Asset Allocation – Page 20

Book Review: That Thing Rich People Do

Posted on 13 November 2010 by David Merkel

If you know anything about investments, this is not the book for you.? This is the book for your relative or friend that doesn’t have the barest idea about how to manage money.

This was another book that I thought I would not like after the first few chapters.? Too cutesy.? Too certain.? As the book moved on, it broadened out and gave the sort of advice that I would give to neophytes, with a few exceptions.

The book’s title derives from the show “30 Rock,” where the character played by Tina Fey says, “I have to do that thing rich people do, where they turn money into more money.” (Sigh.? I am so glad I don’t own a television.? Hey, let me give you some unsolicited advice: get rid of your television.? You will become far more rational and productive, and then, you will have more opportunities “to do that thing rich people do, where they turn money into more money.”? Sorry, turning rant mode off.)

This book gives the basics:

Saving
Stocks
Bonds
Asset allocation
Warnings on insurance and annuities.
Diversification
Avoiding Fear and Greed
Avoiding Expenses
Avoiding Taxes
Passive Investing (best for neophytes)
Further Reading — if a neophyte needed a book list to expand his knowledge, the author gives a good list.

The book is clearly written, and sometimes engaging, sometimes humorous.? But it gets the job done for neophytes, and that is what counts.

Quibbles

It would have been a benefit to the average reader to point them to Vanguard, especially for bonds, when expenses eat up so much of the returns.

Who would benefit from this book:

Only neophytes will benefit from this book.? It’s not long at ~140 pages; the chapters are easy to read at an average of 6 pages.

If you want to, you can buy it here: That Thing Rich People Do: Required Reading for Investors.

Full disclosure: I asked the publisher for a copy, and they sent one to me.

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.

Book Review: The Insured Portfolio

Posted on 15 October 201015 October 2010 by David Merkel

Do you have a lotta money?? Lotsa, lotsa money?? And is it liquid?? More than $5 million?? If so, I have a book that could help you, The Insured Portfolio: Your Gateway to Stress-Free Global Investments (Agora Series).

There are risks that the rich want to avoid, or at least minimize:

Losses from lawsuits
Estate taxes
Income taxes
Lack of flight capital, if things go really bad
Inflation, or loss of purchasing power
Fear of US degeneration: Do you want leave the US, renounce your citizenship, and minimize/eliminate your tax liability in the process?? It can be done, at least at present.

The first chapter describes the rise and decline of America.? It is a bit harsh, but for one following demographic trends, it is accurate.? So, why should you keep money in America, if things are so bad?? (Uh, stable politics, relative freedom…)

The second chapter introduces international investing, because diversifying internationally offers greater possibilities for profit and capital preservation, given the greater tendency of the US to inflate the currency.? To the authors, it is a panacea, and I find it somewhat unrealistic.

The third chapter goes into wills and trusts. How do you want to distribute your money after you die?? How much control do you want until then?

The fourth chapter describes insurance policies that minimize taxation, while allowing for limited asset diversification. The strategies are pretty basic, I have seen better.

The fifth chapter goes into tax havens.? Where can you minimize taxes and other costs best? I found this to be pretty boilerplate; if you pay attention, the tax havens are well-known, with their relative liabilities.

The final chapter tries to tie it all together, but it is all generalities, with little additional substance.

This book would be useful to someone who has prospered dramatically and has never considered wealth preservation.? It gives a taste of all of the tools, but does not give enough to execute the tools on their own.? You will have to hire bright? experts to protect your wealth, but at least you will know what they are? doing, and will be able to spot phonies.

Quibbles

I dislike Agora because of the doom-and-gloom outlook that they possess, but this book does not share in that flaw to any large degree.? All of that said, all strategies that use insurance products are very expensive, and there is no proof that you can obtain above average returns on the assets.? The authors talk a good same, but they offer little proof of superior performance.

Who would benefit from this book:

Only the very wealthy could benefit from this book, and many of them have wealth advisers already, who can help them with tax avoidance and estate protection.? But this gives a good introduction to the topic so that a person could be wiser in hiring an adviser.? He would know what the issues are.

If you want to, you can buy it here: The Insured Portfolio: Your Gateway to Stress-Free Global Investments (Agora Series).

Full disclosure: I asked the publisher for a copy, and they sent one to me.

My Interview with David X. Martin

Posted on 27 September 201028 September 2010 by David Merkel

I had the pleasure today of interviewing David Martin who wrote the book Risk and the Smart Investor.? Unlike most of my book reviews, I have the fun of doing a voice interview and doing a written Q&A as well.? This piece will go over my voice interview.

