Performance

Sometimes it is easy to measure performance. The winner of a 100 meter dash is whomever crosses the finish line first. The winning time is directly measurable, using a stop watch – these days down to the hundredths of a second. Run the race faster than it has ever been run before and you are a world record holder…..or are you?

Turns out that you may or may not be the new world record holder, depending on whether your time was wind-aided or not.  A sufficient tail wind will negate your world record, perhaps unjustly if the wind measuring equipment is mis-calibrated.

Measuring things, in fact, ranges from fairly straightforward to down right difficult. There is even a field of study, measurement theory, that occupies the time of some very smart people.  Or as the Encyclopedia Britannica relays: “Measurement, the process of associating numbers with physical quantities and phenomena. Measurement is fundamental to the sciences; to engineering, construction, and other technical fields; and to almost all everyday activities. For that reason the elements, conditions, limitations, and theoretical foundations of measurement have been much studied.”

So in actuality, measuring the speed of a race, the efficacy of a drug, or the return of a mutual fund can be far from straightforward.   One well understood phenomena associated with measurement theory (at least well understood by the measurement theory folks) is that all too often the way in which you measure something determines the results obtained from your experimental model.

Measuring investment performance, in point of fact, is devilishly difficult. Appropriate benchmarks, risk-adjusted returns, relative performance, absolute performance, statistically meaningful time periods, throw it all into the performance pot, stir vigorously and end up with… controversy.

Is a return of 8% in a small cap stock portfolio better or worse than a return of 8% in a large cap stock portfolio? Is an absolute return of 10% a better result than an absolute return of 7%? Does a balanced mutual fund (stock/bond) outperforming the S&P 500 on a trailing one year basis mean the mutual fund manager added value through active management?  Is performance relative to an appropriate benchmark a meaningful indicator of portfolio manager skill over a one-year period?

The answers are: worse ; maybe but not necessarily; again maybe but not necessarily; and no.

By way of explanation:

Small cap stocks are more volatile than large cap stocks. Volatility is the most common measure of investment risk – though certainly not the only one. Small cap stocks also have a higher rate of return historically than large cap stocks. For instance, the Russell 2000 has returned around 125% since 2000 while the S&P 500 is up only about 30% (both returns are net of dividends). Now we can’t actually say the small cap portfolio earning 8% in a given year was a worse performance because short-term results aren’t particularly meaningful. But we can say the small cap result was worse because small cap stocks are more risky, as measured by volatility, than large caps. Therefore, on a risk-adjusted basis, we should expect a higher rate of return from our small cap portfolio. More risk requires higher rates of return to justify exposure to that additional risk.

Likewise, the 7% return might actually be a better result than the 10% return if the amount of risk assumed was sufficiently low. Earn 7% in a portfolio with a standard deviation of 5% and you are far better off than if you are earning 10% in a portfolio that has a standard deviation of 50%. Why? With the 7% portfolio you will earn between 2% and 12% two-thirds of the time while the higher earning 10% portfolio will return anywhere from minus 40% to plus 60% two-thirds of the time. You simply aren’t getting enough additional return to take on that kind of volatility.  And, there is a distinct possibility that the 7% portfolio will actually outperform the wildly volatile 10% portfolio over time because of how returns compound. (e.g. 5%, 12%, 2%, 6%, 3% will beat minus 40%, 50%, minus 20%, 15%, 10% by a wide margin… do the math!)

What about the balanced fund manager beating the S&P 500? Well American Funds is out touting the fact that some of their stock/bond funds have outperformed  the S&P 500 over the last 15 years.  Leaving aside the fact that American Funds wasn’t kind enough to tell investors which of its many funds would outperform the S&P 500 before the fact, the main problem is with the apples to oranges comparison. The S&P 500 is an index of large U.S. stocks. Bonds have had a pretty good 15-year run and are almost certainly responsible for increasing at least some of American Fund’s absolute returns above the S&P 500, which has only returned around 4% annually since the tech bubble popped.  So basically American Funds is saying that the color orange is better than popcorn.

Yes, measuring performance turns out to be not very straightforward at all, whether it’s attempting to verify a new world record, measuring gross domestic product or determining if investment performance is good or….bad.

 

 

The Annuitization Puzzle (Part Two)

Recap:

“It’s now been a full 50 years since Dr. Menachim Yaari showed that by buying an annuity you assure yourself a higher level of consumption in every year that you live, compared to holding a bond. (Yaari, Menachim. 1965. “Uncertain Lifetime, Life Insurance, and the Theory of the Consumer.” Review of Economic Studies, 32(2): 137-150.)“

It is important to understand that Dr. Yaari wasn’t focusing on investment returns in 1965, but on consumption models. To reiterate, he showed that, by owning a fixed annuity, you ASSURE yourself of a HIGHER level of CONSUMPTION compared to holding a bond.  The focus is on guaranteeing a minimum amount of cash flow in the future in the least expensive manner possible, an amount that meets your minimum needs, which in turn gives you the ability to spend the remainder more aggressively, if that is your preference, thus allowing for a more enjoyable retirement!”

For more about annuities in general and the academic literature supporting their use in retirement please read “The Annuitization Puzzle” at https://yourretirementplanning.wordpress.com/

Now: an examination of the specific type of annuity individuals should buy with a portion of their retirement portfolio in order to maximize their consumption spending in retirement as inexpensively as possible…

An annuity is an insurance contract. Insurance is the transfer of risk from one party to another for a payment.  An annuity involves the transfer of risk from one party to another for a payment. Longevity risk is the risk of outliving ones assets. Insurance companies spread longevity risk among many annuity owners. Those annuity owners who die prematurely subsidize those annuity owners who live beyond their life expectancy.  Certain annuities, then, can provide a low-cost means of guaranteeing a specific amount of income for life, because longevity risk is spread out over a large number of annuitants.

To better understand what type of annuity is best for eliminating or minimizing longevity risk with the least possible cost, it helps to understand what makes insurance valuable.  Insurance is valuable when it allows additional spending. The more additional spending insurance allows the more valuable it is to an individual.

For example, 30-year level term life insurance for a 30-year old worker looking to replace income for her dependents, if something were to happen to her, would cost around $900 annually for $1,000,000 in coverage. The total premium paid over the 30-year period is $27,000, providing an insurance payout multiple of at least 37 to 1 (if she were to die in the last year, higher if she died sooner).  Most 30-year olds don’t have the option of self-insuring, of course, but if she did have the $1,000,000 available to self-insure, she would not be able to use that money for other things, as it would need to remain available for income replacement as long as she had dependents relying on her income. In this particular case, paying $900 per year for term life insurance frees up substantial cash for other spending.

“To evaluate the potential insurance benefit, one simply considers the likelihood of a payout. If an insurance payout is unlikely, insurance is generally cheap relative to self-insurance and insurance can provide substantial benefits. If an insurance payout is highly likely, insurance cannot be provided at much of a discount to self-insurance. In such conditions insurance provides little benefit.” (“The Longevity Annuity: An Annuity for Everyone?”, Scott, Financial Analysts Journal, Vol. 64, 2008)

Using this insight, consumers of insurance should allocate their insurance dollars first to insurance that frees up the most spending, which would also be that insurance which is the least likely to payout. Term life insurance is cheap when you are young for a reason – it is very unlikely to payout – but still necessary for a married couple with young children and a stay-at-home spouse. Term life insurance premiums rise sharply in a consumer’s 50s and 60s because the likelihood of a payout rises substantially, making that insurance less valuable, although perhaps still necessary, depending on whether income replacement and debt repayment are still needed, should the major breadwinner die prematurely.

