Dynamic versus Static Investments

One way to categorize investments would be dynamic assets like stocks and bonds and static assets like commodities and art. 

Investment taxonomy is multidimensional. Along one dimension would be concentration/dispersion diversification. For example owning stock in one company alone as compared to several companies within the same industry as compared to several companies among different industries. Still a greater level of diversification can be achieved as an investment portfolio approaches a share in all companies (e.g., broad-market index funds).

Along another dimension would be type of return claim. A stock investor has a residual claim to the profits that remain after all other claims have been satisfied. That is after all creditors have been paid--all liabilities have been settled. A bond investor (lender/creditor) has a primary claim putting them somewhere higher up the priority list. Keep in mind there are various levels for various types of debt issued. 

Along another dimension would be whether the investment generates cash flows or is dependent upon perpetual new buyers at higher prices for its rate of return. Consider my prior partial list and the explanation behind the distinction. 

Still another dimension would be how dynamic are the assets one is investing in. Can the asset maintain or gain value in a changing world? This is where I would like to focus today.

In my thinking dynamic assets are essentially investments in ideas with potential cash flows. Static assets are essentially investments in inputs (costs) where the market is continually working against you and high-risk speculations on future tastes and technologies (future desirability & greater fool theory rolled into one speculative bet). 

With static assets you can be right and still be wrong. The opposite is true of dynamic assets to some degree as businesses can change direction. 

Since static assets have a locked-in nature, they should command a risk premium. Indeed they do but it isn't necessarily sufficient compensation for the added risk of loss they offer. 

The general case is that the more dynamic an asset is the lower its experienced volatility and thus the lower its expected return. But there is more to this story. Volatility is a cruel mistress. It can rob an investor by impairing capital because of the pattern of returns--negative or even just low returns at the beginning of an investment horizon while cash is being pulled out can leave the principle so low that eventual recovery is not possible. Therefore, a static asset with high volatility and high expected return might experience high (negative) volatility, prices going down rapidly, at just the wrong time, early in the investment horizon. Dynamic assets can be the slow and steady that wins the race. 

Volatility's cruelty doesn't end there. It can collapse and vanish as well, but this leaves investors with low expected returns. A static investor needs volatility to justify future returns. 

One should not assume I am saying that one is preferred necessarily to the other. Rather this is one exploration into how assets can be categorized and how to think about investments. Assets along this spectrum fulfill differing objectives with differing opportunity/risk characters. Investing is about tradeoffs.

Consider this stylized linear example: 

Forever people have been trying to eliminate oil: first they were doing so because it was nothing but a nuisance, next they we're doing so because it was getting more and more expensive as more and more of the world's machines ran on it where the solution was to find more and more of it and produce it cheaper and cheaper, and now substitutes are becoming a better and better option. 

To bet on a technology one needs to be compensated for risk with commensurate returns, and because the chance of a given technology profitably working is incredibly small, those need to be exceptionally high potential returns. In that case don’t own oil; own mineral rights. Don’t own proven reserves; own unproven reserves. Don’t own production; own potential production. 

Oil was to the 1920s what cryptocurrency assets might be to the 2020s. Bitcoin, Ethereum, and all other crypto assets are bets on a particular strategy within a particular technology.  So invest with care. These are highly speculative and certainly very static within my classification. Do not mistake the dynamic ability of people and firms with ideas and fluidity to be attributes of the underlying crypto technologies these people and firms may be employing. 

One last example: Diversified real estate is a dynamic asset while concentrated real estate is static. Similarly investment in the rights to a franchise within a geographical area is more dynamic than is the franchise location itself and even more so than the specific land the franchise sits upon. To this end see the picture below and keep looking until you see it:

Traders Bet on Horses; Investors Bet on Horse Tracks

At times it seems that everybody wants to be a trader. Nobody wants to be an investor. 

Trading is exciting. Investing is boring. 

Traders are trying to find the arbitrage, the sure thing, trying to outthink and out play the market. 

Investors are simply trying to participate with the market as efficiently as possible and with a long-term focus. 

For every winning trader there is an equal and opposite losing trader. It is a zero-sum game. 

For every winning investor there are only various beneficiaries all of whom gained on net to one degree or another. It is a positive-sum game. There are no losers in that game provided the investor was a winner and all costs were internalized.*

*Yes, I know those conditional statements are doing a lot of work. 

Paul Kehrer, CC BY 2.0 <https://creativecommons.org/licenses/by/2.0>, via Wikimedia Commons

Annuities - A Troubled Solution in Search of a Problem

Years ago I'm sitting in a San Francisco coffee shop with my wife enjoying breakfast. Without trying to or really wanting to we can easily hear the conversation from a close-by table. It was two young couples. Both were well dressed, but one was decidedly more outgoing and charismatic. One might even describe them as smooth.

They were clearly on travelling together. Somehow their conversation turned to topics that drew my attention. It began innocently enough.

"Well, what are your plans?" or so went the inquiry. "Nobody wants to think about this stuff, but it is important." They were clearly talking about someone who wasn't there. 

"It is hard to know what to do."

"Look, we obviously can't know the future. But with this approach at least you have something to show for it..." Turning to her partner a little too on cue, "Remember Grandma’s experience..."

I don't remember too vividly the exact conversation--I honestly wasn't trying to listen.* It was not a simple case of a couple-friend giving friendly advice. This was a sales pitch. And they were selling the other couple on the idea of long-term care insurance, a type of annuity that has very strict terms regarding when it will be paid along with sharp limits on how much and long payment will occur. 

LTC insurance plans are not bad per se. They can work in practice; though they more frequently work in theory. While I didn't know all the relevant facts in this situation, and it was none of my business regardless, the conversation frustrated me. In fact I was offended. Why?

I was offended because they were using emotion to solve a math problem. Well, more precisely they were disguising an emotional pitch as if it were a math problem, pretending it was a math problem, and not doing or even hinting at any math! 

Presumably there would be some assumption-laden work-up presented at some point before signing on the dotted line. Let's charitably assume there was--that all we were witness to was the initial hook. Regardless, I resented both the approach and the fact that it appeared to be working.

