Financial Professionals Spring 2022

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!

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First, there is a good explainer of the so-called Web 3.0 from Moxie Marlinspike, “a famous cryptographer and computer-security guy, the inventor of the Signal app, etc.,” here.

Charlie Munger commented, “To me, it’s just dementia. It’s like somebody else is trading turds and you decide you can’t be left out.” (For a direct parallel to buying stupid online pictures of apes see this.)

See also:

Cryptocurrency Is a Giant Ponzi Scheme
The Inevitability of Trusted Third Parties

Second, remember that things change: Cleveland was the 19th-century Silicon Valley!

Third, the speech, Trying Too Hard, is over 40 years old now and yet the lessons haven’t been learned. Undoubtedly because, as Upton Sinclair observed in 1935, “It is difficult to get a man to understand something when his salary depends upon his not understanding it.” I highly recommend reading it.

Fourth, “Student loan forgiveness is regressive whether measured by income, education, or wealth.” (source) Brookings Institute is liberal so I would take this to be a pretty good sign that student loan forgiveness (wholesale anyway) is dead.

Fifth, I shared a number of ESG links last quarter. Here’s another one: The Dubious Financial Impact of Impact Investing

Sixth, “Rich people plan for three generations. Poor people plan for Saturday night.” – Gloria Steinem

Seventh, the topic of “Investment Rules” came up in an email exchange, and I wrote a quick list of mine. These are just my simple, and perhaps arbitrary, rules. I’m mostly trying, as Charlie Munger said, to not be stupid: “It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be intelligent.”

  1. No sector investing – I generally don’t have enough sector expertise to have a better opinion than the market.
  2. No zero-sum asset classes (derivatives) – I don’t want to be reliant on someone else losing for me to win. They undoubtedly think they are smarter than me, and there is no obvious reason for me to disagree.
  3. No investments where a negative opinion (shorts) can’t be expressed (IPOs, PE) – When only bullish opinions can be reflected it would be hard for prices to be attractive, or even reasonable.
  4. Don’t buy things with high expense ratios – expensive is, of course, relative, but why have headwinds?
  5. Don’t buy things that are illiquid – I am unconvinced that an illiquidity premium reliably exists. (And Cliff concurs.)
  6. Don’t buy things where the counterparty can change the rules against you in the middle of the game (many insurance products).
  7. Don’t buy things that are expensive (even if it might seem justified) – mean reversion is a real thing (even if folks are confused about what it means).
  8. Don’t buy things that have no possibility of cash flows (i.e. zero dividend stocks are fine, but no NFTs, art, gold, cryptocurrencies, etc.) – there is no way to value such a thing that doesn’t end up being a psychological exercise (“people seem to like it/have always liked it so it must be worth something”).

Eighth, people tend to think that many (if not most) wealthy people became that way through inheritance. But here is the abstract of The (Un)Importance of Inheritances:

Transfers from parents—either in the form of gifts or inheritances—have received much attention as a source of inequality. This paper uses a 19-year panel of administrative data for the population of Norway to examine the share of the Total Inflows available to an individual (defined as the capitalized sum of net labor income, government transfers, and gifts and inheritances received over the period) accounted for by capitalized gifts and inheritances. Perhaps surprisingly, we find that gifts and inheritances represent a small share of Total Inflows; this is true across the distribution of Total Inflows, as well as at all levels of net wealth at a point in time. Gifts and inheritances are only an important source of income flows among those who have very wealthy parents. Additionally, gifts and inheritances have very little effect on the distribution of Total Inflows – when we do a counterfactual Total Inflows distribution with zero gifts and inheritances, it is not much different from the actual distribution. Our findings suggest that inheritance taxes may do little to mitigate the extreme wealth inequality in society.

On a related topic, there is also an informative paper on racial wealth disparities here.

Ninth, there is a good synopsis of the paper I mentioned last quarter here.

Tenth, from Ben Carlson:

[W]hen you boil it down, there are really only two options for investors [today]:

  1. Take more risk
  2. Lower your expectations

Eleventh, because of the rise of indexing and the effect noted in this article, we should probably pay an increasing amount of attention to this chart (average percentage of equities in portfolios).

