Sunday, June 21, 2009

The Aging of the Uncertainty Principle

As a child growing up in one of the small towns, if you will, neighborhoods, pushed together on the island of Manhattan, I collected railroad timetables. Initially it was the maps that attracted me, depicting routes of the railroads often displaying them quite differently than their competitors. Later I became intrigued with the precision of the times of arrival at the various destinations of different trains. I was told that, at some point, I was able to recite to so-called adults, the fact that currently a train was leaving New York and would arrive at a particular destination at a precise time. Perhaps it was the certainty of these predictions that appealed to me during World War II. (I was blissfully unaware of the reality of train delays.) Later in life I remember spending an entire day at both the Detroit and Geneva airports, waiting for the weather to clear so the scheduled flights could take to the sky. I guess it was then that I learned the wisdom in the saying, “If you have time to spare, go by air.” Only reluctantly have I learned that the precision of timetables masks the uncertainty of arrivals and departures.

One of the most common of all beliefs of politicians, marketers, and analysts of all types, is that demographics dictate the future. There is a calming feeling of certainty being able to make mathematically precise predictions of the number of people of various types who will be alive, consuming so much protein, with a specific percentage employed, etc. Actuaries are paid to predict exactly when our poorly designed social security system will reach the single point of no return. That point is the exact date when the inflow from employment taxes will be surpassed by the outflow of benefits. In theory, the importance of this date is to determine how the government will deliver on promised retirement provisions.

Either inflow has to be raised by one means or another or outflows must be modified. Within the Beltway of Washington, tinkering with social security is considered touching the third rail. (Interesting that this is an illusion going back to the electrification of railroads as well as to present day subways.) The date of this presumed point of no return occurs in 2016. This date was partly determined on the projected proportion of people aged 55 who would continue to work. The last estimate was that only 40% would continue to work. Currently the number is about 55% and expected to go higher due to the decline in retirement savings assets caused by the market and economic declines. This is where my sense in traveling by train or by air is alerted; I believe it is wise to presume some margin of safety regarding expected arrival times. My own estimate is that 75% of Americans will continue to work, and most importantly, pay payroll taxes beyond age 55. In some ways this is an extremely bullish view, for it rests on the assumption that members of the 55 and older set are able to find jobs.

Notice that most headlines or declarative statements at social gatherings are begun with a specific prediction as to a future event, be it sporting, political, or market-related. As we are all just large children, we love the certainty of a prediction delivered with the force of a strong personality. Most investment portfolios, particularly those managed by financial institutions, can be summed up as predictions of a specific future. These predictions provide us assurance that we are acting prudently, and that planned expenditures (or outflow) demands can be met. In many ways this is just as childish as having total faith in timetables. To put it bluntly, we don’t have the certainty of a financial statement when it comes to the future, and what it will hold for any of us. What makes the certainty of this belief somewhat incredulous is that this goes against our “bible.” Most securities analysts trained in the black art of the market have read, or at least have been taught from Securities Analysis, originally written by Graham and Dodd. I remember quite vividly taking Professor David Dodd’s course, and listening to his intoning on the need for a margin of safety. Dodd’s margin of safety was defined as an additional discount from current price, after all other discounts were taken for various financial calculations, i.e. inventories, pensions, etc. This margin of safety (in Warren Buffet’s terms, “the moat”), around the future value of a security, is needed to cover for the unknown. While many investment professionals claim they adhere to these principles in terms of individual security selections, their portfolios do not.

Most of today’s portfolios are based solely on the most probable future that is expected. Often this perceived future starts with precise measurements of economic growth, inflation, value of the currencies etc. From these projections (timetables), various expenditure patterns become acceptable or not. I suggest that this approach is not wise and belies the history of human experience. Long-term portfolios, which are not under intensive daily management, should be able to deliver under most conditions (even some extreme ones). This may mean holding, within a portfolio, securities that are cyclically oriented, growth oriented or trading in different currencies.

A more realistic approach is not to plan to spend future income to meet needs, but rather to wait until income is achieved and appropriate reserves are taken for future valuation changes. The approach of earning before spending is often the base of conflicts between the generators of wealth and their families and key charitable interests. A compromise should be possible in the diversified portfolios of both ultra high net worth families and those of more modest size. The compromise should be to “agree to disagree,” that each perceived need requires its own specific portfolio, with its own operating procedures. Some might even follow timetables, while others will keep refreshing their “moats.”

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