Asset Allocation – Page 7

Sixteen Implications of “The Phases of an Investment Idea”

Posted on 2 July 2015 by David Merkel

My last post has many implications. I want to make them clear in this post.

When you analyze?a manager, look at the repeatability of his processes. ?It’s possible that you could get “the Big Short” right once, and never have another good investment idea in your life. ?Same for investors who are the clever ones who picked the most recent top or bottom… they are probably one-trick ponies.
When a manager does well and begins to pick up a lot of new client assets, watch for the period where the growth slows to almost zero. ?It is quite possible that some of the great performance during the high growth period stemmed from asset prices rising due to the purchases of the manager himself. ?It might be a good time to exit, or, for shorts to consider the assets with the highest percentage of market cap owned as targets for shorting.
Often when countries open up to foreign investment, valuations are relatively low. ?The initial flood of money in often pushes up valuations, leads to momentum buyers, and a still greater flow of money. ?Eventually an adjustment comes, and shakes out the undisciplined investors. ?But, when you look at the return series analyze potential future investment, ignore the early years — they aren’t representative of the future.
Before an academic paper showing a way to invest that would been clever to use in the past gets published, the excess returns are typically described as coming from valuation, momentum, manager skill, etc. ?After the paper is published, money starts getting applied to the idea, and the strategy will do well initially. ?Again, too much money can get applied to a limited factor (or other) anomaly, because no one knows how far it can get pushed before the market rebels. ?Be careful when you apply the research — if you are late, you could get to hold the bag of overvalued companies. ?Aside for that, don’t assume that performance from the academic paper’s era or the 2-3 years after that will persist. ?Those are almost always the best years for a factor (or other) anomaly strategy.
During a credit boom, almost every new type of fixed income security, dodgy or not, will look like genius by?the early purchasers. ?During a credit bust, it is rare for a new security type to fare well.
Anytime you take a large position in an obscure security, it must jump through extra hoops to assure a margin of safety. ?Don’t assume that merely because you are off the beaten path that you are a clever contrarian, smarter than most.
Always think about the carrying capacity of a strategy when you look at an academic paper. ?It might be clever, but it might not be able to handle a lot of money. ?Examples would include trying to do exactly what Ben Graham did in the early days today, and things like Piotroski’s methods, because typically only a few small and obscure stocks survive the screen.
Also look at how an academic paper models trading and liquidity, if they give it any real thought at all. ?Many papers embed the idea that liquidity is free, and large trades can happen where prices closed previously.
Hedge funds and other manager databases should reflect that some managers have closed their funds, and put them in a separate category, because new money can’t be applied to those funds. ?I.e., there should be “new money allowed” indexes.
Max Heine, who started the Mutual Series funds (now part of Franklin), was a genius when he thought of the strategy 20% distressed investing, 20% arbitrage/event-driven investing and 60% value investing. ?It produced great returns 9 years out of 10. ?but once distressed investing and event-driven because heavily done, the idea lost its punch. ?Michael Price was clever enough to sell the firm to Franklin before that was realized, and thus capitalizing the past track record that would not?do as well in the future.
The same applies to a lot of clever managers. ?They have a very good sense of when their edge is getting dulled by too much competition, and where the future will not be as good as the past. ?If they have the opportunity to sell, they will disproportionately do so then.
Corporate management teams are like rock bands. ?Most of them never have a hit song. ?(For managements, a period where a strategy improves profitability far more than most would have expected.) ?The next-most are one-hit wonders. ?Few have multiple hits, and rare are those that create a culture of hits. ?Applying this to management teams — the problem is if they get multiple bright ideas, or a culture of success, it is often too late to invest, because the valuation multiple adjusts to reflect it. ?Thus, advantages accrue to those who can spot clever managements before the rest of the market. ?More often this happens in dull industries, because no one would think to look there.
It probably doesn’t make sense to run from hot investment idea to hot investment idea as a result of all of this. ?You will end up getting there once the period of genius is over, and valuations have adjusted. ?It might be better to buy the burned out stuff and see if a positive surprise might come. ?(Watch margin of safety…)
Macroeconomics and the effect that it has on investment returns is overanalyzed, though many get the effects wrong anyway. ?Also, when central bankers and politicians take cues from the prices of risky assets, the feedback loop confuses matters considerably. ?if you must pay attention to macro in investing, always ask, “Is it priced in or not? ?How much of it is priced in?”
Most asset allocation work that relies on past returns is easy to do and bogus. ?Good asset allocation is forward-looking and ignores past returns.
Finally, remember that some ideas seem?right by accident — they aren’t actually right. ?Many academic papers don’t get published. ?Many different methods of investing get tried. ?Many managements try new business ideas. ?Those that succeed get air time, whether it was due to intelligence or luck. ?Use your business sense to analyze which it might be, or, if it is a combination.

