Asset Allocation – Page 5

A Cautionary Tale on Municipal Pensions

Posted on 10 December 201610 December 2016 by David Merkel

Photo Credit: ajehals || Pensions are promises. Sadly, promises are often broken. Choose your promiser with care…

========================================================

If you want a full view of what I am writing about today, look at this article from The Post and Courier, “South Carolina’s looming pension crisis.” ?I want to give you some perspective on this, so that you can understand better what went wrong, and what is likely to go wrong in the future.

Before I start, remember that the rich get richer, and the poor poorer even among states. ?Unlike what many will tell you though, it is not any conspiracy. ?It happens for very natural reasons that are endemic in human behavior. ?The so-called experts in this story are not truly experts, but sourcerer’s apprentices who know a few tricks, but don’t truly understand pensions and investing. ?And from what little I can tell from here, they still haven’t learned. ?~~I would fire them all, and replace all of the boards in question, and turn the politicians who are responsible out of office~~. ?Let the people of South Carolina figure out what they must do here — I’m a foreigner to them, but they might want to hear my opinion.

Let’s start here with:

Central Error 1: Chasing the Markets

Much as inexperienced individuals did, the South Carolina?Retirement System Investment Commission [SCRSIC] chased the markets in an effort to earn returns when they seemed easy to get in hindsight. ?As the article said:

It used to be different, before the high-octane investment strategies began. South Carolina?s pension plans were considered 99 percent funded in 1999, and on track to pay all promised benefits for decades to come.

That was the year the pension funds started investing in stocks, in hopes of pulling in even more income. A change to the state constitution and action by the General Assembly allowed those investments. In the previous five years, U.S. stock prices had nearly tripled.

Prior to that time, the pension funds were largely invested in bonds and cash, which actually yielded something back then. ?If the pension funds were invested in bonds that were long, the returns might not have been so bad versus stocks. ?But in the late ’90s the market went up aggressively, and the money looked easy, and it was easy, partly due to loose monetary policy, and a mania in technology and internet stocks.

Here’s the real problem. ?It’s okay to invest in only bonds. It’s okay to invest in bonds and stocks in a fixed proportion. ?It’s okay even to invest only in stocks. ?Whatever you do, keep the same policy over the long haul, and don’t adjust it. ?Also, the more nonguaranteed your investments become (anything but high quality bonds), the larger your provision against bear markets must become.

And, when you start a new policy, do what is not greedy. ?1999-2000 was the right time to buy long bonds and sell stocks, and I did that for a small trust that I managed at the time. ?It looked dumb on current performance, but if you look at investing as a business asking what level of surplus?cash flows the underlying investments will throw off, it was an easy choice, because bonds were offering a much higher future yield than stocks. ?But the natural tendency is to chase returns, because most people don’t think, they imitate. ?And that was true for the SCRSIC,?bigtime.

Central Error 2:?Bad Data

The above quote said that “South Carolina?s pension plans were considered 99 percent funded in 1999.” ?That was during an era when government accounting standards were weak. ?The?standards are still weak, but they are stronger than they were. ?South Carolina was NOT 99% funded in 1999 — I don’t know what the right answer would have been, but it would have been considerably lower, like 80% or so.

Central Error 3: Unintelligent Diversification into “Alternatives”

In 2009, I had the fun of writing a small report for CALPERS. ?One of my main points was that they allocated money to alternative investments too late. ?With all new classes of investments the best deals get done early, and as more money flows into the new class returns surge because the flood of buyers drives prices up. ?Pricing is relatively undifferentiated, because experience is early, and there have been few failures. ?After significant failures happen, differentiation occurs, and players realize that there are sponsors with genuine skill, and “also rans.” ?Those with genuine skill also limit the amount of money they manage, because they know that good-returning ideas are hard to come by.

The second aspect of this foolishness comes from the consultants who use historical statistics and put them into ~~brain-dead~~ mean-variance models which spit out an asset allocation. ?Good asset allocation work comes from analyzing what economic return the underlying business activities will throw off, and adjusting for risk qualitatively. ?Then allocate funds assuming they will never be able to trade something once bought. ?Maybe you will be able to?trade, but never assume there will be future liquidity.

The article kvetches about the expenses, which are bad, but the strategy is worse. ?The returns from all of the non-standard investments were poor, and so was their timing — why invest in something not geared much to stock returns when the market is at low valuations? ?This is the same as the timing problem in point one.

Alternatives might make sense at market peaks, or providing liquidity in distressed situations, but for the most part they are as saturated now as public market investments, but with more expenses and less liquidity.

Central Error 4: Caring about 7.5% rather than doing your best

Part of the justification for buying the alternatives rather than stocks and bonds is that you have more of a chance of beating the target return of the plan, which in this case was 7.5%/yr. ?Far better to go for the best risk-adjusted return, and tell the State of South Carolina to pony up to meet the promises that their forbears made. ?That brings us to:

Central Error 5: Foolish politicians who would not allocate more money to pensions, and who gave?pension increases rather than wage hikes

The biggest error belongs to the politicians and bureaucrats who voted for and negotiated higher pension promises instead of higher wages. ?The cowards wanted to hand over an economic benefit without raising taxes, because the rise in pension benefits does not have any immediate cash outlay if one can bend the will of the actuary to assume that there will be even higher investment earnings in the future to make up the additional benefits.

[Which brings me to a related pet peeve. ?The original framers of the pension accounting rules assumed that everyone would be angels, and so they left a lot of flexibility in the accounting rules to encourage the creation of defined benefit plans, expecting that men of good will would go out of their way to fund them fully and soon.

