Asset Allocation – Page 8

Numerator vs Denominator

Posted on 11 October 201411 October 2014 by David Merkel

Every now and then, a piece of good news gets announced, and then something puzzling happens. ?Example: the GDP report comes out stronger than expected, and the stock market falls. ?People scratch their heads and say, “Huh?”

A friend of mine who I haven’t heard from in a while, Howard Simons, astutely would comment something to the effect of: “The stock market is not a futures contract on GDP.” ?This much is true, but why is it true? ?How can the market go down on good economic news?

Some of us as investors use a concept called a discounted cash flow model. ?The price of a given asset is equal to the expected cash flows it will generate in the future, with each future cash flow?discounted to reflect to reflect the time value of money and the riskiness of that cash flow.

Think of it this way: if the GDP report comes out strong, we can likely expect corporate profits to be better, so the expected cash flows from equities in the future should be better. ?But if the stock market prices fall, it means the discount rates have risen more than the expected cash flows have risen.

Here’s a conceptual problem, then: We have estimates of the expected cash flows, at least going a few years out but no one anywhere publishes the discount rates for the cash flows — how can this be a useful concept?

Refer back to a piece I wrote earlier this week. ?Discount rates reflecting the cost of capital reflect the alternative sources and uses for free cash. ?When the GDP report came out, not only did come get optimistic about corporate profits, but perhaps realized:

More firms are going to want to raise capital to invest for growth, or
The Fed is going to have to tighten policy sooner than we?thought. ?Look at bond prices falling and yields rising.

Even if things are looking better for?profits for existing firms, opportunities away from existing firms may improve even more, and attract capital away from existing firms. ?Remember how stock prices slumped for bricks-and-mortar companies during the tech bubble? ?Don’t worry, most people don’t. ?But as those prices slumped, value was building in those companies. ?No one saw it then, because they were dazzled by the short-term performance of the tech and dot-com stocks.

The cost of capital was exceptionally low for the dot-com stocks 1998-early?2000, and relatively high for the fuddy-duddy companies. ?The economy was doing well. ?Why no lift for all stocks? ?Because incremental dollars available for finance were flowing?to the dot-com companies until?it became obvious that little to no cash would ever flow back from them to investors.

Afterward, even as the market fell hard, many fuddy-duddy stocks didn’t do so badly. ?2000-2002 was a good period for value investing as people recognized how well the companies generated profits and cash flow. ?The cost of capital normalized, and many dot-coms could no longer get financing at any price.

Another Example

Sometimes people get puzzled or annoyed when in the midst of a recession, the stock market rises. ?They might think: “Why should the stock market rise? ?Doesn’t everyone?know that business conditions are lousy?”

Well, yes, conditions may be lousy, but what’s the alternative for investors for stocks? ?Bond yields may be falling, and inflation nonexistent, making money market fund yields microscopic… the relative advantage from a financing standpoint has?swung to stocks, and the prices rise.

I can give more examples, and maybe this should be a series:

The Fed tightens policy and bonds rally. (Rare, but sometimes…)
The Fed loosens policy, and bonds fall. (also…)
The rating agencies downgrade the bonds, and they rally.
The earnings report comes out lower than last year, and the stock rallies.
Etc.

But perhaps the first important practical takeaway is this: there will always be seemingly anomalous behavior in the markets. ?Why? ?Markets are composed of people, that’s why. ?We’re not always predictable, and we don’t predict?better when you examine us as groups.

That doesn’t mean there is no reason for anomalies, but sometimes we have to take a step back and say something as simple as “good economic news means lower stock prices at present.” ?Behind that is the implied increase in the cost of capital, but since there is nothing to signal that, you’re not going to hear it on the news that evening:

“In today’s financial news, stock prices fell when the GDP report came out stronger than expected, leading investors to pursue investments in newly-issued bonds, stocks, and private equity.”

So be aware of the tone of the market. ?Today, bad news still seems to be good, because it means the Fed leaves interest rates low for high-quality short-term debt for a longer period than previously expected. ?Good news may imply that there are other places to attract money away from stocks.

Ideas for this topic are welcome. ?Please leave them in the comments.

Managing Money for Retirement

Posted on 9 October 20149 October 2014 by David Merkel

Photo Credit: eric731 -- People can budget, but can they manage risk? — Photo Credit: eric731 — People can budget, but can they manage risk?

Investing is difficult. ?That said, we can make it harder still. ?We can encourage people with little to no training to try to do it for themselves. ?Sadly, many people get caught in the fear/greed cycle, and show up at the wrong time to buy and/or sell. ?We get there late, and then our emotions trick us into action, when the rational investor says, “Okay, I missed that move. ?Where are there opportunities now, if there are any at all?”

But investing can be made even more difficult. ?Investing reaches its most challenging level when you are relying on your investing to meet an anticipated and repeated need for cash outflows.