There’s more that could be said here. ?Just be cautious with new investment strategies, whatever form they may take. ?Make sure that you maintain a margin of safety; you will likely need it.

Stocks or Bonds?

Posted on 19 June 201521 June 2015 by David Merkel

I was writing to potential clients when I realized that I don’t have so much to write about my bond track record as I do my track record with stocks. ?I jotted down a note to formalize what I say about my bond portfolios.

One person I was writing to asked some detailed questions, and I told him that the stock market was likely to return about 4.5%/yr (not adjusted for inflation) over the next ten years. ?The model I use is the same one as this one used by pseudonymous Philosophical Economist. ?I don’t always agree with him, but he’s a bright guy, what can I say? ?That’s not a very high return — the historical average is around 9.5%. ?The market is in the 85th-90th percentiles of valuation, which is pretty high. ?That said, I am not taking any defensive action yet.

Yet.

But then it hit me. ?The yield on my bond portfolio is around 4.5% also. ?Now, it’s not a riskless bond portfolio, as you can tell by the yield. ?I’m no longer running the portfolio described in Fire and Ice. ?I sold the long Treasuries about 30 basis points ago. ?Right now, I am only running the Credit sensitive portion of the portfolio, with a bit of foreign bonds mixed in.

Why am I doing this? ?I think it has a good balance of risks. ?Remember that there is no such thing as generic risk. ?There are many risks. ?At this point this portfolio has a decent amount of credit risk, some foreign exchange risk, and is low in interest rate risk. ?The duration of the portfolio is less than?2, so I am not concerned about rising rates, should the FOMC ever do such a thing as raise rates. ?(Who knows? ?The economy might actually grow faster if they did that. ?Savers will eventually spend more.)

But 10 years is a long time for a bond portfolio with a duration of less than 2 years. ?I’m clipping coupons in the short run, running credit risk while I don’t see any major credit risks on the horizon aside from weak sovereigns (think the PIIGS), student loans, and weak junk (ratings starting with a “C”). ?The risks on bank loans are possibly overdone here, even with weakened covenants. ?Aside from that, if we really do see a lot of credit risk crop up, stocks will get hit a lot harder than this portfolio. ?Dollar weakness and US inflation (should we see any) would also not be a risk.

I’ve set a kind of a mental stop loss at losing 5% of portfolio value. ?Bad credit is the only significant factor that could harm the portfolio. ?If credit problems got that bad, it would be time to exit because credit problems come in bundles, not dribs and drabs.

I’m not doing it yet, but it is?tempting to reposition some of my IRA assets presently in stocks into the bond strategy. ?I’m not sure I would lose that much in terms of profit potential, and it would increase the overall safety of the portfolio.

I’ll keep you posted. ?That is, after I would tell my clients what I am doing, and give them a chance to act, should they want to.

Finally, do you have a different opinion? ?You can email me, or, you can share it with all of the readers in the comments. ?Please do.

