The Distribution of Wealth

February 3, 2011

When you can turn on the television and watch riots overseas on a live feed, it’s a little freaky.  Some of what is going on is clearly political, but often politics have their roots in money and economics.  One of the things that Americans constantly worry about in this country is the distribution of wealth–why do the rich always seem to get richer, and what happened to the middle class?  Will economic inequality eventually result in social upheaval?

This article from the New York Times is a reminder of how good we have it.  It shows the comparative purchasing power distributions in the U.S., India, China, and Brazil.  In each country, there are very wealthy people.  In each country, there are poor people.  But the “poor” people in the U.S. are about as poor as the richest 10% of people in India!  An amazing visual:

Source: New York Times/Branko Milanovic

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The Entitlement Problem

January 11, 2011

From Global Economic Analysis, a federal look at what is a global phenomenon.

Source: Global Economic Analysis, Congressional Budget Office

Here is the operative problem:

The main point is from now until 2020, we could eliminate 100% of all federal non-defense discretionary expenditures and still run a deficit.

In other words, cutting out waste, fraud, and abuse will fall way short.  Entitlement programs will need to be cut.  And while entitlement programs are the biggest part of the federal budget, debt service is a rapidly growing slice too.

This process is playing out in developed economies everywhere–Greece, Ireland, Portugal, Japan, Illinois, California, and the entire United States.  Some places will choose to keep  right on spending; others will choose austerity.  These choices could have dramatically different effects on currencies, growth, and ultimately, financial solvency. 

Emerging market countries have defaulted on some of their obligations from time to time in recent memory, but the experience of developed economies being consumed by debt is  something new to most of us–new even to economists.  In the U.S., there is still a vociferous ideological debate between professional economists about the correct path forward.

Ken Rogoff and Carmen Reinhart have written about previous debt-fueled fiscal crises.  In almost all of them, bailouts were initially required, followed by austerity.  If austerity was not imposed, eventually there was some type of default, through partial repudiation of some obligations (like cutting Social Security or state pensions, for example), through inflation, or through outright default.

All of these choices will have investment implications.  Investors will have to be tactically flexible to simultaneously grow their capital and maintain their purchasing power, all the while attempting to avoid catastrophic losses.  Crises create anxiety, but they also create opportunity.  The general public is very turned off to equities and risk in general right now, but rising markets will pull them right back in, so the current condition is likely not permanent. 

If you have excess capital, you are by definition an investor.  How you choose to allocate that excess capital will have a great bearing on your future well-being, so it is imcumbent upon you to make wise choices.  Since no one knows what will happen in the future, the decision framework you select is of critical importance.  We think that trend-following through systematic application of relative strength is the most robust decision framework available.

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Bringing About Great Good

December 31, 2010

Last night I had an opportunity to get to know a person of a quality that I have never before known.  This woman, who must have been in her eighties, left me in awe and in deep thought.  The world has many impressive volunteers who give of their time, talents, and resources for countless worthy causes.  However, I’m not sure how many people there are in the world that would fall into the category of this woman who I sat with for several hours.

Last night, my wife and I volunteered to serve at a homeless shelter.  This particular homeless shelter provided dinner, medical care, clothing, hair cuts, and showers to nearly 200 homeless in our area.  The majority of the homeless had attended such shelters before and knew the flow to the evening.  They knew when to sit at the tables, when to line up for the clothing, where to go for the medical care, when to quietly listen to the “message of hope” from that evening’s speaker, and when to set up a cot to sleep on.  However, there were others who were there for the first time.  It was our responsibility to sit with the unfortunate newcomers to help them get oriented and to give them the information about what resources they could access from the shelter.  I met many people who had fallen on hard times.  Some had mental challenges, some had physical ailments, and some had recently lost their jobs and had run out of options.  Several seemed very bright and capable and I could sense their embarrassment for finding themselves in such a situation.

This eighty-year old volunteer who I found myself sitting next to was completely at ease.  She knew and warmly embraced a number of the homeless.  She whispered in their ears.  I learned that she had spent the last 25 years providing nearly constant service to those in need.  She was a regular at the homeless shelters.  She is a nurse and volunteers on a regular basis to fly to Mexico with a team of medical doctors who provide free medical care for four days each month to long lines of people in need.  Two weeks ago she was serving in an orphanage in Bolivia.  She was leaving at 8 in the morning for another medical trip to Mexico.  Medical service missions have taken her to India, Armenia, and many countries throughout the world.  She spoke of the doctors and pilots who volunteer their services and resources.  This woman seemed happy to give detailed answers to our questions.  I couldn’t help but think that she probably knew that part of her role was to inspire others to join the cause.  However, there was nothing pretentious about her answers.  It became crystal clear that this woman devoted her life to this type of service solely for the purpose of making a positive difference in the lives of those who suffer.  Did I mention this woman must have been in her eighties?

Among the questions that I had for this woman were questions about the funding for the shelters and the medical missions.  I learned enough to know that there is need far greater than the level of current funding.  Money truly is power.  It is not everything, because money without anything else is nothing.

