ZIRP distorts price signals throughout an economy.
Starting with asset prices and asset pricing, ZIRP creates not just a moral hazard by allowing firms to borrow at low rates to buyback stock (thereby boosting EPS and distorting that important price signal) but also factors prominently into asset valuation models artificially lowering the discount rate (which has a multiplicative and not a linear effect in valuation) to distort asset prices with follow-on effects for M&A and resource allocation decisions throughout the economy.
ZIRP just throws the cat among the pigeons. And so long as everyone is dancing to the music, it creates a game of chicken whereby everyone knows it will end badly one day, but everyone is also planning on being the first out the door when the music stops.
Tuesday, February 24, 2015
Current Economic/Market Flashpoints
Unprecedented debt accumulation in China, US, Japan, Australia, UK and other places.
The large decline in oil decimates one of the primary drivers of growth in the US.
The large decline in commodity prices due to the slowdown in China crushes Canada, Brazil and Australia.
Large residential real estate bubbles in Canada, UK, Australia, NZ and China undermine banks in those countries.
QE in Japan and by the ECB sets up a race to the bottom in the currency wars. US can't exit QE because it would blow apart global currency markets.
NIRP set up incentive structures leading to asset mispricings and misallocation of resources.
Financial repression and the failure to reform or clear markets is manifesting in deflation.
Geopolitical instability with potential spillover effects: Ukraine, Syria, Grexit, oil squeeze on Iran & Russia.
The large decline in oil decimates one of the primary drivers of growth in the US.
The large decline in commodity prices due to the slowdown in China crushes Canada, Brazil and Australia.
Large residential real estate bubbles in Canada, UK, Australia, NZ and China undermine banks in those countries.
QE in Japan and by the ECB sets up a race to the bottom in the currency wars. US can't exit QE because it would blow apart global currency markets.
NIRP set up incentive structures leading to asset mispricings and misallocation of resources.
Financial repression and the failure to reform or clear markets is manifesting in deflation.
Geopolitical instability with potential spillover effects: Ukraine, Syria, Grexit, oil squeeze on Iran & Russia.
Monday, February 23, 2015
Plenty of Room for the Major Indexes to Go Higher
In homage to Herman's Hermits, "2nd verse, same as the first..." (this was the same case I made in March 2014)
With large cap tech trading at middling multiples (15x) there is still room for the major large cap indices to go higher.
If large cap tech were to play catch-up (moving from 15x to 18x) it would also likely underpin the rest of the market (maybe even add a little to their valuations) and could see the general market indexes rise another 15%-30%.
Last year at this time we saw the high beta momentum plays get hung drawn and quartered even as large cap tech underpinned the "broader" strength in the market. I say "broader" because breadth actually deteriorated significantly (small-mid caps were hammered) but this was not so evident from the large cap major indices.
With large cap tech trading at middling multiples (15x) there is still room for the major large cap indices to go higher.
If large cap tech were to play catch-up (moving from 15x to 18x) it would also likely underpin the rest of the market (maybe even add a little to their valuations) and could see the general market indexes rise another 15%-30%.
Last year at this time we saw the high beta momentum plays get hung drawn and quartered even as large cap tech underpinned the "broader" strength in the market. I say "broader" because breadth actually deteriorated significantly (small-mid caps were hammered) but this was not so evident from the large cap major indices.
The New Dividend Investing Approach Is The Same As The Old Dividend Investing Approach
QE and financial repression through ZIRP have pushed up prices and forced savers into riskier investments.
One area where investors are doing a deal with the devil is dividend paying stocks. Investors are being pushed up the risk curve (by pushing up prices), hoping that an investment in a dividend paying stock is better than a non-dividend paying stock and that such an approach serves as a proxy for bond yield. They are wrong on both accounts. Theory posits that there is no difference between a dividend paying stock and a non-dividend paying stock (Modigliani equivalence theorem). Evidence shows that when the market swoons, dividend paying stocks swoon just as much as non-dividend paying stocks. Equity risk is still equity risk. If it is true that ZIRP has artificially pushed up dividend stocks relative to non-dividend stocks, then there will be an additional cost to pay when valuations across the equity market equalize.
Hoping that dividend paying stocks provide a bond-like cushion with equity like appreciation is wishful thinking. There is no free lunch in the markets.
Additional Notes:
This is true of investors seeking dividend cover in tech stocks. I doubt they are fully factoring business risk.
It is especially important for investors to not be pennywise and pound foolish. Seeking a 3% yield vs a 2% yield for the market infers taking on additional risk. And it is especially important for investors to beware the addition of a 3% yield pales in significance to a 25% fall in price.
