This is my quarterly missive intended primarily for my fellow financial professionals wherein I share items I have run across or thought about this quarter which I think might be beneficial to you. Enjoy!

This quarter I am speaking at the NAPFA South Region Symposium on February 12th in Atlanta, and FPA of Kansas on March 8th in Wichita.

Later in the year (after tax season) I have seminars for CPAs scheduled (through Surgent) in Texas (Dallas and Fort Worth), and North Carolina (Greensboro, Charlotte, and Morrisville). More will be added soon.

I would love to see you at one of those sessions, and if you are looking for a speaker at your professional conference or event, please feel free to contact me for more information.

First, I was thinking about what goes into quality wealth management. The goal, in our view, is to use wealth management to maximize long-run client happiness in the face of an uncertain future.

I think there are three inputs into the process:

1. Quantitative and Qualitative Data – you have to know the facts about the client, about the tax code, about capital market return history and drivers, etc. You also need to know the “soft stuff” about the client to maximize their happiness.

2. Analytical Ability – you have to be able to “do the math” to calculate whether or not a mortgage should be paid off, an IRA converted to a Roth, how Social Security or a pension should be claimed, etc.

3. Wisdom – exposition below.

The first two items I think are (or should be!) just “table stakes” – they aren’t a differential advantage, a unique selling proposition, or whatever you want to call it. But I think wisdom is what separates the high quality advisor from the typical one. The Socratic paradox is the statement (based on Socrates, but not a direct quote), “I know that I know nothing.” Supposedly this made him the wisest man in Athens. Another great observation (attributed to many sources, but probably from Josh Billings originally) is, “It ain’t what you don’t know that gets you into trouble, it is what you know for sure just ain’t so.”

The problem is acknowledging our ignorance doesn’t make clients very comfortable – it might even prevent us from having any. Imagine if we re-branded Financial Architects like this:

Financial Architects, LLC
“Embracing ignorance since 2005”

But we are ignorant, particularly in our predictions of the future, whether that is the tax code, the yield curve, investment returns, etc. As the Danish proverb (not Yogi Berra!) says, “It is difficult to make predictions, especially about the future.” So, in light of our ignorance, here are a few things that I think are prudent:

1. Spend lots of time trying to become wiser by reading, writing, and thinking. See here for example. Schedule time for thinking, or, even better, empty your schedule like Charlie Munger and Warren Buffett. Bill Gates, and others, take “think weeks.” Leonardo da Vinci observed, “Men of lofty genius, when they are doing the least work, are most active.” I don’t know if any of us would qualify as “men of lofty genius” but I think having free time (like I do today so I can think about this and write this) is important.

2. Recognize that the best predictor of the future is frequently the present. The current yield curve is the best estimate of the future yield curve, the current tax code is probably the best estimate of the future one. I would be cautious about assuming reversion to some “normal” level of interest rates, equity risk premiums, PE ratios, profit margins, etc. – particularly over a short period of time. The exception to this would be if differences are profound, but even then, it is problematic. In 1995 the dividend yield of the market got lower than it had ever been in history, but it turned out to be much better to buy than to sell. In the spring of 2009, the earnings yield (the inverse of the PE) was also lower than it had ever been (due to minuscule earnings) just before the market soared.

3. Given the paucity of information, frequently the best we can do is equal-weight. Sometimes this is called the 1/n strategy. At best it looks unsophisticated, at worst, ignorant. But it is empirically grounded. If your asset allocation models have decimal points, I would (politely) suggest you are overfitting your data. If you have more than half-dozen or so allocations in your model you have probably sliced your asset classes too finely (you may have two or three holdings in each class, but you probably shouldn’t have all that many top-level classes).

4. Be very slow to make tactical changes to a portfolio. We rarely know as much as we think we do, and we certainly will almost always know less than the collective wisdom of all market participants. It is very hard to do nothing, but doing nothing is frequently the optimal move. As Warren Buffett has said, “Much success can be attributed to inactivity. Most investors cannot resist the temptation to constantly buy and sell.” He also stated, “Lethargy, bordering on sloth, should remain the cornerstone of an investment style.”

