Choose: Stocks and Bonds or Bitcoin and Cash

Over lunch this past week an interesting hypothetical was posed. Suppose you were offered one of the following, which would you choose: 

• One million dollars in some initial combination of your choosing between stocks and bonds (fully-indexed, total market coverage), or
• One million dollars in some initial combination of your choosing between Bitcoin and cash (U.S. dollars).

You will be forced to lock it in for 10 years with no changes to it or any ability to borrow against it. After the 10-year period is up, it is yours free and clear (no taxes either at that point).

Without too much thinking or much hesitation, I chose Bitcoin and cash in a 50/50 combination. My wiser colleagues said with as much or more conviction stocks and bonds--I don't recall their combinations if they stated them. Since I am the investment guy, this raised eyebrows. Maybe I'm just also the gambler. To be sure I caveated my decision with the disclaimer that I might change my mind (my guess was low conviction). To be fair the others did similarly but with perhaps a bit less hesitation (somewhat higher conviction).

In general I would assume that all four of us in this conversation are of very similar financial standing adjusted for our ages (there is about a 30-year spread from youngest to oldest). There is not a right or wrong answer on this question--at least not without a lot more information about each chooser including several underlying assumptions (risk tolerance, liquidity needs, expectations about each person's future goals and paths of life, etc.). I don't wish to get into speculation about that here nor try to evaluate the soundness of any starting position. 

What I am interested in is exploring further how we might frame such a tradeoff. One additional outcome from this exercise is thinking about what assumptions one would make about critical variables and the implications of those assumptions. 

Some people would very appropriately, for themselves, choose an allocation of 100% cash. We could argue about that, but again only by digging deeper into their goals and risk tolerance among other things. "Hey, I'll take free money and I want to know it will be basically there for me at the end of the rainbow (inflation be dammed!)." That is potentially a sensible position, but we could write a book (many books have been written) about what extreme conditions must be in place for that to be rational. Geez, I better stop now or that will be this post . . .

So let's just assume we are debating only the question of which outcome has the best highest expected value after 10 years. I strike "best" because that implies more than just the math problem I want to explore.

We need just a few inputs: 

• expected returns of stocks, bonds, Bitcoin, and cash (I am assuming we can get some yield on cash rather than thinking of it as money under the mattress.)
• expected inflation (We are going to look at values in real terms so we don't let the cash option appear better than it actually is--a likely net loser to inflation.)
• probability of various outcomes (Using a range of expected returns we need to know how likely we think those are. The range is really only important for Bitcoin given its unknown future.)

I am going to use Vanguard's capital market assumptions (CMA) for expected returns of stocks, bonds, and cash as well as inflation. To make these always updating predictions evergreen in this post and because these are publicly available information as linked above, I will also post a picture of these below. Please do see Vanguard's website for more information including appropriate disclaimers. 

I am going to totally make up the expected returns for Bitcoin because 1) my guess is as good as yours and 2) the devil is in the probability and the relative outcome versus the others--my accuracy is nearly immaterial if I am in the ballpark. 

Before you dismiss any of this upon glancing at the inflation prediction (range 1.6% - 2.6%), understand that these are 10-year predictions. I hope they are right given what this implies going forward given currently very high inflation rates, but it can easily be the case even with some persistence of current inflation (8% for a year (not that bad yet) plus 5% for a year plus 8 years at 1.6% would land us at the high range).

Note that I am looking at true total market coverage in stocks (U.S. and all international), thus I will combine the growth rates below in the proportion 55/45 U.S./Int'l. Note also that I am only using U.S. bonds in the model. I generally like some international bonds, but I will make this limiting assumption. Regardless, U.S. versus Int'l bond returns are pretty close as you can see in the details below and at the link.

Enough of that already, let's model this thing.