Before I start, why did I decide to do so much with this book?? I did this because I have a love of risk management.? As I read through his book, I sensed a kindred soul who really got what is behind risk management.? I will not put out this much effort for an ordinary book.? I really liked this book, and after my voice interview I can say that I really liked David Martin.

My first question to David Martin was to ask you what motivated him to write the book.? He replied to me that as he had gone through life and learned things, his satchel filled up more and more.? The book was a way of emptying his satchel and giving back to average people.

If I might interject, that is my reason for writing this blog.? I’m not in it for the money; I don’t think David Martin is either.? But for some of us, when you have learned a lot, you feel a need to share it with others, not so much for your ego, but that others can benefit.

My second question to him was, ?If you could make a few key changes to the way we do risk management at financial firms in the United States, what would they be?”? After a pause, and saying that’s a big question, he gave me the following answer:

1) Risk management must be holistic.? It must look to the strategy being pursued, the risk involved, and then the capital needed to pursue such a strategy.

2) The risk manager must not only have a seat at the table but must have a voice at the table, with an independent channel to the Board of Directors like the internal audit function.? The Directors have to be aware of the risks that the company is taking.

3) Risk control must be grounded in reality.? It’s fine to have a quantitative model, but after his run for a while, do you test to see how it has performed?? (David Merkel: It is similar to what happens good insurance firms.? Good firms take the results of their valuation work and feed it back into their pricing, so that they do not under- or over-price their products.)? Testing is key.? Was the model truly predictive?? Did it really work?? Did you compare the results to half a dozen alternative models?

4) There are two visions on risk management.? Vision one is the huge screen in front of the risk manager, with advanced math and analytics, that takes in all the data, and allows the risk manager to make simple adjustments in real time to the quantitative feedback.? Vision two is having people with good business judgment look at the state of the markets and the positioning of the financial institution and making informed decisions.? Like me, David Martin favors the second vision.? Models will never be so good that a businessman with good judgment will be inferior.? This is one place where John Henry will beat the steam drill.

He added his experience the time that he met Peter Drucker.? He asked Drucker how one could predict the future.? Drucker answered that one could predict the future by attempting to create the future.

Now what Drucker said was not dumb, in my opinion.? And David Martin followed that advice by helping to create principles for risk management for buy side firms and for directors of mutual funds.? After all, why wait for the problems to come to you?? Why not create best practices now, and do better business for your clients, making yourself more immune to future lawsuits?

David Merkel: As Cordwainer Smith said in his short story ?Mother Hitton?s Littul Kittons,? “Bad communications deter theft; good communications discourage theft; perfect communications stop theft.”? The idea here is that good business practices are best for the client and the business in question.? Before you get sued, why not put something into place that minimizes your probability of getting sued, by maximizing the probability of doing business right?

My third question was: “Most of my readers are amateur investors.? What would you want to take away from your book?”

He began by talking about process and learning.? There are no magic ideas.? You’ve got to do the dirty blocking and tackling of learning about investments so that you can make intelligent and informed decisions about what you do.? Further, you have to be disciplined about your decision-making.? Don’t be haphazard in making choices.? (As David Merkel has said for a long time: Decision triumphs over conviction.? Discipline yourself to make your investment decisions businesslike.)

He added that all of us need an internal Board of Directors.? Friends who can counsel us when we are stumped.? He himself has such a Board of Directors ? trusted advisors will help when he can’t figure the situation out.? If David Martin needs such a group of men, how much more how much more do average investors like you and me need such advice?

My fourth question was, “What potential problems are under followed in the present financial environment?”

He paused and explained to me that his ideas here are tentative.? Many have been asking him this question, but he is less certain about what the right answer is here.? He then talked to me about information risk.? There are risks to financial systems being hacked. ?Financial companies need to verify the validity of transactions before executing on them.? He mentioned a parallel about the noise the present environment when you get so much spam relative to legitimate mail.? He himself hired a hacker at one point to see how the financial systems of the firm he was working for could be compromised.? He was surprised on how easy it was to do.

As for financial reform, he expressed some skepticism because most of financial reform is fighting the last war.? They are not looking through the windshield, they are looking through the rear view mirror.? They need to look at what the next set of problems might be.

He then said that we have not learned our lessons from the current crisis.? We have beliefs of our country, for which we have not counted the costs.? “Everyone deserves a house.”? “Everyone deserves quality healthcare.”? But what of the costs?? Can society as a whole bear the costs of what many believe are entitlements?

He closed with the comment that somehow Main Street and Wall Street must have some sort of rapprochement.? If the two don’t work together, life will be tougher for both.

My final question was, “If you were to write a follow-up book, what would you write about?”

To my happy surprise, he is considering writing a follow-up book.? It is a book that would focus on risk management for the individual investor by looking through the windshield.? Keep moving on; embrace risk.? Develop processes that will help you embrace risk.? Spend more time thinking and less time slaving.

