proposition work.

I don’t intend that this series have more parts, but if one strikes me, I will write again.

Book Review: Never Buy Another Stock Again

Posted on 2 February 2011 by David Merkel

With this book review, I put a knife to my throat.? Alas, I have been investing in individual stocks for over 23 years, and have done well the whole way.? Is it time to abandon my craft?

No, and I think the author would agree.? He is making a relative argument but the title phrases it in absolute terms.? On average, the advantage of investing in stocks is smaller than commonly believed, and for investors that can’t keep their wits about them when all is going wrong, the results are worse still.

This book attempts to infuse common sense (ordinarily sorely lacking in investments) into readers who are retail investors.

One nice feature of the book is that the author recapitulates everything in each chapter in a closing section entitled “Boiling It Down.”

Another nice feature of the book is that the author went and interviewed clever asset managers to flesh out his own understanding of the topic.? That helped produce a much richer book.

Quibbles

I don’t go in for using stop losses.? I analyze risk, and there will be a tiny number that really hurt, but the cost of using stop losses is missing the frequent snapback rallies, which on average in my experience more than pay for the losses.

Also, in this environment, where everything is so correlated, because of ETFs, he recognizes the difficulty of achieving real diversification.? But in his asset allocation advice, it is as if he forgot this.? If I were rewriting his asset allocation chapter, I would have introduced the concept of the credit cycle, and why good asset allocators vary their positions based on the opportunity offered, rather than a more static view of asset allocation.

I also would have given a little more credit to value investing.? If you are going to be anything but a trader, you may as well focus on value.

But on the whole, this was a very good book, and these are quibbles.? He writes very well, far better than me.

Who would benefit from this book:

Most inexperienced to moderate investors would benefit from this book.? It would help them to avoid common mistakes in investing, as well as make them aware of modern problems in investing that classic texts would not have been aware.

If you want to, you can buy it here: Never Buy Another Stock Again: The Investing Portfolio that Will Preserve Your Wealth and Your Sanity.

Full disclosure: This book was sent to me, because I asked for it, after the publishers offered me a copy.

If you enter Amazon through my site, and you buy anything, 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.

Dave, What Should I Do? (3)

Posted on 18 January 2011 by David Merkel

Some of my friends want to invest with me, but I am not a total solution to anyone’s financial needs, because the only stuff I am managing is the risk capital.? All of my clients have to go through a suitability check, where I tell some of them, “No.? That is too much money to place with me.? You would be placing more money at risk than would be good for you.”

I do that even more with close friends.? Why?? They want to support me.? They have a non-economic reason to invest with me, so I have to be all the more prudent and tell them in many cases, “Not so much invested with me.”? Eeee, my wife worries about investing the money of friends.? So do I, but I also know that I have done well for myself over the last 20 years, and my friends could do worse than investing with me.

So, I have four friends to talk about tonight.

1) 91-year old widow, mother/mother-in-law of some dear friends of mine.? Has all of her money in a money market fund in a bank, and earning what is a very good yield for a money market fund.? Bank isn’t in the greatest shape, but the amount is below the FDIC’s limits.? She doesn’t need the money because she has a pension that more than cares for her needs, and she lives with my friends.? Very conservative lady; does not want to take risk, but she asked for advice.? The excess money would go to her children at death, she already gives them some excess each year now.

I ended up saying that I thought I could earn more for her, but that it was by no means certain.? I thought it would be 1 in 3 over the next ten years that the strategy might lose versus her money market funds.? The FDIC should be good if the US government is good, and for her likely lifetime it probably is.? So she decided to stay where she was.? Easy, and, it keeps the dear old lady from worry.

2) A friend, 55, wants to retire 65-70.? Owns two houses free and clear near DC.? Wants to invest all of his IRA assets with me.? I tell him, “No more than 50% with me, and the rest in bonds.”? So, he says that he has an account at Vanguard.? What should he invest in?? I suggest:

23% Short-Term Investment Grade [VFSTX]
23% High Yield Corp [VWEHX]
23% Inflation Protected Securities [VIPSX]
23% Total Bond Market Index [VBMFX]
8% Long-Term Treasury [VUSTX]

Why did I suggest this?? Credit should do well over the next year, and this portfolio will hedge somewhat against inflation, and to a greater extent deflation.? The duration on this set of funds is below the market average, quality is above, and yield is above as well.? Also, convexity/optionality is above average, and will leave room to make changes.

3) Another friend, born 6 days after me (50), just changed jobs.? Wants advice on the new 401(k) plan, again Vanguard, but a different selection set.? They may want to invest some taxable money with me after that, but who can tell… one thing for sure, I never want to push anyone to invest with me.