Why Life Insurers, Defined Benefit Plans, and Endowments Invest Differently

Posted on 25 April 2015 by David Merkel

Despite the large and seemingly meaty title, this will be a short piece. ?I class these types of investors together because most of them have long investment horizons. ?From an asset-liability management standpoint, that would mean they should invest similarly. ?That may be have been true for Defined Benefit [DB] pension plans and Endowments, but that has shifted over time, and is increasingly not true. ?In some ways, the DB plans are becoming more like life insurers in the way they invest, though not totally so. ?So, why do they invest differently? ?Two reasons: internal risk management goals, and the desires of insurance?regulators to preserve industry solvency.

Let’s start with life insurers. ?Regulators don’t want insolvent companies, so they constrain companies into safe assets using risk-based capital charges. ?The riskier the investment, the more capital the insurer has to put up against it. ?After that, there is cash-flow testing which tends to push life insurers to match assets and liabilities, or at least, not have a large mismatch. ?Also, accounting rules may lead insurers to buy assets where the income will show up on their financial statements regularly.

The result of this is that life insurers don’t invest much in risk assets — maybe they invest in stocks, junk bonds, etc. up to the amount of their surplus, but not much more than that.

DB plans don’t have regulators that care about investment risks. ?They do have plan sponsors that do care about investment risk, and that level of care has increased over the past 15?years. ?Back in?the late ’90s it was in vogue for DB plans to allocate more and more to risk assets, just in time for the market to correct. ?(Note to retail investors: professionals may deride your abilities, but the abilities of many professionals are questionable also.)

Over that time, the rate used to discount DB plan liabilities became standardized and attached to long high quality bonds. ?Together with a desire to minimize plan funding risks, and thus corporate risks for the plan sponsor, that led to more investments in bonds, and less in equities and other risk assets. ?Some plans try to cash flow match expected future plan payments out to a horizon.

Finally, endowments have no regulator, and don’t have a plan sponsor?that has to make future payments. ?They are free to invest as they like, and probably have the highest degree of variation in their assets as a group. ?There is some level of constraint from the spending rules employed by the endowments, particularly since 2008-9, when a number of famous endowments came to realize that there was a liability structure behind them when they ran low on liquidity amid the crisis. [Note: long article.] ?You might think it would be smart to have the present value of 3-5?years of expenditures on hand in bonds, but that is not always the case. ?In some ways, the quick recovery taught some endowment investors the wrong lesson — that they could wait out any crisis.

That’s my quick summary. ?If you have thoughts on the matter, you can share them in the comments.

On Being A Forced Seller in a Panic

Posted on 17 April 201517 April 2015 by David Merkel

No one wants to be a forced seller in a panic. So how does anyone get into that situation? ?Two things: bad planning and a bad scenario.

Let’s start with the obvious stuff: the moment you start using leverage, there is a positive probability of total failure, and more leverage increases the probability. ?Other factors that raise the probability are lack of diversification of assets, a short term for repayment on the leverage, a run on the bank, or restrictive rules on what happens if your assets decline too much in value.

For the big guys, I think that covers most of it. ?With little guys, there is one more painful way that it happens, with insult added to injury.

Assume the man in question has no formal leverage, except maybe a mortgage on his house. ?He has a stock portfolio, and like many, has bought popular stocks that everyone thinks will do well. ?Then a?significant panic hits the market because enough corporate or banking debts are incapable of being repaid.

The value of his portfolio falls a lot, but he doesn’t sell or worry immediately, because he has a solid job and has a buffer of a few months expenses set aside. ?Then the shock hits. ?In the midst of the panic he faces one of the following:

The loss of his job (or severe trouble in his business)
Disability with no insurance
An uninsured casualty of some sort
Divorce
Health problems not covered by insurance
Death (and his wife has to pick up the pieces)
Etc.

Guess what? ?Even though he planned ahead, the plan did not consider true disasters, where two things fail at the same time. ?His buffer runs out, and in order to live, he has to sell stocks at a time when he thinks they are undervalued.

