Personal Finance – Page 27

Risks, Not Risk

Posted on 3 October 20094 October 2009 by David Merkel

While at our last denominational meeting, I made the offer to the pastors of my denomination that if they needed investment advice, they could contact me for advice.? Out of eighty or so pastors that that could have asked for advice, one e-mailed me.? (The pastors and elders did elect me to the pension board, to help manage the relationships with the defined contribution fund managers.? I’ll do my best for them.) The pastor is young-ish, with a wife and six kids.? He had 60% invested in a broad bond fund which had a high exposure to investment grade corporates and high yield (and AAA CMBS), and 40% in a stable value fund. This is a redacted version of what I wrote to him:

You’ve been playing it conservatively.? At this point conservative is good.? If I were not tardy in responding to you (my apologies), I might have suggested taking a little more risk at the time when you wrote.

This is the way that I view asset allocation:? look at the risk factors in the investment markets, and look at the funding needs of the person or institution that owns the assets.? (I.e., so what are we saving for?)

Most people don’t save enough.? The $4000 per year is good, but most people need to put more of a buffer aside than that, whether in IRAs (for retirement) or in a taxable account (for emergencies, future coollege aid to children, etc.)? You have six little liabilities that may need some help starting out as they reach adulthood.? Consider saving more.

Now for the risk factors:

Equities — somewhat overvalued at present.? (US and foreign)
Credit — Investment grade credit is slightly overvalued, and high yield is overvalued.
Real Estate — the future stream of mortgage payments that need to be made is high relative to the present value of properties.? There will be more defaults, both in commercial and residential.
Yield Curve — Steep.? It is reasonable to lend long, so long as inflation does not take off.
Inflation — Low, but future inflation is probably underestimated.
Foreign currency — One of my rules of thumb is that when there is not much compensation offered for risk in the US, it is time to look abroad, particularly at foreign fixed income.
Commodities — the global economy is not running that hot now.? There will be pressures on resources in the future, but that seems to be a way off.
Volatility is underpriced — most have assumed a simple V-shaped rebound but there are a lot of problems left to solve.

What this leads me to is this: I don’t know all of the bond and stock funds you can use at present, though I will after the next pension board meeting.? The bond fund you are using was a great play over the last 9 months, but is probably overvalued now.? If there is a more conservative bond fund, you might want to shift some funds there.? If not, use the fixed fund.? I don’t think we have an international bond fund, or an inflation protected fund?available, but if we do I would add some there.

On a pullback in the stock markets, I would look to add some stock into the mix.? I would add some with the market 10% lower, and would add considerably with the market 30% lower.? If there are international stock funds, I would use them 30/70 with US funds.

Consider this a start of a discussion.? I’m not bullish on much right now.? This is a time to preserve capital, not make returns.? Let me know what you think, and sorry for being so slow to get back to you.

If I were talking to an institutional investor, I would have added illiquidity as a risk factor, which I think is fairly priced right now. I might have also added that I would be bullish on GSE-sponsored mortgage bonds and carefully selected CMBS.

Aside from that, I was pleasantly surprised in Barron’s to see Mark Taborsky of Pimco thinking about asset allocation the way I do.? There is no generic risk.? There are many risks.? Are you getting fair compensation for the risks that you are taking?? If not, invest in other risks, or if there are few risks worth taking, invest in cash, TIPS, or foreign fixed income.

Modern Portfolio Theory has done everyone a gross disservice.? It is not as if we can predict the future, but the use of historical values for average returns, standard deviations, and correlations lead us astray.? These figures are not stable in the intermediate term.? The past is not prologue, and unlike what Sallie Krawcheck said in Barron’s, asset allocation is not a free lunch.? With so many people following strategic asset allocation, assets have separated into two groups, safe and risky.

To this end, it is better to think in terms of risk factors rather than some generic formulation of risk.? Ask yourself, am I getting paid to bear this risk?? Look to the risks that offer the best compensation, and avoid those that offer little or negative compensation.

