Asset Allocation - Three Psychological Inputs

Introduction 

The psychological need of the investor is a major contributor to the dominant asset allocation chosen. This is a preliminary, hopefully useful insight in a world of over-simplification. Further it can be a useful aid in structuring timespan portfolios. For the moment think of an asset allocation spreadsheet with three psychological columns and four timespan rows.

The investment account needs to fill in the matrix below:

TIMESPAN	Income	Value	Growth
Now Operations Portfolio
Intermediate Term Replenishment Portfolio
Long-Term Endowment Portfolio
Longest Term Legacy Portfolio

                        TIMESPAN L Portfolios^®

Income

The oldest investment need is to meet critical expenses. For each investor these may go from the immediate need to put food on the table to obtaining the most expensive item of fashion which can be real estate, life style, breakthrough medical care or the latest gadget. The income need includes the cash generation from capital and capital itself. Enough income is in the end not a statistic but a feeling of well being.

The need for income may be immediate and/or a stream of cash for different timespans. For example, it may be high immediate expenses or future streams of payments requiring well covered cash generations. To the extent of long-term payments in a world of paper or electronic money, the impact of inflation should be considered as to the value of cash levels.

Most income driven investors tend to live very much in the present. They view loss of income as much more serious than a missed opportunity to enhance income and capital generation. They believe that they are conservative, but often they are taking into account only what is present and not the value of current and future income.

At prevailing interest rates on presumed high quality fixed income paper, investors are being pressed to meet perceived payment needs. This is particularly true for US foundations with a tax requirement payout of 5% over time. Currently, in most cases income investors are ignoring the present but low level of inflation. This is reducing the real value of both the spending and capital base.

Our preferred solution is to invest in established companies that have a long history of growing well protected dividends in good times and bad. Currently there are a number of these in the financial services field which we can discuss offline. In these cases I believe the income is secure and generally grows faster than normal inflation. The risk is in the fluctuation of the price of the shares. In many existing cases they are reasonably priced in terms of their intermediate- term outlook.

Value

Value investors really don't like making meaningful mistakes. Perhaps earlier in the investment experience they were exposed to big mistakes made by others or themselves. Their reaction to prevent future mistakes is to accept a well defined price discipline. They will often quote the two big investment rules:  Rule 1: Don't lose money and Rule 2: Don't forget Rule 1. This is the historic coda from my old professor David Dodd of Graham & Dodd fame. This strong survival instinct at times prevents them from buying into big opportunities with substantial risk of loss. They are just the opposite of successful venture capital investors that have more losers than winners but the winners are large enough (and then some) to make up for their losses. Because we live in an uncertain world, most often they own lots of securities to diversify their risks. 

Most of the time they are attempting to arbitrage the difference between current price and some standard of value. It is in the selection of this standard of value where the value investor tribe breaks into sub smaller units  or families. Many of these families use the various corporate accounting statements to determine their values; e.g., book value, net tangible value, revenues per share/per customer or net liquidation value. It has been my experience that often many stocks sell at a 30% discount to their theoretical value. However, normally this discount is not fully captured quickly without some internal or external activist event.   

In effect the value investor lives in the current price range and wishes for the market to relatively quickly recognize the present value. These kinds of investments, when they work well, are found in the Replenishment Portfolio which invests through the present cycle. Because of their risk aversion value investors have better than market performance record, but often underperform when the market is looking for dramatic changes in the future.

Growth

The growth investor fundamentally believes in dramatic change that most do not fully comprehend. The change could be based on technology, radical price movements because of fundamental and largely permanent supply and demand shifts, as well as substantial and lasting impacts of demographic evolution. The successful growth investor not only believes that he or she can spot future changes but also which company can be the most successful exploiter of these changes. Relative to the value investor they are more tolerant of near-term price risk because they see larger and longer-term price rewards. Except for large funds investing in smaller companies they tend to have more concentrated portfolios. However, they are much more sensitive to changes on the horizon  which makes them less patient than value investors. Thus often they have more concentrated higher turnover rate portfolios.

