Concentrate or Diversify, 2 Questions with 3 Answers - Weekly Blog # 594

Mike Lipper’s Monday Morning Musings

Concentrate or Diversify, 2 Questions with 3 Answers

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –

I have been asked to respond to two intellectual investment questions that parallel real word actions. The first question comes from a long-term subscriber of these blogs. The second comes from my preparatory work for a potential investment management client.

1. European Portfolio Manager response to Sub-Zero Interest Rates?
2. Appropriate Structure for a Long-Term Charitable Account?

In my mind both questions revolve around the same risk management question. Is it better to concentrate one’s assets and energy or spread the risk by diversifying? Too often investment people view their problems as special and quite separate from the real-world problems of others. We do this at the risk of not seeing the universality of problems.

Perpetuation of the family/species is at the core of human and animal creation. Due to potential violence, insufficient food, and medical risks, some produce multiple offspring with the hope that some will survive. Others choose to produce a limited number of descendants and protect them carefully. This is the very same quandary that investors face, particularly those with responsibly for others.

One approach to a decision process with two alternatives is to create a barbell type solution by combining the two extremes of diversification and concentration. To be prudent we should not use this barbell decision model. The third element to consider is the presence of other factors, which often determines the appropriate decision.

Reactions to Negative Interest Rates
On the surface, paying a financial institution for the privilege of letting them hold your money, which they then lend out without sharing the proceeds with you, appears to violate Newton’s laws of physics. It suggests a collapsing universe rather than an expanding one, raising the question of why an investor would contribute to such a scam?

Jim Grant, one of the best columnists on fixed income, called for the end of the 38-year bond bull market in this week’s Barron’s. In his column he quoted from a 1981 article by Parker Hall, a deceased but old friend who heralded the beginnings of the bond bull market. Today’s question is somewhat more complex than just betting on a cyclical turnaround in bond prices. It has been made more complicated by the policy dictates of various governments for political purposes. Although interest rates are expressed in their local currency, e.g. euros, they are compared to rates in other currencies and are exposed to different inflation rates. Governments, officially or unofficially, direct their central banks to induce low interest rates to create and preserve jobs, often through problematic loans which create additional market distortions.

Most large fixed income portfolios are managed through or for the political establishment, making it difficult for many managers in Europe to meaningfully exit from negative interest rate paper. However, I am seeing some increased diversification into both high-quality corporate bonds and very long-term government bonds, including century bonds. The latter is interesting in that they’re betting they can, over the long-term of possibly 100 years, reinvest the low yielding coupons at higher expected interest rates. (It is worth noting that the biggest return in long-term bond investing is through the reinvestment of payments at current rates).

If European fixed income managers can get out of the euro they generally will, often by buying US paper. Most cannot and are therefore effectively corralled into the euro and forced to extend their maturities. However, there is a limit as to how much they can lengthen their maturity structure, as many portfolios are designed to pay pension benefits. In most European countries the retirement ages are lower than in the US, thereby limiting maturity elongations.

Portfolio Structure for a Charitable Investment Account
The payout needs for any account requires current cash to make payments. There are two main ways to achieve this. The traditional way is to let the gross income earned on the entire account make the required payments, but due to market price fluctuations the available cash will fluctuate. To the extent that current income is insufficient, proceeds from sales can supplement the cash generated from dividend and interest payments.

We are advocates of another approach which divides expected payment responsibilities into specific timespan portfolio sub-accounts. The most current timespan portfolio should generate the funding necessary to make required payments. This portfolio could be structured in a way where cash or short-term investments satisfy the payment obligations before being replaced with the next timespan tranche. The advantage of this approach is that it makes certain that current bills are paid, regardless of market volatility. It also allows the rest of the portfolio to be invested for longer term horizons.

Charities, even private ones, are fiduciary accounts that are distinct from personal accounts. No one must know how well or poorly one’s personal account performs. Most fiduciary accounts make reports as to the success of their investment program from time to time and the frequency of this reporting can influence how a portfolio is managed. Financial markets are by their nature volatile. Over very long periods a fully invested portfolio of reasonably selected securities or funds should produce a higher return than a portfolio that has frequent changes.

To some degree, in dealing with fiduciaries it is more difficult to manage their expectations than manage the performance of the funds and/or securities. Using a rough rule of thumb, the potential peak to bottom declines are as follows:

     A 10% decline - Three times in a ten-year period
     A 25% decline - Some time over a ten-year period
     A 50% decline - Once in a generation of approximately 25 years

Many investors do not achieve the general returns available in the market because of timing their moves in and out of the market.

Diversification reduces specific risks of individual securities. However, it also reduces the opportunity for doing much better or worse than the market average. Over an extended time period, wise concentration in a small number of choices produces the highest returns, but the results can be volatile.

Pulling these thoughts together the following structure may be appropriate for a charitable account, assuming a ten-year horizon:

     10% in Money Market funds and short-term US Treasuries
     40% in growth funds of various sizes, most in mid/small-cap funds
     30% in international funds, with 2/3rds in Asia
     20% in value funds

The selection of individual funds will be guided by risk tolerance, size of the account, operating procedures, and special factors. The higher the risk tolerance the greater the commitment to a concentrated portfolio of funds.