Likewise, consumers wishing to protect against longevity risk gain the most in additional spending by purchasing annuities that start paying later in retirement, rather than immediately. “More generally, consumers should not pay the load for an annuity for the years in which they are very likely to be alive, so the best strategy is to self-annuitize for the first n years and buy what is called a deferred (fixed)annuity for the out years.” (Benartzi, Previtero, and Thaler, “Annuitization Puzzles, Oct. 2011).

Yet, the small percentage of retirees who do buy annuities overwhelmingly get it exactly backwards, buying immediate annuities that will pay out over a certain period, regardless of whether they live for that entire period or not. The insurance value of such an annuity is minimal (since it doesn’t free up many extra dollars for spending) and is, in fact dominated by a strategy of buying bonds of duration n and an annuity that starts making payments in year n+1 (Benartzi, Previtero, and Thaler, Oct. 2011). Scott, Watson and Hu (“What Makes A Better Annuity?” Journal of Risk and Insurance, 2011) call this result the “annuity market separation theorem.”  A fittingly opaque term for yet another mystery of the human condition – our frequent ability to get it exactly backwards when it comes to decision-making in retirement.

Rather than paying the insurance load for an immediate annuity, which frees up relatively few additional dollars for spending, consumers should allocate the first dollar of insurance to an annuity that begins paying in some out year, such as 100, and then continue to allocate insurance dollars backwards to an age (perhaps 85) up to which they plan to self-insure, thus inexpensively locking in guaranteed income from age 85 until 100.  Meanwhile, bonds are used to generate the necessary cash flows for all years leading up to the start of annuity payments.

A retiree wishing to guarantee a certain level of spending in the latter stages of retirement would do well to consider the longevity annuity, which is specifically designed to meet the needs of retirees interested in eliminating longevity risk. Longevity annuities are not “savings annuities” with payouts dependent on the annuities’ underlying investment performance between the time of purchase and annuitization. Rather, longevity annuities are just like immediate fixed annuities, but without the immediate payments. In other words, a lump sum of money will guarantee a specific annual payout beginning n years from now. Scott (2008) has demonstrated that “annuity-based spending at age 85 can be secured at a substantial discount to bond-based spending.” And in fact “funding spending at age 100 with an annuity costs only pennies on the dollar compared with the cost of a bond.”

Furthermore, the IRS and Treasury in July 2014 finalized the tax treatment of longevity annuities purchased in qualified accounts to eliminate the greatest obstacle to them – the Required Minimum Distribution (RMD).  Required Minimum Distributions must begin by 1 April of the year following the IRA owner turning 70 1/2.  Money placed in a longevity annuity is no longer counted when calculating the RMD, saving IRA owners potentially tens of thousands in taxes over a 20 year holding period.

So again, why allocate a portion of your retirement portfolio to a longevity annuity?  Consider…

“A sample calculation, with actual annuity prices, found that a 65-year old male retiree could increase his guaranteed spending by more than 21 percent by allocating less than 8 percent of his portfolio to an age-85 longevity annuity.” (“The Longevity Annuity: An Annuity for Everyone?”, Scott, Financial Analysts Journal, Vol. 64, 2008)

The answer then is because many retirees would benefit by being able to substantially increase their assured consumption in retirement.  To summarize: Annuities are insurance. Valuable insurance allows one to spend more. The longevity annuity allows one to spend substantially more in retirement. The longevity annuity is valuable insurance for people who may otherwise outlive their investment portfolio.

 

  

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The Annuitization Puzzle

It’s now been a full 50 years since Dr. Menachim Yaari* showed that by buying an annuity you assure yourself a higher level of consumption in every year that you live, compared to holding a bond. (Yaari, Menachim. 1965. “Uncertain Lifetime, Life Insurance, and the Theory of the Consumer.” Review of Economic Studies, 32(2): 137-150.)“

What follows is the first in a two-part article on annuities. The goal is to answer a few basic questions about annuities that might just help you live a better life in retirement. Those questions include: What exactly are annuities? What retirement problems are they designed to solve? And do they actually solve those problems or simply serve as a profit-center for insurance companies?

At the risk of running ahead, and frankly to open minds to the possibility that fixed annuities have a place in your retirement portfolio, we continue with a quick review of the academic literature…

Many of you reading the first paragraph will no doubt latch on to the phrase “compared to holding a bond” and casually dismiss the significance of Dr. Yaari’s work because you own stocks (or at least stock mutual funds) with some portion of your retirement accounts. “It doesn’t apply to me,” you have already told yourself.  “I’m a savvy investor, know exactly what I’m doing, and would never be so foolish as to hold assets that couldn’t at least outperform an annuity!”  All of which entirely misses the point of the discussion at hand, which is how to maximize consumption in retirement.

In a nutshell, retirees will spend a certain amount in retirement in order to survive. The necessities of life, which include food, shelter, utilities, clothes, transportation, property and casualty insurance and, the increasingly big one, health care, are expenses that must be paid.  And most retirees would also like to eat out now and then, see a movie, travel to visit children and grandchildren, and buy a luxury item from time to time.  The spending problem, which all retirees must solve in order to maximize desired spending in retirement, is further complicated by the uncertainty of the retirement period. After all, few of us are given the ability to predict when we will die.  To be clear, failing to spend money that you could have spent, would have spent, and should have spent in order to experience the most enjoyable retirement possible IS A FAILURE!

It is important to understand that Dr. Yaari wasn’t focusing on investment returns in 1965, but on consumption models. To reiterate, he showed with his mathematical proofs that, by owning an annuity, you ASSURE yourself of a HIGHER level of CONSUMPTION compared to holding a bond.  The focus is on guaranteeing a minimum amount of cash flow in the future, an amount that meets your minimum needs, which in turn gives you the ability to spend the remainder more aggressively, if that is your preference, thus allowing for a more enjoyable retirement!

Bonds are a wonderful tool for matching cash flows to liabilities, but it turns out that annuities can improve the solution. Stocks are a less wonderful tool for matching cash flows to liabilities because cash flows from stocks are too variable to ASSURE that the necessary cash flows are available at the correct time and in the correct amounts. Stocks ARE a wonderful way to grow wealth during the accumulation phase of the life cycle, but are less useful during the decumulation phase of the life cycle due to those pesky volatile cash flows.

A pension plan’s real risk is failing to meet its liabilities – just ask the GM and Delphi retirees who suddenly saw pension checks cut sharply as those companies slid into bankruptcy.  An individual’s retirement account is nothing more than a pension plan for one (or two in the case of a couple). Failing to meet your future liabilities, those necessary expenses and discretionary expenses that make up the sum total of your liabilities in retirement, that is the failure that becomes less likely with the judicious use of annuities, according to Dr. Yaari’s research, and confirmed by numerous economists since.  Why then do so few individuals buy annuities in retirement?