Being in the wealth management business, by definition, means that we serve a fortunate clientele who control great wealth.  That wealth can be used for many purposes, some of which are very noble.  After my experiences last night, I don’t know that I have ever felt better about what I do for a living.  Our team (and all other successful money managers) have honed a skill set that has earned us the opportunity to manage large amounts of wealth that have been entrusted to us and to seek to help this money grow to much larger sums of wealth, with the knowledge that much of this money may be put to some very noble uses over time.  Money truly is power, and great wealth can potentially bring about great good.

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How Not to Balance the Budget

December 15, 2010

I’m not claiming that I have any fool-proof solution to balance the budget, but I was intrigued to read this article in the Wall Street Journal detailing the historical experience of tax increases and spending.  In a conclusion that will surprise no one:

In the late 1980s, one of us, Richard Vedder, and Lowell Gallaway of Ohio University co-authored a often-cited research paper for the congressional Joint Economic Committee (known as the $1.58 study) that found that every new dollar of new taxes led to more than one dollar of new spending by Congress. Subsequent revisions of the study over the next decade found similar results.

We’ve updated the research. Using standard statistical analyses that introduce variables to control for business-cycle fluctuations, wars and inflation, we found that over the entire post World War II era through 2009 each dollar of new tax revenue was associated with $1.17 of new spending. Politicians spend the money as fast as it comes in—and a little bit more.

I put the good part in bold.  Clearly, we need some way to encourage savings and investment–consumption doesn’t seem to be a problem!

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Look Ma, No Risk!

November 29, 2010

In a recent article in Pensions & Investments, Robert Pozen took the industry to task for recent changes in the allocation of pension plans:

As corporate pension plans have shifted away from equities, they have substantially increased their allocations to high-quality bonds after the financial crisis. Most of this increase was concentrated in U.S. Treasuries with maturities of one to 10 years. In making this move to high-quality bonds, the trustees of corporate pensions were trying to “de-risk” their portfolios. In their view, more bonds would mean lower annual volatility for their portfolios, which would in turn minimize future corporate contributions to the plans.

Yet this reduction in annual portfolio volatility comes with a price — lower long-term returns. The expected returns of U.S. corporate pension plans now are around 8% per year. The average corporate pension plan was 82% funded in 2009, and that will reportedly fall to 75% by the end of 2010.

Risk is like matter in physics–it cannot be created or destroyed.  Like matter, it just changes form.  Pension funds have not actually “de-risked.”  They have reduced volatility and simultaneously increased their risk of long-term underperformance, not to mention drastically increasing their interest rate risk.  As Pozen points out, this is a big problem because of the terribly underfunded state of pensions today:

Like their corporate counterparts, public pension plans are facing large funding deficits. These plans were on average about 80% funded in mid-2009, and at least eight state plans were less than 65% funded. Even these estimates are overstated because of the unique accounting rules applicable to public pension plans. If public plans were subject to standard pension accounting, their funding deficits would be 20% to 30% larger.

Up to now, public pension plans have been allowed to compute their deficits based on the returns they expect from their portfolios, rather than relevant current interest rates. The Governmental Accounting Standards Board has proposed that public plans begin to use current interest rates of high-quality municipal bonds. However, this proposal would be confined to calculating cash flows needed to eliminate a plan’s current deficit. It would still allow expected returns to be used for valuing existing plan assets.

Given these accounting rules, it is not surprising to see that public pension plans have set expected returns of 8% per year for their investment portfolios.

Wow!  I’d like to be able to report my performance based on my expected return too!  (I added the italics, just because it is so mind-boggling.)  Why stop at 8%?  Public pension plans could eliminate their funding issues simply by assuming that would earn 20% per year!  Besides the bogus accounting for funding deficits, Pozen points out the other flaw in “de-risking:”

To achieve these returns, public pension plans have decreased their equity allocations and instead allocated much more to alternative investments. In other words, public pension plans have not “de-risked” their portfolios by replacing stocks with bonds. Instead, public plans have “up-risked” their portfolios by replacing stocks with hedge funds and private equity funds.
Geez!  Apparently stocks are so risky that pensions would rather own high-fee leveraged hedge funds and high-fee private equity funds!  With the lack of transparency of many of these funds, it simply makes it more likely that some state pension will end up the victim of a mini-Madoff at some point.
This is classic investor behavior—emotional asset allocation.  After you’ve been burned, run away.  Unfortunately, the decisions made by public pension plans affect all of us, either as beneficiaries or as the taxpayers doing the funding.  The urge to reduce risk has led to greater risk.  And it’s prevented many pension plans from earning good returns in relative strength strategies this year.

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Maybe This is Why Warren Buffett is Always So Jovial

July 7, 2010

It turns out that money can buy happiness.  Well, maybe not directly–but researchers were surprised when they examined data from a Gallup survey.  According to a Wall Street Journal synopsis of the results:

A new analysis of Gallup World Poll data, surveying 136,000 people across 132 nations from 2005 to 2006, suggests that income is much more highly correlated to happiness (or at least a form of it) than previously thought.

