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!

First, I don’t do individual securities analysis, but I do like debunking silly reasoning. For at least a few years we have seen items like this (from the LA Times on 9/29/18):

Production and sales of Tesla’s Model 3 are up, albeit at levels far below Musk’s ambitious forecasts. Even after Friday’s drop, the company still carries a market value of $45.1 billion, higher than Ford Motor Co. and just short of General Motors’ $47.5 billion.

The value of a company’s stock is the residual value after creditors are paid. You can think of stock as a call option on the company with a strike price at the value of the debt. More stable companies will have more debt; less stable companies will have less debt. The metric that matters for “value of Tesla vs. X” is TEV (Total Enterprise Value), not stock value. Because the traditional auto manufacturers have far more debt, just looking at the equity value is misleading.

I haven’t taken the time to compute the TEV figures myself, but here are some old figures (2017) that I have no reason to disbelieve (source) just to give you a sense of the difference:

Ford: $237.6 billion
GM: $215.8 billion
Tesla: $64.5 billion

Second, also on the subject of Tesla, I have a crazy theory I thought I would document here so if it turns out right I can say “I told you so” (if it turns out wrong, of course, we will never speak of it again).

I think Elon Musk might be trying to get fired as CEO of Tesla so he can walk away and the implosion of the stock price (which seems pretty inevitable to me) won’t be on him. He can say if he’d been there it would have worked out and investors would have made a lot of money.

In other words, better to lose money from his personal Tesla holdings declining in value and retain the Musk “aura” than to lose on both. I’m probably wrong, but threatening his board that he would quit if they settled and taunting the SEC with “Shortseller Enrichment Commission” just seems like trying to get fired by either the board or the SEC.

Warren Buffett once said, “I try to buy stock in businesses that are so wonderful that an idiot can run them. Because sooner or later, one will.” What is the value of Tesla without Musk? That is the value I would give it.

Third, good Cliff Asness interview here. I love this portion:

ES: You’re as confident as ever in your backtests, confident that the factors you’ve identified are replicable going forward, confident that they’re not the result of data mining or survivorship bias?

CA: I’m always in a panic that they’re the result of data mining or survivorship bias. We spend our lives trying to disprove that. I’ll still wake up sweating once a year, worrying that we’ve just gotten lucky forever.

Since I think the biggest danger in professional investing is hubris (see LTCM), I really like that attitude. As Andy Grove repeatedly said, “Only the paranoid survive.” (It’s a good book too.)

Fourth, last quarter I shared my “wish list for financial institutions” (item 11) and I have an addition:

Since futures contracts are taxed 60% LTCG and 40% STCG, why doesn’t a mutual fund company come out with a fixed income index fund (based on the Barclay's Agg for example) that invests in futures? In other words, is there a reason a company can’t create a better bond index fund designed to be held in taxable accounts by using futures as the investment instead of the actual bonds? At higher interest rate levels, it seems like that would be compelling. Maybe I’m missing something though.

Fifth, on the NAPFA message boards, someone asked about ways to protect assets for someone about to be sued. I answered (in part): “Once you know (or have reason to believe) there are claims, most actions would be deemed fraudulent conveyances.”

But I really liked my closing line, and thought it was worth sharing: “Asset protection strategies are prophylactics not antidotes.”

Sixth, another post on those message boards inquired about arguments for purchasing life insurance on children. A portion of my response (lightly edited):

The highest odds of death, from ages 1 (after infant mortality risk has passed) to 18, is for a 1 year old male and the chance of death (all mortality figures from the RP-2014 tables) is 0.00041 or 1 in 2,439. The lowest is a 10-year-old boy with a chance of death of 0.000072 or 1 in 13,889.

So, the value of the insurance itself for a juvenile, while they are a juvenile, is the death benefit divided by somewhere between 2,439 and 13,889. In other words, if the death benefit is $20k (just to have an arbitrary number to work with) then the true cost of insurance is just $1.44 to $8.20 per year! So the vast majority of the annual premiums are just overhead. In fact, the value of the death benefit is so low, you can ignore it as immaterial and just do a straight time value of money calculation. What is the guaranteed cash value (FV) in year N for an annual premium of PMT (PV is zero)? It’s an annuity due (premiums collected up front), solve for I. I suspect it will be a negative number which means on average you would do better to just put the money in a sock drawer.

Let me do it another way. If you took out a policy for a child age 1 and held it until age 18 and it had a death benefit of $20,000 (sticking with my earlier arbitrary choice) then the total cost of insurance for the whole period is just $61.24 for a boy and $46.70 for a girl. If you have all the rest of the premiums paid in available as cash value at 18 then you still earned zero rate of return. (And I would be shocked if the cash value was that high.)

Seventh, I read a good article on hedge funds.

Eighth, I recommend this article, 16 Characteristics of Critical Thinkers.

I share items on thinking sometimes because what we are fundamentally “selling” is not products, transactions, or strategies, but wisdom. Learning to think better is literally improving our product.