Here is version 1:

I am putting my thumb on the scale to be optimistic about traditional asset returns (stocks and bonds)  making the low case 25% likely and the high case 75% likely, which serves to put my initial Bitcoin/cash choice at a disadvantage. For Bitcoin I am assuming total collapse in the low-end prediction versus only 25% annual growth in the high-end version. I say only as this isn't "to the moon" although it is very strong growth indeed. Keep in mind that Bitcoin has averaged about 94% annual growth over the past 5 years through to today's price of about $38,300. While being conservative? on the high-end growth rate, perhaps I am not appropriately discounting the likelihood of the high side putting it at a 20% chance. I will change that assumption in the next model. 

But just before that, let me explain why I don't think we need to worry about the mixing and matching between individual high and low estimates (e.g., stocks grow at 6.1% while bonds only grow at 1.9% or stocks and bonds are high but Bitcoin and cash are low, etc.). Assets tend to be positively correlated over longer and longer timeframes. Even though stocks and bonds enjoy some degree of poor correlation, these fade away over time as what is good for stocks (a productive, growing economy) is also good for bonds. Likewise, a world that has Bitcoin doing well probably has stocks doing well, and a world where inflation is low, stock and bond returns are also probably low. Regardless, the heart of the debate isn't going to be impacted by these details. 

Here is version 2:

Ouch! Even though I made the low-high range for stocks and bonds 50/50, the move to make low to high outcomes 95/5 for Bitcoin destroys that option. But if that is really more like the future likelihood of the outcome range for Bitcoin, perhaps stronger return possibilities on the high end are as well. So . . .

Here is version 3: 

I greatly increased the growth rate for Bitcoin using 38.6% annual growth. This isn't a randomly chosen number. This would correspond to a Bitcoin price of approximately $1,000,000, which some roughly project as a possible destination (who knows?). Regardless, stocks and bonds still look better. So let's do just two more for the sake of good order . . .

Here is version 4:

The only change here is to make the Bitcoin high possibility a little more likely moving it from 5% to 10%. And wow! Look how sensitive the difference result is to this change. Obviously this should come as no surprise as this whole thing is about Bitcoin's high end. I guess we could run just one more taking a look at a more moderate Bitcoin but also a less than total bust low-end for it.

Finally, here is version 5:

So, allowing for a Bitcoin future in any future (low end is 10% annual decline in value) gives us a fairly strong case for my gamble on some combination of Bitcoin and cash. 

Having gone through this process would I now change my mind? I will stick with 50/50 Bitcoin and cash. But that strongly suggests a question: how can I justify that choice given that I don't have an existing portfolio that looks anything like that. I am personally overwhelmingly "boring" with an almost all-stock portfolio with just a bit of crypto sprinkled in. 

At the risk of a slight digression into the post I keep promising this will not be, allow me to defend my rationality. This hypothetical is a forced gamble. My retirement investments are different in that regard. Those I can and do change periodically including both allocation as well as contribution. I get to guide those and adjust them. The hypothetical gift invested is a Ron Popeil "set it and forget it". Part of why I cannot invest more in Bitcoin (aside from it wisely not being a 401(k) option (looking right at you, Fidelity)) is that I likely cannot tolerate the variance. If I can get in and get out of it, I am as more likely to make the wrong in/out moves as the right ones. And that is before the tax-drag effect. 

Besides that, my investment reality is the retirement assets I actually do have. This hypothetical is a lottery ticket idea. If I win the lottery, my reality materially would change. I could afford more and different risk. In this sense and surprisingly, if the hypothetical was $10,000 in stocks and bonds versus Bitcoin and cash, the rational decision for me might have been stocks and bonds! Whereas the typical person would say, "that is too little to worry about the risk, let it ride!", I would counter, "I can't afford to take the the riskiness of Bitcoin at that magnitude ($10,000)." Along this one dimension, I would be right. 

I want exposure to big upsides. Unfortunately, these are difficult to find and doubly difficult to stick with. In a sense this thought experiment has revealed some of my own limitations on putting my money where my mind and heart and mouth are. 

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Should Tipping Be My Only Charity?

I'm considering going a year where my only form of charity will be excess tipping--an amount well over and above what I would otherwise give. Before you dismiss this out of hand, consider the problem of charity  My ability to connect with truly effective altruism is very limited even if I religiously adhere to the formal EA movement or even if I completely reject the EA network. What I can do is reward good work and people working in general through gratuity. 