Franco Modigliani drew attention to the “annuitization puzzle” in his Nobel acceptance speech, given in 1985.  About annuities he said: “It is a well-known fact that annuity contracts, other than in the form of group insurance through pension systems, are extremely rare. Why this should be so is a subject of considerable current interest. It is still ill-understood.”

The puzzling part for economists stems from the fact that rational choice theory predicts that, at the onset of retirement, households will find annuities attractive because they address the risk of outliving one’s income (Yaari, 1965). The risk of outliving ones income is known as longevity risk and it increases with every medical break through.  The average life expectancy for a person who was 65 years old in 2012 is 19.3 years – 20.5 years for women (85.5) and 17.9 years for men (82.9). In 1991, life expectancy was only 79 years for women and 72 years for men, according to the U.S. Census Bureau.

Framed another way, a man’s life expectancy increased by more than 10-years and a woman’s by 6.5-years over that 21-year period. The unexpected years are a precious gift, but can also lead to a potential cash flow crisis for many. Worse still, depleted assets in the out years of retirement are often further eroded by unexpected medical expenses, the predictable unpredictable health issues that only serve to heighten the uncertainty of decumulation planning.

Nor was Modigliani the last prominent economist to worry over the annuity puzzle. “The sum of this evidence,” writes Benartzi, Previtero, and Thaler in 2011, “makes a strong case that people should be making greater use of annuities to increase their consumption level in retirement, deal with uncertainty, and help solve the cognitively difficult tasks of deciding how fast to draw down their wealth and when to start retirement. Why don’t they?” (Annuitization Puzzles – Benartzi, Previtero, Thaler 2011)

Lest you think the three authors little more than shills, pushing lucrative annuities for the insurance industry….

Shlomo Benartzi received a Ph.D. from Cornell University’s Johnson Graduate School of Management, and is currently a Professor and co-chair of the Behavioral Decision-Making Group at UCLA Anderson School of Management.  Richard Thaler is the director of the Center for Decision Research, and is the co-director (with Robert Shiller, Nobel Laurette) of the Behavioral Economics Project at the National Bureau of Economic Research. He will also serve as the President of the American Economic Association in 2015.  As well, Thaler is the co-author (with Cass R. Sunstein) of the global best seller Nudge, in which the concepts of behavioral economics are used to address a number of public policy issues, including 401k savings rates, medicare enrollment decisions, and environmental policy choices.

Clearly it would be a mistake to dismiss annuities solely as a profitable construct of greedy insurance companies bent on separating retirees from their savings, although some types of annuities might fairly be described as exactly that.  Perhaps it is those “profitable constructs of greedy insurance companies” that have soured individuals on all annuities, leading to the under use of appropriately designed annuities purchased in the appropriate circumstances.  Regardless, the academic case for utilizing fixed annuities in retirement is firmly rooted in consumption theory. It would behoove retirees and those preparing for retirement to take a closer look at annuities…

And that we shall do in the second part of this examination of annuities as retirement tool.

Preview:

An annuity is an insurance contract. Insurance is the transfer of risk from one party to another for a payment.  An annuity involves the transfer of risk from one party to another for a payment. Longevity risk is the risk of outliving ones assets. Insurance companies spread longevity risk among many annuity owners. Those annuity owners that die prematurely subsidize those annuity owners who live beyond their life expectancy.  Certain annuities then can provide a low-cost means of guaranteeing a certain amount of income for a certain period, or for life, because longevity risk is spread out over a large number of annuitants.

However, there are many annuities sold every day that are hazardous to your financial health. Variable annuities, for instance, are expensive and usually fail to deliver the growth that is promised when they are sold.  As an example, I just reviewed a variable annuity that has managed to earn its owner all of 1.2% per annum from 1999, when it was purchased, through year-end 2014. Mind you, the underlying investments are primarily stock mutual funds. By comparison the S&P 500 has returned approximately 4.9% during the same period. The difference in terminal wealth is substantial, with a $100,000 investment in the S&P 500 index providing an ADDITIONAL $77,194 in profits over the 14 year period.

Next: an examination of the annuities individuals should buy with a portion of their investment portfolio in order to give themselves the ability to maximize their consumption spending in retirement, if that is their preference…

*Menachem Yaari was a Professor of Economics at the Hebrew University of Jerusalem, where he holds the Schonbrunn Chair in Mathematical Economics. His undergraduate degree, in economics and philosophy, was granted by the Hebrew University in 1958. From 1958 to 1962, he was a graduate student at Stanford University, earning a Ph.D. in economics and statistics. From 1962 to 1965, he was assistant professor and then associate professor at Yale University and a member of the Cowles Foundation for Research in Economics.

 

Winter Is Coming

You don’t really understand, at first, what Ned Stark and his fellow Northerners mean when they solemnly intone, “Winter is coming” in an accent somewhat reminiscent of a Scottish highlander.  But eventually you come to understand that the Westeros seasons aren’t quite the same as ours here in the real world. Game of Thrones is hurtling into its fifth season and, if there is one thing that viewers have come to expect, it is to expect the unexpected. There is a randomness about the plot, good guys and bad alike, suddenly dying in all sorts of unexpected and gruesome ways, that keeps the audience (or at least keeps me) frantically adjusting my expectations about who will ultimately prove themselves winners and who will…die. (It is infuriating to me beyond all words that the Starks of the North continue to die for their honesty, while less savory characters profit from deceit).

Yet how like the real world of finance, where randomness also reigns, disguised as causal narrative. Where the less savory seem to win at least as often as those financial professionals who strive to put their clients’ interests first. Let’s set aside, for now, the obvious need for better education of both the public and the advisors who serve it, as well as better regulation of the giant investment firms who profit tremendously at the expense of the very same public. And instead return to the coming Winter and what we can do to prepare for it…

Let’s begin by revisiting Mohamed El-Erian’s article written for Project Syndicate last fall. Why? Because it’s even more pertinent than ever to the likely future course of the U.S. stock market. Winter is coming and it only remains to be seen when it will start in earnest and how inhospitable it will be this time.

“By repeatedly repressing financial-market volatility over the last few years, central-bank policies have inadvertently encouraged excessive risk-taking, which has pushed many financial-asset prices higher than economic fundamentals warrant. To the extent that continued currency-market volatility spills over into other markets – and it will – the imperative for stronger economic fundamentals to validate asset prices will intensify.” By Mohamed El-Erian Project Syndicate, Nov. 13, 2014

(My) Translation: The Federal Reserve and other central banks around the world have artificially propped up capital markets by providing extraordinary amounts of cheap liquidity to speculators. The markets are in trouble if fundamentals don’t improve enough to justify artificially elevated prices. Forecast: There is only a small probability of economic fundamentals improving sufficiently to justify an S&P 500 price almost twice fair value.  There is a much higher probability that the market will trade lower at some point as the normal process of unfettered price discovery resumes and the market seeks fair value.

First, let’s start with some charts, two of which show the current overvaluation of the S&P 500, a third that shows a very high probability forecast of coming 10-year returns (in excess of 90% correlation), and finally a chart of Gross Domestic Product on a year-over-year basis going back to 1960 (with recessions in grey).