This happens to some degree in the depths of bear markets, because unemployment and credit panics are correlated. ?Other contingencies may not be correlated, but a certain number of them happen all the time — the odds of them happening when the stock market is down is still positive.

What can be done? ?Here are a few ideas:

Hold a bigger buffer. ?Maybe toss in some high quality long bonds, as well as cash.
Reduce fixed commitments.
Insure most reasonably possible large insurable contingencies — death, disability, health, liability, etc.
Keep a rolling hedge of protective puts (costly)
Increase portfolio quality and diversification to lessen the hit.

The time plan for a flat tire is before you have one. ?As an example, I keep wrenches that are better than what the automakers put in their tire changing kits in my cars. ?The same is true for financial disasters. ?The planning is best done in the good times, like now. ?Consider your financial and personal risks, and adjust your positions accordingly, realizing that no one can survive every panic. ?Eventually you have to trust in God, because no earthly security system is comprehensive.

From Stream to Shining Stream

Posted on 11 April 201512 April 2015 by David Merkel

There’s one thing that is a misunderstanding about retirement investing. It’s not something that is out-and-out wrong. It’s just not totally right.

Many think the objective is to acquire a huge pile of assets.

Really, that’s half of the battle.

The true battle is this: taking a stream of savings, derived from a stream of income, and turning it into a robust stream of income in retirement.

That takes three elements to achieve: saving, compounding, and distribution.

What’s that, you say? ?That’s no great insight?

Okay, let me go a little deeper then.

Saving is the first skirmish. ?Few people develop a habit of saving when they are relatively young. ?Try to make it as automatic as possible. ?Aim for at least 10% of income, and more if you are doing well, particularly if your income is not stable.

Don’t forget to fund a “buffer fund” of 3-6 months of expenses to be used for only the following:

Emergencies
Gaining discounts for advance payment (if you know you have future income to replenish it)

The savings and the “buffer fund” provide the ability to enter into the second phase, compounding. ?The buffer fund allows the savings to not be invaded for current use so they can be invested and compound their value into a greater amount.

Now, compounding is trickier than it may seem. ?Assets must be selected that will grow their value including dividend payments over a reasonable time horizon, corresponding to a market cycle or so (4-8 years). ?Growth in value should be in excess of that from expanding stock market multiples or falling interest rates, because you want to compound in the future, and low interest rates and high stock market multiples imply that future compounding opportunities are lower.

Thus, in one sense, you don’t benefit much from a general rise in values from the stock or bond markets. ?The value of your portfolio may have risen, but at the cost of lower future opportunities. ?This is more ironclad in the bond market, where the cash flow streams are fixed. ?With stocks and other risky investments, there may be some ways to do better.

1) With asset allocation, overweight out-of-favor asset classes that offer above average cashflow yields. ?Estimates on these can be found at GMO or Research Affiliates. ?Rebalance into new asset classes when they become cheap.

2) Growth at a reasonable price investing: invest in stocks that offer capital growth opportunities at a inexpensive price and a margin of safety. ?These companies or assets need to have large opportunities in front of them that they can reinvest their free cash flow into. ?This is harder to do than it looks. ?More companies look promising and do not perform well than those that do perform well.

3) Value investing: Find undervalued companies with a margin of safety that have potential to recover when conditions normalize, or find companies that can convert their resources to a better use that have the willingness to do that. ?As your companies do well, reinvest in new possibilities that have better appreciation potential.

4) Distressed investing: in some ways, this can be?market timing, but be willing to take risk when things are at their worst. ?That can mean investing during a credit crisis, or investing in countries where conditions are somewhat ugly at present. ?This applies to risky debt as well as stocks and hybrid instruments. ?The best returns come out of investing near the bottom of a?panic. ?Do your homework carefully here.

