Wednesday, January 16, 2019

Firing Male Brokers and Financial Advisors

The article Consider Firing Your Male Broker by Investment Advisor Representative Blair duQuesnay in the New York Times has generated a firestorm of comments. Most readers didn’t like the obvious sexism, but I’m more concerned about the muddled reasoning.

The article says research shows women investors outperform men, and therefore, you should choose a female financial advisor or broker. This reasoning presupposes that financial advisors and brokers are focused on the performance of their clients’ portfolios. This is far from the truth.

Most financial advisors and brokers are salespeople who sell what their employers tell them to sell. Typically, they either don’t know or don’t care that what they’re selling isn’t good for their clients. The fact that so many advisors invest their own money the same way they invest their clients’ money shows they don’t have bad intentions.

Even those advisors and brokers who know they’re hurting their clients didn’t necessarily start out this way. But they started to figure out that what they’re told to sell isn’t helping their clients, and they either lived with this knowledge or eventually quit. Some of those who quit go on to get higher designations and work in different environments with more autonomy so they can do a better job for their clients. Unfortunately for investors, this type of advisor typically takes only higher net worth clients.

If a new rule outlawed all male financial advisors and brokers, after a few years of hiring and employee turnover, the typical female advisor would either not know or not care that what they’re selling isn’t good for their clients. Large financial institutions run their operations to get profitable behaviour from their employees whether they’re women or men.

We might then ask whether women should run the financial institutions. The filtering process for high-powered positions in big companies is much more severe than it is for becoming a financial advisor or broker. The only people who move high up on the corporate ladder are those willing to run the company profitably. This applies equally to male and female executives. Whether there is sexism or not during the climb up the corporate ladder, you can bet that those who reach the highest rungs are focused on profits.

In the end, this article isn’t helping investors choose a better advisor, and it isn’t shaping a better path forward for the financial industry. But if investors accept its message, it might help some female financial advisors and brokers meet their sales targets.

Monday, January 14, 2019

Skating Where the Puck Was

Diversifying your portfolio reduces volatility and improves compound average returns. Portfolio theorists dream of finding risky asset classes with low correlation to known risky asset classes. However, author William J. Bernstein argues that correlations between asset classes have been rising. He explains why this is so in his book Skating Where the Puck Was: The Correlation Game in a Flat World, the second book of his four part Investing for Adults series.

One of the side effects of rising correlations is that everything tends to crash at once. We are moving toward “a cohort of nearly identically behaving asset class drones.” “When everyone owns the same set of risky asset classes, the correlations among them will trend inevitably toward 1.0.”

Bernstein asks “Will things really get that bad?” The surprising answer is “We are, in fact, already there; further, it’s always been that bad. Yes, international REITs were a wonderful diversifying asset, but the ordinary globally oriented investor, and even most extraordinary ones, did not have access to them before 2000. Ditto commodities before 1990 or, for that matter, foreign stocks before 1975.” “Diversification opportunities available to ordinary investors were never as good as they appeared to be in hindsight.”

There is some good news, though. “Short-term and long-term risk are indeed two very different things.” Bernstein gives data showing that monthly returns show high correlation, but 5-year returns show much lower correlation. So, your asset classes tend to crash together, but if you wait long enough, their returns tend to drift apart and give some diversification benefit.

In the past, early investors in new asset classes benefited from diversification, but those who pile in later are “skating where the puck was.” It’s necessarily the case that as many investors buy into an asset class, its correlations with other asset classes rise.

My takeaway from this book is that I can’t avoid market crashes that affect most of my portfolio. I’m best off to live on safe liquid assets and wait out any market declines in the rest of my portfolio.

Thursday, January 10, 2019

The Ages of the Investor

Different stages of life call for different investing approaches and the need for transitioning from one stage to the next. William J. Bernstein addresses this challenge in his short book The Ages of the Investor: A Critical Look at Life-cycle Investing, the first book in his four part Investing for Adults series. His suggested method of transitioning toward retirement is very sudden.

Bernstein splits life-cycle investing into opening moves, middle game, and endgame. When you’re young, he suggests taking on as much risk as you can handle. Because this book is aimed at “investing adults,” he presumes the reader knows that stock picking and market timing are losing strategies. So, in this context, “risk” means compensated risk that comes with higher expected returns and comes mainly from stocks. Young investors are best off taking as much risk as they can handle without losing their nerve and selling out when stocks hit a difficult patch. “The young investor’s first encounter with a significant market decline serves mainly to ascertain her true risk tolerance.”