The last 30 years have taught us that plan sponsors are nothing like angels, playing for their own advantage, with the IRS doing its bit to keep corporate plans from being fully funded so that taxes will be higher. ?It would have been far better to not let defined benefit plans assume any rate of return greater than the rate on Treasuries that would mimic their liability profile, and require ~~immediate~~ relatively quick funding of deficits. ?Then if plans outperform Treasuries, they can reduce their contributions by that much.]

Error 5 is likely the biggest error, and will lead to most of the tax increases of the future in many states and municipalities.

Central Error 6: Insufficient Investment Expertise

Those in charge of making the investment decisions proved themselves to be as bad as amateurs, and worse. ?As one of my brighter friends at RealMoney, Howard Simons, used to say (something like), “On Wall Street, to those that are expert, we give them super-advanced tools that they can use to destroy themselves.” ? The trustees of?SCRSIC received those tools and allowed themselves to be swayed by those who said these magic strategies will work, possibly without doing any analysis to challenge the strategies that would enrich many third parties. ?Always distrust those receiving commissions.

Central Error 7: Intergenerational Equity of Employee Contributions

The last problem is that the wrong people will bear the brunt of the problems created. ?Those that received the benefit of services from those expecting pensions will not be the prime taxpayers to pay those pensions. ?Rather, it will be their children paying for the sins of the parents who voted foolish people into office who voted for the good of current taxpayers, and against the good of future taxpayers. ?Thank you, Silent Generation and Baby Boomers, you really sank things for Generation X, the Millennials, and those who will follow.

Conclusion

Could this have been done worse? ?Well, there is Illinois and Kentucky. ?Puerto Rico also. ?Many cities are in similar straits — Chicago, Detroit, Dallas, and more.

Take note of the situation in your state and city, and if the problem is big enough, you might consider moving sooner rather than later. ?Those that move soonest will do best selling at?higher real estate prices, and not suffer the soaring taxes and likely?diminution of city services. ?Don’t kid yourself by thinking that everyone will stay there, that there will be a bailout, etc. ?Maybe clever ways will be found to default on pensions (often constitutionally guaranteed, but politicians don’t always honor Constitutions) and municipal obligations.

Forewarned is forearmed. ?South Carolina is a harbinger of future problems, in their case made worse by opportunists who sold the idea of high-yielding investments to trustees that proved to be a bunch of rubes. ?But the high returns were only needed because of the overly high promises made to state employees, and the unwillingness to levy taxes sufficient to fund them.

[bctt tweet=”Seven central errors committed by the South Carolina Retirement System and politicians” username=”alephblog”]

When I was a Boy…

Posted on 29 November 2016 by David Merkel

Photo Credit: Jessica Lucia?|| That kid was like me… always carrying and reading a lot of books.

===========================================

If you knew me when I was young, you might not have liked me much. ?I was the know-it-all who talked a lot in the classroom, but was quieter outside of it. ?I loved learning. ?I mostly liked my teachers. ?I liked and I didn’t like my fellow students. ?If the option of being home schooled had been offered to me, I would have jumped at it in an instant, because then I could learn with no one slowing me down, and no kids picking on me.

I read a lot. A LOT. ?Even when young I spent my time on the adult side of the library. ?The librarians typically liked me, and helped me find stuff.

I became curious about investing for two reasons. 1) my mother did it, and it was difficult not to bump into it. ?She would watch Wall Street Week, and often, I would watch it with her. ?2) Relatives gave me gifts of stock, and my Mom taught me where to look up the price in the newspaper.

Now, if you knew the stocks that they gave me, you would wonder at how I still retained interest. ?The two were the conglomerate Litton Industries, and the home electronics company?Magnavox. ?Magnavox was bought out by Philips in 1974 for a price that was 25% of the original cost basis of my shares. ?We did worse on Litton. ?Bought in the mid-to-late ’60s and sold in the mid-’70s for a 80%+ loss. ?Don’t blame my mother for any of this, though. ?She rarely bought highfliers, and told me that she would have picked different stocks. ?Gifts are gifts, and I didn’t need the money as a kid, so it didn’t bother me much.

At the library, sometimes I would look through some of the research volumes that were there for stocks. ?There are a few things that stuck with me from that era.

1) All bonds traded at discounts. ?It’s not that I understood it well, but I remember looking at bond guides, and noted that none of the bonds traded over $100 — and not surprisingly, they all had low coupons.

In those days, some people owned individual bonds for income. ?I remember my Grandma on my mother’s side talking about how little one of her bonds paid in interest, given that inflation was perking up in the 1970s. ?Though I didn’t hear it in that era, bonds were sometimes called “certificates of confiscation” by professionals ?in the mid-to-late ’70s. ?My Grandpa on my father’s side thought he was clever investing in short-term CDs, but he never changed on that, and forever missed the rally in stocks and long bonds that kicked off in 1982.

When I became a professional bond investor at the ripe old age of 38 in 1998, it was the opposite — almost all bonds traded at premiums, and had relatively high coupons. ?Now, at that time I knew a few firms that were choking because they had a rule that said you can never buy premium bonds, because in a bankruptcy, the premium will be automatically lost. ?Any recoveries will be off the par value of the bond, which is usually $100.

2) Many stocks paid dividends that were higher than their earnings. ?I first noticed that while reading through Value Line, and wondered how that could be maintained. ?The phrase “borrowing the dividend” was bandied about.

Today as a professional I know that we should look at free cash flow as a limit for dividends (and today, buybacks, which were unusual to unheard of when I was a boy), but earnings still aren’t a bad initial proxy for dividend viability. ?Even if you don’t have a cash flow statement nearby, if debt is expanding and earnings don’t cover the dividend, I would be concerned enough to analyze the situation.