Institutional investors will tell you, portfolio decisions are almost always easier when there is more cash flowing in than flowing out. ?It means that there is one dominant mode of thought: where to invest?new money? ?Some attention will be given to managing existing assets — pruning away assets with less potential, but the need won’t be as pressing. ?(Note: at really high rates of cash?inflow, investing gets really tough as well, but that’s another story, and one that I successfully lived though 1998-2003…)

What’s tough is trying to meet a?cash withdrawal?rate that is materially higher than what can safely be achieved over time, and earning enough?consistently to do so. ?Doing so as an amateur managing your own retirement portfolio will be a particularly hard version of this problem. ?Let me point out some of the areas where it will be hard:

1) You don’t know how long you, your spouse, and anyone else relying on you will live. ?Averages can be calculated, but particularly with two people, the odds are that one will outlive an average life expectancy. ?Can you be conservative enough in your withdrawals that you won’t outlive your money?

2) My estimate of what the safe withdrawal rate is on a perpetuity is the yield on the 10-year Treasury Note plus around 1%. ?That additional 1% can be higher after the market has gone through a bear market, and valuations are cheap, and as low as zero when you are near the end of a bull market.

Now, most?people people with discipline want a simple spending rule, and so those that are moderately conservative choose that they can spend 4%/year of their assets. ?At present, if interest rates don’t go lower still, that will likely (60-80% likelihood) work. ?But if your income needs are greater than that, your odds of yields over the long haul go down dramatically.

3) Will you be able to maintain an iron discipline, and not overspend your assets? ?It’s tempting to do so, and the temptation will get greater when bad events happen that break the budget, whether those are healthcare or other needs. ?It is incredibly difficult to?avoid paying for an immediate pressing need, when the soft cost?is harming your future. ?There is every incentive to say, “We’ll figure it out later.” ?The odds on that being true will be low.

4) How will you deal with bear markets, particularly ones that occur early in retirement? ?Can?you and?will you reduce your expenses to reflect the losses? ?On the other side, during bull markets, will you build up a buffer, and not get incautious during seemingly good times?

This is an easy prediction to make, but after the next bear market, look for a scad of “Our retirement is ruined articles.” ?Look for there to be hearings in Congress that don’t amount to much — and if they do amount to much, watch them make things worse by creating R Bonds, or some garbage like that.

5)?Avoid investing in too many income vehicles; the easiest temptation to give into is to stretch for yield — it is the oldest scam in the books. ?This applies to dividend paying common stocks, and stock-like investments like REITs, MLPs, BDCs, etc. ?They have no guaranteed return of principal. ?On the plus side, they may give you capital gains if you use them right, buying them when they are out of favor, and reducing exposure when everyone is buying them.

Another easy prediction to make is that junk bonds and non-bond income vehicles will be a large contributor to the shortfall in asset return in the next bear market, because a decent number of people are buying them as if they are magic. ?The naive buyers think: all they do is provide a higher income, and there is no increased risk of capital loss.

6) Avoid taking too much?or too little risk. It’s psychologically difficult to buy risk assets when things seem horrible, or sell when everyone else is carefree. ?If you can do that successfully, you are rare. ?What is achievable by many is to maintain a constant risk posture. ?Don’t panic; don’t get greedy — just stick to your investment plan through the cycles of the markets.

7) As assets shrink, what will?you liquidate? ?The best thing would be?being forward-looking, and liquidating what has the lowest risk-adjusted future return. ?What is achievable is selling assets off from everything proportionally, taking account of tax issues where needed.

8 ) Are you ready for Social Security to take a hit out around 2026? ?Once the trust fund gets down to one year’s worth of?payments, future payments get reduced to the level?sustainable by expected future contributions. ?Expect a political firestorm when this becomes a live issue, say for the 2024 Presidential election. ?There will be a bloc of voters to oppose leaving benefits unchanged by increasing Social Security taxes.

9) Be wary of inflation, but don’t overdo it. ?The retirement of so many people may be deflationary — after all, look at Japan and Europe so far. ?Economies also work better when there is net growth in the number of workers. ?It will be tempting for policymakers to shrink what liabilities they can shrink through inflation, but there will also be a bloc of voters to oppose that.

10) You need a defender of two against slick guys who will try to cheat you when you are older. ?If you have assets, you are a prime target for scams. ?Most of these come dressed in suits: brokers and other investment salesmen with plausible ways to make your money stretch further. ?But there are other scams as well — run everything significant past a smart younger person who is skeptical, and knows how to say no when needed.

Conclusion

If this all seems unduly dour (and I haven’t even talked about defined benefit plan issues), let me tell you that this?is realistic. ?There are not enough resources to give all of the Baby Boomers a lush retirement, without unduly harming younger age cohorts, and this is true over most of the developed world, not just the US.

Even with skilled advisers helping you, you need to be ready for the hard choices that will come up. ?Better you should think through them earlier rather than later. ?Who knows? ?You might take some actions that will lower your future risks. ?More on that in a future post, as well as the other retirement risk issues.

The Art of Extracting Large Commissions From Investors

Posted on 28 August 2014 by David Merkel

The dirty truth is that some investments in this life are sold, and not bought. ?The prime reason for this is that many people are not willing to learn enough to save and invest on their own. ?Instead, they rely on others to corral them and say, “You ought to be saving and investing. ?Hey, I’ve got just the thing for you!”