Finally, once dividend cuts come down the pike they have a double whammy effect wrt to falling dividend and falling price. What worked on the way up - increasing dividend, increasing price - works in reverse on the way down (as Cramer would say, "that is a house of pain")
One area where investors are doing a deal with the devil is dividend paying stocks. Investors are being pushed up the risk curve (by pushing up prices), hoping that an investment in a dividend paying stock is better than a non-dividend paying stock and that such an approach serves as a proxy for bond yield. They are wrong on both accounts. Theory posits that there is no difference between a dividend paying stock and a non-dividend paying stock (Modigliani equivalence theorem). Evidence shows that when the market swoons, dividend paying stocks swoon just as much as non-dividend paying stocks. Equity risk is still equity risk. If it is true that ZIRP has artificially pushed up dividend stocks relative to non-dividend stocks, then there will be an additional cost to pay when valuations across the equity market equalize.
Hoping that dividend paying stocks provide a bond-like cushion with equity like appreciation is wishful thinking. There is no free lunch in the markets.
Additional Notes:
This is true of investors seeking dividend cover in tech stocks. I doubt they are fully factoring business risk.
It is especially important for investors to not be pennywise and pound foolish. Seeking a 3% yield vs a 2% yield for the market infers taking on additional risk. And it is especially important for investors to beware the addition of a 3% yield pales in significance to a 25% fall in price.
Finally, once dividend cuts come down the pike they have a double whammy effect wrt to falling dividend and falling price. What worked on the way up - increasing dividend, increasing price - works in reverse on the way down (as Cramer would say, "that is a house of pain")
Tuesday, February 17, 2015
The State of Financial Consultant Direct Calls
Just received a call from a TD Ameritrade Consultant who had taken over my account (I didn't know I was part of someones book) from a guy who has moved on from TD...It was not particularly compelling.
She had recently come over from Schwab having been at Schwab for six years prior. Doesn't inspire confidence when you see the revolving door of financial consultants.
Several things she said left me incredulous:
If that is the state of Fidelity, Schwab, TD Ameritrade direct sales then they really need to sharpen their pencils. They are in pole position with their existing clients and it really shouldn't take much to upsell additional services.
She had recently come over from Schwab having been at Schwab for six years prior. Doesn't inspire confidence when you see the revolving door of financial consultants.
Several things she said left me incredulous:
- In the first instance she mentioned they were doing a sales promotion - ding! ding! ding! I don't like being sold to - that would reward me with $100 for every $25,000 I moved over (0.40% - you've got to be kidding me).
- In the second instance she tried selling me on some management program (forget the name I have seen it advertised before) explaining how it uses independent research house Morningstar to construct portfolios from the best 37,000 mutual funds (emphasizing twice that 37,000 number to highlight how difficult it is to navigate the financial marketplace). I asked whether that included Schwab and Fidelity funds which she had dished previously as implying their programs were biased by including them, and she was not sure. And when I asked if any Fidelity and Schwab funds might rate well, she unbelievably said she didn't think so (remember, this is someone who has been selling Schwab funds for six years).
- She indicated the fees for the managed program ranged from 0.3%-1.25% with an average of 1%. Ouch. 1% for a little bit of automatic tax harvesting. That can't end well.
- She spoke about Tony Robbins new book that raved about TD Ameritrade as though he were an authority upon the subject.
If that is the state of Fidelity, Schwab, TD Ameritrade direct sales then they really need to sharpen their pencils. They are in pole position with their existing clients and it really shouldn't take much to upsell additional services.
Monday, February 16, 2015
The Only Spending Rule You Will Ever Need
From Financial Analysts Journal article by M. Barton Waring and Laurence Siegel.
It may be a slight overstatement but they make the case that the decision rule you want to work with in the decumulation phase if you don't want to run out of the money is as follows:
"Each year, one should spend (at most) the amount that a freshly purchased annuity - with a purchase price equal to the then-current portfolio value and priced at current interest rates and number of years of required cash flows remaining - would pay out in that year." [they call this the annually recalculated virtual annuity or ARVA]
Investors who behave in this way will experience consumption that fluctuates with asset values, but they can never run out of money.
It may be a slight overstatement but they make the case that the decision rule you want to work with in the decumulation phase if you don't want to run out of the money is as follows:
"Each year, one should spend (at most) the amount that a freshly purchased annuity - with a purchase price equal to the then-current portfolio value and priced at current interest rates and number of years of required cash flows remaining - would pay out in that year." [they call this the annually recalculated virtual annuity or ARVA]
Investors who behave in this way will experience consumption that fluctuates with asset values, but they can never run out of money.