3) A lot of people were down on stocks and bonds — there was a kind of malaise, and it did not just emanate from Jimmy Carter’s mind. [Cue the sad Country Music] Some concluded that inflation hedges like homes, short CDs, and gold/silver were the only way to go. ?I remember meeting some goldbugs in 1982 just as the market was starting to take off, and they disdained the idea of stocks, saying that history was their proof.

The “Death of Equities” came and went, but that reminds me of one more thing:

4) There was a decent amount of pessimism about defined benefit plan pension funding levels and life insurer solvency. ?Inflation and high interest rates made life insurers look shaky if you marked the assets alone to market (the idea of marking liabilities to market was at least 10 years off in concept, and still hasn’t really arrived, though cash flow testing accomplishes most of the same things). ?Low stock and bond prices made pension plans look shaky. ?A few insurance companies experimented with buying gold and other commodities, just in time for the grand shift that started in 1982.

Takeaways

The biggest takeaway is to remember that as a fish you don’t notice the water that you swim in. ?We are so absorbed in the zeitgeist (Spirit of the Times)?that we usually miss that other eras are different. ?We miss the possibility of turning points. ?We miss the possibility of things that we would have not thought possible, like negative interest rates.

In the mid-2000s, few thought about the possibility of debt deflation having a serious impact on the US economy. ?Many still feared the return of inflation, though the peacetime inflation of the late ’60s through mid-’80s was historically unusual.

The Soviet Union will bury us.

Japan will bury us. ?(I’m listening to some Japanese rock as I write this.) 😉

China will bury us.

Few people can see past the zeitgeist. ?Many can’t remember the past.

Should we?be concerned about companies not being able pay their dividends and fulfill their buybacks? ?Yes, it’s worth analyzing.

Should we be concerned about defined benefit plan funding levels? Yes, even if interest rates rise, and percentage deficits narrow. ?Stocks will likely fall with bonds if real interest rates rise. ?And, interest rates may not rise much soon. ?Are you ready for both possibilities?

Average people don’t seem that excited about any asset class today. ?The stock market is at new highs, and there isn’t really a mania feel now. ?That said, the ’60s had their highfliers, and the P/Es eventually collapsed amid inflation and higher real interest rates. ?Those that held onto the Nifty Fifty may not have lost money, but few had the courage. ?Will there be a correction for the highfliers of this era, or, is it different this time?

It’s never different.

It’s always different.

Separating the transitory from the permanent is tough. ?I would be lying to you if I said I could do it consistently or easily, but I spend time thinking about it. ?As Buffett has said, (something like)?”We’re paid to think about things that can’t happen.”

Ending Thoughts

Now, lest the above seem airy-fairy, here are my biases at present as I try to separate the transitory from the permanent:

The US is in better shape than most of the rest of the world, but its securities are relatively priced for that reality.
Before the US has problems, Japan, China, OPEC, and the EU will have problems, in about that order. ?Sovereign default used to be a large problem. ?It is a problem that is returning. ?As I have said before — this era reminds me of the 1840s — huge debts and deficits, with continued currency debasement. ?Hopefully we don’t get a lot of wars as they did in that decade.
I am treating long duration bonds as a place to speculate — I’m dubious as to how much Trump can truly change things. ?I’m flat there now. ?I think you almost have to be a trend follower there.
The yield curve will probably flatten quickly if the Fed tightens more than once more.
The internet and global demographics are both forces for deflationary pressure. ?That said, virtually the whole world has overpromised to their older populations. ?How that gets solved without inflation or defaults is a tough problem.
Stocks are somewhat overvalued, but the attitude isn’t frothy.
DIvidend stocks are kind of a cult right now, and will suffer some significant setback, particularly if interest rates rise.
Eventually emerging markets and their stocks will dominate over developed markets.
Value investing will do relatively better than growth investing for a while.

That’s all for now. ?You may conclude very differently than I have, but I would encourage you to try to think about the hard problems of our world today in a systematic way. ?The past teaches us some things, but not enough, which should tell all of us to do risk control first, because you don’t know the future, and neither do I. 🙂

“Do Half” Applied

Posted on 22 November 2016 by David Merkel

Photo Credit: Attila Malarik?|| In many but not all situations, doing half is a smart idea!

==================================

Four major stock indexes, the?DJIA, S&P 500, Nasdaq, Russell 2000 all closes at records on the same day. ?From that same article,?Ryan Detrick, senior market strategist for LPL Financial said that it was the?first time all of those indexes set records on the same day since December 31, 1999.

For those that missed the rally, do you feel bad about it? ?Regretful? ?Really, it’s too bad that the bear bug got you to the degree that you acted on it. ?Those who have read me for a long time know that I often sound bearish, because I am natively bearish. ?But, I don’t let it force me to take aggressive actions. ?There is a point where I will hedge everything, but that is around 2600 on the S&P 500 at present. ?I sit and worry a little, let?Portfolio Rule Seven?trim a little as my stocks hit new highs, but I won’t let cash go over 20% — we’re at about 16% now. ?After I?Bumped Against My Upper Cash Limit, I bought more stock — good thing too, at least in the short run.

If you think this is all a mirage, and there aren’t any structural reasons why the market should go any higher, and you are not going to do anything here — well, good for you. ?Maybe you are right, and you can buy lower someday. ?Just don’t get jumpy if the market continues to rise, and you don’t have much in the game. ?(To those so inclined, don’t be macho fools and try to short into new highs — wait until there is some blood on the sword before shorting, something that I almost never do because of the bad risk/reward tradeoff.)