That thing could be:

Life Insurance
Annuities
Front-end loaded mutual funds
Illiquid securities like Private REITs, LPs, some Structured Notes
Etc.

Perhaps the minimal effort necessary to avoid this is to seek out a fee-only financial planner, and ask him to set up a plan for you. ?Problem solved, unless…

Unless the amount you have is so small that when look at the size of the financial planner’s fee, you say, “That doesn’t work for me.”

But if you won’t do it yourself, and you can’t find something affordable, then the only one that will help you (in his own way) is a commissioned salesman.

Now, to generate any significant commission off of a financial product, there have to be two factors in place: 1) the product must be long duration, and 2) it must be illiquid. ?By illiquid, I mean that either you can’t easily trade it, or there is some surrender charge that gets taken out if the contract is cashed out early.

The long duration of the contract allows the issuer of the contract the ability to take a portion of its gross margins over life of the contract, and pay a large one-time commission to the salesman. ?The issuer takes no loss as it pays the commission, because they spread the acquisition cost over the life of the contract. ?The issuer can do it because it has set up ways of recovering the acquisition cost in almost all circumstances.

Now in some cases, the statements that the investor will get will?explicitly reveal the commission, but that is rare. ?Nonetheless, to the extent that it is required, the first statement will?reveal how much the contractholder would lose if he tries to cash out early. ?(I think this happens most of the time now, but it would not surprise me to find some contract where that does not apply.)

Now the product may or may not be what the person buying it needed, but that’s what he?gets for not taking control of his?own finances. ?I don’t begrudge the salesman his commission, but I do want to encourage readers to put their own best interests first and either:

Learn enough so that you can take care of your own finances, or
Hire a fee-only planner to build a financial plan for you.

That will immunize you from financial salesmen, unless you eventually become rich enough to use life insurance, trusts, and other instruments to limit your taxation in life and death.

Now, I left out one thing — there are still brokers out there that make their money through lots of smallish commissions by trading a brokerage account of yours aggressively, or try to sell you some of the above products. ?Avoid them, and?let your fee-only planner set up a portfolio of low cost ETFs for you. ?It’s not sexy, but it will do better than aggressive trading. ?After all, you don’t make money while you trade; you make it while you wait.

If you don’t have a fee only planner and still want to index — use half SPY and half AGG, and add funds periodically to keep the positions equal sized. ?It will never be the best portfolio, but over time it will do better than the average account.

One final note before I go: with insurance, if you want to keep your costs down, keep your products simple — use term insurance for protection, and simple deferred annuities for saving (though I would buy a bond ETF rather than insurance in most cases). ?Commissions go up with product complexity, and so do expenses. ?Simple products are easy to compare, so that you know that you are getting the best deal. ?Unless you are wealthy, and are trying to achieve tax savings via the complexity, opt for simple insurance products that will cover basic needs. ?(Also avoid product riders — they are really expensive, even though the additional premiums are low, the likely benefits paid are lower still.)

Book Review: Investor Behavior

Posted on 21 August 2014 by David Merkel

Ordinarily, I read all of the books that I review, but when I don’t, I tell my readers. This book I started to read, but I found it so dry that I started skimming it. It’s not that I don’t know the material; it is that I do know it.

The book covers most areas of behavioral finance, however, it does it in an academic way. ?The book would be ideal for academics and those that appreciate an academic approach to finance, that want to have a taste of many different areas of behavioral finance.

There are more engaging books for practitioners and average investors to read — you would even do better reading articles like this from a leading blogger. ?(Those at Amazon, please come to Aleph Blog if you want the links.)

Summary

?When I review books, I try to say who it would be good for — in this case, it is academics. ?Let average market participants seek elsewhere for more engaging content. ?If you still want to buy it, you can buy it here:?Investor Behavior: The Psychology of Financial Planning and Investing.

Full disclosure: The PR flack?asked me if I would like a copy and I said ?yes.?

If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.? Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.? Whether you buy at Amazon directly or enter via my site, your prices don?t change.

The Victors Write the History Books, Even in Finance

Posted on 21 August 2014 by David Merkel

?It ain?t what you don?t know that hurts you, it?s what you know that ain?t so.?

(Attributed to Mark Twain, Will Rogers,?Satchel Paige, Charles Farrar Browne,?Josh Billings,?and a number of others)

A lot of what passes for investment knowledge is history-dependent, and may not serve us well in the future. ?Further, a certain amount of it is misinterpreted, or, those writing about it, even really bright people, don’t understand the hidden assumptions that they are making. ?I’m going to clarify this by commenting on three graphs that I have seen recently — two that I think deceive, and one that I think is accurate. ?Let’s start with one of the two, which come from this article at AAII, interviewing Jeremy Siegel:

Leaving aside the difficulties with the data from 1802-1871, there is an implicit assumption of buying and holding that undergirds these statistics. ?Though the lines look really smooth now in hindsight, for those investing at the time they were often scared to death in bear markets, selling out at the worst possible time, and in bull markets, getting greedy at the worst possible time.