I ended up suggesting:

15% V Wellington Trust TIPS Portfolio
15% V Short-Term Bond Index
10% V Target Retirement Income Trust (30% equities)
10% V Total Bond Market Index
10% V FTSE All-World Ex-US Index
10% Templeton Foreign Equity
10% V PRIMECAP
10% V Midcap Value
10% Longleaf Partners Small Capital

That would give reasonable diversification across a broad number of scenarios, and a tilt toward equities versus bonds — 53/47%.

4) The widow of the dear guy I call “The Collector” asked for more advice.? I call him “The Collector” because he bought new funds frequently with new money over many years, and he had a reasonably good eye for managers.? I can kind of guess when he bought them — many did quite well in their time.

But she wants income, so she wants to sell a couple of funds that she owns, and buy some Wells Fargo.? I have no objection to the sale of the funds, but she will not earn much income from Wells Fargo, and she already has too much single stock risk , including existing holdings of Wells Fargo.? What I need to tell her is to use the proceeds add to her holdings in Vanguard Wellington and Wellesley Income funds, both very well run.

I also need to explain to her that total return matters more than current income.? Income can be generated by liquidating small amounts of funds expected to underperform.? (I have given her a list tagging funds add, keep, reduce.)

So it goes.? It is a tough time to be investing, but as a new friend pointed out to me recently, quoting T. Rowe Price, “The hardest time to invest is today.”? Sage words.? The present is always a balance between bullishness and bearishness.

Be Prepared! What if Things Go Right?

Posted on 22 December 2010 by David Merkel

Before I start this evening, the Aleph Blog Lunch scheduled for 12/29 will start at Noon, not 1PM.

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Though the US equity market seems short-term overbought, I want to poke at an area of the investment space that is more bearish than me.? Though I admit there are many problems in the world today, investment is still a question of buying assets that will deliver the greatest amount of purchasing power over time.

And though I don’t think the equity premium is high on average, I certainly prefer stocks to bonds here.? Cash is another matter — I could see both stocks and bonds decline over the next year, though that is not my default scenario.? Commodities are tougher, and I don’t have a strong opinion.

But I could be wrong in a wide number of ways.? If one looked at my personal asset allocation, it would look something like this:

House 15%
Private equity/debt 12% (I’m an angel on the side?? Well, sort of.? I help close friends.? The debt was in my opinion junk grade, and now investment grade.)
Cash 10%
TIPS 3%
Public equities 60%

That doesn’t look so bearish.? Part of my operating philosophy is that over time, things do tend to go right, but not all of the time.? Great Depressions are normal events, not abnormal events.? They occur because we have a debt-fueled expansion in some major asset that is a temporarily virtuous cycle, until players begin relying on capital gains to keep their position financed.? That doesn’t happen, and the asset bubble begins to unwind leading to debt problems.

At present, we are part way through the debt crisis.? The banks aren’t in great shape yet; I still think that their assets may be overstated on their balance sheets.? It remains to be seen whether the banking crisis will turn into? a sovereign crisis.? In the Eurozone, it may be worse.? The mechanisms they are trying to set up are trying to defuse the risks of Eur0fringe credits to Eurocore banks.? Cheaper for Eurocore governments to discourage lending to the Eurofringe, much as that cuts against the concept of a common market.

The debt crisis is not over; it is morphing into a sovereign crisis, aid by the growing unfunded liabilities from government pensions and healthcare.

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At present I see professionals bullish on stocks, and bearish on bonds.? They are expecting that GDP growth will pick up, and inflation be moderate.

I think stagflation is a real possibility, with inflation and unemployment rising. That would be bearish for bonds, and less so for stocks.

But back to my original point. I don’t have simply one estimate of where things are going, I have many estimates, and it is quite possible that things go right.? Governments and policy makers have an interest in making sure things go right, so it is not airy fairy to presume that the present condition will continue, even if real growth slows.

A great trouble with a dynamic economy is that it is not possible to compare eras, because the underlying structures of each era changes.

And so at present I muddle in the middle, investing on the low side of bullishness.

http://alephblog.com/2010/12/18/aleph-blog-lunch-12292010/

Active Share

Posted on 18 December 201019 December 2010 by David Merkel

I often have to deal with practical “small institution” problems, because of the church I belong to.? Here are two of them:

1) The pastors have a defined contribution plan.? There are two questions.? Are the funds the best that we can get?? Are the asset allocation options that draw from those funds properly calculated? (Two-thirds of the pastors use those.)