Plan for Failure

Posted on 30 September 2009 by David Merkel

Imagine for a moment that you are managing a large corporate bond portfolio for a major institution.? One of the first things you should internalize is that you will be wrong.? You will buy bonds of companies that will get into unexpected trouble, and their prices will decline.? Or, you play it safe as a panic deepens, and then as the fog lifts, you underperform because you did not hold onto risky bonds that would recover.

Face it: in volatile times we get it wrong.? We panic at troughs, and chase the rabbit when the market runs contrary to our bearish expectations.? But what do you do when you are on the wrong side of a trade?

The first thing to do is sit down with all concerned parties and ask their opinions.? (If you are working on your own, this point is moot.)? If everyone who has an opinion agrees, and the position still worsens, the final step must be taken.? Look at all external analytical opinion, and find someone that disagrees.? Circulate the disagreeing opinions out, and ask all concerned parties what they think.? Or, simply ask, what arguments have they made that we haven’t heard?? Do those arguments make any sense?? If they make sense, close out the position.? If not, it may be time to add more amid the pessimism.

But it is better to prepare in advance for bad times than to react on the fly.? Good investment processes plan for failure.? They realize that not every investment will win, and so they limit the downside of possible bad investments through:

Diversification
Hostile review when the investment falls by a given amount.
Limitations on size of positions.
Holding safe assets

Good investment management considers where asset values could go in the short run, and the possibility that money could be pulled if performance is bad enough.? But it also looks to the long run value of the assets, and is willing to sell when values are too high, and buy when values are too low.

As a corporate bond manager, when I got on the wrong side of a trade, I would call my analyst to me and ask her for her unbiased opinion.? If she was certain that things were good, and gave good answers to my questions, I would add to my positions.? But if she gave me the sense that things were falling apart, I would take my losses.

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When I went to work for a hedge fund in 2003, one of the first questions I was asked was? how I would position the portfolio.? I found myself to be the lone bull.? When asked why, I said that we were in the midst of a liquidity rally, and that short positions were poison when liquidity was adequate to finance marginal companies.? My argument was not bought, but I focused my part of the portfolio on marginal insurance companies that would benefit most from the liquidity wave.

Today, there are many bearish hedge funds that are licking their wounds.? What to do?

1) First, assess your funding base.? Estimate how much assets will leave if the underperformance persists.

2) Look at your positions relative to your expectation of prices two years out.? Eliminate the positions with the lowest risk-adjusted expected returns, whether short or long.? Keep the positions on (or add to them) that offer the most promise.

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Bad times offer an opportunity to concentrate on best ideas.? Good times offer opportunities to avoid risk.? In this time of liquidity prompted by the Fed, take the opportunity to lessen risk, because eventually the Fed will have to shift its position, and suck liquidity out of the economy.

On Vanilla Products

Posted on 26 September 200927 September 2009 by David Merkel

Though Congress may not mandate the sale of vanilla financial products to consumers, it is worth thinking about the concept in general. I have written two articles that argued that consumers should only simple products from insurers:

Life Insurance: A Bet You Don?t Want to Win
The Pros and Cons of Buying Annuities

Men (this includes women) are good at analyzing questions of more and less with one variable.? Stick to that, and most men do well.? When there are two or more variables, the rationality breaks down, because the average man does not know how to analyze the pricing tradeoffs.

Term insurance and deferred annuities are relatively simple; the markets are competitive because men can make simple price comparisons across similar products.? That’s why insurers try to sell unique combination products.? The more unique a product is, the harder it is to compare against products that might be cousins.

The same applies to banks.? I don’t believe that any bank should be forced to sell a product, but it would be smart for some banks to market themselves as “basic banks.”? No products are marketed as bundles, every product is sold separately.? Products are sold at cost plus risk-adjusted profit margin.

Some banks could bring in a lot of business if they did this.? I had a similar idea regarding variable annuities, where a life insurance company would charge a mere 40 basis points per year to wrap a variable annuity, with no guarantees.? It would create the generic tax-deferred mutual fund.