The book covers the life-cycle investing approach promoted by Ayres and Nalebuff that has young investors taking on 2:1 leverage using margin investing or call options on stock indexes. Bernstein lists some problems with this approach but leaves out the most serious problem: your ability to save in the future (and even to avoid withdrawing from savings) is highly risky. Losing your job during a stock market crash could completely wipe out leveraged savings.

An alternative to leverage is stock market investing using factor tilts. I tend to be skeptical that factor tilts will give future results that match past apparent success. Perhaps a slight tilt to small value stocks is sensible, but there is nothing wrong with an unleveraged position in low-cost stock indexes.

Because a mortgage is like a “negative bond,” it’s best to “Pay the damned thing off” rather than own bonds at the same time as holding a mortgage.

Bernstein portrays value averaging (VA) as an alternative to dollar-cost averaging (DCA) and describes VA as “a clever technique pioneered by Michael Edelson.” Value averaging doesn’t work. The main problems are 1) the return calculations supporting VA ignore opportunity costs of cash on the sidelines and interest on borrowed money, and 2) VA can lead to unsafe levels of leverage. I did some experiments to examine actual VA returns if we modify the strategy to eliminate these problems.

As you near retirement (the “endgame”), Bernstein suggests splitting your portfolio into two parts, a “liability matching portfolio” (LMP), and a “risk portfolio.” The idea is that the LMP contains completely safe assets that cover your basic needs for the rest of your life. The challenge is to create a LMP free from inflation risk, longevity risk, and counterparty risk (insurance company bankruptcy).

After examining several LMP approaches that all have risks, Bernstein chooses a ladder of inflation-protected bonds as the best option. This means Real-Return Bonds (RRBs) in Canada and Treasury Inflation-Protected Securities (TIPS) in the U.S. The challenge I see here is that we still have longevity risk. How many years of RRBs are safe?

During the middle game of your investing life “If, at any point, a bull market pushes your portfolio over the LMP “magic number” of 20 to 25 times your annual cash-flow needs beyond Social Security and pensions, you’ve won the investing game. Why keep playing? Start bailing.” The author calls for a sudden sell off of risky assets to buy the LMP. Then any new savings can be invested as riskily as you like.

This LMP idea would be more appealing if it handled longevity risk. How do I know that 20 to 25 times my annual spending needs is enough? If an investor bails out into a LMP in her 50s anticipating working to 65, but loses her job, the LMP is suddenly not enough for a longer retirement.

One side note most Canadians would agree with: the U.S. has “a dysfunctional health-care system and an inadequate safety net.”

On the subject of safe spending from a portfolio: “Below the age of 65, a 2% spending rate is bulletproof, 3% is probably safe, and 4% is taking chances. Above 5%, you’re taking an increasingly serious risk of dying poor. (For each five years above 65, add perhaps half a percentage point to those numbers.)”

It has become popular to plan for reduced spending throughout retirement. I’ve written many times about flaws in this idea. Bernstein takes this further by explaining why we might want to spend more in the future, even in inflation-adjusted terms. “Worker productivity, wages, and per capita GDP all grow at a real rate of about 2% per year. So will your expectations. Would you be happy with a 1960s standard of living? When everyone else has or will soon have an iPad, could you stand to live without one?”

Overall, I recommend this book for its critical thinking about life-cycle investing. However, I take issue with some of the specific recommendations.

Friday, January 4, 2019

Short Takes: All-in-one ETFs, Bankruptcy, and more

I managed only one post in the past two weeks:

Rational Expectations

Here are some short takes and some weekend reading:

Canadian Couch Potato reviews iShares’ new all-in-one ETF portfolios and compares them to similar ETFs from Vanguard.

Doug Hoyes makes sense of some Canadian debt statistics. One of his conclusions: “I fully expect our Homeowners’ Bankruptcy Index to rise, dramatically.”

Preet Banerjee interviews Melissa Leong, author of the new book Happy Go Money: Spend Smart, Save Right and Enjoy Life.

Big Cajun Man got into the spirit of the holidays with 12 days of Christmas debt.

Robb Engen at Boomer and Echo implores us to stop giving markets our attention.

Thursday, January 3, 2019

Rational Expectations

It’s not easy to choose your portfolio’s asset allocation and decide how to change it as you head into retirement. William J. Bernstein discusses the many considerations that affect asset allocation decisions in his book Rational Expectations: Asset Allocation for Investing Adults, the last of four books in his Investing for Adults series.