It was a learning moment for me. As analytical as I want things to be, the truth is humans are emotion-driven beings. Many of our decisions are based on feelings. We seek social desirability and find comfort in confirmation. 

This is why confident people are charming. Especially it is so when they are selling us something. 

How you say it versus what you say--delivery versus content. They will remember how confident they were in you long after they have forgotten what you actually said. 

I remembered this story as I read this recent piece from Vanguard, Guaranteed Income: A Tricky Trade-Off. From the summary bullet points:

The math is clear. A certain income can leave retirees better prepared for an uncertain lifetime. But retirees’ reluctance to annuitize suggests that the irrevocable decision to exchange liquid wealth for guaranteed income is about more than math.**

It is not too much of an exaggeration to say that there are two types of people in the financial products industry: those who sell annuities and those who detest them. A derogatory but perhaps not unfair way of describing annuities is to say that they are never bought always sold. Another is that the primary beneficiary on a variable annuity is the sales person.

Annuities work extremely well in theory. They are straightforward instruments that spread risk and smooth income. 

In practice they are extremely complicated, notoriously misleading, and very expensive. There are exceptions. The regulations around them have improved the situation some, but I would argue strongly that this is a second-best solution behind simply allowing more competition in the industry in the first place. World-class fine dining in Napa Valley isn't because of world-class restaurant regulation. 

If you're paying attention, you'll have noticed a paradox. I started by showing that people often use emotion to sell a financial solution but then argued that emotion is keeping people from adopting those same financial solutions. But that really isn't a mystery. If people are reluctant to listen to the clear math supporting annuitizing future income, it stands to reason that emotion will be perhaps necessary to get them over the hump. 

*In fact they were so bad at attempting to be discrete that I can only assume we too were part of the sales audience.

**The Vanguard piece points to fear of regret and a strong bequest motive as the major obstacles to annuity adoption. I liked their analysis, but I don't think they sufficiently considered just how few good, honest annuity options there are. Hard to buy what isn't being sold--especially with fair options that do leave bequests. And it is harder and harder to sell them. Whether deserved or not (it is definitely deserved!), annuities have been given a bad name by all the many investment advisors who rail against them. 

A Greater Sage Theory

Just a few wondering thoughts on the latest techno-investing development--non-fungible tokens or NFTs.

What gives a collectible object value? Are NFTs like Beanie Babies or Picasso paintings? 

Think of this as a spectrum between pure speculation and pure intrinsic value. An object never lies entirely on one end or the other of this dimension. Where it resides is also not necessarily stable.

Fine art is "fine" in that it has a low degree of speculation relative to perceived intrinsic value. 

Gold is the ultimate financial consensual hallucination – – we can easily, reliably believe that it will have value across societies and well into the future. It is much more difficult to believe that Beanie Babies will have that quality. Picasso paintings are somewhere in between.

Scarcity is an important quality for determining marginal value, but it doesn't say much of anything about intrinsic value. This is the crux of the diamond-water paradox. I think there are two important subtypes of scarcity as it relates to collectibles: organic and manufactured.

Organic scarcity is producing 10,000 Babe Ruth cards and only 1,000 survive decades into the future. Manufactured scarcity is knowing that 10,000 Derek Jeter cards are desired but only producing 1,000 of them. 

Organic scarcity might be thought of as "authentic", but that too is in the eye of the beholder. The 1,000 Babe Ruth cards aren't any rarer in the example above given those parameters.

NFTs are a manufactured scarcity. However that is not very important except to the extent that someone values genuine authentic scarcity--the organic kind--as opposed to fabricated scarcity. Yet I can easily see an appreciation for the manufactured scarcity nature of NFTs. So don't be too quick to dismiss the limited denominator as a factor for these collectibles.

To the extent you can believe that people will continue to value the interestingness of NFTs along with the thing (art work, sports moment, etc.) that a particular NFT is associated with, you can credibly and reliably believe that that specific NFT will have value. 

At this point they are obviously deep on the speculation side of the speculation vs intrinsic value spectrum. Time will tell.

A Crowding Theory to Explain the Trade of the Decade

Bold title, I know. Yet while there may be some hyperbole in it, we do face a situation in equity markets quite unlike anything we've seen since the dot-com tech bubble era. 

[Disclaimer: This is not investment advice because I don't know you. I am not analyzing your situation, your appropriateness or suitability for equity or any other investment idea, your goals, or your risk tolerance. This is an attempt to explain what I believe to be the valuation existent in the market today. Read at your own risk.]

I. The Trade of The Decade

Typically with tolerable variation equities are "cheap" or "expensive" at the same time. The Great Recession was a period where equities went on sale, so to speak, for those willing and able to bear the risk. You didn't have to be brilliant; you just had to be brave. Buying and holding throughout the deepest points of the downturn (roughly Oct 2008 - Mar 2009) was a rewarding investment. Make no mistake it was not easy to do this as for years after the market bottomed it still never felt quite safe, but that is what investors generally and equity investors specifically get rewarded for--buying when no one wants to. 

At least they should be rewarded for that. And the expected reward is the "risk premium"--the expected return over and above the return for a risk-free investment. Think of it simply as the premium you should expect to earn for bearing the risk. Every investment has one. Sometimes it is relatively high like for stocks in the early 2010s. Sometimes it is relatively low like for stocks in the late 1990s. That "relative" measure could be in relation to its own history alone, the position of that asset class compared to other asset classes, or both. Current market risk premiums are the foundation behind my hypothesis that a big opportunity/challenge is in front of equity investors today.

The "trade of the decade" I allude to is a relative trade. Unlike so many highly-touted trades in history, this one is fairly simple. I wish to briefly outline it without effectively proving it so as to get to the true purpose of this post: a hypothesized reason for the opportunity to exist in the first place. After all, I am a strong supporter of semi-strong efficient markets theory (EMH).