In the same way, some backs could win a lot of business offering generic credit cards, simple mortgages, etc.? The only difficulty is getting through gatekeepers, because the average American does not search for the best deal.? Gatekeepers often offer what compensates themselves best.

Aside from complex tax planning reasons, simple products are usually the best.? I encourage my readers to look over the financial services that they use, and aim for simplicity.

On Life Settlements

Posted on 8 September 2009 by David Merkel

Well, thank you Rolfe Winkler and Reuters.? I go off-line on Sundays because it is the Sabbath, so I don’t review the web or catch e-mail, but when Rolfe e-mailed me and I saw it on Monday morning, I felt I had to give him a response.

Now, my response was a brief one, for me.? There was more to say, some of it of a personal nature, but I was busy this weekend.? We moved six of our children into different rooms, repainted two of them, and simplified our lives — I have more trash sitting outside than I have ever seen in my life.? The house is simpler and prettier than ever before, and our two oldest now both have their own rooms.

So, what I wrote was significant, but limited.? Let me fill in some gaps.

First, the efforts on life settlements have been going on for a long time.? This is not new, but has been happening for a little less than 20 years.? Over the last ten years I have been personally invited to be a part of three (maybe more) of these enterprises, and I have turned them all down early because of the ethical issues involved.? I genuinely believe in the concept of insurable interest.

Second, life insurance is for the most part sold, not bought.? I used to have trouble with that, but there are many people who will not save or seek protection unless someone goads them to do so.? Those who will not actively look out for themselves pay a price relative to those who seek coverage unbidden.

Surrender charges exist on life insurance policies to allow insurers to recover the cost of the commission that they have not amortized.? As GAAP accounting would suggest, all revenues and expenses are spread over the life of the policies.? The significant cost of acquiring a life insurance policygets recovered over the life of the policy.? If a policy owner wants to surrender early, the insurance company has a surrender value or cash value that reflects no loss to the insurer on average.

Pretend for a moment that you are a life insurer.? You want to make a profit, or if a mutual, break even.? You test/underwrite potential insured lives before the policy is issued to assign policies to the proper rating class for them.? The more accurate you are, the more polices you will write, and the fewer surrenders you will have.? But over time, people change.? After issue, insureds tend to get more sloppy in their lives, on average.? Also, things that could never have been caught in underwriting emerge.

Those doing life settlements aim at the policies where there have been negative health events since issue.? Death is considerably more likely, and so the value of the policy is worth more.

Think about it: you as the insurance company did your best job to estimate the risk involved. You did it assuming that policies could not be sold, whether really or synthetically.? You already knew that those who were healthy in the future would surrender and seek another carrier, but thought the those who were less healthy would persist to some degree.? Well, with life settlements, the unhealthy persist at a much higher level, which bites into profits.

This is the box that life insurers are in.? They can’t lock in policyholders, but policyholders can hang on, refinance (so to speak), or sell off their obligations.? That is a tough equation for life insurers to work through, and to the degree that life settlements are allowed, premiums will have to rise to compensate for the loss of profitability.

Book Review: Finding Alpha

Posted on 3 September 2009 by David Merkel

I found this book both easy and hard to review.? Easy, because it adopts two of my biases: Modern portfolio theory doesn’t work, and the equity premium is near zero.? Hard, because the book needed a better editor, and plods in the middle.? I don’t ordinarily do this, but I felt the reviews at Amazon were valuable, particularly the most critical one, which still liked the book.? I liked the book, despite its weaknesses.

One core idea of the book is that risk is not rewarded on net.? It doesn’t matter if you measure risk by standard deviation of returns, beta, or credit rating (with junk bonds).? Junk underperforms investment grade bonds on average.? Lower beta and standard deviation stocks overperform on average.

A second core idea is that some people are so risk averse that they only accept the safest investments, which leaves investment opportunities for those that are willing to compromise a little with credit quality or maturity.? Moving from money markets to one year out is an almost riskless move for most, and usually adds a lot of excess return.? Bond ladders do the same thing, though Falkenstein does not discuss those.

Also, the move from high investment grade to low investment grade does not involve a lot more investment risk, but it does offer more yield on a risk adjusted basis.