Rather than just provide a set of model portfolios, the book includes a range of topics to help the reader choose his or her own allocation. These topics include historical asset-class returns, factor tilts, market efficiency, asset location, risk tolerance, your brain, liability matching portfolio, ETFs, rebalancing, and a lot more. You’re not left entirely on your own in building a portfolio; there are tables of recommended funds to cover the different asset classes.

To explain the intended meaning of “adult,” Bernstein says, “If the terms ‘standard deviation,’ ‘correlation,’ and ‘geometric average’ are Greek to you, or if you think you can time the market or pick stocks, then don’t buy this book.”

One quote that illustrates how Bernstein generally thinks clearly and correctly about investing is “The purpose of investing is not to simply optimize returns and make yourself rich. The purpose is to not die poor.” To this end, the author suggests that once you’ve saved enough to cover your future basic living expenses for the rest of your life, you should sell risky assets and buy government inflation-protected bonds. You can then invest any additional savings as riskily as you like.

Future stock returns are likely to be lower than they were in the past because it used to be difficult and expensive to own even a fraction of a stock index, “Prices stayed low, and the financial rewards were correspondingly high.” Further, “as societies grow wealthier, the supply and demand balance of capital shifts in favor of its consumers (companies) and away from its providers (investors).” The result is lower expected returns.

“Once you’ve arrived at a prudent asset allocation, tweaking it in one direction or the other makes relatively little difference to your long-term results.” What matters more is “your ability to stick to it through thick and thin.”

“When academics aggregate stock return data from many nations, statistically significant evidence of mean reversion appears. But since all the data come from the same time period, it’s hard to tell.” The existence of mean reversion means annual returns are correlated over time, which invalidates portfolio optimization methods that assume independence over time.

“Asset returns behave approximately lognormally,” but not exactly. A portfolio optimization technique called mean-variance optimization (MVO) assumes lognormal returns, and often gives crazy results. These crazy results come from a combination of the lognormal assumption and MVO being very sensitive to the accuracy of estimates of expected returns. Rather than use MVO, “I suggest a more profitable way to design your portfolio: stuff half the money in your mattress and lend the other half to your drug-addled nephew.”

On the subject of bonds, “sooner or later, we’re going to have an inflationary crisis, and in such an environment, long duration will be a killer.” “Bondholders of developed nations can expect to suffer permanent capital loss that equity holders will avoid.” For your fixed-income component, Bernstein recommends sticking to short-term government bonds and CDs (the U.S. equivalent of Canadian GICs). I don’t often find others who agree with the decision I made in my own portfolio to avoid corporate bonds and long-term government bonds.

Unfortunately, Bernstein has muddled ideas about asset location. He “largely” disagrees with the idea that “you should adjust downward the assets in your ... accounts by their estimated future tax exposures.” He reasons that assets are fungible, so “why should the exact stock/bond allocation of each [account] matter?”

The allocation in each account doesn’t matter. It’s the overall after-tax allocation that matters. By focusing on pre-tax asset allocation, Bernstein draws the incorrect conclusion that you should put assets that produce higher returns in accounts with lower expected tax rates. In reality, the author is mistaking tax efficiency for choosing a higher after-tax allocation to risky higher-return assets. When we hold the after-tax asset allocation constant, the supposed tax efficiency disappears.

The book quotes some interesting work by Philip Tetlock on market forecasters. The most extreme forecasts are the most wrong, but the media prefers extreme forecasts, and forecasters prefer media attention. “This sets up a positive feedback loop in which the media not only seeks out the most inaccurate forecasters but also worsens their forecasts.”

“Q. How do we know that economists have a sense of humor? A. They use decimal points.” It’s better to think clearly and make decisions that are approximately correct rather than rely too heavily on models that give precisely wrong results.

“Because threshold rebalancing tends to ‘catch’ market peaks and valleys more effectively than simple calendar rebalancing, I believe it is likely to be superior to calendar rebalancing.” I agree, but I wouldn’t recommend watching your portfolio daily in case a big market move triggers a need to rebalance. I’ve set up a spreadsheet that alerts me by email if I should rebalance my portfolio.

As for rebalancing thresholds, Bernstein gives some advice and concludes with “If you wind up rebalancing an asset class more than once per year on average, you should widen your thresholds. If you’re hardly rebalancing at all, narrow the thresholds.” The problem is that appropriate thresholds depend on portfolio size. My own work in this area may seem complex, but it factors in portfolio size, and in the end it’s just a few lines on a spreadsheet.

Overall, this is a valuable book for helping investors think about their asset allocations in sensible ways. I recommend it to anyone who meets the author’s definition of an “adult” investor.