But if you are feeling jumpy and think you should get in on the action, let me give you two words:??Do Half.?? If at normal valuations you would have 60% of your assets in stocks, and you have nothing in stocks now, don’t take position above 30%. ?Go up to half of a normal position. ?If things continue to go up, you will be happy you have something in the market.??If things go down you can bring it up to a full position on weakness, and be grateful you didn’t go up to 60% all at once.

Now, I’m not telling you to buy anything, invest with me, or anything like that. ?I just know that regret is one of the most powerful forces in the market, and lots of people make stupid decisions under its influence. ?Rules that I use, like “Do Half” and the portfolio management rules are designed to keep me from making rash decisions influenced by my emotions.

The same “Do Half” rule could be applied to lightening up on bond positions and other matters, like raising cash or edging into commodities. ?(I am doing neither of those now — they are just examples from others that I know.)

The main idea is to be self-controlled, and not let emotion drive you. ?Investing is a business; determine your policies, and act on them, whether you do it yourself, or farm it out to others. ?But if you?feel that you have to do something now, then my advice to you is “Do Half.” ?[bctt tweet=”But if you feel that you have to do something now, then my advice to you is ‘Do Half.'” username=”alephblog”]

Estimating Future Stock Returns, June 2016 Update

Posted on 21 September 2016 by David Merkel

This is my quarterly update on how much the market is likely to return over the next 10 years. ?At the end of the last quarter, that figure was around 6.54%/year. ?For comparison purposes, that is at the 77th percentile of outcomes — high, but not nosebleed high, which to me, is when the market is priced to?return 3% or less. ?That’s when you run.

Adding in quarter to date movements, the current value should be near 6.3%/year (79th percentile).

With all of the hoopla over how high the market is, why is this measure not screaming run? ?This is because average investors, retail and institutional, are not as heavily invested in the equity markets as is typical toward the end of bull markets. ?There are many articles calling for caution — I have issued a few as well.

From an asset-liability management standpoint, bull markets get particularly precarious when caution is thrown to the wind, and people genuinely believe that there is no alternative to stocks — that you are missing out on “free money” if you are not invested in stocks.

We aren’t there now. ?So, much as I am not crazy about the present state of the credit cycle (debts rising, income falling), there is still the reasonable possibility of more gains in the stock markets.

===================================

For more on this series, see the first four articles in this search, which describe the model, and its past estimates.

Estimating Future Stock Returns, March 2016 Update

Posted on 10 June 2016 by David Merkel

You might remember my post?Estimating Future Stock Returns, and its follow-up piece. ?If not they are good reads, and you can get the data on one file here.

The Z.1 report came out yesterday, giving an important new data point to the analysis. ?After all, the most recent point gives the best read into current conditions. ?As of March 31st, 2016 the best estimate of 10-year returns on the S&P 500 is 6.74%/year.

The sharp-eyed reader will say, “Wait a minute! ?That’s higher than last time, and the market is higher also! ?What happened?!” ?Good question.

First, the market isn’t higher from 12/31/2015 to 3/31/2016 — it’s down about a percent, with dividends. ?But that would be enough to move the estimate on the return up maybe 0.10%. ?It moved up 0.64%, so where did the 0.54% come from?

The market climbs a wall of worry, and?the private sector has been holding less stock as a percentage of assets than before — the percentage?went from 37.6% to 37.1%, and the absolute amount fell by about $250 billion. ?Some stock gets eliminated by M&A for cash, some by buybacks, etc. ?The amount has been falling over?the last twelve months, while the amount in bonds, cash, and other assets keeps rising.

If you think that return on assets doesn’t vary that much over time, you would?conclude that having a smaller amount of stock owning the assets would lead to a higher rate of return on the stock. ?One year ago, the percentage the private sector held in stocks was 39.6%. ?A move down of 2.5% is pretty large, and moved the estimate for 10-year future returns from 4.98% to 6.74%.

Summary

As a result, I am a little less bearish. ?The valuations are above average, but they aren’t at levels that would lead to a severe crash. ?Take note, Palindrome.

Bear markets are always possible, but a big one is not likely here. ?Yes, this is the ordinarily bearish David Merkel writing. ?I’m not really a bull here, but I’m not changing my asset allocation which is 75% in risk assets.

Postscript for Nerds

One other thing affecting this calculation is the Federal Reserve revising estimates of assets other than stocks up prior to 1961. ?There are little adjustments in the last few years, but in percentage terms the adjustments prior to 1961 are huge, and drop the R-squared of the regression from 90% to 86%, which also is huge. ?I don’t know what the Fed’s statisticians are doing here, but I?am going to look into it, because it is?troubling to wonder if your data series is sound or not.

That said, the R-squared on this model is better than any alternative. ?Next time, if I get a chance, I will try to put a confidence interval on the estimate. ?Till then.

Simple Stuff: What is Risk?

Posted on 15 May 2016 by David Merkel

Photo Credit: GotCredit

This is another piece in the irregular Simple Stuff series, which is an attempt to make complex topics simple. ?Today’s topic is:

What is risk?

Here is my simple definition of risk:

Risk is the probability that an entity will not meet its goals, and the degree of pain it will go through depending on?how much?it?missed the goals.

There are several good things about this definition:

Note that the word “money” is not mentioned. ?As such, it can cover a wide number of situations.
It is individual. ?The same size of a miss of a goal for one person may cause him to go broke, while another just has to miss a vacation. ?The same event may happen for two people — it may be a miss for one, and not for the other one.
It catches both aspects of risk — likelihood of a bad event, and degree of harm from?how badly the goal was missed.
It takes into account the possibility that there are many goals that must be met.
It covers both composite entities like corporations, families, nations and cultures, as well as individuals.
It doesn’t make life easy for academic economists who want to have a uniform definition of risk so that they can publish economics and finance papers that are bogus. ?Erudite, but bogus.
It doesn’t specify that there has to be a single time horizon, or any time horizon.
It doesn’t specify a method for analysis. ?That should vary by the situation being analyzed.