A third core idea is that equities, though more risky than high quality bonds, have not returned that much more than bonds when the returns are measured properly.? See this post for more details.

A fourth core idea is that people are more willing to take risks to be wealthy than theory would admit.? Most of those risks lose money on average , but people still pursue them.

A fifth core idea is that alpha is hard to define.? Helpfully, Falkenstein defines alpha as comparative advantage.? Focus on what you can do better than anyone else.

A sixth core idea is that leverage, however obtained, does not add alpha of itself.? This should be obvious, but people like to try to hit home runs.

A seventh core idea is that when an alpha generation technique becomes well-known, it loses its potency.

An eighth core idea is that people are more envious than greedy; they care more about their relative position in this world than their absolute well-being.

One idea he could have developed more fully is that retail investors are easily deluded by yield.? They underestimate the amount of yield needed to compensate for illiquidity, optionality, and default.? Wall Street makes money out of jamming retail with yieldy investments that deliver capital losses.

Another idea he he could have developed is that strategies that lose their potency lose investors, and tend to become less efficiently priced, leading to new opportunities.? Investment ideas go in and out of fashion, leading to overshooting and washouts.

How one achieves alpha is not defined — Falkenstein leaves that blank, because there is no simple formula, and I respect him for that.? He encourages readers to devise their own methods in areas where there is not a lot of competition.? Alpha? comes from being better than your competition.

Summary

What this all says to me is that investors are too hopeful.? They look for the big wins and ignore smaller ways to make extra money.? They swing for the fences and get an “out,” rather than blooping singles with some regularity.? I like blooping singles with regularity.

I recommend this book for quantitative investors who can find a way to buy it for less than $40.? The sticker price is $95, though it can be obtained for less than $60.? Try to find a way to borrow the book, through interlibrary loan if necessary — that was how I read Margin of Safety by Seth Klarman.? Klarman’s book is not worth $1000.? Falkenstein’s book is not worth $95.? Falkenstein’s very good blog will give you much of what you need to know for free, and even more than he has covered in his book.

This book would also be valuable for academics and asset allocators wedded to Modern Portfolio Theory and a large value for the equity premium, though some would snipe at aspects of the presentation.? Parts of the book are more rigorous than others.

If you still want to buy the book at the non-discounted price, you can buy it here: Finding Alpha: The Search for Alpha When Risk and Return Break Down (Wiley Finance)

PS: Unless I state otherwise, I read the books cover-to-cover, unlike most book reviewers.? The books are often different from what the PR flacks encourage reviewers to think.? If you enter Amazon through my site and buy anything, I get a small commission.

Avoid Risk; Make Money.

Posted on 29 August 200930 August 2009 by David Merkel

Sometimes a single article can change my direction for publishing for an evening.? So it was for this article, Hedge Fund Keeps Reins on Risk.? I had not heard of Graham Capital Management until today, but given what I read, I like what they do — they focus on risk.

I am currently reading Eric Falkenstein’s book, Finding Alpha, and I am a little less than half through it, but he makes the point quite ably that the way to make money is to avoid risk, and that those that do avoid risk tend to do better than those that take a lot of risk.? I know that this is tough to understand for those that have bee indoctrinated by Modern Portfolio Theory, but I will phrase it my own way.? Take risk when you are paid to take it; avoid undercompensated risks.

Here’s the money quote from the WSJ story:

The firm’s risk manager Bill Pertusi leads a meeting at 9:30 a.m. each day in a large room in Graham’s 93-year-old Irish Tudor mansion. There, a group of seven or so people — always including Messrs. Tropin and Pertusi — discusses all aspects of risk: market risks, risks in individual traders’ portfolios and how they have changed since the day before, risks to the way the firm is investing its cash, counterparty risk — or risk that the firm on another side of a trade will fail, even evaluations of whether traders’ are in positions that are “crowded” with other hedge funds.

“I’m not aware of anyone who has a daily meeting just to talk about risk in the absence of talking about opportunity,” according to Leslie Rahl, managing partner of risk-management firm Capital Market Risk Advisors.