In truth I really probably can't make it my only form of charity from a practical standpoint. There are just too many obligations I have to traditional charity (e.g., my church donations, the United Way contributions I make through work, et al.). One could certainly argue the merits of these including how much is charity on my part versus quid pro quo where the quo is social desirability bias, virtue signaling, tax benefits (really just a subsidy for giving), and non-pecuniary benefits (e.g., two days of extra vacation for a continued minimum United Way donation). Nevertheless, I could substantially reduce all traditional and otherwise forms of charitable giving including donations of my time with excess tipping as the substitute. 

Let's consider some rough math on what this might mean. Hypothetically assume my desired annual charitable giving through this experiment to be $10,000. A point of consideration would be if the tipping would be limited to very traditional tipping situations, namely dining, valet, room service, doorman, etc., or if I would extend this to areas like occasional household services, namely plumbers, electricians, furniture movers, etc. One might argue that everyone should be tipped. However, to keep the math easy, I'll limit it to waitstaff in dining. 

Let's further suppose I dine out an average of 7 times a week at a moderate expense, 2 times a week at high expense, and 1 time per four weeks at a very high expense. The kids are with me for the moderate and high expense meals while it is just the wife and I for the very high expense meal, which are the following on average (with just the standard tip of 15%): $50, $100, $300. Per week that becomes $250 ($50x5) + $100 ($100x1) + $75 ($300x1/4) = $425/week or $22,100/year. Of this about $2,883 would be standard 15% tipping ($22,100 - $22,100/1.15)). To "donate" an extra $10,000 through excess tipping through the year, I would be making an implied 52% excess tip ($10,000/$19,217 [the amount spent before standard tip]). Stated another way, the increase is about 45% above the old levels ($10,000/22,100-1).*

Breaking this down by meal type we have a $50 meal becoming about $73, a $100 becoming about $145, and a $300 becoming about $436. Weekly expenses here have gone up $192 ($425 becoming $617). And the annual checks out where $22,100 is now $32,100. 

These would just be averages. I would hold out the ability to vary the amount to zero excess tip to a lot more excess tip based on maybe quality of service or perceived need. Also, I would do this for at least all traditional for-tip service providers. The fact that this would demand a continually updated Excel spreadsheet lending itself to trend and projection analysis along with graphs is indeed a very nice quid pro quo for me.

Some of the pros to this approach are:

1. I have a lot of relevant information close at hand since I witnessed directly the service provided.
2. I know pretty well exactly who it is going to even if there is tip sharing.
3. Related to the two points above, I can weight the charitable gift commensurate with the perceived level of deservedness provided I measure that directly proportional to the service performed. If I want to base it on need, this becomes a con (see below).
4. I am rewarding those who are doing something to improve their own situation as well as my life and others.

The cons are:

1. I am not able to see much into the level of need so as to increase my giving as a result.
2. Related to the first con, I would not be benefiting those who cannot work--very likely a group in much more acute need. However, this is a con of almost all charity as figuring this out is very difficult. My method here at least minimizes the problem of enablement--whereby charitable giving subsidizes and insulates people from the cost of bad decisions and rewards poor work ethic. Moreover, it is actually likely many of the people I would be excess tipping would be closer to people in need so as to aid them. No guarantee they will, but there is no guarantee some other method would be much better.
3. I would most likely be subject to bias in my excess tipping whether it be a subconscious prejudice (e.g., tipping attractive waitstaff or those who somehow connect to me in a way that is probably frivolous like having an interesting accent) or outright mistaken heuristics (e.g., thinking that someone working at an expensive restaurant is less deserving that someone working at a cheap diner).
4. If I am not meticulous about tracking the excess tip, I easily could fall so far behind so as to not meet the donation goal--I would be hesitant to tip someone $2,000 at an end-of-year meal. 
5. I might reduce my exposure to tipping even if inadvertently as the pain of seeing the substantially increased cost could weigh on my decision making. 
6. It might greatly disrupt my social group or the dynamic between me and the places I frequent. This is a big break with norms subject to misunderstanding and bad/unintended signaling. 
7. I may be underappreciating how it will affect me given that this attempt at more direct action on my part will not likely have noticeable results. I might become jaded for bad reasons.
8. I could have a net negative effect on the recipients subsidizing less optimal outcomes for them or hampering their natural progression to bigger and better things. The out of work actor working as a waiter might be cliché, but there is something to it. What if I unintentionally convince a young person to turn down an internship for mistaken hope that there are enough tippers like me out there making waiting tables their highest and best outcome? Did I say enough about how charity is hard?