The above chart is a log chart, which means the 0% line is the average valuation dating back to 1900. The S&P 500 would need to fall to approximately 1100 to return to its average valuation level over the last 114 years.  The chart uses 10-year trailing average earnings adjusted for inflation, replacement cost, and the market’s own trend line as valuation metrics, but a number of other long-term metrics also tell the same tale.

The second chart, courtesy of Dr. John Hussman, adds price/normalized forward operating earnings, price/10-year earnings adjusted for profit margins, market capitalization of non-financial equities/nominal GDP (Warren Buffet’s favorite), and price/revenue… with the same outcome – an S&P 500 that is about double fair value.

And there is a price to be paid for buying overvalued companies. Subsequent returns are impacted by current valuations. Dr. Robert Shiller (he of the Shiller P/E) presented work as far back as 1981 that began to address the correlation between valuation and subsequent long-term returns. Perhaps not particularly useful metrics for a money manager trying to outperform in a currently expensive market, but very useful indeed for a financial planner attempting to model a client’s retirement. Assuming the very long run return of 9-10% for a client’s stock portfolio over the next 10-years amounts to malpractice, given that long-term metrics are forecasting a return of approximately 2% per annum in the coming decade.

The above chart (courtesy of Dr. Hussman) shows both forecast 10-year returns as well as subsequent actual 10-year returns. Note that the subsequent 10-year return line stops at 2004. Note also that the 10-year period ending in 2004 substantially exceeded the forecast (explained by Hussman’s note – “2004 overshoots because 2014 peak overvalued”) However it is important to acknowledge that the over and undershoots of 10-year forecast returns have eventually corrected themselves.

The final chart below shows the economy’s performance over the long term and, in the process, puts current economic conditions into context.

The red dots represent year-over-year growth in the quarter just prior to recession. While it doesn’t yet look as if the U.S. will join much of the rest of the world in recession, it is hard to argue that we are enjoying a robust expansion.  Rather, real per capita GDP is trudging along at about the same punk rate it’s maintained over the last four years or so.

Meanwhile, the S&P 500 is already trading poorly, having lost 3% in January. What catalyst will create sufficient selling to bring in additional selling that ultimately leads to a bear market? No one knows, because ultimately bear markets are psychological events, and science isn’t yet to a point where it can accurately predict psychological turning points in crowd behavior.  But potential exogenous shocks abound, ranging from turmoil in the European Union courtesy of Greece, to fall out from the sharp drop in oil prices as  leveraged energy investments go bad and oil-producing economies struggle.

Market timing is a fools game; risk management is not. Rising volatility and rising uncertainty argue for caution. Interest rates around the world are falling, as are commodity prices. The bond market and commodity complex (copper in particular) have a good track record at sniffing out economic weakness. The currency markets are increasingly volatile as various countries and economic blocks weaken their currencies to deflect deflation from their shores (America is currently accepting the deflationary pulse from overseas).  Large carry trades can be negatively impacted by sudden shifts in the currency markets, causing leveraged entities to blow up. The dollar has risen sharply, which will eventually negatively impact S&P 500 earnings (some 40% to 45% of S&P 500 revenue comes from overseas). The U.S. economy likely can’t withstand dollar strength for overly long. The Federal Reserve faces a difficult choice in 2015 – raise rates, thus strengthening the dollar even further and increasing deflationary pressures in the U.S. – or hold rates steady and risk a loss of credibility. Might their latest communique, with its reference to “international developments”, be the first tiny step toward a retreat from interest rate hikes?

Those of us looking for righteous justice in the Game of Thrones may find ourselves as unsatisfied as those of us hoping to see reason and good sense triumph in the world of investing (and monetary policy). Winter is coming and it will bring with it a season of despair to those unprepared for its chilly blast.

Risk Management Isn’t Market Timing

“By repeatedly repressing financial-market volatility over the last few years, central-bank policies have inadvertently encouraged excessive risk-taking, which has pushed many financial-asset prices higher than economic fundamentals warrant. To the extent that continued currency-market volatility spills over into other markets – and it will – the imperative for stronger economic fundamentals to validate asset prices will intensify.” By Mohamed El-Erian Project Syndicate, Nov. 13, 2014

Translation: The Federal Reserve and other central banks around the world have artificially propped up capital markets by providing extraordinary amounts of cheap liquidity to speculators. The markets are in trouble if fundamentals don’t improve enough to justify artificially elevated prices. Forecast: There is only a small probability of economic fundamentals improving sufficiently to justify an S&P 500 price almost twice fair value.  There is a much higher probability that the market will trade lower at some point as the normal process of unfettered price discovery resumes and the market seeks fair value.

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I was discussing future returns for stocks with a community foundation director and mentioned that the S&P 500 would likely return less than 2% per annum over the next 10-years. She visibly recoiled and immediately labeled me a bear, never mind whether I had a logical reason for the forecast. Likewise, I was chatting with a financial advisor about the investment year a few weeks ago and made the observation that it was currently a high risk environment.  He dropped his chin to his chest, smirking as he shook his head from side to side, managing to convey both amusement and disagreement at the same time. Again, no interest in asking why. Rather, he slowly raised his head until he made eye contact, paused for effect, and then intoned, as if talking to a halfwit, that no one knew where the market was going.

And of course I agree! Academic research manifestly supports the notion that daily, weekly, and even monthly market movements are impossible to predict with any degree of consistency and accuracy. But that wasn’t what I had said. The advisor was opining on market timing and failing to understand that risk management isn’t market timing.

You don’t need to know if the market is going to rise or fall tomorrow to practice risk management. You need only be able to perform basic business valuation, which is the essence of actual investing – as opposed to speculating.  Do basic business valuation with 500 different stocks, add the values together, and you arrive at a fair value for the basket of 500 stocks as a whole.  I believe the concept of business valuation is sufficiently accepted by CPAs, CFAs, the IRS, and academia to dispense with a defense of our ability to value a business (the community fund director’s protests and the so-called financial advisor’s smirk aside).

Speculating on stock price movements is what most mutual funds do. (As opposed to investing in a company for an entire business cycle, or even longer, in order to benefit from rising shareholder cashflow).  In fact, short-term investing (speculating) is so ubiquitous today that it seems the majority of investors, both professional and otherwise, are no longer able to distinguish between speculating and investing. For instance, the average actively managed mutual fund has a turnover of approximately 100% per annum, according to Kiplinger’s and numerous other sources, which means that the average holding period for a typical stock in a typical mutual fund is approximately 12 months.  How ironic that the industry which touts the benefits of long-term investing doesn’t actually practice what it preaches.  And that means that even investors who maintain long-term exposure to a specific mutual fund are actually speculating as well, since they aren’t maintaining long-term exposure to specific stocks either. Mutual funds are merely conduits for stock (and bond) ownership. It is the underlying portfolio that determines exposures. The mutual fund manager speculates, as evidenced by rapid portfolio turnover. The mutual fund investor speculates by proxy.