First, some assumptions:

1. Markets are generally efficiently priced. This means all important known information is thoroughly and quickly incorporated into market prices. Therefore, an investor should not expect to be able to outperform the market. 
2. Risk tolerance (degree of risk aversion) among investors and risk outlook (the economic picture going forward) determine risk premia. The world looked very scary in March 2020 and investors' general appetites for risk were substantially lower than usual. 
3. Risk premiums today are generally low across all asset classes. A couple of ways to say this in everyday language are: equity returns going forward (next ten years) will be lower than what we have enjoyed historically especially in the last 11 years and interest rates look to be lower for longer (lower than historically and for longer than typically has been the case). Caveat: risk premiums can be low and returns look high and vice versa. I am being a bit casual with how I equate risk premiums and future returns as compared to history, but I believe the underlying point holds.

Here is the problem, opportunity, and challenge all rolled up into one. Today certain portions of the stock market look fairly expensive (high valuation) while other parts look fairly attractive (low valuation). To be more concrete about it the high/low valuations are in comparison to those specific equity subclasses' own history. However, adding to the puzzle the risk premia for those asset classes look typical for the expensive group while they likely are desirable for the attractive group. 

Even a sloppy reader at this point is growing quite frustrated by the fact that I haven't identified which groups of stocks I put into the expensive and attractive categories. That is intentional as I don't want that to be the takeaway from this post, but I will now relieve that frustration as long as you know I am NOT effectively proving my case. Take this too as assumption. 

From the perspective of valuation, large-cap stocks in the U.S. (especially growth-style stocks) are expensive compared to their own history. Small-cap stocks in the U.S. (especially value-style stocks) are cheap compared to their own history. International stocks (especially value-style stocks) are also cheap compared to their own history. One way to measure valuation is to look at the current market price compared to the earnings, the P/E ratio. The higher the ratio all else equal the more expensive the stock.

One of the best ways to see this is to look at long-term analyses of real (inflation-adjusted) price/earnings ratios. The most famous of these is Shiller's CAPE (cyclically-adjusted PE) for the S&P 500 index. 

We can then do very similar analysis on various other indices considering important subclasses to see how they compare to the S&P 500 (large-cap U.S. stocks). This analysis [summarized in the table below] is where we see these key differences. Namely, that the riskier areas of the stock market (value-style companies, smaller sized companies, international companies, et al.) look relatively inexpensive.

Risk premiums* [analysis and results not shown] both echo some of the valuation analysis as well as tell a bit of a different story. The risk premium for large U.S. stocks is near the median of where it has been over the last 15 or so years meaning that adjusted for risk these stocks look appropriately priced. The risk premium for small U.S. stocks is far above its own historical median meaning adjusted for risk these stocks look very low priced. To a lesser degree the same low price depiction can be ascribed to international value stocks. The risk premium for international growth stocks is more similar to large U.S. stocks (i.e., it is around its historic median). So we have a general range of stocks from those that look appropriately priced (safer stocks like large companies and growth-style companies) to those that still look attractively priced (riskier categories mentioned before).

The risk premium story is not as sanguine for large U.S. stocks as it may appear. Despite my assumption above that interest rates will remain low for a long time, they don't have to. And they can rise meaningfully above current levels and still be historically low. If they do rise, that will have a big impact on stock valuations. Large growth stocks in particular look very sensitive to this risk as their cash flows come far into the future. A rising interest rate means a rising discount rate applied to those cash flows, which reduces the current value of the stock.

The trade of the decade is to fade away from large U.S. stocks and increase exposure to small U.S. stocks (especially value) and international stocks (especially value). The most acute version of this is for large growth versus small value stocks in the U.S. Specifically we could identify indices like the Russell Top 200® Growth Index and compare it to indices like the Russell 2000® Value Index. The reason I call it the trade of the decade is because my more in-depth analysis focuses on 10-year expected returns and risk pricing as well as the fact that it might take a decade to fully play out. The reason you should heed caution before engaging in this trade is (1) this risk might not be for you (it indeed comes with risk not specified in this post) and (2) this is not an endorsement of reducing diversification (I still advocate exposure to large-growth stocks, etc.).

II. The Crowding Theory

IF I am correct about the different relative risk-adjusted valuations for various equity subclasses such as large growth stocks versus small value stocks, interesting questions emerge. How did this come to be? What explains it consistent with EMH?

I believe two crowding effects have brought this about. Flight to safety is the first crowding effect. Sophisticated money avoiding public equities is second. 

Recall my assumption that risk premia are determined by the general level of risk aversion among investors and the market's risk outlook. The tidal wave of the pandemic that unfolded gradually then suddenly from mid-January 2020 through to the market bottom of late March 2020 was a massive reevaluation of risk that triggered an extreme flight to safety. Note that it was not the entirety of the valuation dispersion between various groups of stocks. For some time now growth has been outperforming value, large has been outperforming small, and U.S. has been outperforming international. For U.S. equities the market's reaction to the pandemic was in fact the dominant portion of the differences we see today. 

From Vanguard: 

Difference in annualized total returns over rolling five-year periods

Source: https://advisors.vanguard.com/insights/article/growthvsvaluewillthetideschange

As the risks and worry of the pandemic grew, investors sought refuge in the safest of assets, U.S. Treasury securities. This lowered interest rates to nearly zero across the yield curve. They also derisked in other ways. For those who wanted continued equity exposer, they flocked to the safest equities in the world, large U.S. growth companies. The now much lower interest rate conditions worked in tandem to make these equities more and more attractive. The riskier aspects of the market suffered as investors tended to rotate away from them and into safety. 

So that is how risk premiums for various stocks got so extremely different, but why didn't sophisticated investors step in to absorb the difference? After all, they are supposed to have extremely long (infinite?) time horizons and not be subject to wild swings in risk. 

Sophisticated investors is a bit pejorative on my part. Here I am talking about the so-called "smart money" of institutional investors like endowments and pension funds. They like to think of themselves as cunning lions, but they bunch together like scared, vulnerable sheep. Theoretically, they should be a counterbalance to short-horizon investors who are theoretically much more sensitive to changes in risk appetite and risk conditions. 