Countering this longer list of cons, there are added benefits potentially. One is that this might become habit forming long term--when I return to charitable giving, I might continue excess tipping to some degree. Another is that it could be contagious as it would be as public as any giving I typically would engage in. One virtue of it is that it is a more generous act all things equal since I would not be getting a tax benefit. So rather than having other taxpayers subsidize my charitable choices, I would fully internalize them by going it alone.

If I end up doing this, I'll report back on how it worked in the wild.

*Notice I am ignoring the fact that this tipping is calculated on top of the sales tax--I gave up the ghost on that argument long ago for practicality sake. I don't like it, but the norm seems to be and the easier calculation certainly is to tip on the total after tax.

Crony Capitalism (Vacation Rental Edition)

My wife and daughter just returned from a delightful long weekend in Santa Fe, NM. The entire family will return soon to Saint Francis's fine city where, as Hermann Banks reminds us, strangers are kind and beauty is overflowing and the local government is captured by crony capitalists. In fairness to Banks he never has said as much about local government, but I would imagine he wouldn't dispute it. 

Case in point:

A friend of mine has a vacation home there that he purchased a few years ago for both personal use and as an investment. Part of the investment is renting it out as a short-term vacation rental.

About six months ago I booked his place for my family's trip this coming April. In October I received an urgent text message from the rental property service directing me to check my email. Doing so I saw a short message stating that my reservation was no longer available, they were searching for a substitute property, and would be back in touch soon. I somewhat shrugged it off as being a mistake since I knew the actual owner well. But before I had a chance to contact my friend I received another email regretfully informing me that my reservation was cancelled with no substitute.

I reached out to my friend still thinking this was just a clerical error in their system. While a clerical error had occurred, it had a deeper problem behind it. My friend was somewhat upset but a lot calmer about it than I would have been. In fact I was livid for him and ready to go to the barricades. Not because of my vacation plans being disrupted but because of why this was happening and the implications it had for him.

The short version is this: The property management company had failed to make sure that my friend was current in his short-term rental permit with the city of Santa Fe (and yes, this is enough to get me to the barricades--the fact that a city government makes property owners get permission to use their property . . . but wait, there's more). The failure here was pretty significant in that it had expired the prior December 31st. Shame on the management company for sure. 

Should be no problem, though. Just refile as this should be a formality at this point. My friend does so starting a few days before my cancellation email by calling the proper city office. Keep in mind that my friend lives in Tulsa, OK; so all of this is out of direct control for what it's worth. I'm not sure if being able to go down to city hall would have made things better for him. They probably wouldn't have been better for me if I were in his shoes due to the whole ready-to-storm-the-castle attitude I have in these matters. Nevertheless . . . the city official looks it up and says, "Uh-oh, I don't think we'll be able to do this." 

[I swear this is the short version] It seems there exists another, current, valid in-the-eyes-of-the-Duke-of-Santa-Fe short-term rental permit for a property located within 50 feet of my friend's. You see kids, in America Big Hotel has decided that short-term rentals are a threat to their business. They've convinced well-meaning homeowners that people renting out their property could be scary. Soooo, rather than compete they've helped create rules to stop the madness. 

But this no-longer-short story doesn't end with just a Bootleggers and Baptists tale of the hotel lobby working hard to stifle competition along with the help of residents who think they should be able to dictate what happens on other people’s property. We get some government failure and unintended consequences to boot. 