Graham requires managers of some of its funds to fill in a survey every Friday, answering the question: “How much money would we lose if you had to completely liquidate your portfolio in one, three or five days, in both normal and stressed environments?”

Risks are multi-dimensional, and a wise manager thinks through all aspects of his risks.

How creditworthy are my counterparties?
How readily can I convert my portfolio to cash if I had to?
What are my competitors doing?? Are my positions in strong hands or weak hands?? How many are making the same bet that I am?
Have the fundamentals of my positions changed?? Have the views of other major players in the market changed?
Has the time horizon of other investors alongside of me changed?
What cash flow yield am I likely to get, and how might that vary?
What should we do about major moves in the markets that we trade — go with the trend, or resist it, or ignore the move?
Am I implicitly taking the same bet through seemingly different? areas of my portfolio?

Limit the downside, and the upside will provide for you.? I am not saying to avoid risk, but to take prudent risks.

Now, I try to avoid making a lot of market calls, because those who do make a lot of calls are incautious at best.? I do believe that this is a time for caution with respect to the equity markets and the corporate bond markets.? I agree with Jason Zweig here, it is a time to trim risk positions.

On another front, consider illiquidity.? Taking on illiquid investments is a bet the the future will be very good; there will be no reason to liquidate funds.? This is why there should be a substantial yield or likely return premium for investing where there is no liquid public market.? The university endowments have stumbled here; they needed more liquidity than they thought.?? So have pension plans, who aimed for high returns at the worst possible moment.

That said, some pension plans are taking money off the table in stocks in the present environment.? Good move, I think.? Even the venerable Value Line is recommending lower commitments to common stocks.

Human nature does not change, and that is what makes behavioral finance and value investing stronger.? As the market moves up, shorts cover, but greed and envy drive people to invest more in the hot sectors.

This is not limited to retail investors, though.? Even investment banks are getting into the act.? Add to the leverage and let’s take some sweet bets!? Devil take the hindmost!

I get it, and I don’t get it.? This is a time to decrease risk, even though I might be early.? The troubles of our financial sector are not solved.? Our consumers are still overleveraged.? I don’t see how we get sustainable decent returns on capital in the present environment, aside from stable sectors of the global economy.? Avoid risk; make money.

Questions and Answers

Posted on 25 August 200925 August 2009 by David Merkel

This may become a series, but I’m going to post some questions I have been asked, and the answers that I gave.? Anyway, here goes:

Has anyone prepared a summary of US Treasury bonds, say five years ago and now and looked at average maturity, etc.

GE was taken to task by the investment community in 2002-03 for using very short term money to fund long term lending/capital needs.? Was the investment community right?

Where is the US government right now ? Are they playing the short end of the maturity ladder, if so what could be the reasons why and what are the implications for the investment community?

Thanks for all of your insight.

This is a graph of the average maturity in months of the marketable portion of US Government debt.? Reagan really lengthened the debt, and Bush, Jr. shortened it.? (Just another bad legacy for that economic liberal, Bush, Jr.)? The most notable aspect of that was the elimination of the 30-year bond in 2001, and its subsequent reappearance in 2006.? The Obama Administration is not a known quantity in these matters yet.

The sharp drop from June 2008 to September 2008 I believe is due to the creation of a lot of short-dated debt that was given to the Fed to allow it to grow its balance sheet.

With respect to GE, yes, the lending community was right.? Prudent borrowers match assets and liabilities.? I recently criticized GE for borrowing with too much short-term debt for their finance arm.? As it is, GE has had a wild ride in its stock price, dipping below six this year.? Without the TLGP, who knows?? GE might have had to send GE Capital into insolvency.

In general, I have been an advocate of lengthening the maturity structure of the US government’s debts.? Governments are supposed to try to be permanent; thus they should finance long.? Governments like the generally lower cost of short debt, and so they sometimes finance shorter than they ought to in an effort to save money.? Governments that don’t finance long enough can be subject to runs, such as Mexico in 1994.