Now one might say to me, “But David, forget what happened to individuals. ?As a group, people must made returns like this, because every buyer has a seller — even if some panicked or got greedy, someone had to take the other side of the trade and benefit.” ?True enough, though I am suggesting that average people can’t live with that much volatility. ?Even if you cut 1929-32 in half by being 50/50 Stocks/Treasury Notes, how many people could live with a 40% downdraft without selling out?

But there is another problem: when does cash enter and exit the stock market? ?Hint: it doesn’t happen via secondary trading.

Cash Enters the Stock Market

An Initial Public Offering [IPO], secondary IPO, or rights offering leads people to give money to a corporation in exchange for new shares.
Employees forgo pay to receive company stock.
Shares get issued to suppliers in lieu of cash (common with scammy promoted stocks)
Warrants get exercised, and new shares are issued for the price of cash plus warrants.

Cash Exits the Stock Market

Cash dividends get paid, and not reinvested in new shares
Stock gets bought back for cash
Companies get bought out either entirely or partially for cash.

I’m sure there are other ways that cash enters and exits the stock market, but you get the idea. ?It means that cash is exchanged with the company for shares, and vice versa, not the trading that goes on every day. ?Now, here’s the critical question: when do these things happen? ?Is it random?

Well, no. ?Like any other thing in investing, n one is out to do you a favor. ?New stock tends to be offered at a time when valuations are high, and companies tend to be taken private when valuations are low. ?Thus back in the tech bubble, 1998-2000, a lot of cash got soaked up into companies with dubious valuations and business models. ?With a few exceptions, most lost over 90%+. ?Now consider October 2002. ?How many companies IPO’ed then? ?Very few, but?I remember one, Safety Insurance, that came public at the worst possible moment because it had?no other choice. ?Why else would the IPO price be below liquidation value? ?Great opportunity for those who had liquidity at a bad time.

The upshot is that because stock is issued at times that do not favor new investors, and stock is retired at times that do not favor existing investors, the dollar-weighted?returns for stocks in the above graph are overestimated by 1-2%/year. ?Stocks still beat bonds, but not by as much as one would think.

But here’s a counterexample, taken from Alhambra Investment Partners’ blog:

Note that buybacks don’t follow that pattern. ?Corporate managements often exist to justify themselves, and so a great number of them do not behave like value investors when they buy back stock. ?Part of this is that capital seems cheap during the boom phase of the market, and so they lever the company up, issuing debt to buy back stock at high prices. ?It increases earnings in the short-run, but when the bear market comes, the debt hangs ?around, and intensifies the fall in the stock price.

This is why I favor companies that shut off their buybacks at a certain valuation level. ?If they have to dispose of excess cash to avoid takeovers, pay out special dividends… leave the reinvestment issues to shareholders. ?If they buy back stock at levels that are too high, it does not increase the intrinsic value of the firm, though it might keep the price higher for a little while.

Here’s the other graph??from?this article at AAII, interviewing Jeremy Siegel:

What this graph is trying to say is that if you just buy and hold on long enough, results get really, really certain, and investing a lot in stocks reduces your risks, it does not raise your risks.

I’m here to tell you that is an amplification of the past, and maybe not even the best amplification of the past. ?This is where the victors write the history books. ?Your nation is blessed if:

You haven’t had war on your home soil.
There are no plagues or famines
Socialism is kept in check; expropriation is not a risk (note the many countries grabbing pension assets today)
Hyperinflation is avoided (we can handle the ordinary inflation)

Any of those, if bad enough, can really dent a portfolio. ?We can have fancy statistics, and draw smooth curves, but that only says that the future?will be like the past, only more so. 😉 ?I try to avoid the idea that?mankind will avoid the worst outcomes out of self-interest. ?There have been enough cases in history where that has not proven true, and envy and revenge dominate over shared prosperity.

I’ve already made the comment on how many can’t bear with short-run volatility. ?There is another factor: when you look at the above graph, it represents the average valuation level, yield curve shape, etc. ?If you are applying this model to today, where credit spreads are low, cash earns nothing, the yield curve is wide, equity valuations are medium-high, you would have to adjust the expected returns to reflect what the likely outcomes are, and the graph would not look as favorable. ?Volatility looks low today, but realized volatility is likely to be higher, and will not likely follow a normal distribution.

Closing

My main point here is to beware of history sneaking in and telling you that stocks are magic. ?Don’t get me wrong, they are very good, but:

they?rely on a healthy nation standing behind them
their past results are overstated on a dollar-weighted basis, and
their past results come from a prosperous time which may not repeat to the same degree in the future
you may not have the internal fortitude to buy and hold during hard times.

On the Recent Anxiety in High Yield Bonds

Posted on 8 August 2014 by David Merkel

Quoting the beginning of a recent article at Bloomberg.com:

As?junk bonds?plunge in value, many investors are wondering why.

There?s no obvious explanation for the 1.5 percent decline in U.S. high-yield securities in the past month, or the $9.9 billion of cash pulled from mutual funds that buy the debt. The most likely reason is that investors are increasingly uncomfortable hanging onto bonds that are expensive by historical measures.