Putting Income, Value and Growth to Work

In each cell of our intellectual investment matrix of the three asset allocation types and the four timespan investment periods, the investor should determine the appropriate mix. Thus one might have 60% in income, 30% in value and 10% in growth for the Operational Portfolio; 60% in value and 40% in growth for the Replenishment Portfolio and the reverse in the Endowment Portfolio. The Legacy Portfolio could have 70% in growth and 30% in value. Please note that I do not divide the world into domestic and international. I believe just about every company and most individuals are increasingly impacted by activities beyond their national borders. As indicated in earlier blogs "We are all Global." The location of incorporation or main securities market is a third level sort for administrators and sales people to worry about.

         

Rebalancing

The very next trading day changes the actual allocation from the planned and prior day. Far too many investment organizations rebalance mathematically back to an original allocation. I believe rebalancing is an account-specific responsibility. I am very conscious that most large successful investors/entrepreneurs have made most of their money in a few or even one security. I am also aware that a family's concentrated wealth can be wiped out in a major failure. Thus, I  suggest that rebalancing is a critical decision for the capital owner to make. One can see the degree of concentration will change as investment control shifts from the founder to succeeding generations of family workers and non-workers. Further, to me rebalancing is essentially a market call of quasi permanent market change or a return to some concept of "normal."  The decision may be heavily influenced on payout considerations from how "income" and capital are defined.

What Not to Invest in the Legacy Portfolio

The whole concept of the Legacy Portfolio is that since the current generation of investment managers are responsible there are likely to be future periods of disruptive change compared to the present construct of our investment thinking. Often we may want to focus on investments that would benefit from expected changes. It is equally important to focus on what should not be there.

Two possibly negative trends that should be considered for reduction or elimination in a Legacy Portfolio are:

1.  JPMorgan Chase

I have great respect for JPMorgan Chase and its CEO Jamie Dimon. Personally I have owned the stock for many years and it is our main deposit bank. Nevertheless, it should not be considered in a Legacy Portfolio of companies to benefit from disruptions. I commend Dimon’s brilliant 46 page letter to shareholders that describes their success and outlook. It is the bank’s very success under Jamie that makes me question whether at some future point the stock of JPMorgan Chase may not be an investment leader. If one links the performance of JPMorgan Chase from the date of its merger with Bank One  its stock was up 211% compared with a gain for the S&P500 of 154.8% and the S&P Financials 32.3%. For the last ten years the annual compounded growth was +8.6%, vs. +6.9% for the S&P and -0.4% for the financials. JP Morgan Chase has been a great stock. In the same period the large foreign banks have retreated. My fundamental concern is that it is less likely that the bank's relative performance advantage will continue. I expect that at some point the global financial businesses will be restructured to reduce the odds of continued  success for the current bank.

2.  Urban Real Estate

The second area to possibly exclude in the Legacy Portfolio is urban real estate. Cities are absorbing rural populations all over the world for sound economic and demographic reasons. At some point there will be intolerable overcrowding and with the advent of the internet and driverless vehicles, some of the people and capital will migrate to exurbia.

Whether these two thoughts work out, the key message is to look for those investments that will be advantaged and disadvantaged in the future.

Your Thoughts? 

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A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.

Reading What is There and What Isn’t

Introduction

We are all information junkies. I am always questioning trying to find out what might be important. Thus I am absorbing both hard and soft data in my investment diet. I never know what can turn out to be a good source of facts, knowledge, or perspective; for instance my dentist, who is something of a data hound about his practice. While I was a captive in his chair and being a bit upset he was not streaming the daily programs from Bloomberg TV as usual, we were instead discussing the importance of data. He then gave me a bit of insight. On the cover of his data notebook there was  the following quotation:

“Everything that can be counted does not necessarily count; and everything that counts cannot necessarily be counted.” -Albert Einstein

Not only did this make sense but I am a bit addicted to Dr. Einstein as a great mathematical physicist. My wife Ruth and I have stayed in the rooms that were used by the good doctor at the Athenaeum, the faculty club at Caltech where he visited regularly. In thinking about what Albert Einstein contributed it occurred to me it was not new data that he discovered, and not only to recognize the meaning of what was known, but also what was not captured in the data. He identified what was missing.