For example, a person close to or recently entering retirement should be invested positionally to withstand the risk of market volatility. The same can be said of any investor--they should be so positioned. Yet often times they are not. And even more often they are liable to overreact to bad news leading them to drastically alter their investment positioning as an attempt to predict the future. However, I do not think this is a big effect. It is a behavioral story that isn't necessarily as irrational as it seems--extreme events like the Great Recession and COVID pandemic give us insights into our attitudes on risk tolerance not apparent before. 

At the same time the sophisticated investors themselves are subject to the same types of risk tolerance reevaluation. Rather, to be a counter-balance they need to be in the market. The reason why the “smart money” hasn’t absorbed all the excess risk premium in riskier aspects of the market already is because endowments and pensions have trended far from traditional public markets. Endowments have on average reduced their public market equity exposures by 50% in the past 50 years going from about 60% to less than 30%. They are crowding away from public equities making them unavailable to provide a counterweight. 

To be sure riskier assets have done well in the past few months--small-cap U.S. stocks were up 35% for the three months ending in January 2021. The primary catalyst were vaccine developments in November. Add to that improvement in our understanding of the true risks of the pandemic as well as rapidly improving economic fundamentals. Even still, risk premiums in risky assets (value, small cap, international stocks) are at elevated levels compared to their own history as well as their safer equity counterparts. 

As risk aversion gradually (and perhaps in sudden bursts) returns to normal levels and as the risk outlook continues to improve, my hypothesis is that those assets with outsized risk premiums will perform relatively well (high confidence) and absolutely well (moderate confidence). 

Incidentally while this bodes well for public risk assets, it likely portends poorly for alternatives (private equity, venture capital, hedge funds, et al.). That is a crowded space with not much low-hanging fruit, and what is there is very expensive to be had. 

*The reason I deliberately gloss over the risk premium results is the model I am referring to is proprietary, but more importantly the calculation of risk premia is art and science. Laden with assumptions, it can be very much argued over in fine detail. However, I believe the depiction above is well grounded and firmly supported by a wide range of reasonable underlying assumptions. For more on this topic see Research Affiliates work among many others. 

All Aboard!

Apropos of nothing in particular . . . 

Invest with the perspective that we are just passengers on trains. 

We are not the engineer. 

We are not a little kid laying out a model train set. 

We can choose the trains we board and the ones we avoid. 

Some are faster. Some have better safety. Some have more amenities. 

None are perfect, but some combinations are much better at getting us to our destination, and, importantly, we do not all have the same destinations. 

We cannot dictate the trains' schedules, speed, route, etc. 

We just have to accept what the trains before us are offering and decide among that option set--not an ideal, imagined one. 

We do not have to take the most popular trains if they aren't actually the right fit for us. 

Constraints are individual just like goals. For example, even though we both want to go from Los Angeles to Chicago, the Silver Streak may be best for you but not for me because I have a lot more luggage to transport and that train has limited capacity. 

It can be good to have a travel agent to help plan our trip, and a great conductor can help guide the journey. But it is us who have to decide, board, and endure the journey including if the train breaks down forcing us to find alternative options. 

Understanding Investment Expected Outcomes

Winkler's Law of Investor Risk/Return Trade-Offs: Any time an investor begins a statement affirming they understand the basic risk/return trade-off (high return comes with high risk, low risk implies low return), they are invariably about to implicitly or explicitly argue against it. 

There are specific meanings of risk and return as used here. This is financial risk and return. Risk can be understood as variance or volatility of price. Return is the outcome realized (selling price plus income derived during the time held minus the price paid and costs borne). Once you realize that "high/low" return doesn't mean "good/bad" return but rather means "big/small" return, you'll be a lot closer to understanding what finance people understand about risk/return. Risk and Return are simply two names for the same thing in this framework.

If you buy a share of stock at $100, hold it for a year collecting $2 in dividends, and then sell it, the outcome is going to be high or low. If you sell it for $101 or $95, the outcome was low in either case. In this hypothetical the return and risk were both low. Selling for $10 means a $3 profit ($2 dividend plus $1 price improvement). Selling for $95 means a $3 loss ($2 dividend minus $5 price deterioration). Regardless, the outcome of an approximate 3% return (positive or negative) is a low return.*

 

When the meaning of "risk" is relaxed to include risk of individual ruin (financial or otherwise), hypothetical scenarios that do occasionally exist move from Low Risk/High Return to High Risk/High Return (extreme example: let's bet on 10 coin tosses in a row where for each one if you choose correctly, I give you $1,000,000 and if you choose incorrectly, you pay me $500,000) or from High Risk/High Return to High Risk/Low Return (fairly common example: concentrating nearly all of one's financial wealth in a single stock). 

Bad decision making can move hypothetical scenarios from High Risk/High Return to High Risk/Low Return (example: excessive amounts of slot-machine play--the repetition gives the house a greater and greater advantage . . . start with a 90% payout return, then keep playing . . . 90% times 90% times 90% means the house goes from a 10% edge keeping a dime for every dollar you wager to a 27.1% advantage keeping 27 cents for each dollar through the rewagering). 

The grid is generalized and one should think of these realms as in the extreme. There are certainly examples that would technically fall into the unrealistic realms (hence the name unrealistic rather than impossible). These opportunities (Low Risk/High Return) and pitfalls (High Risk/Low Return) are fleeting, rare, difficult to truly experience, and usually of small magnitude. To good to be true is basically a mathematical and economic fact. 

*Yes, "low" is a relative term--relative to the state of the world. Just assume with me that most returns that are 3% are "low" or change the numbers to make it so in your mind. The amount isn't critical to the point.

Does Active Investing Work in Theory?

We know active investing almost always doesn't work in practice. The vast majority of professional money managers underperform their respective index over meaningful periods of time. Let that sink in. Compared to what we could easily do on our own through indexing, most of the people we pay very large sums to invest our money give us back less after they do their job and take their fee. For those few that do, we say they earn alpha--return in excess of the market for the same level of risk taken. 

As a side note realize something. Your Uncle Fred with all the great stock picks or your friend who just quit his job to start day trading and who has actually has been making money trading stocks, bonds, options, or whatever HAS NOT been taking the same level of risk as any index. Those two happen to be winners in a likely random pool of many people taking on tremendously more risk than they realize. If 10,000 people all flip coins ten times in a row, some of them almost certainly will get ten heads in a row (singularly by itself a 1 in 1,024 chance). 