Chalk this one up to a collective bout of angst that looks quite different from the 3.2 percent drop in speculative-grade bonds in May and June of last year. That rout was triggered by the prospect of less Federal Reserve stimulus and, while a withdrawal of easy-money policies still weighs on investors? minds, that?s not the full story now.

On June 24th, the junk bond markets were fairly tightly bid, and volume in the main high yield ETFs [JNK & HYG] were moderate. ?By August 1st, that bid had seemingly disappeared, but volume in the main high-yield ETFs were high. ?Many running for the exits. ?Things have calmed down?since then, at least it seems that way. ?Have a look at this set of credit yield curves:

Source: FRED

Credit quality goes down as you go from left to right on my chart. ?The lower rated the?bonds, the more they fell, which was the opposite of slower moving but long-lasting bull phase. ?Let’s look at what the losses/gains were like in percentage terms:

Date	5-yr Tsy	AAA	AA	A	BBB	BB	B	CCC	JNK ($/sh)	HYG ($/sh)	SPY ($/sh)	DVY ($/sh)
6/24/14	1.70	2.57	2.44	2.67	3.44	4.20	5.09	7.91	41.80	95.24	194.70	76.51
8/1/14	1.67	2.54	2.45	2.70	3.50	4.89	6.05	9.16	40.21	92.04	192.50	73.67
8/6/14	1.66	2.52	2.44	2.68	3.50	4.83	5.97	9.11	40.54	92.64	192.07	72.79
Divs									0.86	0.39
Return to 8/1	0.30%	0.39%	0.21%	0.16%	0.12%	-2.32%	-3.31%	-4.18%	-1.75%	-2.95%	-1.13%	-3.71%
Return to 8/6	0.36%	0.50%	0.29%	0.27%	0.17%	-2.03%	-2.92%	-3.87%	-0.96%	-2.32%	-1.35%	-4.86%

The return calculations are approximations. ?These are indicative, not exact. ?The losses on high yield debt haven’t been horribly large over this period — around 3% give or take, and the ETFs surprisingly did a little better. ?No panic in investment grade bonds, and the losses of the stock market have been minor over that time, leaving aside the fact that the market rallied for a few more weeks after high yield began to slide.

But here’s an odd bit — take a look at the last column in my table. ?That last column is the iShares Select Dividend?ETF [DVY], a very popular place for getting alternative yield. ?It yields about 3.1% now — a little less than you can get on BBB bonds, but ?maybe the dividend will grow. ?(It usually does.)

When you have many different parties going into the markets seeking income, not caring where they get it from, and a shock hits one part of the market, the effect flows to other areas ?If all of a sudden yields on junk bonds look cheaper, the yield trade-offs of buying junk and selling dividend paying common stocks looks attractive.

Now there are few permanent rules for yield relationships — even in corporate debt on its own. ?We can calculate average spread differences, sure, but there is a LOT of variation around those means (which may even bear no resemblance to future means). ?If it is that difficult asking what the right spread tradeoffs are?with?bonds different qualities, then how would we ever come up with the right tradoffs for common stocks, preferred stocks, REITs, MLPs, bonds of varying qualities, etc?

The best we can do is something like GMO does, and go to each asset class?and try to estimate the free cash flow yield of each asset class over the next full market cycle (5-10 years) given the current prices being paid. ?The higher the price paid, the lower future returns will be, and vice-versa. ?Assume that valuations will normalize over the forecast horizon, and don’t just look at valuations using earnings. ?Try book, free cash flow and sales as well. ?Results will vary.

So remember,?The Investments Matter More than their Form. ?Also remember,?Ignore Yield. ?Focus on what is building value for you in every investment. ?I like to own stocks where earnings quality is high,?valuations are low, and free cash flow gets put to good use. ?Do I always get that? ?No. ?But if I get it right enough of the time, then returns will be good enough.

Back to the beginning, though. ?Is this move in the junk bond market a hiccup, or the start of something big? ?I’m open to other opinions, but for it to be something big, you have to have a lot of things that look misfinanced. ?Where are there economic entities with short-term debt financing long term assets that look overvalued? ?Where have debts grown the most? ?I can’t identify a class like that unless we try student loans, or government debts. ?Corporate debt has grown, but doesn’t seem unreasonable now.

So, with high yield, I lean toward the hiccup. ?But even at current yields, it is not cheap. ?Speculators may play; I will stay away.

Can the “Permanent Portfolio” Work Today?

Posted on 6 August 20146 August 2014 by David Merkel

Another letter from a reader:

Dear Mr. Merkel:

I just discovered your blog through Valuewalk, which I read most days. I haven’t read much yet on your blog, but from what I’ve seen, I really like your insights and comments.

I’ve been thinking for a long time about the idea of a permanent portfolio concept, based on writing from years ago of an investment analyst, Harry Browne, now deceased. I’ve been thinking about this for my own investment requirements and also because I intend to write a book on the subject.