Twelfth, I have updated our version of the so-called “periodic table of investing” or “investment quilt.” It has the last fifteen years, but the spreadsheet I work from has data from 1992 (the commodity index begins during 1991) so here are the ranked returns over that longer (30 year) period:

US REITs 10.80%
US Large Stocks 10.60%
US Small Stocks 10.10%
Moderate Portfolio 8.20%
US HY Bonds 7.70%
Emer.Mkts. Stocks 7.60%
Int'l Large Stocks 6.10%
Inv. Grade Bonds 5.30%
Real Assets 2.70%

I also updated the data in the following through year-end 2021 (or with 2022 tax numbers):

Thirteenth, T+1 and STP might be coming.

Fourteenth, it may be, as the Zen proverb says, that “The wise adapt themselves to circumstances, as water moulds itself to the pitcher.”

But I prefer this:

“The reasonable man adapts himself to the world: the unreasonable one persists in trying to adapt the world to himself. Therefore all progress depends on the unreasonable man.” – George Bernard Shaw

Fifteenth, the paper, Earning from History? Financial Markets and the Approach of World Wars is from 2008 but perhaps worth re-reading in light of the situation in Ukraine (and a revanchist China). See also: Does China think long-term while America thinks short-term?

Sixteenth, I think I wrote about this strategy last year, but here’s a new article on basis bump planning.

Seventeenth, from 10 Lessons I’ve Learned from 10 Years Pursuing Financial Independence:

“Life is really simple, but we insist on making it complicated.” – Confucius

Almost every single wealth-building strategy can be boiled down to three steps:

  1. Spend less than you earn
  2. Invest the surplus
  3. Wait

That’s it… seriously.

Eighteenth, I’ve referenced the Marshmallow Test over the years (here for example), but it seems the effect is very weak in replication.

Nineteenth, I rant talk a lot about the importance of maxing out contributions to tax-advantaged accounts (IRAs, 401(k) plans, Roths, etc.). Since you can’t “catch-up” later, anytime you don’t contribute the maximum (or if you withdraw more than required) you are reducing the benefits of these accounts.

(It’s one of my four rules for guaranteed financial success.)

That probably sounds pretty anodyne, but I think this is really important and I don’t think people really get it – particularly in an inflationary environment. The tax code imposes taxes on those phantom gains!

Let’s assume a tax rate of just 25% (it keeps the math pretty easy) and an investment with no real return (if there is a higher real return the tax-advantaged account is even better).

The United States actually already has a wealth tax of sorts created by the intersection of the tax code and inflation. At 25% tax rates and 2% inflation (the Fed’s target) we are all subject to a wealth tax of half a percent per year on many investments (the taxable ones). At an inflation rate of double that, it’s 1%. At a tax rate of 50% rather than 25% it would also double to 1%. This past year inflation was 7.5%, so for higher income people, who may have a marginal rate of around 50% in a high tax state, they have had a wealth tax of 3.25% on investments generating ordinary income that were not sheltered in retirement accounts! (Under the current tax code, if you hold investments until death you can avoid taxes on the unrealized gain portion though.)

So, in a taxable account, you lose your marginal tax bracket times the inflation rate since you bought the asset. You may have high returns so that you didn’t feel it, but the government still effectively confiscated a portion of your property if there is any inflation at all.

At zero inflation or zero tax rates you lose nothing, but as inflation and rates increase you lose more and more. But in a tax-advantaged account you lose nothing! (Assuming you don’t commingle pre-tax and after-tax funds.)

Let’s do four examples: Deductible IRA (same math as a 401(k), 403(b), etc.), Roth IRA, Taxable Account, and Non-Deductible IRA.

We’ll assume just a one-year holding period (the differences increase significantly over longer periods due to compounding), a 25% tax rate (low for ordinary income property, about right for capital gains for many people), and 10% inflation (high, but in 1980 it was 12.5%). This will show how terrible inflation is (because of the tax code). Our hypothetical investments will just keep up with inflation – so you “really” don’t make anything. Of course the math is the same if you made 10% when inflation was a low figure, but it seems particularly painful when you pay taxes when you really didn’t even get ahead!