Market timing is an attempt to profit by increasing or decreasing exposure to an asset class based on an expected return path for that asset, typically over a time period ranging anywhere from a few minutes to several months (but well short of a complete business cycle). Speculating in a stock is an attempt to profit by increasing or decreasing exposure to a stock based on an expected return path for that stock, also over a short period of time (on average one-year based on the trading patterns coming out of the mutual fund complex). Speculating with individual stocks is just as pointless an undertaking as market timing.  After all, it is the same game, just on a different scale.  But if the logic of sums doesn’t sway you then there is also the overwhelming evidence accumulated by academics over the past five decades or so…market timing doesn’t work, and neither does stock timing.

Fortunately, risk management has zero to do with market timing.  Investing is buying future shareholder cash flow at a price that will earn the investor an acceptable rate of return. Historically, investors in the S&P 500 have required an approximately 6.5% real rate of return to accept the risk of owning the S&P 500. Ergo the price that will earn an investor a 6.5% real rate of return going forward is the fair value (assuming investor requirements haven’t changed – a safe assumption since human behavior hasn’t changed in millennium).

Buy at a price above fair value and expect to earn a below market rate. Buy below fair value and expect to earn an above market rate. Buy at fair value and, by definition, earn the long-term real return rate of 6.5%.  Fortunately there are half a dozen very good long-term measures of value that can be substituted for the tedious and time-consuming task of doing basic business valuation 500 times.  Warren Buffet’s favorite is Market Capitalization to Gross Domestic Product (mkt cap/GDP). Price to replacement cost, price to trailing 10-year average earnings adjusted for inflation, price-to-book, and price-to-sales work just as well however – all highly predictive of subsequent returns.

Risk management is not market timing. Risk management is a basic component of successful investing. When valuation risk is present, common sense dictates reducing risk in your portfolio to account for the higher-than-normal risk environment (Conversely, adding risk to your portfolio when valuations are compelling – as they clearly were with the SP 500 trading below 800 in early 2009 – is also simple common sense). Next time your financial advisor tells you not to worry about valuation risk (because no one knows how to determine fair value for the market) fire him!

Myopic Loss Aversion

“Anyone who stops learning is old, whether twenty or eighty. Anyone who keeps learning stays young. The greatest thing you can do is keep your mind young.” Mark Twain

“Education: that which reveals to the wise, and conceals from the stupid, the vast limits of their knowledge.” Mark Twain (again)

“Most people aren’t rational most of the time. Just look around.” Chris Norwood

“You can fool all the people some of the time, and some of the people all the time, but you cannot fool all the people all the time.” Abraham Lincoln

Many people live their lives wisely, in plain view. Yet wisdom is rarely recognized until too late, if at all.  Others bray incessantly to the world using the big, interconnected electronic stage that is the 21st century. Radio, broadcast television, cable television, the internet, each a quantum leap in data flowing to YOU. Masters of the universe all, the pundits daily add their opinions to the cacophony of big data that comprises the 24/7 of today’s reality.

Yet data is not knowledge. Opinions are not, by their very utterance, worthy. And, in fact, too much data can be harmful to your wealth. More damaging still is the deluge of data presented to you intertwined with the detritus of opinion.

For we are a poor vessel for the electronic age, flawed in our ability to discriminate accurately between facts, opinions, and illusions (delusions?), or to calculate even the simplest of probabilities for that matter.  How then to improve our investing decisions, even as we drown in a waterfall of information on a torrential scale never imagined before the microchip?

Let’s start with a definition, followed by prediction garnished with… data.

Myopic loss aversion is the combination of a greater sensitivity to losses than to gains and a tendency to evaluate outcomes frequently, or so write Shlomo Bernatzi and Richard Thaler in their oft quoted May 1993 study, “MYOPIC LOSS AVERSION AND THE EQUITY PREMIUM PUZZLE”. The economists experimentally tested two implications of myopic loss aversion. First they conducted a study to see if investors who display myopic loss aversion (pretty much everyone) would be more willing to accept risks if they evaluated their investments less often. Second they looked at changes in investor behavior if all payoffs were increased enough to eliminate losses. (In other words, rewards were increased sufficiently to overcome our natural aversion to loss, thus encouraging risk taking).

Their findings?  Investors will accept more risk if they get less feedback from their portfolio. Investors will also accept more risk if they believe that profits are likely to outweigh losses by (on average) two to one.*  Put another way, “In a task in which investors learn from experience… The investors who got the most frequent feedback (and thus the most information) took the least risk and earned the least money.”

Too much information, too much feedback, reduces returns. A startlingly important finding from a wealth management perspective.  Starkly stated by the authors, “investors appear to choose portfolios as if they were operating with a time horizon of about one year… even if they have long-term investment goals such as saving for retirement or managing a pension plan.”

Bernatzi’s and  Thaler’s paper is but one piece of the puzzle surrounding investor (mis)behavior. Numerous studies have followed and the behavioral finance literature is now rich with actionable information for investors. (For example: A substantial value premium exists – low ratios of price to fundamentals have higher average returns. Mental Accounting, Loss Aversion, and Individual Stock Returns, Nicholas Barberis and Ming Huang* Journal of Finance August 2001)

Let us leave off with just one additional observation however, so as not to contribute overly much to the thunderous river of data and opinion that threatens to drown those who choose to swim in it.

Less can be more. Paying less attention to portfolio results over shorter periods of time will lead to more satisfying long term results (assume a properly diversified portfolio appropriately risk-adjusted for your financial plan).

*Anomalies: The Endowment Effect, Loss Aversion, and Status Quo Bias – Kahneman, Knetsch, and Thaler The Journal of Economic Perspectives 1991

Grace Under Pressure

I had a very nice annual meeting a few weeks ago with one of my favorite clients.  He’s a nice man with a keen intellect. He understands investing and, even better, understands monetary policy. He ran a successful regional bank for many years after all.  My client is someone I can talk with about Federal Reserve policy and its impact on the economy and the capital markets, and know he will have useful insights to share with me in return.

My client is 83 years old and suffers from Parkinson’s disease.

Google grace under pressure and it pops up as the title of Rush’s 10th album released in 1984, as part of a Forbes magazine title, as the title of a multimedia website about Burma, a Times magazine title about how to achieve it, ubiquitous is the phrase.

Yet search for its origins and one finds it first in a profile piece written by one Dorothy Parker about none other than Earnest Hemingway, when he responded to Parker’s question, “Exactly what do you mean by ‘guts’?”  Hemingway replied: “I mean, grace under pressure.”

As a high school student I read Hemingway and remember that “grace under pressure” was Hemingway’s definition of courage, from a man who presumably learned something about courage during his time in Italy in 1918, where he was wounded while passing out supplies to soldiers.  The Italian government gave him a Silver Medal of Military Valor for dragging  a wounded Italian soldier to safety.

Guts, courage, whether one in the same or different shades of some deeper essence, my client has them in abundance. His cheerfulness, his obvious enjoyment of life, despite a debilitating disease that makes living a daily challenge, is uplifting and humbling.

And yet, there are complications that come with aging, complications made worse by chronic illnesses such as Parkinson’s disease. Complications that draw in family members out of concern for a father’s health, a mother’s well-being, or… the family money.  Who is trustworthy and who is not?  It’s a dilemma made worse by the interconnected society in which we live. A society that makes investment gurus available 24/7. shouting advice at us from our televisions, or confidently telling us which investments to buy and which to sell in blog after internet blog.  AND WE LISTEN!