The big problem with a permanent portfolio today, versus 30 years ago, in my judgement, is identifying a long term fixed income vehicle would survive a major financial collapse. Browne always used 30 year US Treasury bonds, in an era when it seemed clear those bonds could survive a monetary deflation.

Of course, the Fed isn’t about to institute a policy of sustained monetary deflation any time soon, on a voluntary basis. Any such deflation would occur, either because the Fed were unable or unwilling to monetize assets fast enough to head off cascading cross defaults and massive bonk failures; or because the Fed decided to let the house of cards collapse, in some future recession-panic, because it became obvious to a plurality of Fed governors that to prop up the house of cards would guarantee hyper inflation in short order. Of course, a hyper inflation would not only destroy the financial system, including the central bank; it would overturn the established political order, and cause a famine as the division of labor fell apart.?

I think a monetary deflation will happen sooner or later, because of a financial “accident” (that reasonable people can foresee). Even if the central banks were to cause a hyper inflation, when that inflation ends after two or three years, the currency must be renounced. Then we would get deflation for a while via some new currency.

Since I think the deflation risk is realistic, I’m trying to figure out what-if any-bond instruments could survive deflationary destruction. Obviously, in a monetary deflation, all investment prices plummet, except default-free bonds. Default free bonds would rise in price, as interest rates plummeted. However, I’m not clear as to what bonds might work as vehicles in a permanent portfolio, because T bonds are no longer a reliable safe haven from eventual political default.

There might well be sovereign bonds in other countries that are more friendly to free enterprise and private property than contemporary US, and hence less prone to sovereign bond default,? but this introduces the risk of currency fluctuations. So it’s not a perfect solution. Perhaps some foreign sovereign debt combined with US Treasury debt would partly work. It has also occurred to me that some US utility or pipeline firm etc. might offer debt or preferred stock or other forms of fixed income debt/equity ownership that would survive default. In a terrible depression, I’d assume some utility companies would continue to function although, of course, not flourish. Obviously, any such debt or equity would be a very special situation, since most firms are now loaded to the gills with debt, making them poor risks to survive a crushing deflation.

My impression is all this is right up your ally. (Except for my musing-theorizing about the risk of monetary deflation, which no doubt makes me seem like a religious fanatic or political crazy.) Anyway, I’d be interested if you think this problem can be solved. In other words, do you think some private debt issues that are long term or even medium term exist to be discovered that could avoid default in a huge deflationary depression? How would you go about conducting a search for such safe U.S. corporate bonds or other fixed income instruments?

What I really need to do is immerse myself in reading about fixed income analysis. Which I hope to get to in a few months.

None of my fixation with bonds has to do with forecasting a decline in interest rates; until the next crisis, rates on the long end could easily climb. I’m looking for a secure volatile instrument that would gain in price as other investments were falling during a financial panic and subsequent depression.

Thanks for reading through all this. I look forward to spending a lot of hours in the future on your blog.

Yours truly,

Dear Friend,

I have written about the Permanent Portfolio concept here. ?I think it is valid. ?At some point in the near term, I will update my analysis of the Permanent Portfolio, and publish it for all to see, which I have not done before.

In a significant inflation scenario, gold would soar, long T-bonds would tank, T-bills would actually earn nominal but not real money, and stocks would likely trail inflation, aside from investors that invest in low P/E stocks. ?The permanent portfolio would likely do okay.

Same ?for a deflation scenario. ?Stocks will muddle. T-bonds will do well. ?T-bills will do nothing. ?Gold will do badly. ?That said, the permanent portfolio concept is meant to be an all-weather vehicle, and has done well over the last 44 years, with only 3 losing years, and returns that match the S&P 500, but with half the volatility.

I’m usually not a friend of ideas like this, but the Permanent Portfolio chose four assets where the price responses to changes in real rates and inflation fought each other. ?The rebalancing method is important here, as it is a strategy that benefits from volatility.

With respect to where to invest in fixed income?to benefit from a depression is a touchy thing — it’s kind of like default swaps on the US government, which are typically denominated in Euros. ?How do you know that the counterparty will be solvent? ?How do you know that the Euro will be worth anything?

Personally, I would just stick with long US Treasuries. ?The US has the least problems of all the great powers in the world. ?You could try to intensify you returns by overweighting long Treasuries, but that is making a bet. ?The Permanent Portfolio makes no bets. ?It just takes advantage of economic volatility, and rides the waves of?of the economy. ?As a group, stocks, T-bonds, T-bills, and gold, react very differently to volatility, and as such do well, when many other strategies do not.

Warren Buffett is “scary smart,” so says Charlie Munger, who is “scary smart” himself. ?I think Harry Browne was “scary smart” with respect to the Permanent Portfolio idea. ?But am I, the recommend-er “scary smart?” ?I do okay, but probably not “scary smart,” so take my words with a grain of salt.

Sincerely,

David

PS — As an aside, I would note that if everyone adopted the “Permanent Portfolio” idea — gold would go through the roof, because that is the scarcest of the four investments.

