Sunday, March 12, 2017

Managing Opportunity Costs


All who at least tangentially follow the stock market know that at some time in the future stock prices will experience a major decline. I know I am premature, but as a securities analyst, portfolio manager, investor and entrepreneur I need time to position my mind and my emotions.  I want to be prepared intellectually and emotionally to survive the decline and participate in the eventual subsequent rise.

As I have previously written, I believe sentiment or if you prefer the standard phrase, rising animal instincts, have become the driving force for stock prices rather than the various statistical ratios which as professional investors we are comfortable. The two present indicators I follow that demonstrate rising sentiment are, (1) the supposedly retail flows into Exchange Traded Funds (ETFs) and (2) the relative movement of bond yields.

Just at the time that preordained lists of stocks are showing less cohesiveness or if you prefer correlation, media are reporting a significant increase in the use of ETFs by the retail public. Stock prices within various groups are moving differently, thus individual security selection has become more needed for investment success. In the broad market indices the financial and utility sectors are moving not only at different speeds but in some different directions. Within the sectors there is considerable difference in individual stock price moves. For example, within the banking sector until quite recently the prices of many smaller banks have been much stronger than those of the mega banks. The price/earnings ratios on many of the smaller banks is considerably higher than those of their larger peers.

The yields on a list of intermediate credits tracked by Barron's has been flat thus far this year, 4.54% in the first week of the year and 4.57% last week shows relatively stable while there is less demand for a similar list of the highest quality bonds with their yields rising from 3.46% to 3.62% last week. The professionals in the bond market tend to be much quicker than equity people to changes in credit conditions.

First Week of 2017
Last Week
Intermediate Credit
Source: Barron's

Preparing Mentally and Emotionally 

As is often the case, we are our own worst enemies. When stock prices decline we tend to measure the fall either from peak prices or purchase prices. Neither is particularly useful in assisting future investment activities. Both peak prices and purchase prices are historical accidents and don't have any forecasting value.

We should go back to our base case whether we are serving institutional or individual investors. Our goal should be to arrange payments that will cause people to react positively to the intended use of the money. With that in mind, investment success is an intermediate step toward our goal of delivering the needed funding. Whether we succeed or not is the opportunity cost that we pay to have the opportunity to achieve our goals. One can look at high opportunity costs (losses, fees, taxes, and efforts including emotions) as premiums to get the chances of better results.

At the racetrack the objective is to walk away with more money than when we entered. Not only do we count our losing bets against our winners, but we should also include our expenditures. In both the racetrack and investment experience we should add in the time and expenses of our analysis, perhaps deducting something from the continuing value of our analysis. If one bets on favorites with low odds and expected higher probability, that is a grinding-out game. On the other hand if one chooses less popular and higher paying prices, if successful, typically the win/loss ratio will be worse than those of the favorite player. However, at the end of the day one can walk away with more money. For some, the second player (regardless of monetary result) could have more thrills than the winner of expected results. To many these thrills are in and of themselves a gain on the day unlike those experienced by the player who is with the crowd. In many ways the opportunity to achieve these thrills is an opportunity cost worth enduring.

Our problem as professional portfolio managers is to mix both extremes in a specific portfolio for a client's needs to make future payments. We believe that first recognizing the various timespans for future payment aids in identifying the levels of current and future risks which are appropriate for the accounts. Within each of the timespans one can employ the appropriate balance of lower risk and higher risk funds and securities. 

At the end of the day we get our thrills by meeting the payment goals of the account through a satisfactory level of investment success.

Post Script

Ruth and I hope that our readers in the Northeast US find themselves safe and warm during this coming week’s inclement weather.

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