After that we had a bit of a discussion about liquidity, and how difficult it is to explain as well as how it can throw monkey wrenches into the best financial plans.? He felt that most problems from liquidity could be solved through business judgment, but that it would often cut across the short term goals of many financial firms.

What I have not captured in my comments here are the number of times that he emphasized how risk control must be a whole firm process, and how senior management must be committed to risk control.

To close this off, I will say that I found the interview refreshing.? David Martin has a very intelligent view of risk.? Risk must be embraced, but only at reasonable costs, and in view of decent returns.

So with that I once again recommend the book Risk and the Smart Investor. If you want to, you can buy it here: Risk and the Smart Investor.

Full disclosure: I was asked if I would review a copy of the book.? It sounded interesting, so I said I would consider it; I was e-mailed an advance copy of the book.

Book Review: Outperform

Posted on 24 September 201024 September 2010 by David Merkel

There are some books, when I read them, that strike me wrong at first, but end up being satisfying in the end.? This book was one of those.? What I expected was a book that would give novel insights to individual investors, showing them how they could do better in the markets by imitating endowments.

This book came to the bold conclusion that there wasn’t much that individual investors could learn from endowments.? I appreciate such honesty, even though that will lead to fewer book sales.? Why is this true?

We all look for simple formulas that can improve our investment returns.
Endowments have balance sheets that allow them to invest longer-term.? Retail investors have a greater need for short-term liquidity, or, at least have a greater tendency to panic.
Retail investors are not large enough to invest in sophisticated asset classes.? Alternative investments have higher minimum dollar amounts.
Most endowments have invested in staff that are capable of analyzing complex investment opportunities.? Here would be my challenge for an average retail investor: hand them a copy of an asset backed securities prospectus, and see if they can make heads or tails out of it.
Endowments that have large staffs are also capable of analyzing third-party managers, without being slaves to the common theories that dominate the minds of most consultants.

The book begins with a basic explanation of endowments, moves through historical performance of endowments and asset allocation, and then explains the various strategies that endowments use.? After that, it interviews a large number of chief investment officers from public and private universities.? I appreciated the fact they chose lesser-known chief investment officers.? It gave me a better feel for the mindset of the average chief investment officer of university endowments.? Some were very smart, some were not so smart, most were in-between.

After that the book interviewed advisors and managers that would aid the chief investment officers of university endowments.? I felt that this was a weaker part of the book.? I came to that conclusion because they are consultants.? Does that make money in the short run, regardless of what the best results are, tend to be less reliable in their opinions than those that have their necks on the line.

One of the topics that was hot in the book was the question of liquidity.? As I have written about in a number of my blog posts, when the bull market in risk assets was running hot, many endowments and pension funds neglected the value of liquidity.? Some of the chief investment officers were prepared, and some were less prepared.? Regardless, most of them learned their lessons.? It’s similar to what happened after LTCM.? When you see bright investors get skinned as a result of neglecting the value of liquidity, you take notice.? All of a sudden, arbitrage does not seem so easy.? In the same way here, imitating Harvard and Yale is not a road to easy riches.

Another theme in the book as I see it, is that alternative asset classes are not as rewarding as they seem.? Many of them involve leverage.? Many of them are limited in terms of their capacity.? There are large variations in manager quality.? Late imitation is a recipe for disaster, as it is with almost all investment strategies.

This is a very good book, but for the average investor, it will not be useful.? Yes, it is useful to understand that endowment strategies are not useful for retail investors.? But you don’t need to buy a book to know that; you have read that here.

Quibbles

If I had been the authors of the book I would’ve spent more time with the introduction.? That said, they make up for it by having good conclusion.? I also would have eliminated most of the advisors and managers, and instead, interviewed still more chief investment officers.? They have valuable opinions; their necks are on the line for the decisions that they make.

Who would benefit from these books:

This book would be valuable for people who think that there are some great secret about investing, and think that the big guys have all the advantages.? It’s not true.? The big guys have the advantage of having balance sheets.? Retail investors have the advantage of being flexible.? This book is valuable in my opinion for investment professionals that want to get into the mind of the chief investment officers of endowments.

If you want to, you can buy it here: Outperform: Inside the Investment Strategy of Billion Dollar Endowments.

Full disclosure: Without asking, I was mailed a copy of the book.

Book Review: The Elements of Investing

Posted on 21 September 2010 by David Merkel

This is a basic book.? A very, very basic book.? Did I mention this is a basic book?? Well, it is a basic book.

Sorry about that.? When you read a lot of sophisticated stuff on investing regularly, and then read The Elements of Investing, you know that you have to take a step back and re-think investing for everyone.

