Book Review: The Algebra of Wealth

Scott Galloway uses a unique style in his book The Algebra of Wealth: A Simple Formula for Financial Security.  Rather than offer generic advice to choose a career that pays well, Galloway takes the tone of someone telling you privately what he really thinks of various career options, for example.  He takes a similar approach to other topics as well.  Readers may not agree with all of his advice, but they can’t say his opinions weren’t clear.  

The book is divided into chapters on focus, good habits, and avoiding mistakes; choosing a career and developing skills; spending, saving, and budgeting; and investing.  The blunt commentary on choosing a career was the most interesting part of the book.  

For those concerned that this is some sort of math book, it isn’t.  The few formulas in the book are mostly not intended to be taken literally.  For example, “focus + (stoicism x time x diversification),” and “value = (future income + terminal value) x discount rate.”  That latter formula is vaguely close to a value formula, but is unlikely to be helpful to anyone who doesn’t already know the actual formula.

Career choice

Many writers have taken sides on whether to “follow your passion” in picking a career.  Galloway’s take is interesting.  “Don’t follow your passion, follow your talent.” “Passion careers suck,” and “work spoils passion.”  “Focus on mastery; passion will follow.”  I’ve certainly suspected that the reason I had passion for my career and the sports I’ve played is because I was good at them.

Because few entrepreneurial ventures succeed, working for a large organization “offers better risk-adjusted returns.”  “As a society, we romanticize entrepreneurship.” “The defining characteristic of an entrepreneur” is lacking “the skills needed to succeed in a large organization.”  Most entrepreneurs “did not start companies because they could, but because they had no other options.”

Jobs in the trades can be very lucrative, but “We have shamed an entire generation into believing a trades job means things didn’t work out for you.”  Pursuing a college or university degree isn’t the best option for everyone.

Loyalty

These days, employers offer little loyalty to their employees, “and that has made our loyalty to one another, as individuals, even more important.”  “Mike Bloomberg once said, ‘I have always had a policy: If it’s a friend and they get a promotion, I don’t bother to call them; I’ll see them sometime and make a joke about it.  If they get fired, I want to go out for dinner with them that night.  And I want to do it in a public place where everybody can see me.”

Savings Goals

“Ambitious savings goals … can backfire.”  Research shows “people set overambitious goals for savings in the future.”  “Set a goal for saving this month, and you are likely to be realistic and achieve your goal.  Set a goal for saving in six months, and you are likely to set an unrealistic goal and fail to meet it.”  I can’t say I found this to be true for me about saving money, but it’s definitely true for my exercise goals.

Financial planning

“Failing to consider inflation is a common but severe oversight in financial planning.”  Ignoring inflation entirely can be devastating, but assuming it will remain at some fixed low level is dangerous as well.

“You aren’t paying [financial advisers] for investment returns.  Over the long term, nobody beats the market.  And if someone does have the secret to above-market returns, they aren’t going to be sharing it with you for a fixed percentage.  You’re paying an adviser for planning, accountability, and confidence.”

Investing

Invest “in a half dozen low-cost, diversified exchange-traded funds (ETFs) that put the majority of your money in U.S. corporate stocks.”  This is solid advice, but 6 ETFs may be high these days.  There are many good solutions that use 1-3 ETFs.

Galloway’s take on the passive/active investing debate.  Once they get to $10,000 in long-term savings, he tells people to invest $8000 passively, and $2000 actively, and to invest anything past $10,000 passively.  The $2000 “is enough that when you lose, you’ll feel the pain, but it’s not so much that you’re putting your future economic security at unnecessary risk.”  The idea is to learn whether you’re cut out for active investing without risking too much.  Galloway recommends avoiding active funds.

Those who delve into stock picking need to look out for EBITDA.  “CEOs like to emphasize EBITDA [rather than actual profit figures] for the simple reason that it makes their business look more profitable.”  “There has been a trend toward even more aggressive metrics, especially among early stage companies, usually described as ‘adjusted EBITDA.’”  Galloway describes the justification for such metrics as “dubious.”