I hope the US government takes the opportunity to finance long while it is still cheap to do so.? My guess is that the opportunity gets wasted; not that the average maturity shrinks a lot, but that it doesn’t grow much.

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What does your husband say about this? Small investors don’t bother?

> http://money.cnn.com/2009/07/29/pf/steve_lehman_federated_investors.fortune/index.htm

This one came to my wife for me.? Quoting from the article, my response was:

>>So what’s a retail investor to do? Lehman’s answer: Leave it to the pros. “It’s never been more difficult [to invest],” he says, “and it will remain more challenging than ever. Unless someone really has a flare for investing and enjoys doing it, I would say don’t waste your time.”<<

Small investors should probably use low cost index funds and vanilla Exchange Traded Funds.? That will lower their costs, which will raise their returns.? It is rare for outperformance to persist in funds management, particularly as the funds under management for any manager grows.? There are some value managers that are worthy of being invested in over the long haul for equities, and if you want a list, I will provide one.

David

PS — to the editors at Money — “flare” s/b “flair”

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We have a certificate of deposit that we are cashing out and are wondering if buying some gold would be a better way to protect our savings? Considering the way the government is spending money, it seems the only way to be safe from the inflation that is coming.

This is a tough one. A lot depends on whether the government inflates their way out of this or not. I almost think they have to, but they could have done it in the Great Depression/WWII, and did not. They raised taxes, and the best investment was government bonds for a long while.

This situation is probably different. Gold will preserve purchasing power over the long haul, but it rarely does more than that. Sometimes, that’s the best you can do.

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I don’t have a good place to post this last bit, so here it goes: here is a recent audio interview of me. I only wish we had focused more on investing topics. For those interested, I had my notes in front of me, which cited a number of my articles.

Full disclosure: I don’t own any gold, aside from my wedding band.

Book Review: The Myth of the Rational Market

Posted on 14 July 200914 July 2009 by David Merkel

There are few books that I read that leave me feeling as if I have taken a trip down memory lane.? The Myth of the Rational Market was that for me.

In my junior year at Johns Hopkins, I wrote my senior thesis on predicting splits in the stock market.? I had to do it in my junior year because I had applied to do a combined BA/MA in political economy in my senior year.

My thesis, springing from what I had learned in Dr. Carl Christ’s class on financial economics (which in itself was an anomaly in the political economy department), forced me to analyze the then-fresh literature on event studies on efficient markets, including the famous paper by Fama, Fisher, Jensen, and Roll on how it was impossible to make money off of stock market splits.

That paper was important, because prior research was not agreed on the topic, and it was an example of something not all that significant that could be a signal of greater things — that managements would only split the stock when they had confidence.

Young David, having been raised in a home where his self-trained mother had regularly beaten the market, found the efficient markets hypothesis less than compelling.? Like his mother, he felt that superior analysis of fundamentals should outperform.

But here was a situation where it was obvious that stocks that split outperformed before they split.? My thesis asked, “Could splits be predicted?”

Going through the literature, I came up with some variables that could be useful — some were valuation-based, some were technical (price, volume), and some were anomalies (insider trading).? I ended up finding that stock splits could be predicted more often than not, but more importantly, that the variables that correlated with stock splits were more generally correlated with outperformance (in the 7%/yr region).? Those variables included valuation, momentum, and insider trading — which for a paper written in 1982 was notable.? I concluded that the Efficient Markets Hypothesis was flawed, also notable for its time.

Wait — this is a book review.? As I read Justin Fox’s work, I admired its ambition.? This attempts to cover financial markets efficiency, with some efforts toward economic efficiency generally.? It covers a lot of ground — all of the major players in the efficiency of financial markets debate are featured, and written about in simple language — there are no equations to wade through as I once did.? This book is comprehensive, and touches on many of the more obscure critics of the Efficient Markets Hypothesis.? Bright men who are tangential to the Financial Economics profession get their play — Kahneman, Tversky, Minsky, Mandelbrot, and more

Many of these men that questioned market efficiency went down the same trail that I did; they were led by the data, which conflicted with neoclassical economic theory.? Many of them came to my view that the market is pretty efficient, but not perfectly so.? Efforts at finding inefficiency promote market efficiency.? Efficient markets make people lazy, which leads to inefficiencies that can be profited from.