Written by Burton G. Malkiel & Charles D. Ellis, two notable investment writers favoring low cost indexing, and with a forward from David Swensen, you know that it will be a traditional buy-and-hold analysis.? (Though there is something funny here.? The authors criticize using the complex asset classes that Swensen uses, and Swensen criticizes buying individual stocks, which the authors use in small measure.)

The book has five sections:

Saving
Indexing
Diversify
Avoid Blunders
Keep it Simple

The section on saving is excellent, and offers many ways that people can cut their spending without ruining their lives.

The indexing section is fine, though it overstates the inability of investors to beat the indexes.? Yes, the market can’t beat the market as a whole, but dedicated investors following value and momentum can beat the market, until too many copy those unpopular strategies.

Diversification is wise.? But there are limits.? If one is going to be active, be active, and ignore the index.? Otherwise, be passive and index.? What’s that, you say: “If I miss by too much, I will lose a lot of assets.”? Sorry, but that is the price of being an active manager.? If you are going to do it make the most of it; don’t hug the index.? But the wag will say, “just avoid being in the bottom quartile.? You only get fired in the bottom quartile, so hug the index.”? The behaviors that benefit managers are not the same ones that benefit clients.

They recommend rebalancing, which I do as well.? They also recommend value investing in moderation.

I am totally in agreement with the chapter on avoiding blunders.? You win by not losing, and compound it over time to really build value.

The section on keeping it simple focuses on asset allocation, tailoring investment returns to individual situations, and is pretty basic.? I found little objectionable here, but I would spend some time analyzing when asset classes are cheap or dear.

They have an appendix on saving on taxes which is valuable, but if I had been in their shoes, I would have described additional strategies to lower tax liabilities off of both capital gains and losses.

Quibbles

They treat international investing as a free lunch, which it is not due to confiscation, currency risks, war, plague, famine, financial failure, etc.? The last forty years have been special, because of peace in developed economies.? That may not be true in the future.? I invest internationally, but only 25% of assets at most, and only in places where I trust the rule of law.

Who would benefit from these books:

This is the perfect book for your dumb brother-in-law (or similar) who has excess cash flow, and always seems to lose money on his investments.? Given the section on saving, it could also be valuable for your spendthrift brother who is constantly complaining about being in debt.

This is a very basic book.? Give it to the clueless; it cetainly won’t hurt them, and it might help them a lot.

If you want to, you can buy it here:?The Elements of Investing.

Full disclosure: Without asking, I was e-mailed a copy of the book.? Personally, if I were the publisher, I would send a physical copy.? Not that I am going to post it for free use, but I know that many will.

Asset Allocation Book Reviews: 7Twelve and The Flexible Investing Playbook

Posted on 21 September 2010 by David Merkel

When I get a book on asset allocation in the mail, I say to myself, “Another book on asset allocation?? What is there to say that is new on the topic?”

Tonight I review two decidedly different books, and end up praising the conventional book, and dissing the unconventional book.? Since I am not a fan of most conventional asset allocation, I am personally surprised by this result, but now let me explain why I reached this conclusion.

Where’s the Meat?

I don’t know about you, but personally, I hate books that talk big, and don’t reveal any of the significant details of their theories.? Can I figure out approximately how they did what they did?

Now, I am not looking for simple rule-based books either — “Follow this simple formula and make money!”?? But there should be enough to allow someone reasonably well-attuned to the markets to be able to say, “Yes, this is reasonable.? I don’t know all of the details, but I have some reasonable idea of how they did it.”

I don’t have that reasonable idea with The Flexible Investing Playbook.?? From what I can gather, they propose Dynamic Asset Allocation that is rather aggressive, trying to catch turns in markets.? I say aggressive, not because they advocate large moves; they don’t.? But the efforts to catch turns is a difficult endeavor, and they don’t give me enough grist for the mill, that I could set up my own approximate model for switching, if I wanted to do that.

One strength the book has is identifying alternative asset classes that can smooth the ride for investors.? Sadly, they don’t offer easy ways for investors to pursue these strategies.

On the other hand

7Twelve is static in asset allocation, urging investment in index funds (or active funds if you must), and rebalancing regularly.? The book urges investment in 12 index funds, which gives a very diversified mix.? The reason for the book’s name, is that the 12 funds have a limited track record, lasting from 2000-2009.? But an approximation to the 12, with only seven indexes, has a track record that goes from 1970-2009.