Book Review: Reducing the Risk of Black Swans

Posted on 24 July 2014 by David Merkel

This is a very short book. I read the whole thing in 40 minutes. ?It has one main idea: what if you could create a less variable portfolio that returns as much as the traditional 60%?S&P 500,?40% Barclays Aggregate blend? ?Wouldn’t you want that?

Most of us would want that. ?I would want earning more at the same level of volatility as the market, but that is another matter.

The authors take us through a variety of backtests, showing us portfolios that did well in the past, if you had invested in them.

They show how investors could have done better by tilting their portfolios toward value socks, small stocks, and international stocks, eventually showing a portfolio invested 60% in 5-year Treasuries, and 40% in stocks that tilt small, value, and international.

Voila! Same returns, with less volatility than the?60%?S&P 500,?40% Barclays Aggregate blend.

But there is a catch here. ?This is the past being amplified — will the future be the same? ?Value stocks are undervalued on average, and small stocks outperform on average, but what if you are in an environment like now, where small stocks are overvalued, value is neutral to undervalued? ?Tilt to value, yes, but maybe don’t tilt small.

Also, with yields so low on five-year Treasuries at 1.65%, that should be reflected into the future for the strategy, so maybe the amount of bonds should be reduced?

The biggest weakness that the book has, and this is true of many books, is that it follows a mean-variance framework. ?The market is far more volatile than a normal distribution, with crises happening far more frequently than a normal distribution would anticipate.

Quibbles

Investing is not a science; it is an art. ?Our principles are vague and subject to many forces beyond our recognition and control.

They make the rookie mistake of describing the calculation of long-term investment returns as a arithmetic mean (Page 16). ?Pros do a geometric mean, which calculates the continuously compounded average return of a buy-and hold investor.

On page 18, their explanation of correlation is weak. ?That said, even great publications like The Economist have blown that in the past, then using my explanation of correlation verbatim (back in the mid-90s).

Summary

This is a good book as it teaches you to tilt you portfolios to value and small companies on average. ?The person who would benefit most from this book is someone who wants to get more out of his investments, but doesn’t want to spend a lot of time on it. ?If you want to, you can buy it here:?Reducing the Risk of Black Swans: Using the Science of Investing to Capture Returns with Less Volatility.

Full disclosure: The PR flack?asked me if I would like a copy and I said ?yes.?

A Letter from a Young Investor

Posted on 19 July 2014 by David Merkel

Before I get to the letter, I recommend reading,?You’re Ready for Retirement, but Your Savings Aren’t by Jonathan Clement, if you have access to the Wall Street Journal. ?Main point: if you can work until age 70, do that, and then retire.

Here’s the letter:

Hi David,

A little background about myself. ?I am a 24-year male, and have been working for a little over a year. ?The only knowledge I have on investing is passive index fund investing through the book Bogleheads.? I don’t really look at my holdings other than to re-balance every year.

I am currently investing for retirement by maxing out a RothIRA, maxing out a 401k? (that allows a Brokerage account) and some in a taxable Vanguard index fund.? My holdings consist of the total stock and total bond market index funds (90/10). From my current positions my portfolio return has been 20.6%. I calculated the return by return = (market_change + dividends) / total_money. I don’t know if this is a correct formula. The time frame of my holdings is from Jan2012 – June2014.?

I went to a finance workshop that my church was hosting and there was a panel of finance experts (CPA, lawyer, financial advisor) that were indirectly encouraging active investing over passive investing through personal anecdotes.?

Looking at my current portfolio performance, I have a hard time seeing the value in spending time in learning how to actively invest and about finance in general. Currently, I do not follow up on business and market news nor am I reading any economic/investing blogs or magazines. Again, my only investing knowledge is from the Bogleheads book, and so I feel that active investing would be a daunting task.?

Do you have a comparison of an active investment portfolio’s returns (that uses your 8 portfolio rules) against an index fund (such as the Vanguard total stock market) during a bull and bear market? ?Also, do you have any advice on where to begin learning about active investing in general? How should one invest for different goals, say investing for retirement in 40 years vs. investing for a home purchase in the Bay Area in 5-10 years? I’m having a hard time seeing how I would balance time in regards to learning about investing, advancing my career through outside studying, serving in my local church, spending time to witness to family, friends and co-workers, and communion with God.? It seems like passive investing is a simpler solution with a decent average long-term return of 7%. I know I am young, have a lot to learn about life and sometimes stubborn in my thinking, so any thoughts and/or advice would be greatly appreciated.

These are the questions I will try to answer:

Should you move to active investing, and are there some alternatives that would allow you gain some of the benefits of active investing, without costing you a lot of time?
Do I have a track record that is publicly available?
Where to learn about active investing?
How should I invest if I want to buy a house in the Bay Area in 5-10 years, and how does that differ from investing for retirement?
Is the time put into learning about investing really worth it when I have so many other social and spiritual commitments?

But ?I will answer them in a different order.

Is the time put into learning about investing really worth it when I have so many other social and spiritual commitments?

You can’t be good at active investing without putting time in at least at the level of a hobby, say, one?hour per day, six days a week. ?When I launched into studying investments at age 27, I already had two advantages — A mother who was self-taught in investing (and beat most mutual fund managers handily), and an academic background in economics and finance (which had its pluses and minuses).