If only the pundits who were wrong about the outcome of both the BREXIT referendum and the last US election knew how to look at the data that was and wasn’t, they wouldn't have been so embarrassingly wrong.

I am going to review a set of investment inputs which cross my desktop screen to seek to extract both their meaning and what is missing.

China

To my mind there is no more important topic for long-term investors to track than China. Many believe that it is only a matter of time before China will become the largest economy in the world and all that occurrence implies. We would be badly misled if we applied the lessons from our own history to China. First, we come from political cultures where our leaders for the most part were trained in law, military, or farming. Most of the current leadership in China spent time learning engineering. As part of that experience they were indoctrinated into rigorous planning as a dominant discipline. While there may be periodic disruptions there, their life is much more orderly than is what is experienced in the developed economies. 

When Premier Li, states that there will not be a hard landing as their economy shifts to fulfilling internal demand for goods and services from being export driven, I am reasonably confident that the record, as published, will show that the Premier was correct. His was not an idle boast. The Chinese political school attempts to study every conceivable possibility. They want to be good generals that are never surprised (or defeated) like Julius Caesar who claimed a great victory in what is today's France and then spent the next three days burying his dead. Also as Steve  Roach from Yale University has written from his long experience in China, the leaders know that shifts in global leadership are gradual not abrupt. Their planning doctrine allows them to be patient as long as they are making progress every day.

In the real world not everything goes as planned. For instance the public traded price of Huishan Dairy  dropped 85% in one day. From what I have been reading, many successful entrepreneurs are involved with many different activities. These men and women, are often highly leveraged, possibly with bank loans from friendly local/regional banks which they have significant stock positions.

What was not there? First disclosure, in this case the entrepreneur was missing for at least one day. Second, there was no market mechanism to slow or halt the decline, (nothing exists in China and other places like the old US specialists on the floor of the New York Stock Exchange) or in this case similar to other markets after a ten or fifteen percent drop, trading is suspended. Third, there is no equivalent to the Glass Steagall and similar Acts to avoid commercial interests affecting loans and stock purchases of banks. I suspect in a still planned central economy we will see these holes filled. Nevertheless, Western investors need to recognize the practical differences between their home markets and the newer markets in China. (This is why my accounts prefer to use mutual funds that are managed by specialists who have been trained locally.)

While in the US we are still waiting on the surge in infrastructure spending to repair our railroads, roads, bridges, tunnels, and airports, China is well ahead in its construction phase. What is quite different is that in their drive for the "One Belt, One Road" strategy they see it as a way to export their overcapacity in steel and related industries. They want to do this for trading purposes and bringing other nations and markets closer to them. Perhaps more importantly it would somewhat lessen the reduction in heavy industry jobs. I also believe like with the Eisenhower Interstate Highway system in the US, the "one road" program would aid the shifting of military people and goods where needed quickly both internally and to the borders.  All of this is dependent upon detailed planning and a high level of engineering.

United States

Applying Dr. Einstein's approach to two US focused factoids may give us some pause for thought:

Credit Suisse notes that the number of publicly traded stocks in the US has dropped in half from 1996 to the present, 7300 to 3600. (I think that is an over-simplification and could be those stocks just listed on the exchange; nevertheless there is not doubt that the number of public companies has declined.) Whatever the actual number except in industries where there is significant capital risk (technology and consumer demand for fashions) entrepreneurs are preferring to stay private until they receive an appropriate bid for the company. I know that was my idea. Not only are investors disadvantaged by this trend, it is quite possibly the economy will suffer also, as private companies with less debt will tend to be smaller in terms of revenues and job creation. The current Administration wants to reduce regulation to address this problem. I suggest they also need to focus on death taxes on private companies. There have been too many family farms and businesses that had to be sold to pay death taxes. This was a concern for me.

Combined with the reduction of the number of publicly traded companies there has been a twenty-fold growth in the number of CFA^® Charterholders (Chartered Financial Analysts) which did not serve as a barrier to entry that some may have wished. If the number of eligible securities is down and the number of analysts is rising, the odds of analysts discovering new worthwhile investments is declining.

One of the results of the difficulty of finding a lot of new worthwhile investments is the growth in popularity of Exchange Traded Funds and Products. Some analysts, portfolio managers, and security salespeople have gravitated to ETFs and ETPs.