5) Avoid losses. ?Remember:

Margin of safety. ?Valuable asset well in excess of debts, rule of law, and a bargain price.
In dealing with distress, don’t try to time the bottom — maybe use a 200-day moving average rule to limit risk and invest when the worst is truly past.
Avoid the areas where the hot money is buying and own assets being acquired by patient investors.

Adjust your portfolio infrequently to harvest things that have achieved their potential and reinvest in promising new?opportunities.

That brings me to the final skirmish, distribution.

Remember when I said:

You don’t benefit much from a general rise in values from the stock or bond markets. ?The value of your portfolio may have risen, but at the cost of lower future opportunities.

That goes double in the distribution phase. The objective is to convert assets into a stream of income. ?If interest rates are low, as they are now, safe income will be low. ?The same applies to stocks (and things like them) trading at high multiples regardless of what dividends they pay.

Don’t look at current income. ?Look instead at the underlying economics of the business, and how it grows value. ?It is far better to have a growing income stream than a high income stream with low growth potential.

Also consider the risks you may face, and how your assets may fare. ?How are you exposed to risk?from:

Inflation
Deflation and a credit crisis
Expropriation
Regulatory change
Trade wars
Etc.

And, as you need, liquidate some of the assets that offer the least future potential for your use. ?In retirement, your buffer might need to be bigger because the lack of wage income takes away a hedge against unexpected expenses.

Conclusion

There are other issues, like taxes, illiquidity, and so forth to consider, but this is the basic idea on how to convert present excess income into a robust income stream in retirement. ?Managing a pile of assets for income to live off of is a challenge, and one that most people?are not geared up for, because poor planning and emotional decisions lead to subpar results.

Be wise and?aim for the best future opportunities with a margin of safety, and let the retirement income take care of itself. ?After all, you can’t rely on the markets or the policymakers to make income opportunities easy. ?Choose wisely.

Advice on Organizing Asset Allocations and Managers

Posted on 26 February 2015 by David Merkel

I was reading an occasional blast email from my friend Tom Brakke, when he mentioned a free publication from Redington, a UK asset management firm that employs actuaries, among others. I was very impressed with what I read in the 32-page publication, and highly recommend it to those who select investment managers or create asset allocations, subject to some caveats that I will list later in this article.

In the UK, actuaries are trained to a higher degree to deal with investments than they are in the US. The Society of Actuaries could learn a lot from the Institute of Actuaries in that regard. As a former Fellow in the Society of Actuaries, I was in the vanguard of those trying to apply actuarial principles to risk management, both when I managed risks for insurance companies, worked for non-insurance organizations, and manage money for upper middle class individuals and small institutions. Redington’s thoughts are very much like mine in most ways. As I see it, the best things about their investment reasoning are:

Risk management must be both quantitative and qualitative.
Risk is measured relative to client needs and thus the risk of an investment is different for clients with different needs. ?Universal measures of risk like Sharpe ratios, beta and standard deviation of asset returns are generally inferior measures of risk. ?(DM: But they allow the academics to publish! ?That’s why they exist! ?Please fire consultants that use them.)
Risk control methods must be?implemented by clients, and not countermanded if they want the risk control to work.
Shorting requires greater certainty than going long (DM: or going levered long).
Margin of safety is paramount in investing.
Risk control is more important when things are going well.
It is better to think of alternatives in terms of the specific risks that they pose, and likely future compensation, rather than look at track records.
Illiquidity should be taken on with caution, and with more than enough compensation for the loss of flexibility in future asset allocation decisions and cash flow needs.
Don’t?merely avoid risk, but take risks where?there is more than fair compensation for the risks undertaken.
And more… read the 32-page publication from Redington if you are interested. ?You will have to register for emails if you do so, but they seem to be a classy firm that would honor a future unsubscribe request. ?Me? ?I’m looking forward to the next missive.