Even some experts in behavioral finance were surprised:

What was interesting about the study was how universal the desire for financial success was across the world. “People in Togo and Denmark have the same idea of what a good life is, and a lot of that has to do with money and material prosperity,” Daniel Kahneman, professor emeritus of psychology and public affairs at Princeton University, told the Washington Post. “That was unexpected.”

To me, it’s not so surprising.  If you work in the financial services field, you see firsthand how hard people strive to achieve financial success for themselves and their families.  When they fail, they are miserable.

Warren Buffett, on the other hand, has a lot to be happy about.  He has lifelong buddies (Charlie Munger), new friends (Bill Gates),  influence, and financial security.  Although he might be less happy if his friends and influence went away, he probably wouldn’t be miserable because he would still have financial security, Cherry Coke, and the t-bones at Gorat’s.

Source: Yahoo! News

Financial security is a much more important financial good than people give it credit for.  Like most quantities, it seems to be relative.  A retired executive might feel pinched or deprived at a different level of retirement income than a retired janitor, for example.  This psychological insight led some clever financial service professional in the hazy past to popularize the “70% of income in retirement” rule of thumb, which is completely relative.  There’s probably a paper waiting to be written on the S-curve of satisfaction with relative retirement income levels–above (and below) certain thresholds, satisfaction is probably reliably high (or low).  In between, there may be a steep incline, where rising assets equate with rising happiness.  At this point in the curve–where most of us are–the impact of good or bad financial advice can be huge.

Perhaps financial advisors can’t do much about the current worldwide financial malaise, but they certainly have the ability to influence and improve their clients’ finances through the encouragement of savings and the pursuit of sensible investment policies.

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The Naked Truth About Capital Markets

May 5, 2010

Here is the naked truth: capital markets are designed to reallocate money from dumb people to smart peopleIf that weren’t true, smart people wouldn’t play.  Smart people don’t play unless they have a probability of winning.  For example, smart people don’t tend to play the lottery.  (If you have ever wondered why the PowerBall winner is always a nitwit and flat broke again in three years, now you know.)  This might be the real reason that the rich continue to get richer.  I have a high degree of conviction that if one took all of the money in the world and split it equally among all of its inhabitants, ten years later the people who have the money now would be likely to have the money again, simply because they understand what it takes to be successful in capital markets.  Although I wrote the first sentence of this article for shock value, the naked truth is actually quite comforting.

Now, when I use the word “smart,” in the context of capital markets, I’m not talking about IQ at all.  You don’t have to be a university professor or have an extensive financial background to be smart.  In fact, it’s even possible those things could work against you.  Rather, being smart about the capital markets requires a very specific skill set consisting of three things.

1) KnowledgeSmart means understanding which return factors are likely to outperform over time.  If you plow through all of the investment literature as we have, you will see that it largely boils down to two return factors: relative strength and value.  Both are robust and work in numerous formulations.  Although we use a proprietary relative strength factor, there’s no one formulation that is magic.  Success is mainly a matter of consistently exposing the portfolio to the return factor.  Pick one–or both–because they complement one another extremely well.  If you have just this small nugget of knowledge, you are miles ahead of the game.

2) Discipline.  Smart means understanding that execution is more important than knowledge.  It’s not enough to have the knowledge of which return factors will likely work over time.  You need to have a systematic method of exposing the portfolio to your chosen return factor in a disciplined fashion.  You cannot waver or let your emotions get in the way–and believe me, your fear will try to run you into the ditch during every correction.  Maintain your emotional balance.  You must remain resolute up to and including the end-of-the-world scenario.  Maybe the world will end and I will be wrong about all of this.  Probably not.  If you consistently expose your investment capital to a good return factor in a disciplined way, you are light years ahead of your competition.

3) PatienceSmart means understanding that great patience is required.  Most investors, I suppose, would like to get rich quick.  That’s unlikely to happen.  In a karmic kind of way, the universe actually makes you earn your money by going through trials and tribulations.  The E-ticket ride you get in capital markets is never easy, and often not pleasant.  Both relative strength and value go in and out of favor as return factors, sometimes slipping into eclipse for years at a time.  Great investors are enveloped with a kind of Zen-like calmness.  They are neither their profits nor their losses.  You can’t take giddy mental ownership of your equity high-water mark or despair at your drawdown during a correction.  Stay centered and let compounding work its magic.  The journey of a thousand miles really does begin with a single step, but don’t forget that it also takes a long, long time to walk a thousand miles!