  • Deductible IRA:
    • You make $1,000 (which would be $750 net spendable after income taxes).
    • You contribute it to your IRA and pay no taxes on it (because it was deductible).
    • The $1,000 grows 10% to become $1,100.
    • You liquidate and pay 25% in taxes or $275 leaving you with $825.
    • Recap: including all taxes, you could have $750 to spend immediately or $825 a year later. That’s 10% return.
  • Roth IRA:
    • You make $1,000 (which would be $750 net spendable after income taxes).
    • You pay $250 (25%) in income taxes and put the remaining $750 in the Roth (no deduction).
    • The $750 grows 10% to become $825.
    • You liquidate and pay no taxes (because it’s a Roth).
    • Recap: including all taxes, you could have $750 to spend immediately or $825 a year later. That’s 10% return.
  • Taxable Account:
    • You make $1,000 (which would be $750 net spendable after income taxes).
    • You pay $250 (25%) in income taxes and put the remaining $750 in the Taxable Account (no deduction).
    • The $750 grows 10% to become $825.
    • You liquidate and pay $18.75 (25%) in taxes on the $75 gain.
    • Recap: including all taxes, you could have $750 to spend immediately or $806.25 a year later. That’s 7.5% return.
  • Non-Deductible IRA:
    • You make $1,000 (which would be $750 net spendable after income taxes).
    • You pay $250 (25%) in income taxes and put the remaining $750 in the IRA (no deduction).
    • The $750 grows 10% to become $825.
    • You liquidate and pay $18.75 (25%) in taxes on the $75 gain.
    • Recap: including all taxes, you could have $750 to spend immediately or $806.25 a year later. That’s 7.5% return.

So if you use either fully deductible or fully tax-free accounts you don’t lose anything at all to taxes on growth (even phantom growth due to inflation), but if you use a taxable account or an account that is merely tax deferred, you lose your tax bracket times your growth rate each year.

(The above is an oversimplification that assumes full recognition of gains, etc. each year. Over multiple periods the non-deductible IRA will win vs. the taxable to the extent there are dividends, interest, and turnover, on the other hand, the taxable account will win vs. the non-deductible to the extent the returns are taxed as capital gains rather than ordinary income. But in all cases using a fully tax-deductible or tax-free account wins over taxable or merely tax-deferred. If your tax bracket increases though, the Roth is better, if it decreases the deductible IRA is better. Full exposition here.)

Twentieth, I’m sure you have seen this by now, but IRS RMD regs on inherited retirement accounts are out now (here) and a summary from Ed Slott can be found here. From Investment News (quoting Carol McClarnon, a partner at global law firm Eversheds Sutherland):

[T]he proposed regulations somewhat unexpectedly say that when RMDs have already begun to the participant, after death distributions must continue to be made in years one to nine in that situation, with the remaining account balance distributed no later than year 10.

Twenty-first, Charlie Munger recently spoke at the Daily Journal annual meeting (video, transcript). Good stuff from a guy who’s 98.

Twenty-second, I took a few common indices and looked to see how they performed in months where the S&P 500 had a negative total return. This occurred in about 1/3 of the monthly observations using the longest common data from February 1991 to the end of 2021. I found that:

  • Only bonds have a positive result (not surprising)
  • Foreign holdings don’t really help (EM actually hurts)
  • Value is a little better and Growth a little worse
  • Small cap is a little worse than large cap (also not surprising)
  • REITS, HY, and Commodities help, but:
    • The REITS come with very large dispersion combined with the bad combo of negative skewness and excess kurtosis (fat tails)
    • HY is less negative, but even more negative skewness and excess kurtosis
    • Commodities don’t look bad here at all

Small value isn’t bad for compound return over time despite an atrocious recent history – it’s the only one that beat the S&P 500 in both down periods and overall.

Twenty-third, good post on Sharpe Ratios here. I don’t annualize my Sharpe ratios for exactly the reason mentioned. But then my figures look odd compared to annualized ones (you can’t compare the two).

Twenty-fourth, a few years ago, I opined that, while we should certainly keep an eye on it, I didn’t think so-called robo-advisors were a significant threat. The analogy I used was that back in the late 1990’s brokerage firms were similarly worried about online trading – and they were really worried. If your business model is that you get paid for trades (rather than advice) you should be worried. I also used the TurboTax vs. CPA analogy.

It looks like my thinking has been vindicated.

I continue to believe that focusing on high-net-worth clients with high-touch and high-quality service is the best strategy to remain successful – and we should move constantly toward higher net-worth, quality, and service.