Now, here are a few places where I differ with them:

Caveats

Aside from pacifying clients with lower volatility, selling puts and setting stop-losses will probably lower returns for investors with long liabilities to fund, who can bear the added volatility. ?Better to try to educate the client that they are likely leaving money on the table. ?(An aside: selling short-duration at-the-money puts makes money on average, and the opposite for buying them. ?Investors with long funding needs could dedicate 1% of their assets to that when the payment to do so is high — it’s another way of profiting from offering insurance in of for a crisis.)
Risk parity strategies are overrated (my arguments against it here:?one, two).
I think that reducing allocations to risky assets when volatility gets high is the wrong way to do it. ?Once volatility is high, most of the time the disaster has already happened. ?If risky asset valuations show that the market is offering you significant deals, take the deals, even if volatility is high. ?If volatility is high and valuations indicate that your opportunities are average to poor at best, yeah, get out if you can. ?But focus on valuations relative to the risk of significant loss.
In general, many of their asset class articles give you a good taste of the issues at hand, but I would have preferred more depth at the cost of a longer publication.

But aside from those caveats, the publication is highly recommended. ?Enjoy!

Living in the Land of Worries, Part 1

Posted on 3 January 20154 January 2015 by David Merkel

There is always a reason to worry, and always enough time to panic.

Look over there, behind that bush: interest rates are rising. In Europe and China, deflation is threatening. The geopolitical situation is in many ways tense over Russia and Middle East issues. Japan is a mess. Emerging markets will get hit when the Fed starts to tighten.

I could go on, and talk about the longer term demographic problems that we face, and other aspects of lousy government policy, but it would get too long. The point is, there are things that you can worry about. But what should you do?

For many people, worry paralyzes. If there are significant potential problems, they won’t invest, or they will keep their investments very simple and safe. They may fall prey to those who scam by offering “safety” though gold, guns, food storage, life insurance products, etc. Is there a better way to avoid worry?

The first way to avoid worry is to realize that more things can go wrong than do go wrong. Many of the things you might worry about will not happen. Second, even when things do go wrong, the market prices often reflect those possibilities, so the markets may not react badly. Third, the markets have endured many crises in the past and have come back from those crises. Fourth, in the worst crises you can imagine, it will not matter what you do if those take place — you will lose a lot, but so will everyone else. If no strategy can work in the worst problems, you should spend your time praying rather than worrying.

Some might say to me, “But I don’t want to lose a lot of money! I’m relying on it for my retirement (or whatever).” If that is your problem, the answer is simple — invest less in risk assets. Give up some potential return so that you can sleep at night. That has been my advice to a bunch of pastors who generally don’t understand the markets at all. We offer them blended portfolios of risky and safe assets ranging from low volatility to the volatility level of the stock market. I tell them to look at what the blended portfolios have lost in 2008, and size the risk of their holdings to what they can live with in terms of risk if they had to liquidate at a bad time. If they are still squeamish, I tell them to take the risk level down another notch.

There is a risk to not taking enough risk, and that will be the point of part 2, but it is better for the squeamish to implement a sub-optimal plan than no plan. It is also better for the squeamish to implement a sub-optimal plan than a plan that they can’t maintain, because they get too scared.

Solutions have to be real-world to meet people where they are. After that, maybe we can try to teach people not to worry, but human nature is difficult to change.

PS — for any that might say that they are worried that they aren’t going to earn enough to be able to retire or stay comfortably retired, part 2 will have something to say there as well.

Learning from the Past, Part 2

Posted on 2 January 201516 February 2015 by David Merkel

Happy New Year to all of my readers. May 2015 be an enriching year for you in all ways, not just money.

This is a series on learning about investing, using my past mistakes as grist for the mill. ?I have had my share of mistakes, as you will see. ?The real question is whether you learn from your mistakes, and I can say that I mostly learn from them, but never perfectly.

In the early 90s, I fell in with some newsletter writers that were fairly pessimistic. ?As such, I did not do the one thing that from my past experience that I found I was good at: picking stocks. ?Long before I had money to invest, I thought it was a lot of fun to curl up with Value Line and look for promising companies. ?Usually, I did it well.