Skepticism vs Cynicism
Skepticism yes. Cynicism no.
Skepticism in moderation is healthy, just as most foods in moderation are healthy. You need to be skeptical when evaluating companies, management and claims about the future.
Skepticism when it is overdone descends into cynicism. Cynicism is harmful because it is a static state of mind. It is unyielding, unbending and prone to dogma. Cynicism tends to be overwhelmingly negative, and as such distorts the bigger picture of positive growth, development and improvement.
Skepticism in moderation is healthy, just as most foods in moderation are healthy. You need to be skeptical when evaluating companies, management and claims about the future.
Skepticism when it is overdone descends into cynicism. Cynicism is harmful because it is a static state of mind. It is unyielding, unbending and prone to dogma. Cynicism tends to be overwhelmingly negative, and as such distorts the bigger picture of positive growth, development and improvement.
Saturday, February 14, 2015
Asset Allocation and Risk Sharing With The Government
Notes from "Two Key Concepts for Wealth Management and Beyond" Financial Analysts Journal.
Tax deferred accounts are like partnerships in which the investor owns (1-t) of the partnership principal and the government owns the remainder, where t is the marginal tax rate when the funds are withdrawn. The government shares in both the return and the risk of assets held in taxable accounts.
A dollar of pretax funds in a tax deferred account is less valuable than the same amount in a Roth. The type of account in which an asset is held affects the portion of the asset's risk borne by the investor and returns received by the investor (due to taxes).
Tax deferred accounts (TDA): 401k, 403b, Individual IRA, SEP, SIMPLE.
Tax exempt accounts: Roth, 529.
In an estate planning context, a tax exempt account analogue is making a taxable gift that would trigger an imminent transfer tax in exchange for not paying a transfer tax upon the donor's death.
A tax deferred account is analogous to a limited partnership in which the investor is like the general partner and owns (1-t) of the partnership interest, and the government is the limited partner and owns t of the partnership interest. As the general partner, the investor gets to decide where the funds are invested and when they are withdrawn subject to RMD. The investors true economic interest in a tax deferred account is 1-t. The after tax value of the tax deferred account grows tax exempt, not tax deferred. The individual investor receives 100% of pretax returns and bears 100% of the risk on after tax funds in a TDA.
The government shares in both the risk and return on assets held in taxable accounts. Investors bear less than 100% of the risk and receive less than 100% of the returns in taxable accounts.
The difference between the risk and return sharing characteristics of a tax deferred account and a taxable account is driven by the difference in the tax base of the two structures. Tax liabilities for tax deferred accounts are a proportion of principal value. Tax liabilities for taxable accounts are based on incremental returns.
You've got to look at TDA on their present after-tax value to get asset allocation right. An after tax portfolio optimization procedure will simultaneously solve both the asset allocation and asset location decisions. Result: hold bonds in retirement account and stocks in taxable account. The best assets to hold in the taxable account are those that make the best use of the preferential long term gains tax treatment, ie. equities. Also, in an after tax optimization environment, a larger portion of stocks are allocated in the portfolio.
The present value of the future tax liability is smaller for high risk assets than for low risk assets. Although the future value of the tax liability of a TDA is likely to be greater when the account is invested in stocks, the tax liability must be discounted at a higher rate which exactly offsets its higher future value and nullifies the notion that locating assets with higher expected returns in TDAs shelters the investor from paying more taxes.
Choosing the proper savings vehicle simply reduces to comparing the marginal tax rate today with the expected marginal tax rate when funds are withdrawn. If the prevailing tax rate when funds are withdrawn is less than the tax rate when they are invested, the TDA will accumulate more after tax wealth than the tax exempt account, et vice versa.
Contribution limits effectively allow an investor to shelter a larger investment of after tax funds in a Roth 401k as compared to a regular 401k. Contribution limits favor the use of Roth 401ks.
Rule of thumb: an individual who expects to have a 25% tax rate during retirement should, in general, convert sufficient funds to take this year's taxable income to the top of the tax immediately below 25%.
The government's partnership interest and risk sharing roles also manifest themselves in optimal withdrawal strategies. As a rule of thumb, you should withdraw funds from the taxable account before the retirement accounts. The proper way to view the effective tax rate is that it is zero for funds held in TDAs and Roths and positive for funds held in taxable accounts. By retaining funds in retirement accounts as long as possible, you will receive a higher after tax rate of return. Some exceptions to the rule: if taxable assets have a very low cost basis; if you have a short life expectancy (it would not make sense to realized capital gains when they could have been avoided due to the step up basis on death); when there is opportunity to withdraw funds from the TDA in retirement when your marginal tax rate is less than the rate at which you contributed funds (ie. due to large charitable contributions, large medical expenses). In retirement withdrawals from taxable accounts are taxed at the capital gains level and should be supplemented with withdrawals from retirement accounts up to the marginal tax rate at which TDA contributions were made.