The theory behind this was that the markets move in broad trends and the prices of ETFs would mirror the performance of the underlying stocks. Increasingly this is not exactly the case. Starting with July 8th 2016, my birthday and the birthday of the Dow Jones Industrial Average, the yield on the 30 year US Treasury went up 48%.  An ETF that was meant to mirror  the move in the 30 year Treasuries was up only 43%. The 5% difference was attributed to fees, interest expense, volatile derivatives, and a shorter bond life. Admittedly this is an extreme occurrence.  If there is an increase in volatility, as expected by some, it may be difficult for the ETF managers to exactly mirror the index they are meant to be tracking closely. All of life is cyclical. At times market prices will track very closely to the center of their universe and this is called concentration. At other times the target universe experiences more diversity. I think we have entered such a phase and we will see an increase that various passive products are not tracking  the performance of their universe because they don't own enough of the winners and too many of the relative losers.

Question: What are sensible investors missing?

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A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.

Bonds Can Hurt Retirement Capital

Introduction

Running out of money is the single biggest fear of all investors and should be of their portfolio managers and other fiduciaries. Unfortunately far too many focus on a perceived capital amount to meet their long-term funding needs. Unfortunate because they do not include allowances for taxes, inflation, and mistakes both in terms of investments and unplanned expenses. Thus their retirement or legacy needs are often understated. Because of these understatements/reasonable errors I believe payout of accumulated capital over 3% annually may lead eventually to the depletion of capital  in part or completely.

Universal Problem

There are apparently a number of perceived missing elements in every country's constitution. The global rise in populism is based on the belief that our society, in other words our government, owes each able bodied person gainful employment, and for the others some form of support. To the best of my knowledge the economic structure of no country is set up deliver on these perceived, unwritten promises. Thus this is the first big problem facing us.

Retirement Capital

However there is a second and perhaps even bigger problem that is accelerating ahead of us. Any quick review of national statistics will show that the need for retirement capital is actually growing faster than the need for jobs. To some degree the need for jobs is being addressed in the much reduced growth in population around the world, except in Africa and some parts of the Middle East. The existing unemployment and under-employment is creating a growing class of people that have little to nothing in the way of retirement capital even if they qualify for the under-funded social security.

Demographically there will be others such as the disabled and currently incarcerated who will enter the retirement stage with little or no capital. Add to these a much larger group of people entering their senior stage when they have not built sufficient retirement capital. All of these people (unlike some of the unemployed) can vote and are more likely to do so than in the past.

The risk to those who believe that they have sufficient retirement capital may be  a gross miscalculation. Eventually our societies will react to these needs. While hopefully they may make investing more profitable by lowering expenses and taxes, the odds are that governments will spend money. In some combination the money will impact taxes on (a) those that have money, (b) inflation for all, and (c) deficits which will drive interest rates up and the value of currencies down. It is these prospects plus the current low real interest rates, after inflation, which makes investing in high quality bonds risky if they have to be sold to make payments. 

Currently the Proper and Improper Use of Bonds

After a long struggle to build sufficient retirement capital with due consideration to the growing needs of present and future beneficiaries, an individual or institutional investor may wish to reduce the risk of losing meaningful amounts of retirement capital, one could properly invest in high quality bonds. This assumes that the current interest rates are above the after-tax inflation rate. Such an investor is both extremely rare and lucky. All other bond owners are speculating as to the future. 

At current interest rates adjusted for inflation and taxes it is difficult to see how bonds can be used to actually build retirement capital as distinct from maintaining it. Many if not most bond holders do so in the belief that there is less price risk in owning bonds than owning stocks or other forms of equity. Historically they are right in that most market declines bonds decline less than the stocks. Thus, I believe the proper way to look at the allocation of assets to bonds is a longer term index of fears of stocks than the VIX or other measures of short-term volatility.