However, I am focused on professionals here. Guys and gals who dress sharp, use all the right jargon, are actually highly intelligent and reasonable, and who most of the time lose money for their clients. Perhaps their clients are buying something else than returns [paging Robin Hanson--investing professionally isn't about making money]. Highly likely in many cases. It feels good to deal with these pros. Plus they can in fact help investors stay disciplined--better to make 5% versus the benchmark's 6% over 10 years than to bail out when the market declines and earn only 1% over that same 10 years. Fortunately for EMH and unfortunately for this theory, this affect has been shrinking to recently be nearly nothing.

So, while active management doesn't work in practice, does it work in theory? Start with the assumption of a manager that can consistently and reliably earn 1% alpha. When her benchmark is up 6%, she is up 7% on average. Why does she need your money? 

I can think of two likely reasons:

1. She could want to use it to reduce her own risk. 
2. She could have more opportunity than she can herself realize.

Notice that these are not altruistic motivations. The first is fairly unfavorable for the client--you are giving her money not for your benefit but for hers. She uses the additional funds to smooth out the volatility in her own income. When you pay a management fee to her, you are directly subsidizing her income. And just the use of the funds themselves is an indirect subsidy allowing her to invest more broadly. All of this might be justified if the second reason holds.

In the second she only would invest your money once she has invested all of her own money including all the money she can borrow at less than the total return of the investment, which is the market return plus alpha (6% plus the 1% in this case). Theoretically and in practice she will charge you a small fee to cover transaction cost plus a little profit to her to let you participate in her investing endeavors. Yet as we saw in the first reason she should probably be paying you as you are giving her a benefit of lower risk in the form of a smoother income stream.

Essentially this is an arbitrage which we know is going to have a limited capacity. Even if she is in that elite company of professionals who can outperform the market, her last idea (say the last stock her analysis says to buy) will be her worst idea and only be at best just as good as the market itself. It seems very likely by the time she gets to your money, we are firmly in reason-one (personal risk reduction) territory. 

This is quite damning for professional money management--in theory. What might save it and asset managers like myself who do in fact invest client money with money managers? 

First, we must admit just how challenging it is to find professionals who can outperform the market. Second, we must consider that the first reason above, income-smoothing risk reduction, might actually have a win-win aspect to it. Yes, she does enjoy less risk by using your money, but she doesn't get this for free. In fact she is probably risk averse enough that the second reason doesn't hold firmly.

Rather than fully lever all of her available resources--put her risk at ludicrous speed--she would likely prefer giving you most all of the risk of her performance and collect a steady fee for doing so. She is giving up the potential for return upside so that she has only very little downside risk. This flips the concern from being a pure doesn't-work-in-theory problem to being a pure principal-agent problem. sigh We can't catch a break. Now we have to worry that she isn't incentivized properly to continue to do what we hope she can do--outperform the market at the same level of risk. But at least we partially rescued active management in theory.

As bad as this is (in theory), this is in public market active management. The same forces are at play plaguing private markets like private equity and private debt. At least public markets are not opaque, very hard to benchmark, illiquid, et al.

Some Secrets to Investing Success

To be a "successful" investor, you've got to start by defining success. It is different for just about everyone. Two investors with nearly identical demographics including age, lifestyle, and net worth can have significantly different financial goals. And financial goals are almost never determined along one dimension. Thinking they are is a formula for a typical 80s movie, and most were bad depictions of how investing works even though they have classic status.

Here are five hot tips to get you a leg up on the competition:

1. Get a head start. As a Sooner I can tell you there is no substitute.

Imagine you, a very conservative person, begin investing at age 25 by putting $100 per month into a very safe bond index fund (perhaps BND). You do this for 20 years (240 months straight). Let's suppose this bond investment grows at an average rate of 3.5% per year. Although you put in $24,000 of your own money, that money is growing on average as it is invested. So after the 240th month you would expect to have about $34,576 of which about $10,576 is the growth of the investment. At that point when you are 45 years old you stop saving additional money and just let the bond investment grow for the next 20 years or until you are 65 years old (40 total years of investing). 

Now imagine me, a rather aggressive person the same age as you, waits until you are done putting money in to begin my own investing. At that point, 20 years after you started, I start investing $100 per month and I don't stop adding $100 per month until age 65 (20 years of adding to my investment just like you) and I invest in a stock fund with more risk and return potential (perhaps VT). Let's suppose this stock investment grows at an average rate of 8% per year--more than double your investment return per year. After 240 months I've added just as much as you, $24,000 of my own money. I've also enjoyed a higher rate of return on those investments. But do I have as much in total? In this case, no.

At age 65 you have over $68,798 while I have only $57,266. And if you would have chosen the stock fund instead of the bond fund keeping the other assumptions the same, you would have over $266,914--being early is an amazing difference!

See the chart below and notice how starting early allowed you to be invested more conservatively.

Here is a short video showing the same principles at work.

2. Protect against the downside first and foremost.

It is mathematically impossible to save enough and earn enough on that savings to cover spending more than you have. Try it and see. If you save $20 million and earn a return of $40 million on it (a 200% rate of return!), you still cannot spend $61 million. Even if you borrow against the $60 million to try and get an additional $1 million, you have to come up with that $1 million to pay back the loan. Spending prudence should seem self evident. So too should investing prudence because you mathematically cannot spend investment earnings you do not achieve. 

If I put all my investment (eggs) into one stock or bond (basket so to speak) and that stock or bond goes broke, my investment is gone. If I put all my investment into two stocks or bonds and one of those goes broke while the other is fine, I have only lost half of my investment. Repeat this logic for more and more individual investments, and you will eventually get to a point of diversification where the impact of picking a complete lemon (stock or bond that goes to zero) is immaterial to you. That should be a goal for most investors.