My friend was taken aback at the news he couldn't get a permit because one nearby already existed (a new rule) but was immediately relieved relaying to the official, "Who has a rental? I know all my neighbors, and none of them rent." Upon further inspection, the city official realized that there are two roads with the same name in Santa Fe. The other permit is for a property miles away from my friend's. He could get it after all. Just need to have the local inspector swing by the next day to validate it all. Phew, that was close . . . but wait, there's more . . . as you probably suspect knowing what came next for me. 

The inspector comes out to my friend's house. Presumably begins checking boxes. Sees that there is another property located within 50 feet holding a short-term rental permit by looking it up just like the prior city official did. So he promptly denies the permit and goes about his day. 

This triggers a very fast and unforgiving process in the several rental property agencies my friend uses for his listing. Because I'm sure so as to not fall afoul of city governments everywhere and their crony capitalist controllers, they act swiftly to cancel all of my friend's future rentals. Remember this is October right before a busy Thanksgiving and Christmas season and he depends on repeat business as well as referrals. Along with all of these would-be customers, it is now that I receive a cancellation via email. 

At this point my friend was already on top of getting this reversed--I would not say satisfactorily resolved. He cleared it up with the city and over a LONG weekend was square to lease his property. Then came damage control. Many apologetic messages later with many discounts offered and still a large number of permanent cancellations foregone, he had done all he could to salvage some of his 9+ months of bookings.

It is hard seeing the system work the way it is actually, ultimately intended. It is harder still being a victim of it.

Summer Rental

The Rules of Investing Club

1. Stay invested - Don’t time the market. Timing the market is not just impossible. It is multiplicatively destructive in two ways: bad decisions compound mathematically and the likelihood of mistake compounds with attempts.
• Sub-rule - Know what this means. It applies when the market is “down” and when it is “up”. What makes you think you can define these? What makes you think you’ll both get it right on the exit/entry (at least twice) and have the nerve to make the proper moves at that time. Also, wouldn’t timing imply buying low? So why are you bailing after a crash?... oh, because even though you didn’t see the downturn coming up until this point, you now can see definitively that a further decline lies ahead.
2. Keep a cash reserve equal to X months expenses - X is up to you. A typical rule is 6 months, but mileage will vary. Be sure to include access to credit as a buffer as long as you also take into account that the event that causes you to tap into this safety reserve might also be damaging your credit access. Notice how this rule helps with adhering to the first rule.
3. Diversify - The only "free lunch" in investing as it allows for (some) risk reduction without return reduction (up to a point) when done properly.
4. Outsource - SPIVA. You ain’t special and just about no one else is either. Therefore, use well-run, low-cost, TRUE index funds. (Besides Vanguard, Fidelity and Schwab are also typically good providers.)
5. Do what it takes to stay on plan - Employ dollar-cost averaging (DCA) or enroll in forced (passive) contribution increases or use a professional as a commitment partner.
• Sub-rule - Make sure the pro has incentives that are congruent with your own, has the right credentials (CFA and CFP being the gold standards but experience matters a lot too), and is cost competitive. 

The Local Maximum Problem

Ever since being introduced to this concept, I’ve been intrigued by it and see examples of it more and more throughout life, business, and public policy. This is the problem that occurs when people get stuck in a situation that is the best near-term or near-possible outcome but is not the best possible yet reasonable long-term outcome. 

The analogy is to imagine four people playing a game that has them blindfolded and linked arm-in-arm in a square configuration. Each member of this team is responsible for one of the cardinal directions (north, south, east, and west). Their goal is to locate the highest point possible. They experiment by taking steps to see if a step in that direction is up or down. If the step is down, they don’t take it. If the step is up, they take it. They keep walking until none of the four can make a step that is in the upward direction. This point is the conclusion of their game by reaching the local maximum. However it is most likely not the highest point on the surface where they’re walking. They just can’t reach (or detect) a higher point by virtue of their own rules. 