Investors with a small kernel of knowledge and oodles of discipline and patience are likely to see money flow their way over time–that’s how capital markets are designed to work.  As you can see, “smart” relates much more to temperament than IQ.  I would go so far as to say the temperament piece is probably the most important.  While most investors engage in dumb behaviors like  jumping from questionable method to method, adding money when they feel good about their results, pulling money out when they are temporarily panicked, measuring results over a short period of time, hiring and firing managers like a revolving door, and generally running about like a chicken with its head cut off, smart investors pursue reliable return factors with discipline and immense patience.  If you take the perspective that the market is designed to take your money when you do something dumb, investors would be well-advised to think about their behavior carefully before every portfolio change.

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Theory versus Practice

April 22, 2010

William Sharpe, a Nobel Prize winner in Economics, wrote a recent paper about how the 4% retirement spending rule is inefficient.  MarketWatch had a recent feature discussing his paper–and more than anything about the spending rule itself, the piece made me think about how large the gulf in finance is between theory and reality.  As Yogi Berra is reported to have quipped, “In theory, there’s no difference between theory and practice.  But in practice, there is.”  (There’s a link to Mr. Sharpe’s paper in the MarketWatch article.)

The 4% retirement spending rule is clearly a rule of thumb, and I am sure that most practitioners modify it depending on the client’s circumstances.  (We prefer a 3% spending rule, and I’ve seen other rules based on the yields available.  For example, one paper I read advocated a spending rule of 125% of the yield on the S&P 500, arguing that you can spend more when yields are high than when they are low.)  Mr. Sharpe says the 4% spending rule is too simplistic.  He’s right–rules of thumb are supposed to be simplistic.  But no one using it is really going to mistake it for the be-all-and-end-all.

An extraordinarily complex retirement spending rule that takes many complicated factors into account is just as likely–or maybe even more likely–to fail.  The real world is a much messier place than an ivory tower.  Things that seem like good ideas in theory, even to Nobel Prize winners (I’m thinking Long-Term Capital Management here), often fail miserably in practice. 

The reason that complicated things never work in real life is that there are too many unknowns in the equation.  In modern portfolio theory, market returns and correlations between assets are not stable, so the whole thing is essentially unworkable.  A perfect retirement spending rule could be made for each client if the practitioner only knew exactly what their investments would earn each year and how long the client would live.  That’s not going to happen, so we are left with rules of thumb.

The most important thing about any modeling approach is how robust it is.  If you jiggle around the inputs, does it fail miserably or does it continue to work?  Is it based on historical inputs which are guaranteed to change, or does it just adapt without making assumptions?  We have strong feelings about this.  The fewer factors a modeling approach uses, the less likely it is to be knocked down by some unanticipated factor interaction.  We use a single-factor model and test rigorously for robustness (you can read our white paper on Bringing Real-World Testing to Relative Strength here).  Academic finance would be much more useful to real investors if they kept in mind another saying:  it is better to be approximately right than precisely wrong.

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Investing for Income

April 16, 2010

As the front end of the baby boomers hit retirement age, investing for income has become their mantra.  Retirees are often sold terrible investments because of their known propensity to lunge at income the way a starving fish attacks a baited hook.  But is investing for income desirable, or even possible?  Let’s take a look at the income possibilities from bonds, stocks, and alternatives.

Bonds are boring and safe, and are usually the first place investors go for income–except that with current interest rates, there isn’t much income available.  Most retirees can’t live on 2-year Treasury yields of 1.04%, and moving out to the 30-year Treasury at 4.72% brings with it a significant chance of getting hurt by inflation.  Yields on junk bonds (euphemistically known as high-yield bonds) are higher, but that crosses over from investing for income to its less glamorous cousin, “reaching for yield.”  Junk bonds might work for a while, as long as the economy is in recovery mode, but are probably not a long-term solution for a retiree.  As the saying goes, “More money has been lost reaching for yield than at the point of a gun.”

Many investors have looked to the stock market for dividend yield.  Doug Short has a nice piece on the disappearing yields in stocks on his excellent site.  The chart below is taken from his article.  Stock prices have been rising, but dividend yields have been going the other direction.

Click to enlarge. Source:

The traditional high-dividend sectors for investors were always banks, oil stocks, utilities, and REITs.  When stock prices plunged in 2008, many banks eliminated or severely slashed their dividends.  Some REITs had the same problem.  Oil stocks and utilities don’t have nearly the dividend yields they used to.  All of the dividend cuts and reductions caused the high-yielding equities to do worse than the general market.  (See the chart below for a comparison of the S&P 500 to the Dow Jones Select Dividend Index ETF.)

Source: Yahoo! Finance

Alternatives range from MLPs (typically finite lives and unstable income streams) to all sorts of structured products.  This morning someone sent me an offering flyer for a 12-year 8% CD, where the quarterly rate is based on the slope of the yield curve.  8% was the cap rate, but it could drop to 0% if the yield curve flattened out.  I’m not sure Mrs. Jones is ready to speculate with derivatives.

All in all, it appears that the income investor has hit a rough patch and there seems to be no easy way out.  I’m going to let you in on a secret that very few investors know: capital gains can be spent just as easily as dividends.  Ok, that’s not really a secret at all, but many investors act like it is.  They chase yield so they can spend the income, but really, total return is all that matters.