Remember, the size of the government's partnership interest in a TDA is determined by the tax rate and not by the timing of the withdrawal.
A combination of TDAs and tax exempt accounts in retirement can be advantageous because it provides the flexibility necessary to design the optimal withdrawal mix in the then prevailing tax environment.
Related to the gifting assets now or bequeathing them later issue: Foregoing the gift of an asset that would trigger an transfer tax in favor of a bequest that would trigger an estate tax upon the donor's death is analogous to investing in a TDA. Conversely, opting for a bequest in lieu of a gift is analogous to investing in a Roth.
Asset Location: individuals should locate lightly taxed securities in taxable accounts and heavily tax securities in retirement accounts to the greatest degree possible, while maintaining their risk return preference.
Choice of Retirement vehicle: in general, if the marginal tax rate in retirement is expected to be lower than this year's tax rate, then the individual should save in a TDA.
IRA-Roth conversion: if this year's marginal tax rate is lower than the expected retirement withdrawal tax rate, it pays to convert funds to a Roth account this year. The optimal conversion amount would push an investor to the top of the tax bracket just below their estimated marginal tax rate in retirement.
Tax deferred accounts are like partnerships in which the investor owns (1-t) of the partnership principal and the government owns the remainder, where t is the marginal tax rate when the funds are withdrawn. The government shares in both the return and the risk of assets held in taxable accounts.
A dollar of pretax funds in a tax deferred account is less valuable than the same amount in a Roth. The type of account in which an asset is held affects the portion of the asset's risk borne by the investor and returns received by the investor (due to taxes).
Tax deferred accounts (TDA): 401k, 403b, Individual IRA, SEP, SIMPLE.
Tax exempt accounts: Roth, 529.
In an estate planning context, a tax exempt account analogue is making a taxable gift that would trigger an imminent transfer tax in exchange for not paying a transfer tax upon the donor's death.
A tax deferred account is analogous to a limited partnership in which the investor is like the general partner and owns (1-t) of the partnership interest, and the government is the limited partner and owns t of the partnership interest. As the general partner, the investor gets to decide where the funds are invested and when they are withdrawn subject to RMD. The investors true economic interest in a tax deferred account is 1-t. The after tax value of the tax deferred account grows tax exempt, not tax deferred. The individual investor receives 100% of pretax returns and bears 100% of the risk on after tax funds in a TDA.
The government shares in both the risk and return on assets held in taxable accounts. Investors bear less than 100% of the risk and receive less than 100% of the returns in taxable accounts.
The difference between the risk and return sharing characteristics of a tax deferred account and a taxable account is driven by the difference in the tax base of the two structures. Tax liabilities for tax deferred accounts are a proportion of principal value. Tax liabilities for taxable accounts are based on incremental returns.
You've got to look at TDA on their present after-tax value to get asset allocation right. An after tax portfolio optimization procedure will simultaneously solve both the asset allocation and asset location decisions. Result: hold bonds in retirement account and stocks in taxable account. The best assets to hold in the taxable account are those that make the best use of the preferential long term gains tax treatment, ie. equities. Also, in an after tax optimization environment, a larger portion of stocks are allocated in the portfolio.
The present value of the future tax liability is smaller for high risk assets than for low risk assets. Although the future value of the tax liability of a TDA is likely to be greater when the account is invested in stocks, the tax liability must be discounted at a higher rate which exactly offsets its higher future value and nullifies the notion that locating assets with higher expected returns in TDAs shelters the investor from paying more taxes.
Choosing the proper savings vehicle simply reduces to comparing the marginal tax rate today with the expected marginal tax rate when funds are withdrawn. If the prevailing tax rate when funds are withdrawn is less than the tax rate when they are invested, the TDA will accumulate more after tax wealth than the tax exempt account, et vice versa.
Contribution limits effectively allow an investor to shelter a larger investment of after tax funds in a Roth 401k as compared to a regular 401k. Contribution limits favor the use of Roth 401ks.
Rule of thumb: an individual who expects to have a 25% tax rate during retirement should, in general, convert sufficient funds to take this year's taxable income to the top of the tax immediately below 25%.