But this is a blog on finance and investing risk, so now I will focus on that large class of situations.

What is Financial Risk?

Here are some things that financial risk can be:

You don’t get to retire when you want to, or, your retirement is not as nice as you might like
One or more of your children can’t go to college, or, can’t go to the college that the would like to attend
You can’t buy the home/auto/etc. of your choice.
A financial security plan, like a defined benefit plan, or Social Security has to cut back benefit payments.
The firm you work for goes broke, or gets competed into an also-ran.
You lose your job, can’t find another job?as good, and you default on important regular bills as a result. ?The same applies to people who run their own business.
Levered financial businesses, like banks and shadow banks, make too many loans to marginal borrowers, and find at some point that their borrowers can’t pay them back, and at the same time, no one wants to lend to them. ?This can be harmful not just to the?banks and shadow banks, but to the economy as a whole.

Let’s use retirement as an example of how to analyze financial risk. ?I have a series of articles that I have written on the topic based on the idea of the?personal required investment earnings rate [PRIER]. ?PRIER is not a unique concept of mine, but is attempt to apply the ideas of professionals trying to manage the assets and liabilities of an endowment, defined benefit plan, or life insurance company to the needs of an individual or a family.

The main idea is to try to calculate the rate of return you will need over time to meet your eventual goals. ?From my prior “PRIER” article, which was written back in January 2008, prior to the financial crisis:

To the extent that one can estimate what one can reasonably save (hard, but worth doing), and what the needs of the future will cost, and when they will come due (harder, but worth doing), one can estimate personal contribution and required investment earnings rates.? Set up a spreadsheet with current assets and the likely savings as positive figures, and the future needs as negative figures, with the likely dates next to them.? Then use the XIRR function in Excel to estimate the personal required investment earnings rate [PRIER].

I?m treating financial planning in the same way that a Defined Benefit pension plan analyzes its risks.? There?s a reason for this, and I?ll get to that later.? Just as we know that a high assumed investment earnings rate at a defined benefit pension plan is a red flag, it is the same to an individual with a high PRIER.

Now, suppose at the end of the exercise one finds that the PRIER is greater than the yield on 10-year BBB bonds by more than 3%.? (Today that would be higher than 9%.)? That means you are not likely to make your goals.?? You can either:

Save more, or,

Reduce future expectations,whether that comes from doing the same things cheaper, or deferring when you do them.

Those are hard choices, but most people don?t make those choices because they never sit down and run the numbers.? Now, I left out a common choice that is more commonly chosen: invest more aggressively.? This is more commonly done because it is ?free.?? In order to get more return, one must take more risk, so take more risk and you will get more return, right?? Right?!

Sadly, no.? Go back to Defined Benefit programs for a moment.? Think of the last eight years, where the average DB plan has been chasing a 8-9%/yr required yield.? What have they earned?? On a 60/40 equity/debt mandate, using the S&P 500 and the Lehman Aggregate as proxies, the return would be 3.5%/year, with the lion?s share coming from the less risky investment grade bonds.? The overshoot of the ?90s has been replaced by the undershoot of the 2000s.? Now, missing your funding target for eight years at 5%/yr or so is serious stuff, and this is a problem being faced by DB pension plans and individuals today.

The article goes on, and there are several others that flesh out the ideas further:

Simple Summary

Though there are complexities in trying to manage financial risk, the main ideas for dealing with financial risk are?these:

Spend time estimating your future needs and what resources you can put toward them.
Be conservative in what you think you assets can earn.
Be flexible in your goals if you find that you cannot reasonably achieve your dreams.
Consider what can go wrong, get proper insurance where needed, and be judicious on taking on large fixed commitments to spend money in the future.

PS — Two final notes:

On the topic of “what can go wrong in personal finance, I did a series on that here.

Investment risk is sometimes confused with volatility. ?Here’s a discussion of when that makes sense, and when it doesn”t.

Risk vs Return — The Dirty Secret

Posted on 11 May 2016 by David Merkel

I’m thinking of starting a limited series called “dirty secrets” of finance and investing. ?If anyone wants to toss me some ideas you can contact me here. ?I know that since starting this blog, I have used the phrase “dirty secret” at least ten times.

Tonight’s dirty secret is a simple one, and it derives mostly from investor behavior. ?You don’t always get more return on average if you take more risk. ?The amount of added return declines with each unit of additional risk, and eventually turns negative at high levels of risk. ?The graph above is a vague approximate representation of how this process works.

Why is this so? ?Two related reasons:

People are not very good at estimating the probability of success for ventures, and it gets worse as the probability of success gets lower. ?People overpay for chancy lottery ticket-like investments, because they would like to strike it rich. ?This malady affect men more than women, on average.
People get to investment ideas late. ?They buy closer to tops than bottoms, and they sell closer to bottoms than tops. ?As a result, the more volatile the investment, the more money they lose in their buying and selling. ?This malady also affects men more than women, on average.

Put another way, this is choosing your investments based on your circle of competence, such that your probability of choosing a good investment goes up, and second, having the fortitude to hold a good investment through good and bad times. ?From my series on dollar-weighted returns you know that the more volatile the investment is, the more average people lose in their buying and selling of the investment, versus being a buy-and-hold investor.