Segmentation, like the distinction investors often impose between income and principal, is a natural function of the mind.  Many retirement planners have been using this human tendency to segment things by presenting a retirement income solution that consists of a number of buckets, a solution that is generally well-received by clients.

The first bucket is the liquidity bucket, where spending will be drawn from.  The second bucket is the income bucket, which is typically put into some kind of fixed-income investment.  The third bucket is the growth bucket.  By segmenting the growth portion, the investor might be more willing to leave it alone as it gyrates with the market.

When there is a particularly good quarter or good year, the growth bucket can be trimmed back and the proceeds “deposited” into the liquidity bucket.  Obviously, you could use any number of buckets depending on how finely you choose to segment the investment universe.  The relative size and specific composition of each bucket would be determined by the client’s situation.   Most often, all of this can be done within one account.  The buckets are mental, but they help separate the investments and their specific purpose in the client’s mind.

When viewed in the context of buckets within a single account, it becomes quite apparent that total return is what counts.  Investing for income may be a misnomer; investing for total return is the real deal.

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A not so Happy Valentine’s Day

February 17, 2010

What could be more appropriate on Valentine’s Day than an article about being in the red?  Tom Raum of Associated Press published an alarming article Sunday on why US debt will keep growing even with recovery.  It looks like there are some very difficult choices ahead for voters and their representatives.  Current projections have our national debt exceeding our GDP within the next few years.  In addition, the interest on that debt will be 80% of the federal budget within a decade.

Needless to say, if the government does not act on this problem, the financial markets certainly will at some point.  For example, Reuters recently reported that some of China’s generals have called for using our debt as a weapon against us by having their government sell off U.S. Treasury bonds if we sell arms to Taiwan.

We do not profess to know all that is needed to solve this problem, although obviously we need to throttle back the government gravy train.  As responsible voters, we need to contact our representatives to get them to take the budget problem seriously.  But as investors, we need to have enough flexiblity in our investment policy to position our assets to protect them if our representatives don’t act.

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Politics 101

February 2, 2010

Last week I read something in the WSJ that made my head spin.

A bill was voted down in the Senate which would have created a bipartisan commission whose job would be to tackle the enormous budget deficit the United States is currently running.  The key words here are bipartisan commissionThis article, taken from the Lawrence Journal, sums up a few of the constraints the commission would have had, which would have kept either party from gaining unchecked authority in balancing the US budget.

The failed bill wasn’t a mandate on how to solve the deficit; it was a bill about setting up a framework of discussion for solving the deficit.  There’s a difference between the two, and the bill would have allowed many paths to a solution.

The deficit clearly needs to be addressed before the U.S. ends up with a forced fiscal austerity program like Greece.  If you want to get a sense for how rapidly our public debt is growing, here’s a website devoted to tallying our nation’s debt: Debt Clock.  (Be sure to hit Refresh a couple times to get a sense of the pace.)  It’s scary and breathtaking.

Anyway, back to the bill voted down in the Senate.  Apparently, six  Senators co-sponsored the writing of the bill, put their name on the bill, and then voted “No” during the roll-call. It might help to repeat the sentence a few times to appreciate the full effect.  The behavior of our elected officials is quite discouraging.  How can anyone justify even one second of the time these six Senators spent working on this bill, only to vote against it during the roll call?  What is the point?  I don’t think there is an easy answer to the deficit problem, but it doesn’t seem like voting against your own bill is part of the solution!

To solve a problem, it seems necessary to first identify the problem’s cause.  If your books are deeply in the red, you must either cut costs, sell assets, or raise revenues.  None of the options is an easy way out; eventually, somebody will have to foot the bill.  It’s not going to be a pleasant process for anybody, but maybe things would be more efficient if our government learned to collaborate a little more effectively.

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Financial Crisis Inquiry Commission

January 13, 2010

The big news of the day is that the Financial Crisis Inquiry Commission kicked off proceedings in earnest today.  Apparently they are planning to spank all of the CEOs of the major banks, or at least give them a timeout and take away their milk and cookies.

Both FT Alphaville and The Atlantic had interesting articles about testimony that was heard or should be heard.

The FT Alphaville article is about rethinking the incentives embedded in the system, which seems like a really good idea regardless of one’s political persuasion.  The Atlantic’s article is about the amount of leverage that banks were allowed (and still are) to take on—quite eye-opening.

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Bureaucracy–and its Debt–Kills

January 5, 2010

Economic geniuses Carmen Reinhart and Kenneth Rogoff have authored another paper on the pile up of public debt and its effect on economic growth–based on 200 years of data.  (Note to Congress: It’s so refreshing to see actual evidence for economic policy recommendations!)  The Wall Street Journal has a synopsis of their argument here.

One finding: Countries with a gross public debt debt exceeding about 90% of annual economic output tended to grow a lot more slowly. For advanced countries above the 90% threshold, average annual growth was about two percentage points lower than for countries with public debt of less than 30% of GDP.