For the first question, we have a board member who works for a major fund consultant.? He will easily be able to answer the question.? As for the second question, I have analyzed how the offered funds have done over the last 20 years.? Those allocations have done well in the past.? The problem is, when did the consultant do the look backwards and set the percentages?

The tendency is that once the percentages are set, future performance tends to decline.? Select managers who have done better than they normally would, and watch them regress to the mean, or worse.

My view is select managers that have done well for reasons that are not common to the environment that they were in.? There are often trends that benefit certain managers, then once the trend goes, they are gone as well.? But who did well in spite of the trend?? Those are managers to look at.

2) Recently, four members of my congregation came to me and said, “Here’s the list of managers in my401(k), who should I invest with?”? and “Here’s the portfolio my husband left me (after death), what should I do?? I can never turn down a friend, and particularly not a widow.

This was interesting.? As I looked into the mutual funds, I relied less and less on the performance statistics, and Morningstar stars, but looked at the actual portfolios in concert with performance, and decided that those with unusual portfolios with reasonably good performance were better choices.? Why?? They aren’t following the market.

Today, I ran into a name for that concept: Active Share.? How much does a manager vary from the index?? If you’re going to be an active manager, you ought to vary from the index quite a bit.? That is what you should be paid to do.

“But wait,” says the fund marketer, “Beating the index is the best, but missing the index is the worst.? We survive best with performance that is out of the fourth quartile.? So hug the index as you make modest bets against the index.”

Those are the portfolios I want to avoid.? An article in the WSJ concurs.? Don’t pay active fees for index-like performance.

I feel that way about my own investing.? If I am not looking at stocks that are less considered than most, then what am I getting paid for?? I would rather fail unconventionally than succeed conventionally.

And yet I know that managers that have high active shares, though they may do well on average, get excluded by fund management consultants, because they are too unpredictable.

Look, I am trying to make money for clients.? Consultants are a necessary evil in that process.?? Clients would be better off without consultants, but that will never happen, because clients want to stay out of the fourth quartile.

My active share is large, and I have done well.? Does that mean that a lot of people will invest with me?? Probably not, because they are not willing to endure an odd portfolio that isn’t mainstream.? Well, that is their loss.

Book Review: What Investors Really Want

Posted on 18 December 2010 by David Merkel

Meir Statman wants to tell us about the human condition.? We make bad economic decisions regarding investments.? That comes mostly from having multiple desires regarding investing that are inconsistent.? What are our problems?

We look for free lunches.
We think he past is prologue.
We get hopeful.
We want to look like a winner for friends.
We follow the herd.
We are reckless with money not easily earned.
We save too little.
We want an option on riches, and a guarantee against poverty.
We are loss averse.
We are tax averse.
We want to be accepted into exclusive investments.
We want our investments to reflect our values.
We want fairness.
We want our progeny to thrive.
We don’t know what we are doing, can someone teach us?

The spirit of the book says to me that most people don’t have the vaguest idea on what to do with investments.? They invest for many reasons, many of which are not economic.

This is a reason why pension plans should strip the investment authority away from participants, and put it in the hands of trustees.? Face it, only 20% of people at most know how to invest.? Amateurs have a hard time? distinguishing between the long-run and the short-run.

My take is that one has to unemotional, Vulcan-like, in investing, in order to be successful.? Our feelings, whether of fear or greed, deceive us.? We must resist and suppress our feelings in order to be good investors.? And as for me, it took me 5-10 years to get there.? By the time I was done, I created a system that tied my hands when I would be tempted to make a rash decision.

Quibbles

Page 84 demonstrates how short-sighted people pay up for flexibility, paying credit card rates for extra cash. On pages 96-97, he managed to convince me by bad arguments that the old system of segregating capital and income is correct.? Truth, a market-base spend in rule would float with the 10-year Treasury yield, with adjustment for how optimistic we are about the stock market.? Unless the income taken from an endowment floats with the market, it is not possible to be fair across eras.

The book describes our problems in economic decision-making, but provides no cure.? The last chapter tries to make up for it, by suggesting that an intelligent mix of paternalism and libertarianism would be the best solution.

Yes, that would be the best solution, but the devil is in the details, and the author spells out few of them.

Who would benefit from this book:

Anyone wanting to understand why he makes bad economic decisions would benefit from this book.? That would include most of us, and me.? As you read it, think of how you would change your behavior for your good.? Personally, I have designed my buying and selling methods in the stock market to avoid these troubles, but it means I have to have no emotions in the market, and that is tough to do.

If you want to, you can buy it here: What Investors Really Want.

Full disclosure: This book was sent to me, because I asked for it.