But I didn’t do that in that era. ?Instead, I populated my portfolio with international stock and bond funds, commodity trading funds, etc., and almost nothing that was based in?the USA. ?I played around with closed-end funds trying to see if I could eke alpha out of the discounts to NAV. ?(Answer: No.) ?I also tried shorting badly run companies to make a profit. ?(I succeeded minimally, but that was the era, not skill.)

I’ve been using my tax returns from that era to prompt?my memory of what I did, and the kindest thing I can say is that I?didn’t have a consistent strategy, and so my results were poor-to-moderate. ?I made money, just not much money. ?I even manged to buy the Japanese equity market on the day that it peaked, and after many months got out with a less-than-deserved 3% loss in dollar terms because of offsetting currency movements.

One thing I did benefit from was learning about a wide number of investing techniques and instruments, which benefited me professionally, because it taught me about the broader context of investing. ?That said, it cost time, and some of what I learned was marginal.

But not having a good overall strategy largely means you are wasting your time in investing. ?You may succeed for a while with what some call luck, but luck by its nature is not consistent.

Thus, I would encourage all of my readers to adopt an approach that fits their:

Knowledge
Personality
Available time

You have to do something that you truly understand, even if it is hiring an advisor, wealth manager, etc. ?You must be able to understand the outer edges of what they do, or how will you evaluate whether they are serving you well or not? ?Honesty, integrity, and reputation can go a long way here, but it really helps to know the basics.

Picking fund managers is challenging enough. ?How much of their good performance was due to:

their style being in favor
new cash flows in pushing up the prices of the assets that they like to buy
a few good ideas that won’t be repeated
a clever aide that is about to leave to set up his/her own shop
temporary alignment with the macroeconomic environment
or skill?

Personality is another matter — some people don’t learn patience, which cuts off a number of strategies that require time to work out. ?Few things also work right off the bat, so even a good strategy might get discarded by someone expecting immediate results.

Time is another factor which I will take up at a later point in this series. ?The best investment methods out there are no good for you unless you can make them fit into the rest of your life which often contains the far more important things of family, recreation, faith, learning, etc. ?It’s no good to be a wealthy old miser who never learned to appreciate life or the goodness of God’s providence in life.

And so to that end, I say choose wisely. ?My eventual choice was value investing, which isn’t that hard to learn, but requires patience, but can scale to the time that you have. ?For those that work in a business, it has the side-benefit that it is the most businesslike of all investment methods, and can make you more valuable to the firm that you work for, because you can learn to marry business sense with your technical expertise, potentially leading to greater profit.

For me, I can say that it broadened my abilities to think qualitatively, complementing my skills as a mathematician. ?The firms I worked for definitely benefited. ?Maybe it can do the same for you.

Till next time, where I tell you how value investing is *not* supposed to be done. 😉

PS — one more note: it is *very* difficult to make money off of macro insights in equities. ?Maybe there are some guys that can do that well, but I am not one of them. ?Limiting the effect of my insights there has been an aid to doing better in investing, because it forces me to be modest in an area where I know my likely success is less probable.

On Financial Risk Statements, Part 1

Posted on 13 December 2014 by David Merkel

Most formal statements on financial risk are useless to their users. Why?

They are written in a language that average people and many regulators don’t speak.
They often don’t define what they are trying to avoid in any significant way.
They don’t give the time horizon(s) associated with their assessments.
They don’t consider the second-order behavior of parties that are managing assets in areas related to their areas.
They don’t consider whether history might be a poor guide for their estimates.
They don’t consider the conflicting interests and incentives of the parties that?direct the asset managers, and how their own institutional risks affect their willingness to manage the risks that other parties deem important.
They are sometimes based off of a regulatory view of what can/must be stated, rather than an economic view of what should be stated.
Occasionally, approximations are used where better calculations could be used. ?It’s amazing how long some calculations designed for the pencil and paper age hang on when we have computers.
Also, material contract provisions that are hard to model/explain often get ignored, or get some brief mention in a footnote (or its equivalent).
Where complex math is used, there is no simple language to explain the economic sense of it.
They are unwilling to consider how volatile financial processes are, believing that the Great Depression, the German Hyperinflation, or something as severe, could never happen again.