The results are particularly relevant at a time when debt levels in the U.S. and other countries at the center of the financial crisis are rapidly approaching the 90% threshold. Gross government debt in the U.S., for example, stood at 85% of GDP in 2009 and will reach 108% of GDP by 2014, according to IMF projections.

Unsurprisingly, economies engaged in paying off the cost of massive government bureaucracies and unrestrained public spending have a hard time being productive.  It’s just difficult enough paying off the debt.  With the U.S. projected to hit the 90% threshold shortly, it’s time to diversify your portfolio.

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Right on Schedule

December 14, 2009

The Commission on Bedget Reform has come up with a proposal to shrink the Federal deficit.  This article from the Wall Street Journal gives some of the highlights.  Of course, there’s a catch:

They recommend waiting until 2012 to implement policy changes to avoid harming their re-election prospects the economic recovery.

The strike-through is mine, obviously.  But the economic recovery is a pretty good cover story. 

In other words, balance the budget–just not now.

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We Are All Bankers Now

November 10, 2009

Back in May, the WSJ ran a piece about the “vanishing millionaires” of Maryland.  In a nutshell, the state government of Maryland mandated an additional tax on households in the highest tax brackets, in an effort to raise state tax revenues. Surprise! There were a few thousand LESS millionaires living in the state come tax time, and tax revenues fell drastically.

And today we have “Praying for Big Bank Bonuses.”

File this under “I” for Irony.  All those big, bad bonuses are actually good for something…tax revenues for state governments running massive deficits. The article approximates that “one in five New York state tax dollars come from Wall Street.”  In New Jersey, the incumbent governor was just booted out, in part because of his inability to wrestle a deficit projected to reach $5 Billion by the next year.  The numbers just aren’t adding up.

There are plenty of ways to spin this story. Here’s mine!

From Wikipedia: “Sometimes unintended consequences can far outweigh the intended effect.”

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Chaotic Evolution

November 4, 2009

John Kay of the Financial Times has recently written a nice article explaining why the chaos of free markets leads to significantly better results than centrally-planned economies, as has been tried and failed in the Soviet Union, East Germany, Nigeria,  and Haiti (and periodically makes inroads in economies found in Great Britain, the United States, and others.)

Kay explains that free markets generate superior results because:

Prices act as signals – the price mechanism is a guide to resource allocation rather than central planning. Markets are a process of discovery – an economy adapts to change through a chaotic process of experimentation. The third element is the capacity of the market to bring about diffusion of political and economic power. This is the most effective way to protect society from rent-seeking – a culture in which the principal route to wealth is not creating wealth, but attaching oneself to wealth created by others…

… Centralized systems experiment too little. They find reasons why new proposals will fail – and mostly they are right. But market economies thrive on a continued supply of unreasonable optimism. And when, occasionally, experiments succeed, they are quickly imitated.

If market economies are better at originating and diffusing new ideas, they are also better at disposing of failed ones. Honest feedback is not welcome in large bureaucracies, as the UK government’s drug advisers can testify. In authoritarian regimes, such reporting can be fatal to the person who delivers it.

Disruptive innovations most often come to market through new entrants. The health of the market economy depends on constant replenishment of ideas, often from unpredicted sources. If you had been planning the future of the computer industry in the 1970s, would you have asked Bill Gates and Paul Allen? If you had been planning the future of European aviation in the 1980s, would you have asked Michael O’Leary or Stelios Haji-Ioannou? If you had been planning the future of retailing in the 1990s would you have asked Jeff Bezos? Of course not: members of the politburo, cabinet or large company board would have consulted grey men in suits like themselves.

I wholeheartedly agree with Kay’s macro-economic analysis.

Furthermore, this line of logic also underpins the process that we employ to manage money.  Price (specifically relative price performance) acts as a signal to guide portfolio allocation.  We rely on rules-based relative strength models to sort out the winners from the losers from a given investment universe.  We buy any security that meets our criteria and sell every security out of the portfolio that fails to maintain strong relative strength.  There are no committee meetings where the portfolio managers debate the merits of the stocks before making a decision.  There is no emotional attachment to current holdings.  Rather, the models, which we have designed,  execute a plan that is based on a method with a track record of generating superior investment results over time.  A large percentage of our trades turn out to be either losers or just market performers.  To the uninitiated, the process can indeed appear to be chaotic.  It certainly leads to inferior investment results over certain periods of time (just like free-market economies periodically experience difficulty.)  It is only a minority of our trades that turn out to be the big long-term winners.  Frequently, the trades that end up generating the biggest gains are trades that made us scratch our heads when they were added to the portfolio.

It turns out that perceived chaos, on both the macro-economic level and on the portfolio management level, leads to very desirable outcomes over time.

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Rethinking the 401k

October 22, 2009

Time recently carried a long article that, depending on your point of view, is an expose of the problems with 401k plans or a hatchet job.  The article relates the problems with 401ks by telling the stories of a number of retirees from Occidental Petroleum, which was one of the first large corporations to adopt this type of defined contribution plan.  The writers contend that in most cases, the employee would have been better off in a traditional defined benefit pension plan.  So let’s take a look at their criticisms of the 401k.