The twelve asset-subclasses are:

Large, Medium and Small US Stocks
Developed Foreign Stocks
Emerging Foreign Stocks
Natural Resources Stocks
Commodities
REITs
Barclays’s Aggregate Bonds
Inflation-protected Bonds
Foreign Bonds
US Cash

And the seven asset classes are:

US stocks
Foreign stocks
REITs
Resources
US bonds
Foreign bonds
US cash

And the book shows how in the past, an equal weighted blend provided? better total performance, and even better when compared to return volatility.

One additional note, the clever cover art helps prove that seven is half of twelve at least if using Roman numerals.? No wonder Rome fell.

Quibbles

In 7Twelve, there is a lot of “past is prologue.”? It ignore the factors that made 1970-2009 a special environment:

General peace.
Declining volatility
Increasing globalization.

It also ignores that not everyone could follow such a strategy because there would be scaling problems.? We would run out of small and midcap stocks, and emerging market stocks, and REITs and commodity stocks.? Even commodities would run up in price, and then provide subpar returns.

But if few follow such a prescription, such diversification could be wise, so long as there is no major war.? WW III can’t happen, right?

Who would benefit from these books:

I am not sure who could benefit from The Flexible Investment Playbook.? As for 7Twelve, those lacking a sound diversification strategy could benefit.? The strategy is simple enough to implement.

Both books provide significant and clever commentary in investing, if that is enough to commend buying books.

If you want to, you can buy either here: 7Twelve: A Diversified Investment Portfolio with a Plan, or The Flexible Investing Playbook: Asset Allocation Strategies for Long-Term Success.

Full disclosure: I received each book from the publisher; I don’t think I asked for either one.

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Twenty Questions for the Author of Risk and the Smart Investor

Posted on 11 September 2010 by David Merkel

This is the first time I have done something like this, but I am interviewing an author of a book on Risk Management, which delves into the nature of the current crisis.? My interview occurs before the book is published, and lends to its publicity, which I don’t mind because I think it is an excellent book. The book is entitled, “Risk and the Smart Investor,” and is written by David X. Martin.? Anyway, here are the questions that I will ask him:

Imagine you are talking to a bright 12-year old girl.? How would you explain to her why and how the financial crisis happened?
I was fascinated with the structure of your book, which I found tedious and hokey at first, but I grew to like it.? The way I see it, you introduce the topic through your experience, then explain the theory, then show neglect of it led to failure, and then you give us the stories of Max and Rob.? How did you hit upon this intriguing and novel way to write your book?
Why do you suppose so few people in risk management, and senior management at major financial firms, were unwilling to consider alternative views of the sustainability of the risks being taken as the risks got larger and larger relative to the equity of individual companies, the industry as a whole, and the economy as a whole?
As a risk manager, bosses would sometimes get frustrated with me when they wanted a simple answer to a complex question that had significant riskiness.? They did not like answers like, ?I don?t know, it could have six significant effects on our company.?? How can we convey the limits of our knowledge in a way that management can get the true uncertainty and riskiness of the environment that we work in?? How can we get management to consider scenarios that are reasonable, and could harm the company, but few others in similar situations are testing for?
In your experience, how good are the managements of financial companies at establishing their risk tolerances?? Better, how good are they at enforcing those limits, such that they are never exceeded?
How do you create a transparent risk culture in a firm?? How do you get resisters to go along, even if it is management that does not see the full importance of the concept?
Are most cases where a person or a company fails to diversify intentional or unintentional?? Do we put too many eggs in one basket more out of ignorance or greed?
Why do you suppose that checks and balances for risk management are not built into the cultures of many financial companies?
I have a friend Pat Lewis who developed a risk management system for Bear that could have prevented the failure of the firm, but it was ignored because it got in the way of profit center manager goals.? Was it the same for you at Citigroup when your ?Windows on Risk? got tossed out the window?
Can culture and personal judgment work in risk management ever?? Take Berkshire Hathaway ? risk control is embedded in the characters of a few people, notably Warren Buffett and Charlie Munger.? If the culture is really, really good, and it comes from the top, can risk management work when it is seemingly informal?? (Remember, you don?t want to disappoint Warren.)
How can you teach younger people in risk management intuition about risk that helps them have a healthy skepticism for the results of impressive complex modeling?
Is it possible to do effective risk management in a financial firm if management is less than wholeheartedly committed to the goal?
Aside from AIG, and other financial insurers, the insurance industry came through the crisis better than the banks because they focused on longer-term stress tests, and not on short-term measures like VAR.? Should the banking industry imitate the insurance industry, and focus on longer-term measures of risk, or continue to rely on VAR?
Seemingly the big complex banks did not analyze their liquidity risk, particularly with repo lines.? Why did they miss such an obvious area of risk management?
How much can risk management be shaped in financial firms by the compensation incentives that employees and managers receive?
I have often turned down shady deals in business, saying that you only get one reputation in this world.? How do you encourage an attitude like this in financial firms among staff?
A lot of portfolio management and risk management is juggling different time frames.? Is there a good structure for balancing the demands of the short-, intermediate-, and long-terms?
Most developed country economic players assume that wars will have no impact on their portfolios.? Same for famine, plague, or environmental degradation.? What can you do to get investors to think about the broader risks that could materially harm their well-being?
Are Rob?s more common in the world than Max?s??? That?s my experience; what do you think?
At the end of your book, one of your friends dies.? Did you mean to teach us that even if we manage our risks right, we still can?t overcome problems beyond our scope, or were you trying to say something else, like creating a system or family that can perform well after you die?