The government's partnership interest and risk sharing roles also manifest themselves in optimal withdrawal strategies. As a rule of thumb, you should withdraw funds from the taxable account before the retirement accounts. The proper way to view the effective tax rate is that it is zero for funds held in TDAs and Roths and positive for funds held in taxable accounts. By retaining funds in retirement accounts as long as possible, you will receive a higher after tax rate of return. Some exceptions to the rule: if taxable assets have a very low cost basis; if you have a short life expectancy (it would not make sense to realized capital gains when they could have been avoided due to the step up basis on death); when there is opportunity to withdraw funds from the TDA in retirement when your marginal tax rate is less than the rate at which you contributed funds (ie. due to large charitable contributions, large medical expenses). In retirement withdrawals from taxable accounts are taxed at the capital gains level and should be supplemented with withdrawals from retirement accounts up to the marginal tax rate at which TDA contributions were made.
Remember, the size of the government's partnership interest in a TDA is determined by the tax rate and not by the timing of the withdrawal.
A combination of TDAs and tax exempt accounts in retirement can be advantageous because it provides the flexibility necessary to design the optimal withdrawal mix in the then prevailing tax environment.
Related to the gifting assets now or bequeathing them later issue: Foregoing the gift of an asset that would trigger an transfer tax in favor of a bequest that would trigger an estate tax upon the donor's death is analogous to investing in a TDA. Conversely, opting for a bequest in lieu of a gift is analogous to investing in a Roth.
Asset Location: individuals should locate lightly taxed securities in taxable accounts and heavily tax securities in retirement accounts to the greatest degree possible, while maintaining their risk return preference.
Choice of Retirement vehicle: in general, if the marginal tax rate in retirement is expected to be lower than this year's tax rate, then the individual should save in a TDA.
IRA-Roth conversion: if this year's marginal tax rate is lower than the expected retirement withdrawal tax rate, it pays to convert funds to a Roth account this year. The optimal conversion amount would push an investor to the top of the tax bracket just below their estimated marginal tax rate in retirement.
The Retirement Conundrum
Notes from Jason Scott's FAJ article "The Longevity Annuity: An Annuity For Everyone?"
The retirement conundrum is how to "turn a pool of assets into a stream of retirement income."
Academics says annuities are the way to go. People don't like annuities and the advisory industry doesn't like annuities. Annuities are too complicated, too expensive, and force you to give up your assets.
The research indicates that a deferred annuity (as distinct from an immediate annuity) is optimal for retirees unwilling to fully annuitize. For a typical retiree, allocating 10-15% of wealth to a deferred annuity set to start late in retirement creates spending benefits comparable to an allocation to an immediate annuity of 60% or more.
It was four decades ago that economic theory concluded that individuals who wish to maximize guaranteed spending in retirement should convert all their available assets to an immediate annuity.
Deferred annuities are preferable to immediate annuities because of the well documented behavioral biases in decision making and maximize the insurance benefit per premium dollar.
The benefit of insurance depends upon the cost of insurance to the cost of replacement of the asset insured. You are looking to maximize the benefit per premium dollar (self insurance cost - insurance cost)/insurance cost). 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 must of a discount to self insurance.
Securing spending in the future with bonds (liability matching using zeros) is analogous to setting aside the full replacement cost of the car (or income desired). A zero coupon annuity offers spending in 20 years at nearly a 50% discount to self insurance in the bond market.
Implication: Get retirees or those close to retirement to take some portion of their accumulated assets and purchase a 10, 15, 20, 25 year deferred annuity. They can use the difference to live on (along with social security) until the deferred annuity kicks-in (while using the residual assets as well).
Immediate and deferred annuities just represent a bundle of zero coupon annuities. The difference is that immediate annuities add near term, low value annuity payments to the bundle, ie. they are much more expensive because they are much more likely to be claimed.
The optimal bundle of zero coupon annuities to purchase depends upon the amount of assets the retiree is willing to annuitize.
Uber wealthy don't really need to deal with this issue. Also the poor (those with few liquid assets) and the unhealthy are not good candidates for deferred annuities.
The retirement conundrum is how to "turn a pool of assets into a stream of retirement income."
Academics says annuities are the way to go. People don't like annuities and the advisory industry doesn't like annuities. Annuities are too complicated, too expensive, and force you to give up your assets.
The research indicates that a deferred annuity (as distinct from an immediate annuity) is optimal for retirees unwilling to fully annuitize. For a typical retiree, allocating 10-15% of wealth to a deferred annuity set to start late in retirement creates spending benefits comparable to an allocation to an immediate annuity of 60% or more.
It was four decades ago that economic theory concluded that individuals who wish to maximize guaranteed spending in retirement should convert all their available assets to an immediate annuity.
Deferred annuities are preferable to immediate annuities because of the well documented behavioral biases in decision making and maximize the insurance benefit per premium dollar.