Since stocks are a long duration investment, don’t buy them unless you are going to hold them long enough for your thesis to work out. ?Things don’t always go right in the short run, even with good ideas. ?(And occasionally, things go right in the short run with bad ideas.)

For more on this topic, you can look at my creative piece,?Volatility Analogy. ?It explains the intuition behind how volatility affects the results that investors receive as they get greedy, panic, and hold on for dear life.

In closing, the dirty secret is this: size your risk level to what you can live with without getting greedy or panicking. ?You will do better than other investors who get tempted to make rash moves, and act on that temptation. ?On average, the world belongs to moderate risk-takers.

You Can Get Too Pessimistic

Posted on 7 May 20169 May 2016 by David Merkel

Photo Credit: Kathryn || Truly, I sympathize. ?I try to be strong for others when internally I am broken.

Entire societies and nations have been wiped out in the past. ?Sometimes this has been in spite of the best efforts of leading citizens to avoid it, and sometimes it has been because of their efforts. ?In human terms, this is as bad as it gets on Earth. ?In virtually all of these cases, the optimal strategy was to run, and hope that wherever you ended up would be kind to foreigners. ?Also, most common methods of preserving value don’t work in the worst situations… flight capital stashed early in the place of refuge?and?gold might work, if you can get there.

There. ?That’s the worst survivable scenario I can think of. ?What does it take to get there?

Total government and?market breakdown, or
A lost war on your home soil, with the victors considerably less kind than the USA and its allies

The odds of these are very low in most of the developed world. ?In the developing world, most of the wealthy have “flight capital” stashed away in the USA or someplace equally reliable.

-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-==-=-=-=-=-=-

Most nations, societies and economies are more durable than most people would expect. ?There is a cynical reason for this: the wealthy and the powerful have a distinct interest in not letting things break. ?As Solomon observed a little less than 3000 years ago:

If you see the oppression of the poor, and the violent perversion of justice and righteousness in a province, do not marvel at the matter; for high official watches over high official, and higher officials are over them. Moreover the profit of the land is for all; even the king is served from the field. — Ecclesiastes 5:8-9 [NKJV]

In general, I think there is?no value in preparing for the “total disaster” scenario if you live in the developed world. ?No one wants to poison their own prosperity, and so the?rich and powerful?hold back from being too rapacious.

-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-==-=-=-=-=-=-

If you don’t have a copy, it would?be a good idea to get a copy of?Triumph of the Optimists. ?[TOTO] ?As I commented in my review of TOTO:

TOTO points out a number of things that should bias investors toward risk-bearing in the equity markets:

Over the period 1900-2000, equities beat bonds, which beat cash in returns. (Note: time weighted returns. If the study had been done with dollar-weighted returns, the order would be the same, but the differences would not be so big.)
This was true regardless of what presently developed nation you looked at. (Note: survivor bias? what of all the developing markets that looked bigger in 1900, like Russia and India, that amounted to little?)
Relative importance of industries shifts, but the aggregate market tended to do well regardless. (Note: some industries are manias when they are new)
Returns were higher globally in the last quarter of the 20th century.
Downdrafts can be severe. Consider the US 1929-1932, UK 1973-74, Germany 1945-48, or Japan 1944-47. Amazing what losing a war on your home soil can do, or, even a severe recession.
Real cash returns tend to be positive but small.
Long bonds returned more than short bonds, but with a lot more risk. High grade corporate bonds returned more on average, but again, with some severe downdrafts.
Purchasing power parity seems to work for currencies in the long run. (Note: estimates of forward interest rates work in the short run, but they are noisy.)
International diversification may give risk reduction. During times of global stress, such as wartime, it may not diversify much. Global markets are more correlated now than before, reducing diversification benefits.
Small caps may or may not outperform large caps on average.
Value tends to beat growth over the long run.
Higher dividends tend to beat lower dividends.
Forward-looking equity risk premia are lower than most estimates stemming from historical results. (Note: I agree, and the low returns of the 2000s so far in the US are a partial demonstration of that. My estimates are a little lower, even?)
Stocks will beat bonds over the long run, but in the short run, having some bonds makes sense.
Returns in the latter part of the 20th century were artificially high.

Capitalist republics/democracies tend to be very resilient. ?This should make us willing to be long term bullish.

Now, many people look at their societies and shake their heads, wondering if things won’t keep getting worse. ?This typically falls into three?non-exclusive buckets:

The rich are getting richer, and the middle class is getting destroyed ?(toss in comments about robotics, immigrants, unfair trade, education problems with children, etc. ?Most such comments are bogus.)
The dependency class is getting larger and larger versus the productive elements of society. ?(Add in comments related to demographics… those comments are not bogus, but there is a deal that could be driven here. ?A painful deal…)
Looking at moral decay, and wondering at it.

You can add to the list. ?I don’t discount that there are challenges/troubles. ?Even modestly healthy society can deal with these without falling apart.

-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-==-=-=-=-=-=-

If you give into fears like these, you can become prey to a variety of investment “experts” who counsel radical strategies that will only succeed with very low probability. ?Examples:

Strategies that neglect investing in risk assets at all, or pursue shorting them. ?(Even with hedge funds you have to be careful, we passed the limits to arbitrage back in the late ’90s, and since then aggregate returns have been poor. ?A few niche hedge funds make sense, but they limit their size.)
Gold, odd commodities — trend following CTAs can sometimes make sense as a diversifier, but finding one with skill is tough.
Anything that smacks of being part of a “secret club.” ?There are no secrets in investing. ?THERE ARE NO SECRETS IN INVESTING!!! ?If you think that con men in investing is not a problem, read?On Avoiding Con Men. ?I spend lots of time trying to take apart investment pitches that are bogus, and yet I feel that I am barely scraping the surface.