I believe governments are particularly susceptible to this problem. The rewards for experimentation that drive one out of a local maximum are very dispersed or completely irrelevant to those bearing the costs of experimentation. This is more than just people not wanting their cheese moved or having their apple cart disrupted. This is the very legitimate concern that an ambitious idea is going to have significant negative outcomes or the potential rewards will not accrue to those bearing the risk. It is an acute combination of asymmetric risk-reward and principal-agent problems.

The many, many public and private failures in the COVID pandemic are vivid examples. Perhaps the most costly in the United States were the CDC and FDA's insistence on using their own developed testing (staying with the controllable and familiar) and as important if not more so the refusal to allow challenge trials to speed the vaccine development process. Sadly this list goes on and on from "pausing" the Johnson & Johnson vaccine to not approving AstraZeneca's. 

The position those in power have taken are understandable but completely inexcusable. And we have ourselves to blame as these mistakes are just the latest examples of how the FDA works against medical advancement and is a deep net cost to society. 

To be sure individuals, firms, and other organizations are also susceptible to the LMP. Notice, though, the degree to which these entities are somewhat or greatly better structured and incentivized to resist and correct it.  

As a general rule, the more insulated and protected an entity is from competition, the more vulnerable they are to a local maximum. Hence, traditional banks are more vulnerable than are start-up fintech firms. 

To whom a firm or organization is held responsive has strong implications for its fragility to local maximums. As a firm is more responsive to those who reap rewards proportional to risk taken, it will better prevent the LMP. Hence, non-profits (highly responsive to donors rather than customers) are more at risk than are profit-seeking firms (highly responsive to owners and customers). 

Within a firm the dominant force becomes existing and entrenched stakeholders who are in comfortable, conventional positions. Hence, no one in marketing will ever suggest the firm experiment by not running ads. 

The degree to which a person faces public scrutiny or cannot capitalize on public adoration, the more they will rest once finding the local maximum. Hence, a public figure with a lot to lose/little to gain will tend to play it safe. 

Risk bearing requires compensation in the form of return, and this risk-return should be commensurate, symmetrical, and willfully accepted. Those are tough hurdles to achieve. All the more so when we are relying on force rather than persuasion. 

P.S. I believe Arnold Kling deserves credit for introducing me to this concept.

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. 

I Was Desperate. Honestly Afraid. And Completely Helpless.

At first it was gradual, and then all of a sudden it was acute. I could be blamed for putting myself in such a position--at least it was somewhat my fault. But live long enough and you'll inevitably find yourself at the mercy of those around you, willing and desperate to take their help, and completely without options. 

It was late. Very late. And I was on a rain-drenched highway. Tired. Unable to go farther. And very hungry. 

I hadn't called ahead because I hadn't planned to be there. But there I was on a highway in the middle of nowhere Texas. To say I was between large cities was both true and meaningless. The middle of the Pacific Ocean is between large civilizations. 

I am a strong believer in the power of the consumer--that if you shop around and negotiate, you can drive a great bargain. But I was at the mercy of the supplier--a mere price taker that night. 

A warm meal, a dry bed, a safe place. My needs were a short list. Yet not fulfilling each would be critically bad. Drive on and the risks grew exponentially. Try to negotiate a better deal, and my only options might evaporate before my desperate eyes. 

Any slightly observant person could see my position of weakness. Any slightly opportunistic person could sense my vulnerability. So how bad did it get?

Not too bad at all under the circumstances. The motel owner had stayed up late, as it turns out, just for me on the off chance I would be there in need of his accommodations. His accent made clear he and I were not born and raised in the same place. I was a stranger on his doorstep, but he welcomed me as one would a good, long-time acquaintance. I paid him $159 for a room with a hot shower and comfortable bed I would use for the next 8 hours. After, he (or his staff) would have to clean it up restocking and doing laundry. I would leave without saying goodbye. 

Before that shower, I needed food. Two in the morning is not when many meals are served as evidenced by the many closed restaurants. No one ever starves missing one meal, but it can be quite unpleasant to do so. And good decisions are not made on an empty stomach and a poor night's sleep from the same. The 24-hour restaurant made sure that wasn't my fate. I was their only customer in the 45 minutes I spent. At least three people (couldn't tell if there were more in the back) gave me nourishment and quiet companionship all for the price of $23.