The benefit of insurance depends upon the cost of insurance to the cost of replacement of the asset insured. You are looking to maximize the benefit per premium dollar (self insurance cost - insurance cost)/insurance cost). 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 must of a discount to self insurance.
Securing spending in the future with bonds (liability matching using zeros) is analogous to setting aside the full replacement cost of the car (or income desired). A zero coupon annuity offers spending in 20 years at nearly a 50% discount to self insurance in the bond market.
Implication: Get retirees or those close to retirement to take some portion of their accumulated assets and purchase a 10, 15, 20, 25 year deferred annuity. They can use the difference to live on (along with social security) until the deferred annuity kicks-in (while using the residual assets as well).
Immediate and deferred annuities just represent a bundle of zero coupon annuities. The difference is that immediate annuities add near term, low value annuity payments to the bundle, ie. they are much more expensive because they are much more likely to be claimed.
The optimal bundle of zero coupon annuities to purchase depends upon the amount of assets the retiree is willing to annuitize.
Uber wealthy don't really need to deal with this issue. Also the poor (those with few liquid assets) and the unhealthy are not good candidates for deferred annuities.
Life Cycle Investing in Theory and Practice by Zvi Bodie
Scientific studies of actual financial behavior have revealed people consistently make certain mistakes because of lack of knowledge, faulty logic, cognitive dissonance, and biased statistics.
Practice is far behind theory. Contemporary theory uses multiperiod hedging techniques and contingent claims analysis, while online quant models appear to be ad hoc blends of trial and error Monte Carlo forecasting and Markowitz static mean-variance model of efficient portfolio diversification.
Important insights from modern financial science:
The fraction of an individual's financial wealth optimally invested in equity should "normally" decline with age for two reasons. The first stems from the fact that human capital is usually less risky than equity and that the value of human capital usually declines as a proportion of an individual's total wealth as one ages. Second, at any given age, the greater the flexibility an individual has to alter their labor supply, the greater the amount they will invest in risky assets. Those with more risky human capital should start out with lower levels of risky assets. The complexity of the financial services marketplace is a good reason for the industry to develop more simple, guaranteed return products and for advisors to help clients navigate the shoals.
Economists generally believe that people are made better off when offered more choices, as long as they can always choose what they had before (the value of choice and options). But when people do not have the knowledge to make choices that are in their own best interests, increasing the number of choices does not necessarily make them better off. In fact it may make them more vulnerable to opportunistic salespeople or unqualified professionals. The industry is heavily biased toward equities for the long run.
New Life Cycle Products
Accumulation phase: occupational funds, college accounts, real estate accounts
Retirement phase: escalating annuities, bundled-risk annuities
Escalating annuities provide guaranteed minimum standard of living defined in terms of a flow of lifetime consumption. Payments increase with inflation and with the performance of the market, and increases are locked in for life. (not the same thing as a variable annuity)
People don't like annuities because they lose control of their money.
Practice is far behind theory. Contemporary theory uses multiperiod hedging techniques and contingent claims analysis, while online quant models appear to be ad hoc blends of trial and error Monte Carlo forecasting and Markowitz static mean-variance model of efficient portfolio diversification.
Important insights from modern financial science:
- A person's welfare depends not only on their end of period wealth but also on the consumption of goods and leisure over their entire lifetime.
- Multiperiod hedging (rather than time diversification) is the way to manage market risk over time, ie. buckets.
- The value, riskiness and flexibility of a person's labor earnings are of first order importance in optimal portfolio selection at each stage of the life cycle.
- Habit formation can give rise to a demand for guarantees against a decline in investment income.
- Because of transaction costs, agency problems, and limited knowledge on the part of consumers, dynamic asset allocation will and should become an activity performed by financial intermediaries, rather than by retail customers (the value add of advisors).
- Measure of welfare: lifetime consumption of goods and leisure (vs wealth).
- Time frame: Many periods where stocks are risky in short and long term (vs single period where stocks seem safe in long run)
- Risk management: precautionary saving, diversification, hedging, insuring (vs precautionary saving, diversification)
- Quant model: dynamic programming and contingent claims analysis (vs mean variance efficiency and Monte Carlo simulation)
- Capital market expectations: inferred from current prices, eg. swaps curves and implied volatilities (vs based on historic statistics)
The fraction of an individual's financial wealth optimally invested in equity should "normally" decline with age for two reasons. The first stems from the fact that human capital is usually less risky than equity and that the value of human capital usually declines as a proportion of an individual's total wealth as one ages. Second, at any given age, the greater the flexibility an individual has to alter their labor supply, the greater the amount they will invest in risky assets. Those with more risky human capital should start out with lower levels of risky assets. The complexity of the financial services marketplace is a good reason for the industry to develop more simple, guaranteed return products and for advisors to help clients navigate the shoals.