The entire stock or bond market basically cannot go to zero. If it does, you got bigger problems than your IRA balance like the colossal asteroid that must have struck the Earth. In fact, the history of economic growth has been a reliable (eventual) pattern of higher highs and higher lows. Diversification is your first best risk reducer against the threat of ruin.

3. Grab the right rate of return.

It is all about beta not alpha. Beta is the fancy way of saying give me the market's performance. Alpha is the fancy way of saying give me something different (hopefully better) than the market's performance. Beta is passive investing, boring, dull, easy, anybody can do it. Alpha is the sexy stuff. Alpha is the smart money, the guys zigging when the panicked sheep are zagging. At least, that is the story so many like to tell.

The fact is overwhelmingly most professional money managers do not beat their benchmark. Let that sink in--the guys paid millions of dollars to add value for investors by being better than their benchmark are most of the time subtracting value. Investors are paying a fee to get a lower rate of return than they could otherwise.

The key decision for most investors is not "can I beat the market?" but rather "can I be the market, and what market do I want to be?" Remember, every investor is different--different risk tolerances, different various goals, different unique circumstances and biases, etc. Getting the right mixture of various investments (AKA, asset allocation) is the first best method of achieving your financial goals--notice how this works hand in glove with diversification. The asset allocation decision will almost exclusively determine the risk/return path your investments travel making other decisions small contributors to performance.

4. Look for the rewards of liquidity and transparency.

Listen to Jason Zweig among so many others. Don’t trust hedge funds. Understand that private equity = public equity minus liquidity minus transparency plus fees plus leverage. As Cliff Asness points out, let others accept a discount for illiquidity (when a premium would be the theoretical demand of investors). You want access to your money while invested in assets and processes you can understand, fully benchmark against, and truly see the value of. 

5. Resist temptation and envy--the key drivers of FOMO.

This one has many short sub components (here are a few):

• Don't time the market -- This is an impossible task and anyone who tells you different is a liar or a fool.
• Therefore, stay invested and on your long-term plan -- Uncle Freddy very likely doesn't know something you should be emulating. This time (any time) is very probably NOT a time to go to (some different asset allocation as compared to your long-term plan).
• You will never be significantly invested in the best performing single investment because of rules 2 & 3 above -- You don't want the risk that has only luck as its investment thesis.

The bottom line of this is successful investing generally is simpler, cheaper, and duller than advertised.

A Price Paradox

This is a continuation of my previous post "Markets Don't Hate Uncertainty".

Don’t think about the stock market like you do for a specific good like, say, bananas. If a large group of the banana-consuming public suddenly decides they don’t like bananas very much anymore, the demand curve for banana shifts massively to the left meaning market prices will fall greatly and future quantities produced/consumed will too--remember the immediate supply curve is nearly vertical and the long run supply curve is much closer to horizontal.

However, that is not the case for stocks. The value of stocks is determined by the net present value of future cash flows. In simple terms: Buying a stock means being a part owner of a company. As an owner you are entitled to a share of future profits (eventually paid out as dividends--a reasonable, simplifying assumption). Those profits come in the future, so we have to value them today at a discount since a dollar today is worth more than a dollar tomorrow--the so called time value of money (TVM). Adding up all future cash flows individually discounted for how far out into the future they are gives us a figure for net present value (NPV). This is the "value" of the stock, which should equal its price. Let's assume for now there is no uncertainty about expected future profits.

An essential premise in the banana hypothetical is that the value of bananas has plummeted. Remember value is always a subjective concept. Suppose a large demographic group like the Baby Boomers in aggregate start reducing their desire to hold equity investments (stocks), it is not because they don’t believe in the value of stocks in general. Rather it is likely due to the fact they don’t want to have an asset exposure so much tied to the volatility associated with stocks. So they want to reduce their investment holdings in stocks. So in one sense there is no reason to believe that their selling activity should materially change the price of stocks because the investment value of stocks (NPV of future cash flows) is unchanged in the market overall.

But they are trying to sell, and their selling has to be met by buyers. In order to find a willing buyer they should have to offer a more attractive (lower) price than the current price. Hence, we have a paradox--prices shouldn't change but they have to change. The solution lies in a reframing of what investors are trying to achieve. They don't want stocks for the sake of stocks--this would be the banana model. They don't want the future cash flows per se--those are only attractive relative to the price paid for them given the risk associated with realizing them. They want the expected return--the future cash flows purchased at an appropriate price today adjusted for the risk.

So in order for Baby Boomers to sell their stocks they have to increase the expected return of stocks from the perspective of the buyer. Since they can't affect the future cash flows, they have to do one of two things: Either lower their prices to attract buyers or find buyers with different discount rates (buyers who don't value a dollar today as much as a dollar tomorrow). Realize, we are still assuming no disagreement about the expected future cash flows. That wrinkle is not needed to explain this hypothetical or the paradox. Everyone can agree on the expected future cash flows and still people want to exchange their positions (i.e., Baby Boomers want to sell and reduce market risk and buyers want to take on that risk).

Here is the graphical way to think about those two options available to the stock-selling Baby Boomers:

The colored lines B and C represent the change in price over time. The slope of these lines is the expected return. In the first case (top chart) prices today decline along path A and the lower price after Baby Boomers try to sell stocks implies a higher expected return for all stock investors. The market's expected return has increased from the slope of line B to the slope of line C.

In the second case (bottom chart) the difference in how each investor discounts the future price implies a different rate of return. Baby Boomers selling stocks have an expected return of B and buyers of their stock have an expected return of C. (Note: This is related to but not dependent upon Baby Boomers having a shorter life expectancy than buyers. The buyer can be the exact same demographically as long as they have a different discount rate. When compared to the stock-selling Baby Boomers, the buyers value a dollar tomorrow as being closer to the value of a dollar today. Boomers can be selling to other Boomers with lower discount rates.)

You should be feeling uneasy about this for two reasons:

1. Why don't prices today equal that far-off future price? Didn't we assume there is no disagreement about the amount of future cash flows?
2. In the second chart why wouldn't this have already come to fruition? Did stock-selling Baby Boomers suddenly just now increase their discount rates?