If you need help in constructing or reviewing your portfolio, please contact me.



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/09/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2019/09/excess-capital-less-equity.html

https://mikelipper.blogspot.com/2019/08/an-awkward-moment-with-frustration-not.html



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When will Long-Term Prices for Gold and Natural Gas Go Up?

Introduction

One of the ways analysts attempt to get ahead of the market is by “connecting the dots.” The dots are stray pieces of seemingly unconnected bits of information which can lead to a useful insight. During World War II the US Marines were trying to estimate the size of various Pacific islands’ defense forces. As these islands had dense jungles, airborne photo reconnaissance didn’t work. As luck would have it, they were able to recover a bill of lading floating after an enemy ship was sunk. In this document there was the size of the shipment of volley balls that were being sent to the island. Knowing the normal table of equipment enabled them to estimate the size of the enemy forces that would oppose a landing by the Marines. With this new information, the decision was made to bypass the heavily defended island and land on less defended real estate.

The dots that I am trying to connect include a very insightful talk by Jim Grant to the Federal Reserve Bank of New York, actions of three different central banks, a comment by the CEO of Goldman Sachs in an interview, the financial leveraging by a CEO for his own account, and an almost recommendation by the highly respected Wall Street Journal columnist Jason Zweig.

Jim Grant

While I have known and admired Jim Grant for a long time, in a period of just two weeks I have encountered his thinking twice. First was at a small dinner party where he was the host. He spoke persuasively about the government’s attack on market-based pricing. While he was mostly focused on what is being called financial repression (of interest rates), it could also be applied on other areas of administered pricing. Second, John Mauldin, in his weekly letter, reprinted Jim Grant’s talk to the New York Federal Reserve Bank. He dwelt on how far the Fed has moved away from its founders and their philosophy. He points out that while the current Chair of the Federal Reserve System is a renowned scholar of the 1929-1933 depression, he and others would be wise to review the depression of 1920-1921 which was as deep as the “Great Depression,” and by 1922 the US had a vigorous recovery led by the government balancing its revenues and expenditures and not relying on any form of “quantitative easing.” However, his main thrust was that the founders of the Fed in 1913 believed in the gold standard and were horrified at the thought of a fiat currency.

A lot of credit should go to the NY Fed for inviting a well-known critic of its actions into the bank’s hallowed halls and perhaps listening to him. While I do not expect an immediate change of heart by our government manipulators, I am hopeful that this talk can have a ripple affect even if Ron Paul is not sitting in the White House. (Think about the various espoused policies the socialist Eugene Debs advocated in his numerous presidential runs and how over the succeeding years they were adopted by the two main political parties.)

Three central banks

As reported by US Global Investors, in March Mexico added 16.81 tons of gold to its reserves of 122.58 tons, Russia added 16.55 tons to its total reserves of 895.75 tons and Turkey added 11.48 tons to its hoard of 209.6 tons. (These purchases are after 2011, when in aggregate, central banks bought 439.7 tons, the largest increase in five decades.) What is significant to me is that all three of the buyers in the month would benefit if the price of oil went up and thus their economies would benefit. Perhaps they are addressing a more fundamental concern about fiat currencies in the US and Europe. Just possibly someone is listening to Jim.

Natural gas prices

Jason Zweig’s Saturday column in the Wall Street Journal is normally very balanced, describing the pluses and minuses of a topic often relying on some academic paper of interest. This week, I was shocked that the column called attention to the very low prices for natural gas and if an investor has a long-term orientation, like the accounts that I serve, there is significant potential in owning a number of the stocks. He included one where the CEO has borrowed substantial amounts to take up the provisions available to him to participate in various drilling opportunities. These are extraordinary times to see these kinds of situations.

Two weeks ago my blog speculated about the possibility of $1/gallon gasoline. This was a “think piece” not to be taken as a prediction, but recognition that the price of oil could go the other way and not climb to ever-higher prices. One of the foundations of this out-of-the-mainstream thinking was a belief that over a ten year period the US could become energy independent and possibly an exporter due to the potential of natural gas to fill its needs.

The bulls of Wall Street

For more than a decade in the past we have learned that when the large firm known as “the herd” was bullish on the US market, then look out. This time I am hearing a somewhat similar belief from a respected leader. Lloyd Blankfein was doing a number of cable television interviews on Thursday. On the one that I saw, he spoke about Goldman Sachs hedges, he thought that the risk was being on the sidelines rather than participating on the upside. Considering how well Goldman Sachs has positioned itself, I find this encouraging.

Conclusion: Putting the dots together

One of the lessons from both basic security analysis and Marine Corps intelligence is that one never gets all the dots to compile a complete actionable picture. While I would like to see more money placed on positive convictions than what I see now, I would use any significant declines to reposition various portfolios to be more aggressive. I don’t believe that we will get much positive momentum until we believe we see some clarity as to what 2013 will bring. Nevertheless, at some point we could see many investors decide all at once that the water is safe and jump in.

Next week’s blog

We are continuing our practice of attending the Berkshire Hathaway Annual Meeting. As usual the questions may be more enlightening than the answers (except when Charlie speaks). I plan to devote next week’s blog to my impressions and will write it on the return flights. Due to air schedules and my iPad, the timing of your receipt may be delayed.
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