Economists generally believe that people are made better off when offered more choices, as long as they can always choose what they had before (the value of choice and options). But when people do not have the knowledge to make choices that are in their own best interests, increasing the number of choices does not necessarily make them better off. In fact it may make them more vulnerable to opportunistic salespeople or unqualified professionals. The industry is heavily biased toward equities for the long run.
New Life Cycle Products
Accumulation phase: occupational funds, college accounts, real estate accounts
Retirement phase: escalating annuities, bundled-risk annuities
Escalating annuities provide guaranteed minimum standard of living defined in terms of a flow of lifetime consumption. Payments increase with inflation and with the performance of the market, and increases are locked in for life. (not the same thing as a variable annuity)
People don't like annuities because they lose control of their money.
What Rate of Return Can You Reasonably Expect by Peter Bernstein
Latest FAJ looks at retirement issues on its 70th anniversary.
Peter Bernstein took a look at stock and bond returns over a two hundred year period to try and figure out whether there was a "basic return" that could be expected for each asset class. He normalized his analysis to take account of starting and ending multiples and yields to ascertain what the return was over those periods.
His basic conclusion was that stock returns exhibited a mean nominal basic return of 9.6% with a standard deviation of 1.6% and some mean reversion elements.
With regard to bonds, the outcome was much less conclusive. The mean nominal basic bond return came to 4.9% with a standard deviation of 2.3%, but there a wide band of uncertainty associated with the data and in fact he concluded we could have no confidence in expecting the nominal basic return because inflation would surprisingly pop up (investors were slow to respond to changing inflation environments) and there was no pattern to the returns (little credence can be attached to what anybody has to say about what the real what the real long term rate of interest should be, has been, or will be in the future over the long run). About the only thing we can say for bond holders is they can make con judgments about future returns beyond the duration of the particular instrument they happen to hold at any given moment.
Bottom-line: long run equity returns were more predictable than long run bond returns (with even greater application for real returns). With equities one can at least conjecture whether the market is high or low (based on recent returns), with the bond market there is no such opportunity.
He concludes that stocks are fundamentally less risky than bonds, not only because their returns have been consistently higher than those of bonds over the long run but also because less uncertainty surrounds the long term return investors can expect on the basis of past history.
Peter Bernstein took a look at stock and bond returns over a two hundred year period to try and figure out whether there was a "basic return" that could be expected for each asset class. He normalized his analysis to take account of starting and ending multiples and yields to ascertain what the return was over those periods.
His basic conclusion was that stock returns exhibited a mean nominal basic return of 9.6% with a standard deviation of 1.6% and some mean reversion elements.
With regard to bonds, the outcome was much less conclusive. The mean nominal basic bond return came to 4.9% with a standard deviation of 2.3%, but there a wide band of uncertainty associated with the data and in fact he concluded we could have no confidence in expecting the nominal basic return because inflation would surprisingly pop up (investors were slow to respond to changing inflation environments) and there was no pattern to the returns (little credence can be attached to what anybody has to say about what the real what the real long term rate of interest should be, has been, or will be in the future over the long run). About the only thing we can say for bond holders is they can make con judgments about future returns beyond the duration of the particular instrument they happen to hold at any given moment.
Bottom-line: long run equity returns were more predictable than long run bond returns (with even greater application for real returns). With equities one can at least conjecture whether the market is high or low (based on recent returns), with the bond market there is no such opportunity.
He concludes that stocks are fundamentally less risky than bonds, not only because their returns have been consistently higher than those of bonds over the long run but also because less uncertainty surrounds the long term return investors can expect on the basis of past history.
Thursday, February 12, 2015
Time Diversification Resurrected
Following on from the prior post taken from Kritzman's article on time diversification in the Financial Analysts Journal.
Here are a few reasons why you might still condition your risk posture on your investment horizon, even though you accept the mathematical truth about time diversification:
(1) You may not believe that risky asset returns are random. If returns revert to their mean, then the dispersion of terminal wealth increases at a slower rate than implied by a lognormal distribution. If you are more averse to risk than the degree of risk aversion implicit in a log wealth utility function, then a mean reverting process will lead you to favor risky assets over a long horizon, even if you are indifferent between a riskless and a risky asset over a short horizon.
(2) You might believe that the extremely bad outcomes required to justify the irrelevancy of time diversification would result from events or conditions that would have equally dire consequences for the so called riskless asset, especially if you measure wealth in consumption units.