I liked this book a great deal.? It gets a bit thin at the end when it tries to incorporate the current crisis into its framework.? More broadly, it is at its weakest where it merely touches on a significant contribution, but does not dig deeper.? That said, a book of 500 pages would be far less readable than one of 300+.

Who would benefit from this book:

Those who are too certain about their positions on market efficiency.
Those that assume that the market is always or rarely right.
Those that select asset managers, because there is a lot of volatility around investment returns.? What is luck? What is skill?? We know less here than we imagine.
Academics in economics that are not familiar with the finance literature, because this would give an outline of the questions involved.

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When I do book reviews, I actually read the books.? In the few cases where I scan a book, I reveal that in the review.? I also offer the easy ability to buy books through Amazon.com, and if you want to buy this book click here:? The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street

Full disclosure: if you buy anything through Amazon after entering through my site, I get a small commission, but your costs do not go up.

Toward a New Concept of Asset Allocation

Posted on 10 July 2009 by David Merkel

To my readers: thanks for your responses to yesterday’s article.? I will do a follow up piece soon.? If you have more comments please make them — they will help me with the piece.? Main new concepts coming — need for a deliverable, speculators can’t trade with speculators, only hedgers.

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Longtime readers know that I am not a fan of modern portfolio theory.? It is a failure for many reasons:

It assumes there is one type of risk, the occurence of which is random.
It assumes that this risk can be approximated by volatility (variance of returns), rather than probability of loss, and the likely severity thereof.
Mean return estimates, volatility estimates, and correlation coefficient estimates aren’t stable.
In crises, correlations head to 1 or -1.? Assets divide into safe and “not safe.”
Problem: some assets always fall into the “not safe” bucket, but what falls into the safe bucket can vary.? Long Treasuries and commodities could be examples of assets that vary during a crisis, depending on the type of crisis.
It does not recognize multiple time horizons easily.? Bonds held to maturity have a different risk profile than a constantly rebalanced portfolio.
Risk is the same for all people, and their decision-making time horizons are the same as well.
And more…

I’m still playing around with the elements of what would make up a new asset allocation model, but a new model has to disaggregate risk into risks, and ask some basic questions:

Where am I getting paid to take risk?
Where am I getting paid to avoid risk?
What aspects of the financial landscape offer the potential for a change in behavior, even if it might take a while to get there?? What major imbalances exist?? Where are dumb people making money?
Where options are available, how is implied volatility relative to long-term averages?
What asset classes have momentum to their total returns?

One good example of an approach like this is Jeremy Grantham at GMO.? Asset allocation begins by measuring likely cash flow yields on asset classes, together with the likelihood of obtaining those estimates.? With domestic bonds, the estimates are relatively easy.? Look at the current yield, with a haircut for defaults and optionality.? Still there is room to add value in bonds, looking at what sectors are cheap.

Are corporate spreads narrow or wide?
How are residential mortgage bonds priced relative to agency bonds, after adjusting for negative optionality?
How steep is the yield curve, and where is Fed policy?
What is the speculative feel of the market now?? Bold? Scared? Normal?
Related, how are illiquid issues doing?? Are they permafrost, or are molasses not in January?
If every risk factor in domestic bonds looks lousy, it is time to make a larger allocation to foreign bonds.
Cash is underrated, and it is safe.

Understanding bonds is an aid to understanding the rest of the market.? The risk factors in play in the bond market are more transparent than elsewhere, but the rest of the markets eventually adjust to them.

With stocks and commodities, the answer is tougher — we have to estimate future demand and supply for commodities.? Tough.? With stocks, we need to estimate future earnings, and apply a P/E multiple that is consistent with the future yield on BBB corporate bonds.? There is some degree of mean-reversion that can help our estimates, but I would not rely on that too heavily.