“My point is not that mass-mediated financial advice is kind (of) like professional wrestling. My point is that mass-mediated financial advice is EXACTLY like professional wrestling,” writes Dr. Ben Hunt, who is an expert in Game Theory, in a recent Epsilon Theory missive. “No one in his right mind should believe that mass-mediated (Jim Cramer) financial advice is the same thing as professional, individuated financial advice. And yet here we are, in a world where the notion of trust has become so warped that every day, thousands of investors question the trustworthiness of their flesh-and-blood financial advisors and tens of thousand more act on their own because they trusted a piece of Narrative-driven advice they heard on the TV or read in the newspaper (or a newsletter).”

But trust is a two-way street, and those flesh-and-blood financial advisors are increasingly unsure who they can trust in return as America ages. From a recent article in Investmentnews.com:

“In January, Michael Kotin, a financial adviser at Wells Fargo & Co., faced a dilemma. Two longtime clients, a couple who had been married for around 60 years and who were both well into their 80s, were accusing each other of being mentally incapacitated and unfit to make decisions involving a jointly owned trust.”

From the same article: “In other cases, financial advisers suspect that their clients are being taken advantage of by con artists.”  And a few paragraphs further down, “These financial institutions are caught between a rock and a hard place,” said Elizabeth Loewy, who served as the chief of the elder abuse unit in the Manhattan District Attorney’s Office for almost three decades. “They don’t have psychiatrists on staff…I feel bad for them.”

Yes, my meeting went well and my client seemed comfortable with our investment posture. He understands, with a breadth and depth frequently lacking among many, that we are in an extraordinarily unusual monetary position, both in the United States and around the world. Uncertainty is extremely high. The unknown unknowns of former Secretary of Defense Donald Rumsfeld lurk in the shadows of monetary and fiscal policy today, gibbering quietly, biding their time. (No, no, no NOT the end of the world, but a time for caution nevertheless as the unknowns of experimental monetary policy and profligate fiscal policy become known).

And yet he is 83 and has Parkinson’s disease. He does sometimes repeat himself and can wander in conversation a bit more than he probably once did. Perhaps that is why his son picked up the phone the day after my client and I met and called the brokerage firm that custodians his father’s accounts. The son wanted to know more about me. Who was I? What was I doing with his father? What was I trying to sell him?  All questions that his father is more than capable of answering directly, or at least that is my belief.

Of course I let my client know about the call and he is going to talk to his son. My client is very proud of his son; I have heard quite a few stories over the years, stories of his son’s successes. The son has every reason to be proud of the father in return. Grace Under Pressure….courage….guts…. in abundance.

 

Yield, Returns, Time Horizon

I had a meeting with a client yesterday. He is a nice man, intelligent, earnest.  My client is 65 years old and is looking for a way to supplement his income. I believe he would be back in the work force if he could find something suitable. He is concerned about his retirement, worried about the next bear market, worried he isn’t making enough now, before the next bear market.  He and his wife recently went to hear an investment guru talk about a way to make 6% per year in commercial mortgage lending with the help of an investment company. They came away with the impression that there is little risk and that their investment time horizon could be as little as one year.  I have offered to review the investment opportunity for them but I already know that it is probably pretty risky. The tip off? A one year investment that earns 6%.

Interest is the price of money, either what a borrower pays or a lender receives. Right now one-year Treasuries are yielding 0.10%, two-year Treasuries are yielding 0.58% and five-year Treasuries are yielding 1.79% (about the same as the official inflation rate). Treasuries are considered risk-free investments (if you don’t worry about inflation eating away the value of your money while the government has it). Notice that the longer the lending period the higher the price of money. Money has a time-value and an investment’s time horizon is integral to determining a fair market price for a lender’s money.

The time value of money is an acknowledgement that money can be made with money. If I make 5% in a year with my $100 in savings then in one year my money is worth $105. A second year of 5% results in $110.25 in my piggy bank.  $100 today is worth $110.25 in two years… at 5%. Or looked at from the future point of view, $100 in two years is worth only $90.70 today because I only need $90.70 today to have $100 in two years… again at 5%.  Using a 10% discount rate I need $82.65 today to have $100 two years from now.  (One can begin to understand why public pension plans insist on maintaining 7% to 8% return assumptions in the face of 14 years of actual returns that have fallen considerably short. Taxpayers may not want to pony up additional money to ensure public pension plans can actually meet their commitments, so let’s just pretend 7% annually is doable going forward even though it’s extremely unlikely, at least over the next 10-years or so).

Investors postpone current consumption in order to consume in retirement. They want their money to earn as much as possible over the shortest time possible.  Why settle for 5% per year if you can get 10%? Of course the answer is because the 10% investment might be too risky (highly variable with an outright loss possible).  In fact, the S&P 500 has returned about 10% annually over the very long run, but investors in the S&P 500 lose money once out of every four years historically*.  So an investment’s risk is part of an investor’s calculation when it comes to required returns. What is the likelihood that the investment will earn less than 10%? What is the likelihood of an outright loss?

Risk then is the other side of the investment coin.  Every expected return must be adjusted for the risk that the investment will fail to provide the expected return. A 5% return that is 100% probable is superior to a 5% return that is only 50% probable with a 0% return also 50% probable .  It is, in fact, possible to calculate average expected returns where return distributions are known.  A 50% probability of 5% and 50% probability of 0% gives the investor an expected return of 2.5%, exactly half of the sure thing.

Investors compete for investments, searching diligently for the highest possible returns with the lowest amount of risk. The competition more or less guarantees that there won’t be many investments with risk-adjusted returns substantially above the rest at any given time. And that means that simply looking at what is out there for any given investment horizon can help an investor gauge the risk of an investment without knowing anything else but the expected return.  For instance, if the marketplace is currently offering 0.10% for a single year in a risk free investment in the form of a U.S. Treasury then investors can’t reasonably expect to earn 6% in a one-year risk free investment.  In fact, there isn’t a risk-free return available out to 30-years that even approaches 6% – the 30-year Treasury currently offers a mere 3.125%.

Moving out the risk continuum a bit nets investors 1.00% for a one-year CD from Ally Bank, 1.20% for a three-year CD and 2.00% for a 5-year CD.  How safe is a one-year investment with Ally Bank (an internet bank)? Not as safe as Capital One 360, which is offering 0.40%, Wells Fargo offering 0.05%, Chase offering 0.02%, and HSBC offering 0.01% for the same one-year time horizon. How do I know? Because the market is demanding a substantially higher price to lend to Ally.  And how do I know that? Investors can take-it-to-the-bank that Ally isn’t paying a penny more in interest on one-year CDs than necessary to attract capital, ergo the market is requiring Ally to pay a substantially higher rate, regardless of how Ally dresses it up in marketing spin. Yes, internet banks likely have a lower cost structure than bricks-and-mortar banks, but there is no business out there, none, that is going to pay more for an input cost (deposits in this case) than they absolutely have to pay.