Dave, What Should I Do? (2)

Posted on 9 September 20109 September 2010 by David Merkel

For what it is worth, I don’t encourage calling me “Dave.”? My wife, my pastor, and some close friends call me that.? I learned to love my given name when I became an adult — David is a wonderful name, and I am glad my parents gave me that name.? It is an informal age, with the benefits and problems thereof.

On with the scenarios:

4) I have had short jobs: helping a young man to decide whether to buy a house or not.? My counsel: not.? So far so good.? Helping an older lady figure a complex tax basis of stock her father left her inside a DRIP.? A pain but a finite process.

5) A friend my age (50s) who runs a successful business asked me for advice ten years ago.? My advice was don’t run with negative working capital; leave some margin for error.? It took him nine years to figure out that I was right, and the business suffered 3-4 near death experiences en route.? Now he is more profitable than ever, and was grateful for my advice.? As a shareholder, I am glad that he listened.

6) A younger friend (30s) who runs a successful small business who asks what he should do with his excess money.? I told him to put it in Vanguard’s Balanced Fund, or the STAR fund, if he really did not need it for his business.? But he is the sort that always wants to do the best, and feels mediocre results are laziness.? I have told him, focus on your business; it is what you are best at.? What you earn on spare cash balances, particularly in this low-return era, will not avail as much as you could by selling more, and providing good service.

7) A friend (50s) a few years older than me has been put to the test.? His employer has offered him a severance package if he leaves of a little more than one year’s income.? His pension, if taken today, will barely cover expenses, but is roughly equal to his salary.? He has no savings, and has helped put 3 of his 5 kids through college, with 2 to go.? I advise that he continues to work, and that he turn down the package, because it is unlikely that he could get work nearly as remunerative.? Risk: his company folds, and he loses the package.

8 ) A friend (50s) who has planned asks whether his plan is wise.? I told him that the asset allocator using DFA is pretty smart, and and the cost is reasonable.? Beating the S&P 500 over 9 years by 4%/year is hot stuff.? My only critique is that it is a 100% equities program, which is fine if you can live with that level of volatility.

9) My pastor came to me in 2007, asking whether he should still be in the money market fund for his defined contribution plan.? I had been waiting for this moment, because he was too cowardly in investing, but it was the wrong moment.? I told him to take the moderate allocation, because moderate and aggressive allocations do the same over time, but the moderate will let you sleep.? He came through 2008 like a trooper, with the losses, and bounced back in 2009.? The mix will do him well over the long run.

His case made me look over the denominational plan.? I concluded that the asset allocations were set one notch too high at each level… technically, the percentages allocated between risky and safe assets might be correct when thinking about lifespan, certainty of future earnings, but does not take into account the fear factor so well, i.e., people changing their strategy in the midst of panic, at the wrong moment.

So I let the pastors know that, and told them to shade their asset allocations to the conservative side last June.? It does not help that we are in a period of debt deflation, which will retard asset appreciation for some time.? It is harder for asset prices to rise, when the buying power from debt is diminishing.

And yet there are more who want my advice but haven’t sent me the documents yet… It reinforces to me that most don’t know what to do with excess money.

Perhaps that is a lesson — most people are technical specialists, and do their jobs well, but many are ill-adapted to managing their excess funds wisely.? Another reason to end Participant-directed defined contribution pension plans, and create trustee-directed plans, or even defined benefit plans.

Yes, this is a paternalistic view, and is at odds with my normal libertarian ways of thinking.? As policy goes, let people be free to have whatever savings/investment plan they like.? But if you care for those that you have some charge over, create a plan that takes the investing out of their hands.? Then make sure that it is prudently invested.

And in the end, remember, though it is almost always better to have more than less, invest in such a way that you, and those that rely on you will make it to your goal comfortably.? Just as valuable is the ability to sleep at night, and know that your plan has enough slack to enable you to take some hits, and come through fine.

Dave, What Should I Do?