So, I don’t know about you, but I’m headed to Starbucks to try to remediate some of my ignorance with some reading…

Second, from this paper:

1. “[T]he typical household holds virtually no financial assets outside of its 401(k).” (and IRAs)
2. “[O]nly half of households have any 401(k)-related holdings” (“401(k)-related” includes IRAs)
3. “The typical household approaching retirement had $135,000 in combined 401(k)/IRA holdings.” (“typical household” means the median household, and “approaching retirement” refers to ages 55-64)

So, half of households age 55-64 (i.e. on the cusp of retirement) have no savings and the half that has something in the middle case has $135k. Thus, if you are 55-64 and have more than $135k in retirement savings you are in the top 25% of U.S. households.

(Also, if these folks are expecting to just work longer they may be in trouble. US News summarizes, “A 2014 Employee Benefit Research Institute survey found that 33 percent of workers expect to retire after age 65, but only 16 percent of retirees report staying on the job that long. Just 9 percent of workers say they are planning to retire before age 60, but 35 percent of retirees say they retired that early. The median retirementagein the survey was 62.”)

Also, for that same 55-64 group, median home equity is $97k. And Motley Fool reports, “According to the U.S. Census Bureau's data, the typical American's net worth at age 65 is $194,226. However, removing the benefit from home equity results in that figure plummeting to just $43,921.”

Third, I was responding to a question on a financial planning message board and wrote what I thought was a great line:

A quality financial plan is optimized for no scenario, but adequate in all of them.

Fourth, this past quarter we saw the 30th anniversary of the 1987 crash. This could happen again. If you weren’t in the business back then (I wasn’t – I was still in college), I recommend watching some Nightly Business Report from that night for a little perspective. You can do so here: part 1, part 2.

Think about how you would react if the market was down more than 20% in a day, but you weren’t even sure what the drop was because the tickers were hours behind. If you put in trades you didn’t know if you got executed or at what price. Our policy is to immediately stop all trading activity and do nothing except reach out to clients to reassure them.

Fifth, while I’m not ready to throw out the loss aversion effect on the basis of one paper, it’s always good to pay attention to disconfirming evidence (i.e. to be on guard against confirmation bias).

Sixth, I assume your retirement projections incorporate some sort of estimate for retiree out-of-pocket healthcare costs (perhaps implicitly rather than explicitly). From this paper, excluding LTC costs, the median retiree spends about $3,681/year – $4,274/year average, and almost $10k (the figure isn’t given but a graph is) for the 95th percentile.

Seventh, a little economics humor:

Eighth, I saw these graphs of asset class returns since the pre-crash peak. U.S. stocks win – even if you perfectly mistimed and bought the high point. Global stocks, well, not so much …

Value has been a problem too:

So, if you did the “right” things and diversified internationally, tilted to value, etc. it hasn’t worked out for a long time …

This is where the mettle of quality advisors is tested. Can we keep clients on-board and on-track, continuing to do the right things even when it hasn’t worked for a while?

Of course, there is a difference between perseverance and stubbornness, but I think this is perseverance. Diversification and value have too much evidence – evidence that is pervasive (in lots of markets and asset classes), persistent (in lots of time periods), robust (to various specifications), and economically meaningful (makes you money, not just a statistically significant t-stat).

This is similar to the late 90’s in a way, but there the pain was brief and acute (huge underperformance for about four years), here it is more of a chronic and dull pain – it just goes on, and on …

Ninth, I sent the graphs and comments in the previous point out to my consulting clients (other advisors who want my advice and perspective) and in response, I got a great question from one of them. He asked:

Does doing the right thing depend on the clients [sic] age? I know this can be a dumb question but what if this time it really is different? Not different in the way value will never be back but what if it takes another 5,6,7 years? Can any of us be “wrong” for that long and still have clients?

I thought it would be helpful to everyone if I walked through how to think about it. This will be a little long, but hopefully useful.