The first retiree case study is Robert Shively.  He is now age 68 and holds a part-time job.  The article suggests that he would have been better off with a fixed $1308/month pension than his current pension of $405/month plus his $70,000 remaining 401k balance.  A lot of information is missing, so it’s hard to tell what the deal is.  We don’t know when Mr. Shively retired, what his original 401k balance was, what percentage of his income he was saving in his 401k while he was working, and how much he is spending.  So despite the article’s contention, I think the information here is inadequate to make a reasonable judgement.

The second retiree case study is Ernie Lucantonio.  He retired in 2005 at age 57 with $350,000 in his 401k.  The article implies that he would have been better off with a pension of $3,100/month.  Ernie, too, took a part-time job.  Elsewhere in the article, it states that Mr. Lucantonio was saving 6% of his salary in his 401k.  So what is the culprit here?  Is it the 401k or is it the fact that the client a) needed to save much more than 6%, probably 10-15%, b) retired early, and c) retired with inadequate savings?  It’s also not clear what Mr. Lucantonio’s spending habits are like because it does indicate that he bought a tricked-out vacation cabin after he retired.  Score: 401k 1, client’s financial planning and acumen 0.

The third retiree case study is Dennis O’Neil.  He also retired early, but the article does not say when.  He is now age 63 and has $500,000 left in his 401k.  The article suggests he would have been better off to have a defined benefit pension payment of $2,200/month.  Mr. O’Neil is worried about running through his 401k in the next decade, and no wonder!  The article says he spends $75,000 per year.  Somehow, no matter how I do the math, the great pension of $2,200/month comes to only $26,400 annually, which would still not even come close to supporting Mr. O’Neil’s spending habits.  (Mr. O’Neil is trying to play the market to stay in the clover–always a clever idea for retirees.)  Again, what is the culprit here?  Is it the 401k or is it the fact that the client a) retired early, b) with inadequate savings, and c) is overspending to an enormous degree?  Score: 401k 2, client’s financial planning and acumen 0.

The article cites the biggest problem with 401ks as the fact that they could drop a lot in the year you decide to retire.  Apparently, risk management and asset allocation do not enter the equation–like maybe it would be a good idea to scale back your risk level in the few years before you retire.  The proposed solution to the 401k crisis is to pay into a plan that will give you a guaranteed income–you put in 6% of your salary and get a guaranteed 26% of your salary in retirement.  Wait a minute here!  Didn’t Mr. Lucantonio save 6% of his salary in his 401k?  If he had had the miracle income guarantee plan suggested by Time, with his pre-retirement salary of “nearly $80,000,” he would be able to draw a guaranteed income of $20,800 ($80,000 x .26) or $1,733/month.  Or alternatively, Mr. Lucantonio could take his stated $350,000 401k balance when he retired and buy an immediate annuity.  I went on to an immediate annuity website to calculate what a joint annuity would be.  Guess what–$1,735/month!  Of course, interest rates were a little higher in 2005 when Mr. Lucantonio actually retired, which likely would have made for a larger payout.  If the annuity did not cover a spouse, the payout is also higher by $200/month or so.  Son of a gun!  The miracle program is apparently already in existence, disguised as an immediate annuity.

Certainly a lot can be done to improve client’s retirement readiness with a 401k.  Help with investment decision-making, counseling on the appropriate savings level, and assistance with asset allocation and risk management are all needed.  And let’s not forget why individuals clamored for 401k plans in the first place: the age of lifetime employment was over and workers were tired of forfeiting pensions with 5-year or 10-year cliff vesting when they changed jobs.  401k plans are portable and always fully vested.

After reading the article carefully, almost every problem these retirees are having has little to do with the structure of the 401k plan.  Almost every problem stems from:

1. inadequate savings rate

2. overspending

3. lack of risk management and/or poor asset allocation decisions as client nears retirement

4. lack of knowledge of other retirement income products

I find it hard to believe that any competent financial advisor would have  suggested retirement, let alone early retirement, to any of these individuals.  And let’s face it: math is math.  If you don’t save enough while you are working, you won’t have enough when you retire.  There’s no magic income guarantee plan that doesn’t exist already.  You might want to read this article, because investors are reading it and they need answers.

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Skin in the Game

October 8, 2009

Most organizations or societies function appropriately when everyone has skin in the game.  Mutual dependence is what makes the world go around.  In tribal societies, the rule is very simple: pitch in and help or we will ban you and you can go hunt on your own.  NFL quarterbacks don’t usually trash their offensive linemen in the media no matter how many times they got sacked on Sunday.  Mutual dependence: one of those scorned linemen might miss a block accidentally on purpose in a later game.  Prior to 1970, investment banks were required to be private partnerships.  Capital was handled carefully because the capital belonged to the partners.  When it is OPM (other people’s money) far less care may be exercised.  Anyone remember 2008?  Even in investment management, Morningstar wants to know how much portfolio managers have invested in their own funds.  Hedge fund managers are often required by prospective investors to have significant investments in their own funds.  The whole point is to discourage abusive behavior on the part of a few members of the organization or society.