There is one more aspect to layer in here: illiquidity of equity investments.? With limited partnerships of any sort, whether they are hedge funds, venture capital, private equity, etc., one has to analyze a few factors:

Where is the sector in its speculative cycle?? Where are secondary interests being sold?
How much capacity do you have for such investments?? How much of your liability structure is near-permanent?? Is the same true of peer institutions?
Is the public equity market overvalued or undervalued?? Public and private tend to track each other.

Beyond that we get to the structure and goals of the entity neding the assets allocated.? Time horizon, skittishness, and understanding levels are key for making a reasonable allocation.

This is just my initial brain dump.? It was spurred by this article in the WSJ, on how asset allocation had failed.? Add in the article on immediate annuities, which are a great aid in personal retirement planning.? For those that think that immediate annuities reduce the inheritance to the children, I would simply say that it is longevity insurance.? If the annuitant lives a long time, he might run out of assets, and might rely on his children for help.? The immediate annuity would be there to kick in something.

Why did asset allocation fail in 2008?? All risk assets failed.? Stocks, corporate bonds, venture capital, private equity, CMBS, RMBS, ABS… nothing held up.? There were just varying degress of loss.? Oh, add in Real Estate, and REITs.? Destroyed.? Destroyed…

When the system as a whole has too much leverage, all risky asset classes get affected.? That’s what happened in 2008, as speculators got their heads handed to them, including many who did not realize that they were speculators.

Seven Notes, Primarily on the Financial Sector

Posted on 7 July 2009 by David Merkel

1)? I have been arguing for a while that commercial mortgages are an unresolved issue with most banks, who still hold their loans at par.? Contrast that with the pricing on Commercial Mortgage Backed Securities [CMBS] or REIT stock prices, which show commercial real estate pricing in the dumps.? Look at these articles: (one, two, three).? How many commercial properties are inverted?? Who knows, but when properties sell for significantly less than replacement costs, it is not a good scene.

Regarding CMBS, as the loss estimates ratchet up, the credit ratings ratchet down.? Securities sold in 2005 and after will suffer, as well as marginal CMBS from earlier vintages.

2)? Outside of conforming mortgages, losses in residential mortgages are considerable.? Consider how S&P is raising its loss assumptions on alt-A loans.? Or consider how being underwater, or close to underwater affects the willingness of people to default.

3)? That last article helps point out a truth that is neglected.? Defaults predominantly happen when borrowers are underwater, or nearly so.? Changing? the mortgage interest rate is cheaper in the short run, but does not cure? the situation as well as reducing the principal (forgiving part of the loan).? Why less loan forgiveness?? Two reasons: Accounting would require a bigger short-term loss, and the government prefers subidizing a piece at a time, so it prefers smaller annual subsidies, rather than a once-and-for-all cure.? They would rather pay over time, and overcommit future budgets, than pay the full freight now, even if it is cheaper in the long run to do so.

4)? But many defaults are strategic.? The owners know which side their bread is buttered on, and they default when their properties are too far underwater (one, two).

5)? The states can’t print money like the Federal government can.? Excluding California, of course, which has its new currency, the IOU.? (We are still waiting for a secondary market to arise.? Perhaps some enterprising bank? will offer to buy IOUs at a discount.? As it is, banks either honor in full or refuse to honor the IOUs.)? The states represent the current troubles better than the Federal government does, because they must meet the challenge through expense cuts and tax increases, both of which are painful.

All that said, next year may be more painful, because of greater unemployment, and lower taxes from real property.

6)? Beware junior debt.? I know that at other times I have used trust preferred securities offensively to make money as the credit cycle turned in 2002, but that is a very hard game to play, and we aren’t there yet for this cycle.

7) I’ve had many people writing me for investment advice, and in the near term, I will try to write a piece that summarizes my views of what to do now.? In broad, I lean toward reducing risk exposure, and sitting on high quality short term debt.? For those that hedge, quality will be rewarded, and structure penalized over the next? 6-12 months.? And, avoid financials, aside from exchanges and insurers with clean assets.