(3) Even if you believe that returns are random, you might still choose to accept more risk over longer horizons than over shorter horizons because you have more discretion to adjust your consumption and work habits. The argument against time diversification assumes implicitly that your terminal wealth depends only on investment performance (poor assumption).
(4) You have a discontinuous utility function.
(5) You are irrational.
Here are a few reasons why you might still condition your risk posture on your investment horizon, even though you accept the mathematical truth about time diversification:
(1) You may not believe that risky asset returns are random. If returns revert to their mean, then the dispersion of terminal wealth increases at a slower rate than implied by a lognormal distribution. If you are more averse to risk than the degree of risk aversion implicit in a log wealth utility function, then a mean reverting process will lead you to favor risky assets over a long horizon, even if you are indifferent between a riskless and a risky asset over a short horizon.
(2) You might believe that the extremely bad outcomes required to justify the irrelevancy of time diversification would result from events or conditions that would have equally dire consequences for the so called riskless asset, especially if you measure wealth in consumption units.
(3) Even if you believe that returns are random, you might still choose to accept more risk over longer horizons than over shorter horizons because you have more discretion to adjust your consumption and work habits. The argument against time diversification assumes implicitly that your terminal wealth depends only on investment performance (poor assumption).
(4) You have a discontinuous utility function.
(5) You are irrational.
Time Diversification
As a mathematical construct time diversification is a fallacious concept.
As a conceptually appealing rule of thumb, time diversification is intuitively appealing.
From Kritzman's Financial Analyst Journal article 1994:
Time diversification is the notion that above average returns ten to offset below average returns over long horizons. Specifically, if returns are independent from one year to the next, standard deviation of annualized returns diminishes with time, ie. the distribution of annualized returns consequently converges as the investment horizon increases.
Paul Samuelson critique: although it is true that the annualized dispersion of returns converges toward the expected return with the passage of time, the dispersion of terminal wealth also diverges from the expected terminal wealth as the investment horizon expands. This result implies that, although you are less likely to lose money over a long horizon than over a short horizon, the magnitude of your potential loss increases with the duration of your investment horizon.
According to the critics of time diversification, if you elect the riskless alternative when you are faced with a three month horizon, you should also elect the riskless investment when your horizon equals ten years, or twenty years, or any duration.
This criticism applies to cross sectional diversification (ie. 1 asset vs 10 asset portfolio) as well as to temporal diversification.
Over time the growing improbability of a loss is offset by the increasing magnitude of potential losses.
The critique is based upon the following conditions holding:
(1) Your risk aversion is invariant to changes in your wealth.
(2) You believe that risky returns are random.
(3) Your future wealth depends only on investment results.
Risk aversion implies that the satisfaction you derive from increments to your wealth is not linearly related to increases in your wealth. Rather, your satisfaction increases at a decreasing rate as your wealth increases.
Financial literature commonly assumes that the typical investor has a utility function equal to the logarithm of wealth. Based on this assumption, it can be demonstrated numerically why it is that your investment horizon is irrelevant to your choice of a riskless versus a risky asset.
As a conceptually appealing rule of thumb, time diversification is intuitively appealing.
From Kritzman's Financial Analyst Journal article 1994:
Time diversification is the notion that above average returns ten to offset below average returns over long horizons. Specifically, if returns are independent from one year to the next, standard deviation of annualized returns diminishes with time, ie. the distribution of annualized returns consequently converges as the investment horizon increases.
Paul Samuelson critique: although it is true that the annualized dispersion of returns converges toward the expected return with the passage of time, the dispersion of terminal wealth also diverges from the expected terminal wealth as the investment horizon expands. This result implies that, although you are less likely to lose money over a long horizon than over a short horizon, the magnitude of your potential loss increases with the duration of your investment horizon.
According to the critics of time diversification, if you elect the riskless alternative when you are faced with a three month horizon, you should also elect the riskless investment when your horizon equals ten years, or twenty years, or any duration.
This criticism applies to cross sectional diversification (ie. 1 asset vs 10 asset portfolio) as well as to temporal diversification.
Over time the growing improbability of a loss is offset by the increasing magnitude of potential losses.
The critique is based upon the following conditions holding:
(1) Your risk aversion is invariant to changes in your wealth.
(2) You believe that risky returns are random.
(3) Your future wealth depends only on investment results.
Risk aversion implies that the satisfaction you derive from increments to your wealth is not linearly related to increases in your wealth. Rather, your satisfaction increases at a decreasing rate as your wealth increases.
Financial literature commonly assumes that the typical investor has a utility function equal to the logarithm of wealth. Based on this assumption, it can be demonstrated numerically why it is that your investment horizon is irrelevant to your choice of a riskless versus a risky asset.
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