The answer to the first objection is this. Even if we assume there is no disagreement about expected future cash flows, there is a degree of uncertainty for them; hence the word "expected". The compensation a buyer/holder of stock receives for risk of investing is the expected return--technically speaking, the equity risk premium. 

Assume a stock will pay a dividend next year equal to all of its assets and profits and then cease to exist. All market participants agree that the dividend next year will be either $0 or $2 per share and that the probability of each outcome is 50%. In that case the expected future cash flow is $1 next year. This means the stock today is worth $1 before any TVM discounting. Once the year has passed and the dividend realized, investors will either have $0 or $2 to show for the $1 they put at risk by buying the stock. Therefore, the future price has to be something greater than the current price or no one would be interested in risking the investment.

The answer to the second objection is a little less elegant. Well, basically we have to be assuming Baby Boomers wanting to sell stock have increased their discount rate (i.e., become more risk averse). Otherwise, we can't have the hypothetical. But this leaves another problem: Why isn't there just one expected return in the market? Well, there is, but in the second chart we are breaking up the market into two segments. The blend of the two lines B and C would be the market expected return. That would be some new line D with a new destination in between the two lines B and C. 

So, what is the solution to the paradox? Will prices change? And if so, did the value of stocks change?

The answer is another paradox: Stock prices changed by going down because stock value went up so stock prices could come down because stock value had to go up.

Baby Boomers in this hypothetical all of a sudden wanted less stock because they wanted less risk. In order to reduce risk they have to sell that risk to someone else. That someone else either must want that same risk relatively more all of a sudden (the source of the second objection to the bottom chart mentioned above) or the Baby Boomers need to reduce the risk by offering a lower price. Some of both will happen meaning stocks get less risky simply because Baby Boomers want less risk--a rather surprising result. Here are the implications:

• The lower the price of stocks, the less risky they are holding expected cash flows and discount rates constant.
• The change of ownership from higher-discount rate investors (Baby Boomers all of a sudden in our hypothetical) to lower-discount rate investors (the buyers of the Baby Boomer's stock) means stocks are less risky to those who now hold stock without any needed change in price or expected future cash flows. 
• Stocks become more valuable when prices go down without any other change or expected future cash flows go up without any other change or discount rates go down without any other change. 
• If expected future cash flows go down and discount rates go up (as has been the case circa March 2020), then prices must go down. 

The moral to this story could be: DON'T REASON FROM A PRICE CHANGE! Prices reflect value. Value for consumption goods and services like bananas and hotel rooms are subjective. Value for financial investment assets like stocks, bonds, and real estate are subjective too. But they are subject to expectations about the future and the value we place on money today versus money tomorrow.

Prices don't simply change, and a change in price doesn't really tell us anything. The price of bananas declining could be because people stopped liking bananas as much or it could be because it just got a lot easier/cheaper to harvest bananas. The price decline tells us that the value of the next (marginal) banana is lower, but that fact by itself doesn't tell us why that is the case.

Stock prices declining could be because investors in aggregate think earnings from holding stocks will now be lower than estimated before or it could be because investors in aggregate value money today more than money tomorrow. The price decline in stocks tells us that on net one or both of these has happened, but the fact by itself doesn't tell us which.

Markets Don't Hate Uncertainty

Markets don’t hate uncertainty.

Markets aren’t sentient beings with feelings. It is much more meaningful and accurate to say markets price uncertainties and risks.

As uncertainty rises, markets adjust prices to reflect that information. As risk tolerance changes, markets adjust prices to incorporate that as well.

The current financial environment gives a helpful, extreme example. Lower prices for stocks are likely reflecting two things: increased risk aversion (higher discount rates) and greater uncertainty about future wealth creation (lower earnings/profits, lower quality of life).

Let's look at each of those causes. First, increased risk aversion: If the average person is becoming more fearful of the future, the rational response for them is to increase how much they value a dollar today as compared to a dollar tomorrow. Technically this means they discount the future by a higher rate than previously. They are raising their discounting rate in the formula:

Money Today = Money Tomorrow less a Discount

$0.90 = $1.00 minus $0.10

[slightly more technically]

Money Today = Money Tomorrow times a Discount Rate

$0.90 = $1.00 * 0.9

(even more technically, 0.9 is approximately a 11.1% discount rate)

If our previous discounting rate was $0.05 for every dollar tomorrow and now it is $0.10 for every dollar tomorrow, then the current value of that future dollar has declined $0.05. Prices today on that future dollar fall from 95 cents to 90 cents.

Second, greater uncertainty about future wealth creation: If the average person thinks that future generation of wealth is going to be less than previously thought, the rational response is to lower their expectations for the future. They are lowering the expectation of money tomorrow in the formula:

Money Today = Money Tomorrow less a Discount

$0.90 = $0.95 minus $0.05

If our previous expectation was to generate a full dollar tomorrow and now we fear tomorrow will only see the generation (creation) of 95 cents, then prices today on that future amount fall from 95 cents to 90 cents.

What happens when both happen at the same time? We then would see a compounding effect in prices today. 

What was once

Money Today = Money Tomorrow less a Discount

$0.95 = $1.00 times 0.95

Is now

$0.855 = $0.95 times 0.9

Prices for money today have fallen $0.095 ($0.95 - $0.855) or 10%.

These are the underlying forces that drive the more complex world in financial markets. Investments in equities (stocks) have fallen significantly in the past month. This is very likely an example of both increased discounting of the future (greater risk aversion) and lower prospects on future wealth creation (lower expected future earnings). The market isn't hating the uncertainty about how risky the world is or what future earnings will be. Rather very appropriately the market is repricing the expected value of what the future will be. 

In every moment that passes new information is revealed about the world. This information is an update to all the prior expectations we had. Some of those expectations get confirmed. Some of them get rejected. But that is too binary a way to look at it. Don't think about right and wrong in terms of predictions. Think about constant adjustment. When substantial new information comes to light like when a virus comes into the world, the virus becomes abnormally very serious, and a pandemic emerges, big adjustments to prices today on values tomorrow naturally and appropriately result. 

Perspective

To the Moon, Alice!