One short section gives one of the best explanations I’ve seen of what bonds are, why they exist, and what players are involved in bonds.

Options markets are “dominated by sophisticated professionals.”  “Retail investors buying individual [option] contracts are minnows who these big fish swallow up for easy profit.”

Conclusion

This book has interesting takes on a variety of important personal finance topics.  Some of it is specific to Americans (mainly tax matters), but the majority of the book is useful to Canadians as well.  Whether you agree or disagree with the opinions expressed, it will make you think.

Inflation is Much Riskier than Financial Planning Software Makes it out to be

As we’ve learned in recent years, inflation can rise up and make life’s necessities expensive.  Despite the best efforts of central bankers to control inflation through the economic shocks caused by Covid-19, inflation rose significantly for nearly 3 years in both Canada and the U.S.  

Uncertainty about future inflation is an important risk in financial planning, but most financial planning software treats inflation as far less risky than it really is.  This makes projections of the probability of success of a financial plan inaccurate.  Here we analyze the nature of inflation and explain the implications for financial planning.

Historical inflation

Over the past century, inflation has averaged 2.9% per year in both Canada and the U.S.(*)  However, the standard deviation of annual inflation has been 3.6% in Canada and 3.7% in the U.S.  This shows that inflation has been much more volatile than we became used to in the 2 or 3 decades before Covid-19 appeared.  In 22 out of 100 years, inflation in Canada was more than one standard deviation away from the average, i.e., either less than -0.7% or more than 6.5%.(**)  Results were similar in the U.S.

Historical inflation has been far wilder than the tame inflation we experienced from 1992 to 2020.  And the news gets worse.  Within reason, a single year of inflation is not a big deal to a long-term financial plan; what matters is inflation over decades.  It turns out that inflation is wilder over decades than we’d expect by examining just annual figures with the assumption that each year is independent of previous years.

The standard deviation of Canadian inflation over the twenty 5-year periods is 14%, and over the ten decades is 27%.  Based on assuming independent annual inflation amounts, we would have expected these standard deviation figures to be only 8% and 11%.  How could the actual numbers be so much higher?  It turns out that inflation goes in trends.  This year’s inflation is highly correlated with last year’s inflation.  Rather than a correlation of zero, the correlation from one year to the next is 66% in Canada and 67% in the U.S.(***)

Even successive 5-year inflation samples have a correlation of 60% in Canada and 56% in the U.S.  It’s only when we examine successive decades of inflation that correlation drops to 23% in Canada and 21% in the U.S.  This is low enough that we could treat successive decades of inflation as independent, but we can’t reasonably do this for successive years.

How relevant is older inflation data?

Some might argue that old inflation data isn’t relevant; we should use recent inflation data as more representative of what we’ll see in the future.  After all, central banks had a good handle on inflation for a long time.  Let’s test this argument.

From 1992 to 2020, inflation in Canada averaged 1.72% with a standard deviation of 0.94%.  Using this period as a guide, the inflation that followed was shocking.  In the 32 months ending in August 2023, inflation was a total of 15.5%.  Using the 1992 to 2020 period as a model, the probability that the later 32 months could have had such high inflation is absurdly low: about 1 in 10 billion.(****)

It may be that older inflation data is less relevant, but our recent bout of inflation proves that the 1992 to 2020 period cannot reasonably be used as a model for future inflation.  There is room for compromise here, but any reasonable model must allow for the possibility of future bouts of higher inflation.

Implications

It’s important to remember that once a bout of inflation has been tamed, the damage is already done.  Prices have jumped quickly and will start climbing slower from their new high levels.  If there has been 10% excess inflation over some period, all long-term bonds and future annuity payments will be worth 10% less in real purchasing power than our financial plans anticipated.  This is a serious threat to people’s finances.