-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-==-=-=-=-=-=-

Things are rarely as bad as they seem. ?Be willing to be a modest bull most of the time. ?I’m not saying don’t be cautious — of course be cautious! ?Just don’t let that keep you from taking some risk. ?Size your risks to your time horizon for needing cash back, and your ability to sleep at night. ?The biggest risk may not be taking no risk, but that might be the most common risk economically for those who have some assets.

To close, here is a personal comment that might help: I am natively a pessimist, and would easily give into disaster scenarios. ?I had to train myself to realize that even in the worst situations there was some reason for optimism. ?That served me well as I invested spare assets at the bottoms in 2002-3 and 2008-9. ?The sun will rise tomorrow, Lord helping us… so?diversify and take moderate risks most of time.

Estimating Future Stock Returns, Follow-up

Posted on 16 April 201617 April 2016 by David Merkel

Idea Credit: Philosophical Economics Blog

My most recent post,?Estimating Future Stock Returns?was well-received. ?I expected as much. ?I presented it as part of a larger presentation to a session at the Society of Actuaries 2015 Investment Symposium, and a recent meeting of the Baltimore Chapter of the AAII. ?Both groups found it to be one of the interesting aspects of my presentation.

This post is meant to answer three reasonable questions that got posed:

How do you estimate the model?
How do we understand what it is forecasting given multiple forecast horizons seemingly implied by the model?
Why didn’t the model how badly the market would do in 2001 and 2008? ?And I will add 1973-4 for good measure.

Ready? ?Let’s go!

How to Estimate

In his original piece, @Jesse_Livermore freely gave the data and equation out that he used. ?I will do that as well. ?About a year before I wrote this, I corresponded with him by email, asking if he had noticed that the Fed changed some of the data in the series that?his variable used retroactively. ?That was interesting, and a harbinger for what would follow. ?(Strange things happen when you rely on government data. ?They don’t care what others use it for.)

In 2015, the Fed discontinued one of the series that was used in the original calculation. ?I noticed that when the latest Z.1 report came out, and I tried to estimate it the old way. ?That threw me for a loop, and so I tried to re-estimate the relationship using what data was there. ?That led me to do the following:

Use this data series from FRED: [A]?Nonfinancial corporate business; corporate equities; liability, Level, and
use these three series from the Federal Reserve: [B] Domestic nonfinancial sectors; debt securities and loans; liability, [C] Rest of the world; debt securities and loans; liability, and [D]?Domestic financial sectors; corporate equities; liability

I tried to get all of them from one source, and could not figure out how to do it. ?The Z.1 report has all four variables in it, but somehow, the Fed’s Data Download Program, which one of my friends at a small hedge fund charitably referred to as “finicky” did not have that series, and somehow FRED did. ?(I don’t get that, but then there are a lot of things that I don’t get. ?This is not one of those times when I say, “Actually, I do get it; I just don’t like it.” ?That said, like that great moral philosopher Lucy van Pelt, I haven’t ruled out stupidity yet. ?To which I add, including my stupidity.)

The variable is calculated like this:

(A + D)/(A + B + C + D)

Not too hard, huh? ?The R-squared is just a touch lower from estimating it the old way… but the difference is not statistically significant. ?The estimation is just a simple ordinary least squares regression using that single variable as the independent variable, and the dependent variable being the total return on the S&P 500.

As an aside, I tested the variable over other forecast horizons, and it worked best over 10-11 years. ?On individual years, the model is most powerful at predicting the next year (surprise!), and gets progressively weaker with each successive individual year.

To make it concrete: you can use this model to forecast the expected returns for 2016, 2017, 2018, etc. ?It won’t be very accurate, but you can do it. ?The model gets more accurate forecasting over a longer period of time, because the vagaries of individual years average out. ?After 10-11 years, the variable is useless, so if I were put in charge of setting stock market earnings assumptions for a pension plan, I would do it as a step function, 6% for the next 10 years, and 9.5% per year thereafter… or in place of 9.5% whatever your estimate is for what the market should return normally.

On Multiple Forecast Horizons

One reader commented:

I would like to make a small observation if I may. If the 16% per annum from Mar 2009 is correct we still have a 40%+ move to make over the next three years. 670 (SPX March 09) growing at 16% per year yields 2900 +/- in 2019. With the SPX at 2050 we have a way to go. If the 2019 prediction is correct, then the returns after 2019 are going to be abysmal.

The first answer would be that you have to net dividends out. ?In March of 2009, the S&P 500 had a dividend yield of around 4%, which quickly fell as the market rose and dividends fell for about one year. ?Taking the dividends into account, we only need to get to 2270 or so by the March?of 2019, works out to 3.1% per year. ?Then add back a dividend yield of about 2.2%, and you are at a more reasonable 5.3%/year.

That said, I would encourage you to keep your eye on the bouncing ball (and sing along with Mitch… does that date me…?). ?Always look at the new forecast. ?Old forecasts aren’t magic — they’re just the best estimate a single point in time. ?That estimate becomes obsolete as conditions change, and people adjust their portfolio holdings to hold proportionately more or less stocks. ?The seven year old forecast may get to its spot in three years, or it may not — no model is perfect, but this one does pretty well.

What of 2001 and 2008? ?(And 1973-4?)

Another reader wrote:

Interesting post and impressive fit for the 10 year expected returns. ?What I noticed in the last graph (total return) is, that the drawdowns from 2001 and 2008 were not forecasted at all. They look quite small on the log-scale and in the long run but cause lot of pain in the short run.