The United States is perhaps close to a tipping point in this regard.  According to the latest tax data, 47% of Americans pay no federal income tax.  Those of us who do are effectively subsidizing most of the nation’s spending.  If you have no stake in the system,   it’s much easier to feel good about taking advantage of it.  Wouldn’t everyone be in favor of massive federal bailouts that benefited them if they weren’t paying for any of it?  Doesn’t it make sense to make everyone have some kind of stake in the system, no matter how small?  After all, as Margaret Thacher famously quipped, “The problem with socialism is that eventually you run out of other people’s money.”

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Burning Down the House

August 3, 2009

Watch out! You might get what you’re after.    Talking Heads, Burning Down the House

I was in a bookstore over the weekend where I saw no fewer than six books suggesting that capitalism and our economic system had failed.  The prescription in most cases was more government and more income redistribution.  They system might be broken, but with the way our business and economic incentives are currently structured, I suspect the prescription of more government intervention will not help at all.  The underlying incentives need to be fixed.

Adam Smith’s “invisible hand” is a useful economic concept.  For a moment, let’s strip away all of the idealogy surrounding the invisible hand and get down to the base assumption: people act in their own self-interest.

Market theorists contend that with everyone acting in their own self-interest that markets run economies much better than bureaucrats.  This is stupid.  Bureaucrats contend that markets favor some groups and disadvantage others, so they should be able to step in and fix things.  This is equally stupid.

The only thing the invisible hand guarantees is that people will act in their own self-interest.  That makes the ultimate outcome mainly a matter of creating the proper incentives.  If you have dumb incentives, the invisible hand will run the economy like a moron.  If you have smart incentives, the invisible hand will run the economy like a genius.

Let’s look at a couple of examples.  Let’s say that you have a private investment partnership, like Goldman Sachs or Smith, Barney, Harris, Upham used to be.  On the one hand, the partners are incentivized to maximize their earnings through trading and underwriting.  On the other hand, since the capital in the partnership is their own money, they are also incentivized not to blow up the firm.  This prevents all manner of lousy underwriting deals and insures that trading leverage is managed carefully.  The result is a company that tries to make as much money as possible without destroying the firm.  This is the invisible hand at work with proper incentives.  Everyone is working in their own self-interest, but those interests are balanced.

Now, think for a moment about a modern institution we will call Megabank.  It is public, not private.  Acting in their own self-interest, the traders and investment bankers are still incentivized to maximize their own compensation.  However, the money the trading desk is using does not belong to the traders–it is other people’s money (OPM).  What are the odds that they will overleverage in an attempt to make a huge bonus?  Likewise, what incentive does an investment banker have to underwrite only good deals?  (In fact, the bad deals usually come with bigger fees—bring it on.)  Plenty of employees will act responsibly, of course, but moral hazard has been introduced.  With everyone acting in their own self-interest, the invisible hand has this firm headed for the emergency room.

Think about AIG’s incentives: if they are allowed to underwrite insurance (credit default swaps) that is incredibly profitable because no reserves are required, is it likely they will underwrite a little or a lot?  Think about a homebuyer’s incentive:  tell the truth and stay in your apartment, lie a little (or a lot) and move into a nice house.  Think about a sub-prime lender’s incentive: if they are allowed to offload all of the bad loans through securitization, are they likely to underwrite a little or a lot?  Are they likely to care about the ultimate credit quality or default rates?  With these sorts of incentives in place, what did policy makers think was going to happen?  Now, what would happen if instead they had to eat their own cooking and retain a significant portion of the sub-prime loans on their balance sheet?  Might that change their behavior?  What if, instead of doing same-day exercise and sale of their stock options, executives had to exercise and hold the company stock for three years after their affiliation with the company ended?  Would their stewardship change in any way? 

The problem with the invisible hand is not that it doesn’t work—the problem is that it works incredibly well.  This puts an enormous burden on policy makers to think carefully about how incentives are structured–and about what the ultimate consequences might be.   Congress appears to have a very limited understanding of either the invisible hand or the consequences of incentives.  It’s safe to say that most parents, who have to deal with kids and behavioral incentives all the time, are doing a better job, since most of their children live and become productive members of society. 

I don’t know whether you think this is a brilliant piece of political economy or something so obvious that a fifth-grader could figure it out.  But we, as a society, have apparently not figured it out.  If we decide we want vast national savings, lots of capital formation and innovation, and a clean environment—all of that is probably achievable with properly thought out incentives.  There are always trade-offs, and incentives usually have to include a lot of carrots and a few sticks.  The invisible hand can’t give us everything, but with thoughtful incentives, we can do a lot better than we are doing now.  We don’t have to let the invisible hand sucker punch us.

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