Imagine if in the summer of 2018 you embarked on the vacation of a lifetime--a 2-year journey to the Moon with SpaceX. This was their "Get Away From It All" package which includes no contact with Earth during the voyage.

While gone, you left me in charge of your affairs including your investments.

You have a wonderful trip and then return late in the summer of 2020.* Settling back into terrestrial life, you ask me for a rundown of what you missed. My reply: "Well, a few things happened here and there. Perhaps most interesting, we had a pandemic."

"A what?!?" you exclaim.

"I know, a once in a generation viral pandemic. It was bad, but not nearly as bad as some of those in history. Still many people died. There was a lot of chaos and confusion at times. Lots of events were cancelled; so life was pretty disrupted for a while. The overall hit to well being for the typical person as meaningfully, negatively impacted." I explain.

"Oh, that is horrible." You dare to ask, "How are my investments?"

"They are worth basically just as much today as they were when you left plus a little for inflation." I say calmly.

"That's wonderful. Surprising even. But how did you manage that?"

"Well, it wasn't much that I did. There were a few moves here and there that probably added a little value--just sped up the time to recovery. For a while the investments had lost quite a bit. You would have been pretty worried had you been around to witness it. And the values were up quite a bit from when you left right up until the pandemic really set in. All in all it was wild times."

Reassured, you say, "Well, I'm glad that is all behind us. I left after a great 9 years of investing, and I got to ignore a crazy few."

. . . The end is not near, folks. There is a LONG journey ahead. If you don't realize those are positive thoughts, you need to re-read the passage above. The pain that has and will hit human life is beyond sadness. Don’t compound your worries with shortsightedness—in investing or any aspect of life. Cherish those around you and make good choices for the long term.




*Make it a three year trip returning 2021 or a four-year trip until 2022 if that makes this more realistic in your view.

To Infinity and Beyond

This is a bit of a followup to the Dracula post from earlier this year. 

Foundations and endowments DO NOT have infinite time horizons. Technically speaking, nothing does. But I would argue they don't even have extremely long time horizons. 

These types of entities have no reason to believe they will exist into the long, far future. At the very least they will transform so dramatically the future them is not the current them--donors, beneficiaries, and employees will all be different as will its mandates, goals, and mission. Over very long periods of time slight changes to average inflation or average rates of return very significantly affect the purchasing power of assets. These are highly uncertain variables where the difference between phenomenal growth and permanently impaired capital is almost imperceptibly small to a current observer. The tax structure governing these entities over the long-term future is also highly uncertain. A related but independent threat is if the powers that be and the powers that will be even allow the entity to exist . . . forever.

Perhaps despite all of this they should act as if they have infinite time horizons? Let's assume a few conditions: 

1. Foundations and endowments in at least some cases are the best available option to serve a desired purpose. (If you simply take this for granted, you probably are not thinking hard enough. These entities may not be the best way to accomplish the goals they ostensibly are designed for.)
2. It is desirable for foundations and endowments in some cases to exist into perpetuity. 
3. It is possible to design and implement an external and internal governing structure and to craft a mission statement conducive for the first two conditions. (This might be where this entire process deviates too far from reality.)

For those entities where a perpetual time horizon is appropriate, we obviously do not want them to engage in behavior that unreasonably jeopardizes that goal. One quick and tempting way to jeopardize it is to spend too much money.* Another is to invest poorly. Notice that this bad behavior is a bit murkier. Investing could qualify as being done "poorly" in a number of contradictory ways. Defining it as taking the wrong risk(s) in the wrong way(s) doesn't provide any clarity other than to suggest how complex and complicated the error can be. 

Tying this back to the question at hand, should they act as if they have infinite time horizons, begs the question: what exactly does that mean? How would they be different as compared to acting as if they had long, but limited time horizons? Let me describe the difference in terms of a couple of problems I can foresee:

• Doing too little good now (spending too little!) so as to safeguard sustainability. Yes, this cuts a bit against the grain of what I've said and implied above. But it is a real risk especially for a perpetuity mindset. Doing more now might solve a problem that wouldn't otherwise exist in the future--keep in mind that our descendants are very likely to be extraordinarily wealthier than us with entirely different problems (even if they aren't that much richer). 
• Investing in a manner that jeopardizes near-term access to sufficient capital. If you have an infinite horizon, what do you care that your 5-year or 10-year or even 20-year returns are very bad as long as the long-term expectation is high enough? In fact, let's tie that money up in illiquid assets if that is the trade-off for above-market performance. Unfortunately, simple beats complex in almost all categories but not in the competition of hope. Which is why a perpetual outlook fosters an esoteric investment strategy. I think these entities should push back against this natural inclination to invest in opaque, illiquid, and non-benchmarkable assets. Any investment that is not accessible (lock-up periods), marketable (secondary market discount), or verifiable (Internal Rate of Return (IRR) is a useful fiction) for a period of time longer than the expected tenure of the investment staff recommending it is highly suspect. I would suggest the same evaluation against the average board member's remaining term. And this is all before we begin a discussion of manager selection and dispersion risk--alternative investing is not about asset allocation; it is about finding the best and avoiding the worst. Good luck with that. 

What about governments? Should they act like they will be around forever? Again, let's consider what this means by jumping to potential problems:

• A government that behaves as if it cannot fail to be or should not cease to be risks being way, way to aggressive--both to its own people as well as others. 
• This encourages disruptive experimentation since the government can simply outlast any temporary ill effects. Normally, disruptive experimentation is my jam, but not for government. Government lacks the proper incentives and the rightful decision makers. 
• Paradoxically this perpetuity outlook also encourages extreme neglect as any problem today will either be solved tomorrow or be some future government administrator's problem.

I think the assumption that foundations, endowments, governments, et al. should behave as if they have unlimited time horizons is sloppy at best and dangerous at worst. Long time horizons are appropriate and very useful for these entities, but there is a big gap between a long time and forever. 

My thoughts for this were spurred in part by listening to this episode of Macro Musings. 

*I will leave for another day further discussion on the well-debunked conventional wisdom that a 5% or even 4% spending rule is likely sustainable in real terms.