We often hear that government bonds are risk-free if held to maturity.  This is only true when we measure risk in nominal dollars.  Because spending rises with inflation, our consumption is in real (inflation-adjusted) dollars.  Bonds held to maturity are exposed to the full volatility of inflation.  We need to acknowledge that bonds have significant risk.  Only inflation-protected government bonds are free of risk.

When financial planning software uses a fixed constant for inflation, like 2% or 2.5%, it is understating the risk posed by inflation.  With constant inflation, bonds held to maturity look risk-free when they aren’t.

Most annuities are also exposed to inflation risk.  Annuities are good for removing longevity risk, but future payments are not as stable in real dollars as they appear to be in nominal dollars.

When software performs Monte Carlo simulations to determine the probability that a financial plan will fail, a poor model of inflation overstates the protection offered by bonds and annuities.  The probability that bonds and annuities will fail to perform their main function of providing safety is higher than these simulators estimate.

It’s fairly easy to write software that performs Monte Carlo portfolio simulations.  The challenge is in correctly modelling investment returns and inflation with reasonable parameters.  Unfortunately, software outputs look equally slick whether this modelling is done well or not.  It’s easy to tinker with model parameters to get the success percentage you want for a financial plan, even if you don’t intend to cheat.

Remedies

One way to address inflation risk is to model it better and simulate it along with stock and bond return simulations.  However, stock and bond returns are not independent of inflation.  If a particular simulation run has high inflation, it’s not reasonable to assume that subsequent nominal stock and bond returns are unaffected.

Along with high inflation, we often get interest rate changes, which affects future bond returns.  Businesses typically raise prices in response to inflation, which can raise future nominal stocks returns.  The interplay between inflation and investment returns is complex.

Some financial planners recognize the problem of fixed inflation assumptions and they run their Monte Carlo simulations with different fixed values for future inflation as a further test of a financial plan.  This helps to some degree, but they are punishing the returns from bonds, annuities, and stocks equally, which doesn’t reflect the reality of inflation’s effects on different types of investment returns.

Because we spend real inflation-adjusted dollars, it’s better to model the real returns of stocks, bonds, and other investments directly.  Instead of studying nominal stock returns to create simulation models, we should study and model real stock returns.  The same is true for bonds and other types of investments such as real estate.

We would still need to model inflation to estimate capital gains taxes and anything else that is based on nominal dollars, but directly modelling the real returns of investments tends to make it easier to properly simulate and test a financial plan.

Conclusion

Most financial planning software underestimates the potential for inflation to disrupt a financial plan.  Measuring volatility in nominal terms is fundamentally misguided, and treating inflation as constant implicitly treats nominal and real quantities as having the same volatility.  As a result of this distortion, bonds and annuities are over-valued as a means to control risk.  Inflation-protected bonds are under-valued.  The success percentages that portfolio simulators calculate for financial plans often have little connection to reality.

Footnotes

(*) All figures used here use the logarithm of Consumer Price Index (CPI) ratios.  This is important for good modelling of inflation and investment returns, but makes only a modest difference in the actual figures.  For example, the average logarithm of annual inflation in Canada for the past century is 2.914%, which corresponds to compound average annual inflation of exp(2.914%)-1=2.957%.

(**) For those who expected inflation to be more than one standard deviation from its mean 32% of the time instead of 22%, this is misapplying the normal distribution (also known as the bell curve).  Inflation figures are far from normally distributed.  Financial mathematics is littered with over-application of the normal distribution.

(***) When a random variable is uncorrelated with its past annual values, the standard deviation of a 5-year sum is sqrt(5) times the standard deviation of a single year.  For decades, we multiply by sqrt(10).  With inflation, the actual correlation is not zero; the autocorrelation coefficient is about 2/3.