First, assume we have two asset classes, Stocks and Bonds. Assume there is no serial correlation in the returns (i.e. no momentum or reversals). Bonds have a lower expected return than Stocks, but less risk too. The mix in that case will entirely depend on risk tolerance – the psychological risk tolerance, the time horizon doesn’t matter. Remember in our set-up I specified no serial correlation. In reality there is negative serial correlation in the short run (i.e. reversals in daily returns), positive serial correlation in the medium run (i.e. momentum over a year or two) and negative serial correlation again in the longer run (i.e. reversals in the five to ten year period). The first and last of those are not tradable (transaction costs kill daily unless you are a market maker, and after a run up stocks may have lower long-run expected returns but it will still almost always be higher than bonds). So, suppose we settle on 60% Stocks and 40% Bonds.

For the 60% stocks suppose we have two options:

• US Stocks
• Int’l Stocks – same expected return as US Stocks, same risk as US Stocks, but not perfectly correlated.

If we are merely trying to maximize risk-adjusted return, it is clear we should split Stocks 50/50 between US and Int’l. But there are two reasons not to:

1. Most people benchmark (at least partially) off of their family/friends/neighbor’s returns. And those folks are overweight US. So going 50/50 won’t maximize happiness since a shortfall compared to others will be more painful than a surplus compared to others would be pleasurable. This is the psychological reason (Kahneman and Tversky's Prospect Theory combined with Framing).

2. This is subtly different from the previous point. We are competing against others for retirement resources so having a portfolio different from everyone else increases the risk of being able to obtain those resources. In other words, suppose my neighbor Bob will invests in US only and at retirement will be buying assisted living services. I invest 50/50 US and Int’l and will end up with either more or less than Bob at retirement. If I “win” I can buy more assisted living than him, but if I lose I get less. But here’s the subtlety, since the “Bobs” in the US outnumber me when US wins it will push up the prices of assisted living (more competition and more willingness to pay on the demand side) so it is entirely rational to partially hedge (since “not losing” is more important than “winning”). This is the objective reason.

So, given that, in my hypothetical example it might make sense to be 40% Bonds, 40% US Stocks, and 20% Int’l Stocks. (This isn’t an asset allocation recommendation, just an exposition of the thinking.)

Now, let’s take it one step further and answer my interlocuter’s interrogatory (how’s that for alliterative, yet pretentious, phrasing?). Suppose we have two choices for our US Stocks:

1. US Core

2. US Value – higher expected return than US Core, same risk as US Core, and perfectly correlated (in reality the risk is actually lower, and the correlation isn’t perfect, but I’m making a point)

In that case, from a purely mathematical perspective you should invest all of it in US Value. Time horizon is irrelevant – do you want higher expected returns or lower ones? Everything else (in my set up) is the same! There are three reasons not to be so extreme however:

1. The issue my correspondent identified – periods of underperformance are likely more painful than periods of outperformance are pleasurable. So, it would make sense from a psychological perspective to not go 100% US Value.

2. In reality, since US Value is also lower risk, we should do even more US Value (potentially even if we had to short US Core to do so).

3. In reality, since the correlation isn’t perfect having some US Core makes sense from a diversification perspective.

Those last two issues are offsetting and in practice not as big a deal. (Russell 3000 Value is 95% correlated to Russell 3000 – that’s not perfect correlation but it’s darn close.)

Make sense? Time horizon is irrelevant except for from a psychological perspective where people are benchmarking off of undiversified (US) or untilted (no factor exposure) portfolios. Which they are. But I can’t give a mathematical answer to the question. It is a function of how well we can manage client expectations (and maybe how sophisticated your clients are). So that’s why I said, “This is where the mettle of quality advisors is tested. Can we keep clients on-board and on-track, continuing to do the right things even when it hasn’t worked for a while?”

Tenth, related to the last point, good portfolios lose regularly. See this article.

Eleventh, I think what this article discusses is true in wealth management as well. Skills and knowledge that two decades ago would have made you a top performer are now merely table stakes. But you may be successful anyway – albeit in a different way.

Twelfth, The CFA Institute Research Foundation just released an updated version of A Primer For Investment Trustees: Understanding Investment Committee Responsibilities. It’s targeted toward a non-professional trustee who may not have an extensive investment background. In the back (page 141) they have additional resources and I thought their selection of “must-reads” was excellent. Here is the relevant portion of the monograph (I added hyperlinks and removed the publisher info):

Must-Reads
Four top-notch general-interest books on investing that provide a basic education in sound investment principles (start with Malkiel):

• Bernstein, Peter L. 1996. Against the Gods: The Remarkable Story of Risk.
• Chancellor, Edward. 2000. Devil Take the Hindmost: A History of Financial Speculation.
• Kahneman, Daniel. 2011. Thinking, Fast and Slow.
• Malkiel, Burton G. 2007. A Random Walk Down Wall Street.