The morning sun brought a new day and a fresh outlook. My car was safely waiting untouched for my departure. I grabbed coffee and a Danish set out for me at the motel before dashing out the door. A quick fill up at a gas station meant I could be on my way not needing to stop for hours. 

I felt slightly uneasy leaving so abruptly that morning. Guilty would be too strong a word, but I was dashing off having taken so much from so many who were so generous to have provided it for so little in return. I can't imagine I'll ever be back on that same highway, and even if I am, it is unlikely I'll ever stop in that little spot again. I hope someone else can do a little more someday to take care of the people who took such good care of me.

P.S. This post's story is truish. It is a amalgamation of true prior experiences in my travels for the purposes of making a point. Life is tough--use markets.

Who You Gonna Call? An Economist

If you had questions about the conditions of the local restaurant market, you wouldn't ask a chef or a restaurant manager.
If you had questions about the OPEC oil cartel or how it's actions affect the U.S. fracking industry, you wouldn't ask a petroleum engineer.
If you had questions about the affect charter schools have on education outcomes, you wouldn't ask a teacher.
If you had questions about the pricing and payment of medical services, you wouldn't ask a doctor.
If you had questions about fractional reserve banking, you wouldn't ask a banker.

Well, you might ask these people, and they might have brilliant, insightful answers. But if they did, it would be because they were using the tools and skills of economics. You might be better off just asking an economist--especially one with expertise in the specific area of interest.

Drs. Fauci and Birx are very important experts in immunology. Their understanding of infectious disease and their roles in the current crisis are keys to us conquering SARS-COV-2. But asking them when we should open society back up and revive the economy from the self-induced coma is likely asking them to speak outside their depth. I am not saying they are incapable of performing the necessary trade-off analysis, but if they are, it is because they will be employing economics not epidemiology.

Just as we did not prepare properly for a pandemic, just as we did not heed the warning signs as this one approached, just as we did not do the relevant cost-benefit analysis as decisions were hastily made and virally accelerated, I fear we are not willing to reasonably and scientifically consider, plan, and execute the return to normal life.

Reversing the lockdowns and shelter-in-place commandments should require us to consider the following at a deep level:

Benefit of reduced infection going forward minus Cost of change in way of life

What would we like to know includes:

1. R0 - the rate of infection now and going forward (both the average and the distribution of typical people and super-spreaders); Robin Hanson's analysis shows the need for an even deeper level of thought. 
2. How did R0 changed over time both as a result of human action and public policy as well as naturally?
3. How many people were infected and when?
4. How did the various policies impact viral transmission, viral impact (did putting asymptomatic infected people, mostly kids, in intense contact with at-risk people, mostly elderly, cause dangerously strong infections--dose makes the poison?), other health results, etc.?
5. How did the various policies impact our way of life? Just how damaging were the policies and how damaging was the virus?
6. What would we do different? How many lives on net did the actions taken save? How much was overall well being benefited by the actions taken? 
7. How would we do it differently in the future?

At this point we don't really know enough to depict the overall tradeoffs and how the equation above would plot in the graph below.

The x-axis runs from maximum virus eradication (all resources thrown at fighting the virus, which is well beyond even the extreme measures we have taken so far) to not changing our lives one bit other than perhaps dealing with infections as they arise including hospitalizations and death. The y-axis is overall societal well being. In the middle is the point of well being that is equal to a world where there was no SARS-COV-2.

Is the trade-off function like one of the solid-line parabolas? Don't get too hung up on the lines I've drawn other than to notice that one is at times above the other. And of course choices we make could allow us to jump from one trade-off frontier to another. But notice the other two stylized functions. Perhaps the virus is so dominant that any effort short of total effort to counter it was a net loser for societal well being (as depicted in the red-dashed line). This is possible but highly unlikely. Yet this in the extreme is the position implied by many in the populace as well as some in power. Alternatively, the virus could be an unfortunate circumstance but not one that at any level deserves us changing our way of life (as depicted in the green-dashed line). This is also possible but highly unlikely. Yet this in the extreme is the position implied by those who might be labeled virus deniers.