I wrote this is 2013:

The blog post below is from Seth Godin and reflects how we should think about competition (see here for example):

True professionals don’t fear amateurs

Professional farmers don’t begrudge the backyard gardener his tomato harvest. That’s silly.

And talented mechanics certainly don’t mind the antics of the Car Talk guys (or their listeners). Sooner or later, if you need a real mechanic, you’ll find one, and if you don’t, well, that’s fine too.

A few years ago, typesetting, wedding photography, graphic design and other endeavors that were previously off limits to all but the most passionate amateurs started to become more common. The insecure careerists fought off the amateurs at the gate, insisting that it was both a degradation of their art as well as a waste of time for the amateurs. The professionals, though, those with real talent, used the technological shift to move up the food chain. It was easy to encourage amateurs to go ahead and explore and experiment … professionals bring more than just good tools to their work as professionals.

The best professionals love it when a passionate amateur shows up. The clarity and intelligence of a smart customer pushes both client and craftsman to do better work.

Gifted college professors don’t fear online courses. Talented web designers don’t fear cloud services. Bring them on! When you need something worth paying for, they say, we’ll be here. And what we’ll sell you will be worth more than we charge you.

If you’re upset that the hoi polloi are busy doing what you used to do, get better instead of getting angry.

This is a good reason to be in the business of serving the HNW market and not the mass market.

Twenty-fifth, great tweet:

We cripple the Russian economy by forcing them to buy Russian yet claim to be strengthening our economy by forcing ourselves to buy American. – Neoliberal (@ne0liberal) March 5, 2022

Twenty-sixth, Jason Zweig’s recent article in the WSJ is good. I really liked the opening anecdote about the legendary investor John Templeton:

In the fall of 1939, just after Adolf Hitler’s forces blasted into Poland and plunged the world into war, a young man from a small town in Tennessee instructed his broker to buy $100 worth of every stock trading on a major U.S. exchange for less than $1 per share.

His broker reported back that he’d bought a sliver of every company trading under $1 that wasn’t bankrupt. “No, no,” exclaimed the client, “I want them all. Every last one, bankrupt or not.” He ended up with 104 companies, 34 of them in bankruptcy.

The customer was named John Templeton. At the tender age of 26, he had to borrow $10,000—more than $200,000 today—to finance his courage.

Mr. Templeton died in 2008, but in December 1989, I interviewed him at his home in the Caribbean. I asked how he had felt when he bought those stocks in 1939.

“I regarded my own fear as a signal of how dire things were,” said Mr. Templeton, a deeply religious man. “I wasn’t sure they wouldn’t get worse, and in fact they did. But I was quite sure we were close to the point of maximum pessimism. And if things got much worse, then civilization itself would not survive—which I didn’t think the Lord would allow to happen.”

The next year, France fell; in 1941 came Pearl Harbor; in 1942, the Nazis were rolling across Russia. Mr. Templeton held on. He finally sold in 1944, after five of the most frightening years in modern history. He made a profit on 100 out of the 104 stocks, more than quadrupling his money.

Mr. Templeton went on to become one of the most successful money managers of all time. The way he positioned his portfolio for a world at war is a reminder that great investors possess seven cardinal virtues: curiosity, skepticism, discipline, independence, humility, patience and—above all—courage.

Twenty-seventh, aside from the annuity emphasis, this article on the most important financial goal in retirement is very good. An excerpt:

As you get older, you should make fewer financial decisions. You want those to be on automatic pilot. This goal is even more important than not running out of money in retirement.

I’m in my early 50s chronologically, and I really enjoy the investment and portfolio construction process. I enjoy optimization. I hope to be doing all that a decade from now.

But in two decades, at 70, I’m not so sure. At 80, I’m not certain I’ll have the financial or technical acumen to deal with whatever investment vehicle will be around then.

And at 90, I won’t want to make these decisions.

I can assure you that if I ever reach 95, there’s no way I plan to log on to Vanguard or Fidelity anymore or check P/E ratios or payout rates.

If I’m alive then, I’ll be happy with a decent bowel movement!

Twenty-eighth, another great piece from Michael Mauboussin on improving our skill is here.

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.

Morgan Housel and Larry Swedroe 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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