That is an outstanding selection (though Kahneman’s title should be Thinking, Quickly and Slowly – those are adverbs people!). If you haven’t read all of those, you probably should. My full list of recommended reading on investing is on pages 7-8 of this paper. (I have three of the four above included on my list – I only omitted Bernstein’s because I limited myself to one book per author and I included a different one of his.)

Thirteenth, two timeless quotes:

“The best way to measure your investing success is not by whether you’re beating the market but by whether you’ve put in place a financial plan and a behavioral discipline that are likely to get you where you want to go.”

“In the end, how your investments behave is much less important than how you behave.”

Both are from The Intelligent Investor by Benjamin Graham (1965 edition).

Fourteenth, in this article, I saw this table:

And decided to convert the measures to percentages, take a simple average, and sort from most expensive to least expensive:

Just thought it was interesting how with all the talk about how expensive the US is, it’s really only emerging Europe (Russia, Poland, Turkey, Hungary, Greece) that’s really cheap.

And see this on why the CAPE may not be as overvalued as it appears.

Fifteenth, the current low volatility may be a bad sign, or perhaps not.

Sixteenth, I read a discussion of brief definitions of “Evidence-Based Investing” and I particularly liked the author’s final take:

Success lies in maximizing the ratios of the numerators to the denominators.

Seventeenth, good post here on confirmation bias.

Eighteenth, good stuff from Gene Fama on lots of topics here.

Nineteenth, many advisors (including some I respect) employ a “bucket strategy” that divides the client’s funds into short-term and long-term buckets (and sometimes into intermediate-term too). While I’m sure that has psychological benefit, I don’t think it works the way people think. The idea (as I understand it) is that the client has some amount in cash to cover the next 2-5 years of expenses, so they don’t have to sell if/when the market is down.

First, that is market timing because it makes the decision of when to replenish the cash account subjective (it implies you can tell when the market is “too low” to replenish the cash).

Second, it doesn’t work that way! In any significant downturn you would be buying stocks even after taking a draw, not selling them. Here’s the math:

Suppose we have a client who is 60/40 stocks/bonds with a 4% draw. Assume the market value of the 40% doesn’t change. How much would the 60% have to decline before we are buying stocks anyway? 10%. Let’s use dollars. On a $1 million portfolio, the $600k declines to $540k. $40k is withdrawn from bonds (you are overweight bonds now) for the client’s living expenses, leaving $360k. Total portfolio value is $900k. $540k/$900k is 60% and (obviously) $360k/$900k is 40%. Any decline larger than 10% in stocks would lead to buying stocks to rebalance back to target.

In short, if you rebalance, you can skip the bucket strategy.

Twentieth, Todd Combs is Warren Buffett’s protégé, and this caught my eye:

What’s a typical day like for you?
I read about 12 hours a day. Our offices are like a library. So I read annual reports, conference call transcripts, trade magazines, etc. Most things are routine, mundane and obvious, but every once in a while you find something interesting worth digging into. Warren and I will usually catch up once or twice a day on stuff that’s going on – deals, stocks, stuff with our companies. Sometimes our managers reach out or a banker calls with an idea, but that’s about it.

(The original source on fsu.edu has been removed, but at the moment a copy can be found here.)

Twenty-first, I am not a social media whiz, but I saw some “best meme of 2017” lists and thought I would try my hand at it:

What do you think?

Twenty-second, if you were ever tempted to own gold to hedge inflation, volatility, or market downturns this paper should discourage you. Ok on hedging the dollar, but I would just make sure my foreign stock funds were unhedged for a better way to do that. Using the last ten years of data (2007-2016) the correlations of the gold funds (the ones that hold the actual metal) were:

• 2.5% correlated with stocks (so basically nothing)
• 4.0% correlated with inflation (so basically nothing)
• 1.4% correlated with volatility (so basically nothing)
• 67% correlated with market downturns (so really big, but in the wrong direction!)
• -43.8% with exchange rates (finally a good aspect!)