We would expect, however, that some type of parabolic function if not one with multiple peaks would properly depict the real world tradeoffs. The devil is in the details, and which function and how we might transform the function to improve our lot is the many-trillion-dollar question. I would like to see it asked more strongly and widely, and I would especially like to see it asked of economists. 

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.

Top 100 Movies - Required Viewing

This is my partially complete list of "classic", right-of-passage movies everyone should see. I had my kids in mind when crafting this list. I drew from a much larger list of movies I want them to experience wanting to cull it down to an elite must-see list. 

It is partially complete because while it is a top 100, I am open to changing what makes the list. But I do feel that 100 is a sufficient number such that to be added to the list a new entrant would need to bump a movie from the list. 

Do not confuse this with a “greatest 100 movies” as this is not a measure of cinematic excellence or advancement of the medium. It is closer to a kind of most culturally important list, which overlaps largely but not entirely with a most popular list. Case in point: no one would list Caddyshack as a movie that set a bar artistically. However, it’s influence on and depiction of the subculture of golf has been phenomenal. I would bet that virtually everyone who has played a round since the movie came out roughly 40 years ago has during a golf outing made or heard a reference (if not many) to that movie. 

Additionally, there are other criteria or factors that to some degree contribute to a movie’s inclusion on the list including: I enjoy the movie/it has some nostalgia value for me, it is a movie that speaks to an important truth/it teaches something about the time it is set in or its genre or its underlying story, and it has cultural importance. Being culturally important and being on the list means that you can’t just read a synopsis of the movie to fully understand the cultural importance. You have to see it to get it.

The list in alphabetical order (sorry about "The" titles):

2001: A Space Odyssey

A Christmas Story

A Few Good Men

A League of Their Own

Airplane!

Alien

Anchorman: The Legend of Ron Burgundy

Apocalypse Now

Apollo 13

Back To The Future

Beetlejuice

Big

Braveheart

Caddyshack

Casablanca

Christmas Vacation

City Slickers

Close Encounters of the Third Kind

Cool Hand Luke

Dead Poets Society

Die Hard

Dirty Dancing

Duck Soup

E.T.

Ferris Bueller's Day Off

Field of Dreams

Fight Club

Fletch

Footloose

Forrest Gump

Ghostbusters

Good Will Hunting

Grease

Gremlins

Groundhog Day

Happy Gilmore

Home Alone

Hoosiers

It's A Wonderful Life

Jaws

Jurassic Park

Karate Kid

Lethal Weapon

Life Is Beautiful

Match Point

Men in Black

Monty Python and the Holy Grail

Mr. Mom

Mrs. Doubtfire

Napoleon Dynamite

North By Northwest

O Brother, Where Art Thou?

Office Space

Old Yeller

One Flew Over The Cuckoo’s Nest

Planes, Trains, and Automobiles

Poltergeist

Psycho (1960)

Raiders of the Lost Ark

Rain Man

Raising Arizona

Remember the Titans

Star Wars: Episode VI - Return of the Jedi

Rocky

Seven

Spaceballs

Spies Like Us

Star Wars: Episode IV - A New Hope

Swingers

The Bad News Bears

The Big Lebowski

The Blues Brothers

The Breakfast Club

The Dark Knight

Star Wars: Episode V - The Empire Strikes Back

The Godfather I

The Godfather II

The Goonies

The Jerk

The Lord of the Rings: The Fellowship of the Ring

The Matrix

The Princess Bride

The Royal Tenebaums

The Sandlot

The Shawshank Redemption

The Shining

The Silence of the Lambs

The Sixth Sense

The Terminator

This Is Spinal Tap

Three Amigos!

Titanic

Top Gun

Trading Places

Vacation

War Games

Weird Science

When Harry Met Sally

Young Frankenstein

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