Moving still further out the risk continuum to commercial mortgages takes us out of the one-year time horizon (commercial loans are typically for longer periods than just one year) but does take us to the asset subclass of interest to my client. Unfortunately, a quick check on line doesn’t show anyone willing to pay a commercial lender anywhere near 6% for the use of their money. Select Commercial Lending LLC (rated “A+” by the Better Business Bureau according to Commercial Lending’s web page) will lend on apartment buildings at 3.60% and office, retail, and industrial properties for as little as 4.25%.  Steelhead Capital advertises multifamily small portfolio ($400,000 to $1mm) money available for 3.90% to 5.15% for 5-year periods. Steelhead can’t get 6% from a borrower without offering a 30-year loan (5.66% to 6.80% rates available).

Hold on! Eureka! Scrolling further down Steelhead’s website reveals one-year money available to borrowers for rehabilitation and bridge loans. Steelhead is only asking for between 7% and 14% on a one-year interest only loan. But why is Steelhead requiring such a high rate for the use of its one-year money? Or put another way why are borrowers willing to pay so much for a one-year loan?  Let’s answer the question by first looking up a couple of definitions, starting with rehab loan.

Investopedia explains that a rehab loan has a “low down payment requirement compared to private-sector mortgages and puts rehab projects within reach for individuals who otherwise could not afford them.  Supporters of this type of loan say it helps improve communities and broadens home ownership opportunities for individuals; critics say that it’s a risky loan product that isn’t offered without government underwriting for good reason.”  Prospect Mortgage’s website includes a bullet on rehab loans pointing out that FHA 203(k) loans “Can be used to buy property otherwise not eligible for financing”.

As for bridge loans, Wikipedia helpfully points out that “Bridge loans are typically more expensive than conventional financing to compensate for the additional risk.”

So the answers to our two questions are: because they can and they can because (desperate?) borrowers have no lower-cost options.

Final Exam: Which of the following investments contains substantially more risk than the others?

A) one-year 0.10% B) one-year 1% C) five-year 5% D) one-year 6%

Yes, I’ll look at the commercial lending operation touted by the investment guru to retirees looking for additional yield (without taking too much risk), but the answer to the Final Exam question is D so I am pretty sure I know what I will find.

*If learning that the S&P 500 loses money every four years on average surprised you then perhaps you had better check your portfolio. We are closing in on our 6th straight year of positive gains.

Medicare, Long-Term Care, and Family

The 98-year old woman lived in an assisted living facility on the eastside of Indianapolis. Wanda* was struggling with dizziness whenever she stood up. Orthostatic hypotension is an excessive fall in blood pressure that occurs when a person stands up or is upright.  Something wasn’t right and the medical personnel at the facility were concerned. And then Wanda fell.

She was admitted to a nearby hospital for treatment. Two of the assisted living facility’s primary caregivers went to the hospital to brief medical personnel about the problems Wanda was having when she stood. They told doctors that Wanda was orthostatic but that they didn’t know why. The doctor overseeing Wanda’s case discharged her after two nights,  but kept her in the hospital for observation for an additional two nights. Wanda was an outpatient for her final two nights at the hospital even though, as far as Wanda or her loved ones knew, the hospital’s medical personnel were taking care of her exactly as they had done before her status change. However, the paperwork drill that “discharged” her from the hospital, but kept her at the hospital as an outpatient, has had severe consequences for Wanda and her family.

Medicare will only cover the cost of rehabilitation following an inpatient stay of at least  three nights. Three nights gets you up to 100 days of coverage by Medicare in long-term care at a skilled nursing facility for rehabilitation (although only the first 20 days are completely covered with the remaining 80 days requiring a co-pay that can run up to $152 per day in 2014). Two nights in a hospital doesn’t get you squat… or not much more than squat. Wanda needed rehabilitation but couldn’t afford it. Worse, Wanda was now a two-person transfer (two people required to move her) and her existing assisted living facility, her home for many years, was unable to accommodate her any longer. It didn’t have the personnel to provide the necessary level of care and Wanda couldn’t afford to hire a private caregiver to augment the assisted living facility’s staff.

Wanda has moved in with her family. Her granddaughter is now attempting to care for her. She did receive some training in transferring her Grandmother so that she could get into a bathtub or use the toilet – her training was paid for in part by Medicare.  The emotional, financial, and physical toll taken on primary and secondary nonprofessional caregivers is substantial.  According to a 2010 study “Beyond Dollars – The True Impact of Long Term Caring”:

• The average age of primary care givers is 53, with 42% caring for a mother, 14% for a father, and 13% for a spouse.
• 42% reported that the care recipient resided in their home for a period of three years or more.
• The financial impact was widespread, with 83% contributing financially, 63% reporting lost income of an average of 23% of household income, 61% reducing savings by an average of 63%, 57% dipping into their own retirement funds and/or savings, 45% cutting back on their own family expenses, 40% reducing family vacations, and 29% borrowing money, taking out a reverse mortgage and/or selling their home.
• 57% provided care for more than 16 hours each week and 31% provided care for more than 30 hours each week.
• Over a third reported direct negative consequences to their own careers, including 44% working fewer hours, 48% lost a job, changed shifts and/or missed career opportunities, 38% incurred repeated absences from work, and 17% found themselves repeatedly late for work.
• The impact on family and relationships included 44% experiencing an increase in stress with their spouse, 27% reported stress with siblings, 23% experienced an increase in stress with their children, 20% reported reduced time with children, and 58% reduced savings for college education.

The hospital personnel who “discharged” Wanda after two nights, moving her from inpatient status to observation services status,  almost certainly knew that by doing so Wanda wouldn’t be eligible for Medicare covered rehabilitation at a skilled nursing facility (SNF) because of Medicare’s 3-day prior inpatient care requirement. Hospital personnel may have also known, but not cared, that moving Wanda to Observation Status (OS) would be more costly for Wanda and her family because there is no cap on beneficiary cost sharing for OS visits.

Why do it then?

Perhaps because The Affordable Care Act added a section to the Social Security Act establishing the Hospital Readmissions Reduction Program, which requires a reduction in payments to hospitals for excessive readmissions (readmissions to a hospital within 30 days of a discharge from the same or another related hospital following a 3-day inpatient visit).

Unintended consequences are very common when attempting to make public policy for complex, dynamic systems where feedback loops exist and the various players adapt. All too often the innocent are harmed. Wanda is worse off and Wanda’s family is worse off…not what was intended at all when the Affordable Care Act was signed into law.

 *Wanda isn’t the 98-year old’s real name. I promised the director of the assisted living facility I wouldn’t use any real names, including her own. She was worried about HIPAA violations.

Food For Thought

A four-year old sits alone in a room in a chair.  The only other piece of furniture is the table in front of her upon which sits a marshmallow and a bell. The four-year old squirms uncomfortably in her chair. It’s obvious to the observers – three adults watching intently through a one-way window – that the four-year old is trying desperately not to look at the marshmallow. In fact, the little girl is squirming in her chair, head turning this way and that, face melting from frown to grimace to determination and back. Suddenly a small hand shoots out and grabs the bell.  The little girl can’t wait any longer; she wants that marshmallow now!