Ninth, last quarter I shared a link to a blog post I wrote on Philosophy of Foreign Investing. I recently wrote a similar post, Philosophy of Fixed Income Investing if you are interested.

Tenth, a summary (free) of a paper (behind paywall) on the lifetime medical spending of retirees is worth a read if you do retirement planning.

Eleventh, this is utterly unimportant, but I was just thinking there are a lot of finance and economics terms that would be great names for a rock band. Some of these are better than others, but consider:

• Accidental Death and Dismemberment
• Adverse Selection
• Bollinger (then it would be the “Bollinger Band” – get it?)
• Creative Destruction
• Dead Cat Bounce
• Gross National Product (this one exists, it’s a comedy troupe in DC)
• Iron Condor
• Moral Hazard

Twelfth, a great quote, “Diversification for investors, like celibacy for teenagers, is a concept both easy to understand and hard to practice.” – James Gipson

Thirteenth, I mentioned this previously (item 16), but now I have the actual paper for you. Also, I saw this summary, which I liked:

Analysis of 400-million-person family tree shows genetics contributes no more than 7% to person’s average lifespan, previously thought to be up to 30%; lifespan of spouses more correlated than siblings of opposite gender.

The whole article at the link above is a good summary of the paper.

Fourteenth, I have been saying for well over a decade that there are four topics that just start arguments among “mixed” groups of advisors (mixed business models):

• Fees vs. commissions
• Active vs. passive management
• Permanent vs. term insurance
• Annuities vs. taxable accounts

No one ever changes their minds (well that may be a slight exaggeration) on these; they just get angry. There are two reasons I think:

1. “Reasoning will never make a Man correct an ill Opinion, which by Reasoning he never acquired” – Jonathan Swift (or, in more contemporary language, “You cannot reason people out of positions they didn’t reason themselves into.”)
2. “It is difficult to get a man to understand something, when his salary depends on his not understanding it.” – Upton Sinclair

An article today had a slightly different list that I thought was interesting (and he used the Sinclair quote above that I like):

• Insurance (permanent and annuities, so two of my four combined into one)
• Paying off the mortgage
• Gold
• Bitcoin

We should all make sure we are using reason and not emotion or biases caused by business model when making client recommendations (and even fee-only folks have conflicts). For example all of the following frequently (not always!) make sense, but will reduce the portfolio size and thus the fees or commissions earned on that portfolio:

• Delay SS claiming – the math generally says wait, but the client will typically draw down their portfolio more while waiting.
• Mortgage payoff – it depends on the client situation, see here for analysis.
• Spending/giving – encouraging additional spending (when it is still at a sustainable level) or giving (to heirs, charity, etc.) may maximize client happiness (and be prudent).
• Pension claiming – recommending the annuitization (rather than a lump sum).
• Immediate annuity purchase – similar to the last point, academics refer to the rarity of this as the “annuitization puzzle”.

Fifteenth, I saw an article on timing the market. I tried a similar exercise many years ago and I couldn’t get any timing strategy to beat buy-and-hold (and rebalance) either (though the risk-adjusted returns were slightly better). Even when stocks are relatively expensive, the expected returns are still higher than fixed income. You also have pretty big business risk (as a portfolio manager) as you would have been out of the market (for example) in the late 1990’s with any type of reasonable timing strategy. (See GMO’s stories of their travails – and they were survivors! “There is no joy in being right and being out of business.”)

Sixteenth, I read this, which was written for doctors but it applies to investment managers also. There are the three areas where, in theory, financial advisors may add value in portfolio management (setting aside value added through financial planning):

1. Setting and maintaining an appropriate strategic asset allocation at the asset class level.
2. Deviating from that strategic allocation by market timing when it seems prudent.
3. Implementing the strategic allocation through superior security selection.

You may recognize those three items from the famous (or infamous, depending on your point of view) Determinants of Portfolio Performance (1995) by Brinson, Hood, and Beebower. In a study of 91 large U.S. pension plans, they determined that the strategic allocation to stocks, bonds, and cash was by far the crucial decision. Indeed, the decisions of which individual securities to buy or the decision to deviate tactically from the strategic allocation (presumably with the view that investments were cheap or expensive) removed value! In other words, if these pension plans had just selected an asset allocation, bought index funds to implement it, and rebalanced back to the target periodically, they would have had better performance.

Having the serenity to accept that there are things you cannot do successfully (market time and stock pick) will help you sleep better at night and avoid burnout. Does this mean we should never engage in market timing or security selection? No. There may be rare times when it is “obvious” some area of the market is mispriced (“obvious” in scare quotes because it will be far more so retrospectively than prospectively) such as tech stocks in 1999, residential real estate in 2007 (and 2009 in the opposite direction), or Japanese stocks in 1991. Notice those examples are the only three I have in the last 35+ years though. While we can try to add value there, it will be a rare opportunity, and we should be appropriately skeptical of our limited abilities and thus not feel stress if we can’t successfully execute. (I also think we can add value with factor tilts, but I would consider that part of the strategic allocation decision, not a security selection decision, but I freely admit that it is a gray area.)