Posted on 8 September 201011 September 2010 by David Merkel

I get requests from local friends fairly regularly for aid in understanding their finances.? While coming home from church recently, I mentioned to my wife that many were seeking my opinion in our congregation.? Her response was, “So what else is new?”? Then I began to list it, family by family, and the congregations that were seeking my opinion for their building/endowment funds, and/or borrowing needs.? As I went down the list, my wife’s responses were “Not them!”, and “Them too?!” and “No!”

What can I say? My wife is the best wife I have ever heard of, but even married to me, economics is a distant topic.? Her father was well-off, but humble, and I am well-off, and I try to be humble.? You can be the judge there.

I say to my friends asking advice, “Remember, I am your friend.? I will take no money, but I won’t hold your hand and guide you either.? I will give you very basic advice, and it is up to you to learn and implement it.”? I don’t want to be a financial planner, but I don’t want to leave friends in a lurch.

With that, the scenarios:

1) 90-year old widow, who lives with her daughter and son-in-law.? Another son-in-law, given to incaution, is advising putting everything into gold and silver.? What to do?

She has adequate assets to support her through the rest of her life.? Her husband was responsible.? I asked her if she needed more income, and she said no.? I told her, then relax, ignore the other son-in-law (I know him to a degree), but if you want to, invest 3-5% in precious metals.? She didn’t see the need, and I told her that was fine.? She asked me what I would do in her shoes, and I said that it was a very difficult environment to be investing in, and that we could not tell what the government might do in a crisis, so the best thing to do was to stay diversified, and invested in companies which would have continued demand.? But if you don’t need the money, don’t take the risk now.

2) 80-year old widow, assets in even better shape.? Her husband was a great guy; an inspiration to me in many ways.? He was a mutual fund collector, and left her a basket of 30+ funds, as well as two homes free and clear.? What to do?? I suggested that she harvest funds that had been doing particularly well and reinvest in funds that had lagged.? I suggested purging certain funds that were likely mismanaged.? I also suggested liquidating one property if she could get an acceptable bid.

3) 50-year old bachelor, never married.? Funds are from TIAA-CREF.? We decided on a 50-50 stock-bond mix three years ago.? Recently we rebalanced to add more equities.? He was disappointed that his portfolio had moved backward.? I said “Welcome to the club.”

I will continue with more in part two, but 2008 blew apart many people’s expectations over what their assets could deliver.? My stylized view of it stems from comments that I got at church.? In 1999, my friends were people into equities, as I was holding back.?? In 2002, many said they were exiting equities, and moving to what they understood, residential real estate.? I was adding fresh cash to my positions, and paying off my mortgage. By 2006-2007, they began getting interested in stocks again.? By 2009, both stocks and residential real estate was tarnished, leaving bonds remaining.

Closing then, with three final notes:

a) The low interest rate policy is definitely hurting seniors, and I believe all investors.? We all become worse capital allocators when there is no safe place to put excess funds.? It tempts people to stupid decisions.? If Bernanke wants to do us a favor, let him resign, and put John Taylor or Raghuram Rajan in his place.? Tempting people to dumb investment decisions hurts the economy in the long run, it does not help us.

It may help the banks have a risk-free arb on short government bonds, but that’s not what we should want either.? If they are sound, they should be lending. Raise short rates, and let the banks have a harder time, and give investors a place to put money while they look for better opportunities.

b) Average people, and sadly, many professionals, are hopeless trend-followers.? They have no sense of looking through the windshield, rather they ask what has worked, and do that.? Mimicry can be a help in much of life, e.g., finding where to buy good furniture cheaply, but is harmful with investing where figuratively the devil takes the hindmost.

c) People get caught on eras, and have a hard time letting go of them.? The 70s biased many against inflation, and toward residential real estate. The residential real estate lesson got reinforced in the ’00s.? The equity markets seemed magical from 1975 to 2007, and asset allocators increased their allocations to equities in response.? Now you hear of “bonds only” asset allocations, just as the amount of juice available in most of the bond market is limited.

People got used to refinancing their mortgage every few years, and enjoying the extra cash flow.? The modern era reveals the hidden assumptions on that: that property values would never fall.

The point: markets aren’t magic.? They can only deliver what the real economy does.? Stocks only do well over the long run if profits do well. Valuations come and go.? Bonds make money off the stated interest (coupon) rate less default losses.? Valuations come and go.? Real estate is worth the stream of services that the land and improvements can deliver.? Valuations come and go.

Now, you can play the “come and go” if you are smart, but with the “come and go,” for every winner there is a loser.? But asset allocators need to be more humble in their assumptions for financial planning and not assume that they can earn more than 2% over the 10-year Treasury, or over expected growth in nominal GDP.? The share of income that goes to profits and interest also tends to mean-revert over time, so humility is needed when:

Illustrating an investment plan for a family
Setting the discount rate for a defined benefit pension plan
Setting the spending rate on an endowment
or even, setting assumptions for the Social Security trust funds.