In what has become one of the most famous experiments in psychology, Walter Mischel and his students exposed 4-year olds to a tempting dilemma. One marshmallow to be eaten at any time or two marshmallows if the 4-year olds could wait 15 minutes. Mischel was researching how self-control and cognitive ability interacted within an individual. Ten to fifteen years later a large gap had opened between those 4-year olds who had resisted temptation and those who had not. Resisters have higher measures of executive control in cognitive tasks and especially the ability to reallocate their attention effectively (Encyclopaedia Britannica).

A simple puzzle – do not try to solve it but listen to your intuition. A bat and ball cost one dollar and ten cents.  The bat costs one dollar more than the ball. How much does the ball cost?  A number came to your mind…was it ten cents? (Thinking, Fast and Slow, Daniel Kahneman – a Nobel Prize winner in Psychology). The intuitive answer – ten cents – is of course wrong. The bat would have to cost one dollar and ten cents for it to cost one dollar more than the ball, which would make the total cost one dollar and twenty cents. The correct answer is 5 cents, the ball costs 5 cents and the bat one dollar and five cents.  The intuitive answer is wrong.  We could certainly have solved the puzzle with a little mental effort and some math. Yet many of us fail to make the small investment in effort required to correctly solve the puzzle. In fact, more than 50% of the thousands of students from Harvard, MIT, and Princeton, who have been given the bat and ball problem, have failed to give the correct answer.  At less selective universities the failure to give the correct answer was in excess of 80%. (Kahneman) Quite literally, they didn’t do the math…

Overconfidence is a reoccurring problem in human decision-making, including in the field of investing. Many people, professionals and amateurs alike, put far too much faith in their intuition. They apparently find cognitive effort at least mildly unpleasant and avoid it as much as possible, according to Kahneman.  In fact, others have shown that effortful mental activity appears to be expensive in terms of glucose consumption, perhaps explaining, in part, why humans appear to resist making a mental effort whenever an intuitive, easy answer presents itself (Baumeister).

The lack of effortful mental activity is also expensive in terms of investment portfolios, as Terry Odean showed with his statistical analysis of 163,000 trades done in 10,000 brokerage accounts over a seven year period.  Odean identified all instances when an investor sold stock and soon after bought another stock. Odean then compared the return of the stock that was sold to the stock that was bought over the following 12 months. The stock sold outperformed the stock bought on average by a very large 3.2%, excluding the costs of executing the two trades. (Odean and Barber, “Boys Will Be Boys”)

Of course, someone has to be on the other end of those losing trades and it is usually the smart money – professional money managers. However, the evidence from over 50 years of research is not supportive of professional money managers and their stockpicking skills either. Professional money managers, including mutual fund managers, fail a basic test of skill – persistent achievement, writes Kahneman.  “The diagnostic for the existence of any skill is the consistency of individual differences in achievement. The persistence of individual differences is the measure of the existence of skill. The evidence from more than 50-years of research is conclusive. For a large majority of fund managers the selection of stocks is more like rolling dice…moreover the year to year correlation between the performance of mutual funds is very small, barely higher than zero.” Again indicating that attempting to pick superior mutual funds (and stocks) is little more than an exercise in coin flipping.

But what about pundits making predictions in their field of expertise?  What about stock market experts confidently laying out the likely course for the U.S. stock market over the next year? Or economists forecasting GDP? Should the public rely on these predictions to adjust their portfolio allocations in order to extract greater returns?

Nope!

Research has conclusively shown that economists can’t forecast. For instance, a majority of economists didn’t think we were in a recession in 1990, 2001, and 2007 after recessions had already begun (The Signal and The Noise, Nate Silver).  “Nobody has a clue,” says Jan Hatzius, Goldman Sachs Chief Economist (The Signal and The Noise). Money managers can’t pick superior performing stocks (Thinking, Fast and Slow, Kahneman). And investors can’t pick superior performing mutual funds (Kahneman).

Widely diversified, low-cost portfolios allow investors far more certainty in capturing the market returns available to them. Widely diversified portfolios prevent investors from “eating the marshmallow early and missing out on a second” and also prevent them from falling prey to the overconfidence bias that leads so many investors to concentrate in the wrong investments at the wrong time.

Maintaining widely diversified portfolios will keep most investors out of trouble most of the time. Judicious risk management can improve returns even further, but one must know ones limits.  Here are four factually true statements: 1) The U.S. stock market is currently trading approximately 80% above its normal valuation level based on a number of long-term metrics with correlations to subsequent returns in excess of 90%*.  2) There will be another bear market. 3) Corporate earnings estimates are some 70% above their long-term average. 4) Corporate earnings margins are historically a strongly mean reverting statistic.

*(Mkt Cap/GDP, Price/Revenue, Tobin’s Q, Shiller’s P/E, Dividend Modal)

Here is an opinion based on those four true statements – the  risk level is unusually high in the U.S. stock market. A second opinion – it is possible that the U.S. stock bull market will last another two to three years but more likely that the next bear market will begin within the next two years.

A reasonable conclusion – adjust your widely diversified portfolio to reduce risk in order to account for the much higher than normal risk currently present in the U.S. stock market.

But preaching patience, diversification, and risk avoidance can cost a wealth manager business, as it did me recently. A case study in immediate gratification (marshmallow eating), overconfidence (coin flipping as a skill), and ignorance (comparing apples to lemons):

My 72-year-old client of nine months can’t afford to lose 30% to 40% of his investment portfolio without seriously jeopardizing his retirement. Further, he probably can’t even afford to break even over the next five to eight years, needing to grow his wealth in order to meet his retirement spending goals.  Unfortunately, the math strongly suggests that S&P 500 returns will be negative over the next five years and only modestly positive over the next 10-years or so (1.063)(0.63/1.25)^(1/10) – 1.0 + .02 = 1.3% annually.

(1+g)*((Avg Mkt Cap/GDP)/(Actual Mkt Cap/GDP))^1/10 – 1.0 + Div Yield.

Importantly, the math is strongly suggestive of two stock bear markets in the next 10 years, bear markets in which my 72-year old client can’t afford to fully participate. A widely diversified portfolio of assets, accompanied by prudent risk management, will give my client the best opportunity of meeting his spending goals in retirement.  Thus we constructed a portfolio designed to earn a rate of return that would allow my client to meet his retirement spending goals, but that would also likely have much more limited losses in a bear market.

Unfortunately, marshmallow eating, coin flipping and lemons will likely prove his undoing at this point because….he is no longer my client. He told me, after he moved his accounts, that he was unhappy his widely diversified portfolio hadn’t stayed up with the S&P 500 over the nine month period, something it was obviously never designed to do. Ironically, the stock portion of his widely diversified portfolio handily beat the S&P 500 during that nine month period, but the apples to lemons comparison masked the stock outperformance)*

*The stock outperformance wasn’t necessarily (or even likely) due to skill (thus the irony) – nine months is far too short a period to ascertain skill.

Regardless, my now ex-client has moved his accounts to a financial advisor, who has apparently assured him that she can get him the S&P 500 rate of return without exposing him to the S&P 500 level of risk. Either that or he is foolishly seeking a rate of return he does not need in order to meet his spending goals in retirement while taking on a level of risk he can not afford, as he will undoubtedly realize in due course…