Bonds Could be Worthwhile

As with all investment strategies there is a time that they are correct and other times when they are wrong. Unfortunately, I can perceive that once again interest rates will be driven so low that they can make bonds attractive to new purchasers. For those who have owned bonds for sometime, the offset is that during such a period if they have to sell their bonds the odds are the prices will be below (and perhaps significantly below) their purchase prices. There have been periods in history when purchasing high quality bonds with highly elevated yields produce in time big price appreciation benefits. My only problem with this strategy is that most of the time by the end of these market recoveries, one would have been better buying equities.

Equity Risk in Some Bonds

High yield bonds and to some extent high interest loans have been called stocks with coupons. This means while these credit instruments are called bonds and loans they have imbedded in them risk of late and/or incomplete repayment as scheduled. Unfortunately many individual and institutional investors have focused on the bond-like attributes of this kind of paper and have enjoyed the performance comparisons of high yield paper out-performing high quality bonds. Perhaps they didn't notice that in most of these periods stocks in general out-performed both high yield and high quality bonds, but they could claim that they were more conservative because they owned bonds and loans and not those risky stocks.

Spending Too Much of the Income

One of the real disadvantages of high yield paper is that most investors spend all of the interest payments as if they were from a high quality source. Note that in many periods the price performance of these assets is below the total return performance results by more than the paid interest . The missing difference is the impact of the defaults on a minority of these bonds. The major credit rating groups regularly publish their estimates of the forthcoming default rates of this asset  To the extent that investors want to spend the payments off of high yield paper, I would recommend that they put into some reserve account at least the current default estimates on the category. Often when defaults rise all of these types of paper fall to some degree in sympathy to the defaulting issues.

Bond Market Liquidity is Illusive

The liquidity in the bond market is considerably less than in the stock market which makes it difficult to sell during periods of unrest. This is particularly true in the high yield market. In one recently recorded instance that is part of a law case, the nominal bid for a bond was 65 ($0.65 per dollar of face value.) A large professional seller encountered the following situation: 60 to sell $1 million, 50 to sell $2-5 million and 31 for more. What is the worth of this account's net asset value with a nominal quote of 65?

The Problem with Bonds are the Bond Buyers

As with most things the problem with various instruments; e.g., guns or fast cars, are not inherent in the instruments themselves, but the people who use them. Utilizing Schroders^* Global Investors Study 2016 one can see individual and institutional investors bring the wrong attitudes to investing in securities and funds. The desired income broken down by location was instructive. Europeans wanted 7.9%, Asians 9.7% and those in the Americas 10.4%. One should not be surprised to learn that the Europeans in aggregate hold a higher allocation to bonds than those in America, but with an older population and more proportion of  debt than those on this side of the pond. Thus they are growing their retirement capital deficit faster as well as having higher unemployment and underemployment which helps to explain their more socialist oriented government. What is most interesting is that those surveyed thought they would live a long time in retirement. In addition, 74% thought they would live sixteen to thirty years in retirement. Contrast that image with their practice of owning particular securities 3.2 years and their advisors recommending holding for on average 4.3 years. In effect what the study is showing is that investors with a long-term need for retirement income plan to trade around five times during their retirement years. While not a perfect comparison, long-term studies of US Mutual Funds suggest those that on average trade less, perform better.

^*Held personally

Bear all of this in mind with the surge of global money going into bond funds at the same time that they are significantly under-performing the average equity fund.

US Investors May Do Better

According to the trade association for mutual funds, ICI, 60% of defined contribution assets are invested in equity funds.  With a significantly older weighted population, 54% of Individual Retirement Accounts are in equities. Roughly half of the money in these two main retirement accounts are in mutual funds. Typically defined contribution and IRA accounts don't trade much. To the extent that they don't trade and invest for longer periods of time they will build retirement capital sums. They could be augmented if the tax people allow these accounts to grow without mandatory redemptions way beyond the current 70 ½ years old.  

If the current US Administration and Congress really want to increase employment, perhaps they will focus on small companies being the largest contributors of new jobs - despite the fact that the number of publicly traded companies has dropped by 3000 over the last twenty or so years. We are down about 1/3 from our previous total.

Investment Conclusions 

At the current time, high quality bonds don't make a lot of sense for most retirement accounts. Also the average US investor, excluding currency, is likely to perform better than their European counterparts. This is particularly true if smart job generating tax programs are put into place.

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Copyright © 2008 - 2017

A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.