(****) Assuming that annual inflation samples are independent and lognormal with a mean of 1.72% and standard deviation of 0.94%, our recent 32-month bout of inflation is a 6.4-sigma event, which has probability of about 10^(-10).  So, the distribution assumptions are clearly not true.

How Investing Has Changed Over the Past Century

Benjamin Graham is widely considered to be the “father” of value investing, the process of finding individual stocks whose businesses offer the prospect of future price gains while offering reasonable protection against future losses.  Graham co-founded Graham-Newman Corp. nearly a century ago.  Stock markets have changed drastically since then.

Early in Graham’s investing career, his approach was to buy stock in companies that were out-of-favour and severely undervalued.  He described these methods in his 1934 book Security Analysis.

But Graham’s investment methods were never static.  As Jason Zweig explained in Episode 75 of the Bogleheads on Investing Podcast:

“People criticize Graham all the time for being old-fashioned, for having these formulaic techniques for valuing stocks, … and then people say these things are all out-moded.  Nobody invests like that any more.  Nobody should.  And that completely misses the mark for two reasons.  First, during his lifetime, Graham revised the book [The Intelligent Investor] several times, and every time he revised it he changed all those formulas.  He updated them to reflect the new market realities at the time the new edition of the book was coming out.  … If he were still around today, he would update all those formulas all over again, and they would look nothing like what’s in the books.  … The second objection is much more basic, which is: that’s not Graham’s message.  … Graham’s message is that if you try to play the same game as Wall Street itself, you will lose.”

Graham recognized that markets change over time.  To keep beating the market averages, as he did for many years, his investment methods had to change over time.

However, in Graham’s last version of The Intelligent Investor in 1973, he wrote

“We have some doubt whether a really substantial extra recompense is promised to the active investor under today’s conditions. But next year or the years after may well be different. We shall accordingly continue to devote attention to the possibilities for enterprising investment, as they existed in former periods and may return.”

Graham expressed optimism that conditions might change so that some version of his investment approach might beat the markets.  However, that hasn’t been the trend.  Markets have become ever more competitive with each passing decade.

Another quote from Graham in the same 1973 book:

“Since anyone—by just buying and holding a representative list [a market index]—can equal the performance of the market averages, it would seem a comparatively simple matter to ‘beat the averages’; but as a matter of fact the proportion of smart people who try this and fail is surprisingly large.  Even the majority of investment funds with all their experienced personnel have not performed so well over the years as the general market.”

By 1976, Graham become more pessimistic about beating markets:

“I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook ‘Graham and Dodd’ was first published; but the situation has changed a great deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost.”

Graham remains a hero to many value investors, despite the fact that 48 years ago he doubted whether analyzing businesses to find good value worked any more.  Graham’s methods worked from 50 to 100 years ago because of the ample dumb money flowing in stock markets.  For superior investors making excess returns to exist, there must be many inferior investors performing worse than market averages.

The proportion of money in stock markets controlled by individual investors has declined steadily over the decades.  Investors who knew little used to buy their own stocks.  Now, many such investors use mutual funds and exchange-traded funds to have their investments controlled by experts.  Dumb money has shrunk as a percentage, and the competition among investment professionals to exploit dumb money has become so sophisticated that few understand it.

Markets have reached the point where many smart investment professionals seem like dumb money when compared to their competition.  In this environment, individual investors have little chance as stock pickers.  In the third edition of The Intelligent Investor, Jason Zweig wrote

“Millions of investors spend their entire lives fooling themselves: taking risks they don’t understand, chasing the phantoms of past performance, selling their winning assets too soon, holding their losers too long, paying outlandish fees in pursuit of the unobtainable, bragging about beating the market without even measuring their returns.”

Markets have changed dramatically over the past century.  Simple methods of beating markets stopped working decades ago.  There may be some brilliant investors, such as Warren Buffett, who can still beat markets, but most investors actively investing their own money are just fooling themselves.  We could make the case that if Graham were around today, he might be a passive index investor.