Other ways to hedge were dramatically worse, gold mining stocks in particular.

Twenty-third, great checklist from Vanguard on how to determine the quality of back-tested data (i.e. find how they gamed it to look good when it really isn’t).

Twenty-fourth, this made me laugh (h/t Dave Nadig via Barry Ritholtz):

The Active Manager’s Prayer
Anonymous

Oh Lord, help me to beat the benchmark. Verily, after costs.

Give me this day my insightful research, visions of undervalued-yet-thinly-held-while-still-reasonably-liquid stocks and a less efficient market.

Deliver me from the effects of low dispersion and non-existent volatility; guide me through the wilderness of low-edge ideas, a dearth of IPOs and overcrowded trades.

As I lift up my eyes to The Fed, may I walk on the right side of QE unwinding.

Yea, though I walk through the valley of ETFs, help me to fear not for, come on, there has to be some respite from billions in daily inflows, right?

And though presently I wander through the desert, may I eventually yoke the power of mean reversion to my benefit.

Lead me into a land of new factors and may they be statistically-significant and predictive in your eyes.

May I not greedily seek top decile performance but, in your favor, at least achieve a top quartile slot, if it be not too much trouble, and may I persist in said performance despite overwhelming evidence against that possibility.

Though I am beset on all sides by a skeptical media and fleeing investors, I will hold steadfast to the hope of a return to prior glories and the attendant 100+ basis points in fees.

Smite the foes of stock picking, oh Lord, and shield us from the further encroachment of the passive hordes.

And remind my brothers from that tribe not to forget that pride goeth before the fall as I have discovered all too well.

In the name of the Fama, the Soros, and the Harry Markowitz. Amen.

Twenty-fifth, Forbes has an exposé on conservation easements. I didn’t know that Georgia was the epicenter of these schemes:

It’s impossible to identify the precise birthplace of the syndicated conservation easement. But it’s safe to say it became an industry in Georgia. Between 2010 and 2012, taxpayers in the Peach State claimed about 36% of all federal tax deductions for easements—despite having only 2.5% of the nation’s land under easement, according to a May 2017 report that Looney, the former Treasury official, published for the Brookings Institution, where he’s now a senior fellow in economic studies. Eight of the 10 biggest syndicators are located in Georgia, according to his research.

Twenty-sixth, I read a recent interview with Harry Markowitz. (Yes, he's still alive!) Strongly recommended: Part I, Part II

Twenty-seventh, great piece on anecdote vs. data here. A little longer, but a very easy read. Worth the few minutes to do so.

Twenty-eighth, sorry, but I just have to rant about this. The headline on 12/29/17, page B1, of the WSJ (above the fold too, so prominent placement) was: “Index Funds Turn Top-Heavy With Tech”

Now, you can write a perfectly reasonable article about tech firms having a significantly larger market cap relative to other firms than they have historically. And you can certainly argue it is unwise for investors to weight the sector so highly. But to blame index funds is just … stupid.

All investors in aggregate own the market, index funds own a market-cap-weighted percentage of the market, therefore so does everyone else! (As Bill Sharpe pointed out in The Arithmetic of Active Management a quarter century ago!)

I don’t know why this is so hard for people to get. Index funds do not set prices of securities or determine weights of holdings. All of that is done by active managers and investors (in aggregate). Index funds merely mechanically reflect that opinion. Again, index funds don’t do price discovery – thus it is irrational to blame (or praise, but you generally don’t see that) them for their holdings! (I am talking about traditional market-cap-weighted funds, you could plausibly make a case that other types of passive funds – smart beta for example – are somehow irrationally weighting and, if enough money is invested in them, that it is distorting the market.)

Finally, my recurring reminders:

J.P. Morgan’s updated Guide to the Markets for this quarter is out and filled with great data as usual.

Jonathan Clements, Morgan Housel, and Larry Swedroe, all continue to publish valuable wisdom. Just a reminder to go to those links and read whatever catches your fancy since last quarter.

That’s it for this quarter. I hope some of the above was beneficial.

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David

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