Ten More Notes on the Current Market Scene

Posted on 24 August 2010 by David Merkel

11) I was surprised to read that there is not a perfect market in interest rate swaps.? They are so vanilla, but counterparty risk interferes.

12) There is always a skunk at the party, and who better than Baruch to dis bonds?? I half agree with him.? Half, because the momentum can’t be ignored entirely.? Half, because profit margins are wide.? But rates are low, and unless we are heading into the second great depression, stocks look cheap.? That’s the risk though.? Is this the second Great Depression? (Or the Not-so-great Depression that I have called it earlier.)

13) Housing is a mess.? The US government has been engaged in a delaying action on defaults, while calling it a rescue effort.? The sag in housing prices may lead to a recession.? The FHA is raising the costs of mortgages because their past loans have had too many losses.

14) Commercial Real Estate continues to do badly while some CMBS performs — no surprise that what is more secured does well.

15) The Fed gets whacked on its lack of transparency.? This could be a trend for the future.

16) In the current difficulties in the Eurozone, the ECB is beginning to suck in more bonds, presumably from peripheral Eurozone countries that are seeing their financing rates rise.? As central banks get creative, a simple question for currency holders becomes what backs the money?? It would seem to be governments, which will absorb losses if central banks generate them, and cover it with additional taxes or borrowing (some of which could eventually be monetized).? What a mess.

17) Bruce Krasting is almost always worth a read, and he digs up something that I had forgotten about how interest is credited on the Social Security Trust Funds.? It’s calculated this way:

The average market yield on marketable interest-bearing securities of the Federal government that are not due or callable until after 4 years from the last business day of the prior month (the day when the rate is determined). The average yield must then be rounded to the nearest eighth of 1 percent.

Krasting thinks that’s too high.? I think that is too low, given the true tradeoff that is going on here.? Think about it: when the government borrows from the SSTFs in a given year, a slice of the benefits incurred over that year don’t get “funded.”? The debt claim to back that should match the maturity profile of those future claims.? Medicare would have some short claims, Disability and Supplemental Security slightly longer, but Old Age Security develops most of the assets, and is a long claim.? Say the average person paying in is 40, and they will retire on average at 65.? That is a 25-year deferred claim that will last for maybe 20 years on average, with inflation adjustment.? The US offers no debt that is that long to back such a liability, so I would argue that the proper rate to use would be that of the longest noncallable debt offered by the Treasury.

But here would have been my second twist on this: they should have absorbed the longest marketable securities from the debt markets, and bought and held them.? That would have looked really ugly as the rates looked piddling against current interest costs.? But today, it would reflect the true costs of the borrowing from the SSTFs, and that cost would likely be greater than what was paid to the trust funds.? My guess is that the interest rate paid on the trust funds today would be higher than 5%, maybe higher than 6%, if a fair method had been used.

If there is enough interest, I could try to run the numbers, but the point is academic.? It would not change the total claims against the government plus SSTFs as a whole, but it might have changed the behavior of the government if it had tried to borrow on a long duration basis, competing for funds with private industry.? It would have revealed the true tradeoff earlier, and shown what a trouble we were heading for.

18) On retained asset accounts, this Bloomberg piece makes me say, “Yes, this is a big enough issue to deal with.”? For MetLife particularly, which has its own bank, it would be simple enough to set up a genuine bank account with all of the statutory protections involved.? If there are risks from forgery, that is big.? Even the risks of not being covered by the state guaranty funds is big enough.

My view is this: full cash payment should be the default, and a genuine bank account an option.? If you have one of these checkbooks now, and you want to minimize your risks, do this: write one check for the balance so that it is deposited in your bank account.? Simple enough.? You can protect yourself with ease here, even without legal change.

19) The yen will continue to rally until the Japanese economy screams.? Currency moves tend to last longer than we anticipate, and secular moves force needed economic changes on countries.

20) Consider what I wrote last week on long Treasuries:

I am not a Treasury bond bull, per se, but I am reluctant to short until I see real price weakness.? And some think that I am only a fundamentalist value investor.? With bonds, it is tough to catch the turning points, and tough to grasp the motivations of competitors.? Better to miss the first 10% of a move, than miss it altogether.

Now, I never expect to be right so fast, but with rates gapping lower on economic weakness — the 10-year below 2.5%, and the 30-year below 3.6%, I would simply say this: don’t fight it.? Let the momentum run.? Wait until you see a significant pullback in prices, and then short.? Don’t be a macho fool fighting forces much larger than yourself.? The markets can remain crazy for longer than you remain solvent.