(An aside to readers; this was supposed to be a “little piece” when I started, but the more I wrote, the more I realized it would have to be more comprehensive.)

Let me start with a brief story. ?I used to work as an officer of the Pension Division of Provident Mutual, which was the only place I ever worked where analysis of risks came first, and was core to everything else that we did. ?The mathematical modeling that I did in there was some of the best in the industry for that era, and my models helped keep us out of trouble that many other firms fell into. ?It shaped my view of how to manage a financial business to minimize risks first, and then make money.

But what made us proudest of our efforts was a 40-page document written in plain English that ran through the risks that we faced as a division of our company, and how we dealt with them. ?The initial target audience was regulators analyzing the solvency of Provident Mutual, but we used it to demonstrate the quality of what we were doing to clients, wholesalers, internal auditors, rating agencies, credit analysts, and related parties inside Provident Mutual. ?You can’t believe how many people came to us saying, “I get it.” ?Regulators came to us, saying: “We’ve read hundreds of these; this is the first one that was easy to understand.”

The 40-pager was the brainchild of my boss, who was the most intuitive actuary that I have ever known. ?Me? I was maybe the third lead investment risk modeler he had employed, and I learned more than I probably improved matters.

What we did was required by law, but the way we did it, and how we used it was not. ?It combined the best of both rules and principles, going well beyond the minimum of what was required. ?Rather than considering risk control to be something we did at the end to finagle credit analysts, regulators, etc., we took the economic core of the idea and made it the way we did business.

What I am saying in this piece is that the same ideas should be more actively and fully applied to:

Investment prospectuses and reports, and all investment and insurance marketing literature
Solvency documents provided to regulators, credit raters, and the general public by banks, insurers, derivative counterparties, etc.
Risk disclosures by financial companies, and perhaps non-financials as well, to the degree that financial markets affect their real results.
The reports that sell-side analysts write
The analyses that those that provide asset allocation advice put out
Consumer lending documents, in order to warn people what can happen to them if they aren’t careful
Private pension and employee benefit plans, and their evil twins that governments create.

Looks like this will be a mini-series at Aleph Blog, so stay tuned?for part two, where I will begin going through what needs to be corrected, and then how it needs to be applied.

Problems in Simulating Investment Returns

Posted on 6 November 2014 by David Merkel

Photo Credit: Hans and Carolyn || Do you have the right building blocks for your model?

Simulating hypothetical future investment returns can be important for investors trying to make decisions regarding the riskiness of various investing strategies. ?The trouble is that it is difficult to do right, and I rarely see it done right. ?Here are some of the trouble spots:

1) You need to get the correlations right across assets. ?Equity returns need to move largely but not totally together, and the same for credit spreads and equity volatility.

2) You need to model bonds from a yield standpoint and turn the yield changes into price changes. ?That keeps the markets realistic, avoiding series of price changes which would imply that yields would go too high or below zero.?Yield curves also need ways of getting too steep or too inverted.

3) You need to add in some momentum and weak mean reversion for asset prices. ?Streaks happen more frequently than pure randomness. ?Also, over the long haul returns are somewhat predictable, which brings up:

4) Valuations. ?The mean reversion component of the models needs to reflect valuations, such that risky assets rarely get “stupid cheap” or stratospheric.

5) Crises need to be modeled, with differing correlations during crisis and non-crisis times.

6) Risky asset markets need to rise much more frequently than they fall, and the rises should be slower than the falls.

7) Foreign currencies, if modeled, have to be consistent with each other, and consistent with the interest rate modeling.

Anyway, those are some of the ideas that realistic simulation models need to follow, and sadly, few if any follow them all.