Markets have noise, particularly during bear markets. ?The market goes up like an escalator, and goes down like an elevator. ?What happens in the last year of a ten-year forecast is a more severe version of what the prior questioner asked about the 2009 forecast of 2019.

As such, you can’t expect miracles. ?The thing that is notable is how well this model did versus alternatives, and you need to look at the graph in this article to see it (which was at the top of the last piece). ?(The logarithmic graph is meant for a different purpose.)

Looking at 1973-4, 2001-2 and 2008-9, the model missed by 3-5%/year each time at the lows for the bear market. ?That is a big miss, but it’s a lot smaller than other models missed by, if starting 10 years earlier. ?That said, this model would have told you prior to each bear market that future rewards seemed low — at 5%, -2%, and 5% respectively for the ?next ten years.

Conclusion

No model is perfect. ?All models have limitations. ?That said, this one is pretty useful if you know what it is good for, and its limitations.

The Limits of Risky Asset Diversification

Posted on 11 December 2015 by David Merkel

Photo Credit: Baynham Goredema || When things are crowded, how much freedom to move do you have?

Stock diversification is overrated.

Alternatives are more overrated.

High quality bonds are underrated.

This post was triggered by a guy from the UK who sent me an infographic on reducing risk that I thought was mediocre at best. ?First, I don’t like infographics or video. ?I want to learn things quickly. ?Give me well-written text to read. ?A picture is worth maybe fifty words, not a thousand, when it comes to business writing, perhaps excluding some well-designed graphs.

Here’s the problem. ?Do you want to reduce?the volatility of your asset portfolio? ?I have the solution for you. ?Buy bonds and hold some cash.

And some say to me, “Wait, I want my money to work hard. ?Can’t you find investments that offer a higher return that diversify my portfolio of stocks and other risky assets?” ?In a word the answer is “no,” though some will tell you otherwise.

Now once upon a time, in ancient times, prior to the Nixon Era, no one hedged, and no one looked for alternative investments. ?Those buying stocks stuck to well-financed “blue chip” companies.

Some clever people realized that they could take risk in other areas, and so they broadened their stock exposure to include:

Growth stocks
Midcap stocks (value & growth)
Small cap stocks (value & growth)
REITs and other income passthrough vehicles (BDCs, Royalty Trusts, MLPs, etc.)
Developed International stocks (of all kinds)
Emerging Market stocks
Frontier Market stocks
And more…

And initially, it worked. ?There was significant diversification until… the new asset subclasses were crowded with institutional money seeking the same things as the original diversifiers.

Now, was there no diversification left? ?Not much. ?The diversification from investor behavior is largely gone (the liability side of correlation). ?Different sectors of the global economy don’t move in perfect lockstep,?so natively the return drivers of the assets are 60-90% correlated (the asset side of correlation, think of how the cost of capital moves in a correlated way across companies). ?Yes, there are a few nooks and crannies that are neglected, like Russia and Brazil, industries that are deeply out of favor like gold, oil E&P, coal, mining, etc., but you have to hold your nose and take reputational risk to buy them. ?How many institutional investors want to take a 25% chance of losing a lot of clients by failing unconventionally?

Why do I hear crickets? ?Hmm…

Well, the game wasn’t up yet, and those that pursued diversification pursued alternatives, and they bought:

Timberland
Real Estate
Private Equity
Collateralized debt obligations of many flavors
Junk bonds
Distressed Debt
Merger Arbitrage
Convertible Arbitrage
Other types of arbitrage
Commodities
Off-the-beaten track bonds and derivatives, both long and short
And more… one that stunned me during the last bubble was leverage nonprime commercial paper.

Well guess what? ?Much the same thing happened here as happened with non-“blue chip” stocks. ?Initially, it worked. ?There was significant diversification until… the new asset subclasses were crowded with institutional money seeking the same things as the original diversifiers.

Now, was there no diversification left? ?Some, but less. ?Not everyone was willing to do all of these. ?The diversification from investor behavior was reduced?(the liability side of correlation). ?These don’t move in perfect lockstep,?so natively the return drivers of the risky components of the assets are 60-90% correlated over the long run (the asset side of correlation, think of how the cost of capital moves in a correlated way across companies). ?Yes, there are some?that are neglected, but you have to hold your nose and take reputational risk to buy them, or sell them short. ?Many of those blew up last time. ?How many institutional investors want to take a 25% chance of losing a lot of clients by failing unconventionally?

Why do I hear crickets again? ?Hmm…

That’s why I don’t think there is a lot to do anymore in diversifying risky assets beyond a certain point. ?Spread your exposures, and do it intelligently, such that the eggs are in baskets are different as they can be, without neglecting the effort to buy attractive assets.

But beyond that, hold dry powder. ?Think of cash, which doesn’t earn much or lose much. ?Think of some longer high quality bonds that do well when things are bad, like long treasuries.

Remember, the reward for taking business risk in general varies over time. ?Rewards are relatively thin now, valuations are somewhere in the 9th decile (80-90%). ?This isn’t a call to go nuts and sell all of your risky asset positions. ?That requires more knowledge than I will ever have. ?But it does mean having some dry powder. ?The amount is up to you as you evaluate your time horizon and your opportunities. ?Choose wisely. ?As for me, about 20-30% of my total assets are safe, but I?have been a risk-taker most of my life. ?Again, choose wisely.

PS — if the low volatility anomaly weren’t overfished, along with other aspects of factor investing (Smart Beta!) those might also offer some diversification. ?You will have to wait for those ideas to be forgotten. ?Wait to see a few fund closures, and a severe reduction in AUM for the leaders…