But my commitment to learning about investing was one hour per day, six days a week. ?After 5 years, I was an investment actuary, which was pretty rare at that time. ?After 11 years, I was hired into the investment department of a medium-sized life insurer. ?17 years later, I worked for a notable hedge fund. ?23 years later, I started my own firm.

Now, there were some spillover benefits for serving the church. ?I have served on various boards of my denomination, chairing some of them, but my knowledge of finance has been a benefit to many of them, and I have been able to prevent a wide variety of errors. ?Even this week, a Christian group in western Pennsylvania reached out to me regarding a “too good to be true investment,” and I told them it was likely a fraud. ?There are ways that we can serve the church with such knowledge. ?Brothers and sisters that I know come asking for advice, and I do not turn them down.

Now, all that said — no, it is probably not worth your time to learn about active investing. ?I wrote two articles a while ago taking both sides of the argument:

Decide what you want to emphasize in your life and service to God. ?The church benefits from a few “numbers guys” (as some refer to me in my denomination), but it doesn’t need a lot of them, if the group trusts them, and they are wise and upright.

Should you move to active investing, and are there some alternatives that would allow you gain some of the benefits of active investing, without costing you a lot of time?

I don’t think you have to move to?active management — you might move to some sort of tilt on you passive management, though. ?Over the long run, tilting to value stocks and smaller stocks has been a smart idea. ?Cap-weighted indexes have most of their assets invested in behemoths that like Alexander the Great, have “no more worlds left to conquer.” ?Investing a disproportionate amount passively in mid- and small-cap stocks can be a wise idea, as can passive investing with a value bias. ?Two sides of the issue:

But,?maybe wait a while before you add some mid- and small-cap value index funds… valuations are relatively high for small and mid-cap stocks at present. ?I have a hard time finding truly cheap stocks at present.

Where to learn about active investing?

As for books, you could look through my book reviews, and scan for the word “value.” ?You could visit the website Valuewalk.com; I have to admit I am impressed with what Jacob Wolinsky has done — it is the “go to” site for value investing.

You can also read the letters of notable value investors — Buffett, Klarman, Marks, and more…

How should I invest if I want to buy a house in the Bay Area in 5-10 years, and how does that differ from investing for retirement?

Let me tell you a story. ?My congregation is near DC. ?My congregation asked me to manage the building fund, and for years, I beat the market, but DC area real estate still appreciated faster.

At the same time, many congregations in the denomination, had received buildings for low prices, or virtually free, but those were mostly in rural areas. ?So at prayer meeting in January 2009, after losing a large amount of the building fund, I asked God to drop a building in our lap, as I could not see any way that I would ever do it through my investing, good as it was.

Two months later, we bid on a short sale for a house with a church use permit. ?We had the assets free and clear for it, and closed in May 2009.

Here is my point to you: geographically constrained markets like the Bay Area — there is no good way for the liquid stocks and bonds to keep up with real estate price increases.?Buying a house in the Bay Area is a tough matter, and it might make sense to match assets and liabilities.

You might want to try to buy real estate related assets in the Bay Area — not sure how you could do that, but it would be the investment closest to funding what you want to own.

As for investing for retirement 40+ years from now, maintain a posture of 70-80% risk assets, and 30-20% safe assets. ?I have been 70/30 most of my life. ?Optimal is 80/20, but I take more idiosyncratic risk, and 70/30 just feels better to me. ?My investments are more concentrated, and the cash levels out the jolts.

Do I have a track record that is publicly available?

Yes and no. ?I send it to those who inquire after my services, but I will send you a copy after I publish this. ?I’ve done well, but I know that it might be due to chance. ?That said, my clients get the same investments that I have, so my interests are aligned with them, aside from the fee they pay me. ?I have no other compensation from my investment management.

What to do when Valuations are High?

Posted on 10 July 2014 by David Merkel

A letter from a reader:

Hi David,

What would you recommend for a long only equities portfolio?

I too think the market may be overheating, but as always, it’s impossible to tell when the party will end. I would have said the same thing last year this time as well.

This is what I am doing now:

Cash is presently 16% of my portfolio.? I let that fluctuate between 0-20%.? I try to be fully invested during crises, and build up some cash when valuations are extended. ?16% means valuations are high, but they could get higher — we aren’t at nosebleed levels.
I have more invested in foreign companies than I normally do.? Around 40% of the portfolio is in foreign companies, which are at present undervalued relative to similar US companies.
Emphasize companies with strong balance sheets, in industries that will not go away.
I own cheap stocks.? The median valuation of the stocks that I own is around 10x earnings, and 1x Net Worth (Book Value).

This isn’t sexy, and if the market roars ahead, my clients and I will underperform.? But if there is a reason that emerges that causes the market to fall, my clients and I will do better than most.

I take more risk when the market is in the tank, and less when everyone thinks things are great. ?This is particularly true when policymakers like the Fed are triumphant over high valuations, and low yield spreads.

This is a time to take less risk, in my opinion, but not a time to take no risk.