You may remember my lame attempt at launching a meme a while back with this:

Seventeenth, I’ve been keeping up with blockchain (and it was covered on the CAIA exam I recently took). Good piece here giving some of the issues.

For the record, I’m bullish on blockchain technology, but not on investing in cryptocurrencies or blockchain companies. In other words, I expect the value to accrue (eventually) to us as consumers, not as investors (in aggregate, someone will probably win the lottery as an investor).

Eighteenth, as mentioned in the previous item, I have been reading up on alternative investments lately (and went ahead and got the CAIA designation) and thinking about investments more broadly.

In theory, the CAPM is exactly right. There should only be two assets (and infinite combinations): a risk-free bond, and risky stocks. You can own all risk-free, or all risky, or even lever the risky by shorting the risk-free. That probably gives you a continuum something like this:

1. Treasury bond (no risk)
2. Corporate bond (a little risk mixed in)
3. High-yield bond (more risk…)
4. Blue-chip stock (even more…)
5. Small-cap stock (still more…)
6. Micro-cap stock (more!)
7. Private equity (more!!)
8. Venture capital (more!!!)

So I think, to a first approximation, PE is nothing more than levered blue chip, etc.

Everything that is not that single, CAPM, type of risk (beta) should not have any excess returns because you can diversify away all risks except that one risk of the market.

Despite the theory, I think there are three sources of return that are not captured on that continuum:

1. Factors such as value & momentum (probably behavioral explanations)
2. Liquidity premium (probably not priced enough though – people don’t worry much about it until market crashes so then it ends up correlated with beta)
3. Other (so-called alternative) risk premia

Regarding that third category, in theory, alternative betas (if they are truly uncorrelated to “regular” beta) should earn the risk-free rate. In other words, if you combine enough uncorrelated alternative betas, you diversify right into no risk which then shouldn’t provide a risk premium. In practice, investors will probably demand some excess returns over the risk free rate for even alternative betas (i.e. alternative risk premia), but it looks (to me at least) like the providers of alternative betas are extracting pretty high fees for them in most cases. Nonetheless, I thought I would make a little list (which I hope to expand over time) of some of these things that in theory would be sources of return that are not (individually) risk-free, but are also uncorrelated to “regular” beta. So, investments that would 1) have no beta (i.e. trivially correlated to the market at most), 2) are long only (i.e. you didn’t get to uncorrelated by shorting out the market exposure), in no particular order:

• Litigation financing
• Catastrophe bonds
• Life/viatical settlements
• IP (movie production, patents, etc.)
• Collectibles/commodities (maybe)

Any you can think of that I have omitted?

Nineteenth, I was talking with an advisor about various things and it got me thinking about things that advisors should either do a lot of or none – i.e. the middle spot is terrible, as you will be inefficient and/or do a terrible job:

• Bill on “held away” assets (retirement accounts, annuities, etc. that can’t be moved “in house” to the advisor)
• Sell insurance products
• Service retirement plans (not SEP, SIMPLE, solo-401(k), but full blown qualified plans)
• Prepare tax returns
• Do cross-border planning and investing
• Do estate planning for folks with significant taxable estates

In other words, if you are going to bill on 50 held-away accounts, that might make sense, but 5? Almost certainly not worth the overhead hassle. If you are going to take 2 clients who live in other countries, or service just one large qualified plan, or do financial planning for a single client with a $100mm net worth (when you have no others over the estate tax limit), you are almost certain to lack appropriate expertise.

Have I missed any?

Twentieth, many people assume that there is a high financial return on elite higher education, but there is long-standing research that it isn’t that simple. A good summary is here. Seminal papers mentioned in that article are here and here.

Twenty-first, seeing GDP by country over time is interesting, this is less than 2 minutes long and I think worth the time.

Twenty-second, getting rich just isn’t complicated (though it may be hard), as noted here. Most millionaires simply “earned a lot, saved a ton, and invested for a long time.”

Twenty-third, expected inflation is remarkably low – well under 2% at all horizons as can be seen from the breakeven CPI computed from the yields on TIPS and “regular” treasuries:

Remember, if you have more nominal bonds than TIPS in your fixed income allocation then you are implicitly taking the “under” on this bet.

Twenty-fourth, the latest U.S. Trust Insights on Wealth and Worth found there were five topics that HNW individuals wanted to discuss more with their advisors:

1. Estate planning
2. Trust options and implications
3. Strategic philanthropy
4. Facilitating discussions about the use of family wealth
5. Teaching children/heirs financial skills

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. (There is no way to filter for just Jonathan Clement’s posts – that I can find anyway – so you have to search manually.)

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

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Regards,
David

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