Financial Professionals Spring 2023

This is my quarterly e-mail missive (affectionately dubbed “the massive missive” by one of my readers) 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, there was a meeting of the Georgia Planned Giving Council and I have a few minor things to share from that:

  • Use the term “charitable gift planning” rather than “planned giving” (planned giving has bequest connotation to most folks now, rather than incorporating lifetime gifts as well)
  • When appropriate this is a good statement to clients, “You may not feel wealthy, but you have enough money to worry about.”
  • Another good client question, “How wealthy do you want your children to be?”

That last one is apparently from Wealth in Families, which was highly recommended.

At a CFA event, the ASFIP (Atlanta Society of Finance and Investment Professionals) Foundation handed out personal finance books that they have been distributing to young people: The Missing Semester

I read it to see if it was something we could use to give to client’s children, etc. and I saw a few good lines (which I am absolutely going to steal) that I thought I’d share:

“Do not let your spending dictate your saving.” (i.e., pay yourself first)
“Everyone drives a used car.” (once it’s off the lot, it’s used!)

There was lots of good advice and other good lines, but those two I thought were novel ones.

[It did have some silliness, there is a table (page 78) that determines how much you need to have saved by 65 to retire on various amounts of income. They forget about inflation. Or, if they remembered inflation, they are delusional in thinking you can get 5% real return with no volatility, Thus, the amounts are way too low (you need 175% of what they say if you use the 4% rule). OTOH, they don’t include Social Security either.]

Second, I did this a few years ago originally, but it came up again in a discussion in our office. We were discussing whether a 706 should be filed for a client’s deceased husband purely for portability of the estate tax exclusion. (You have five years now to file, but it would be a little easier to get done now than try to remember/access the information in five years to do it.) The widow would currently have no estate taxes due, but might if, 1) the limit reverts as scheduled in 2025 to half of what it is now, 2) asset growth is high and spending is low, and 3) she lives a long while.

The question that came up is what are the odds of the limit reverting? If it doesn’t revert, then filing the 706 for this client is a waste of time in any plausible scenario for her. To answer that, I updated some numbers I put together a few years ago. I think the odds of reversion are higher than most people think because the limit is currently so high compared to history; people have forgotten what is “normal.” Here is what it was historically both real and nominal (real is the important one), I also added the projected figures, under current law, for the next few years to the real series:

As you can see, the average exemption (in today’s dollars) from 1916 to 2001 was under $900,000 – i.e., in the last 22 years the real exemption has increased over 1,000%.

That might make it easier to eliminate the tax completely (very little effect on revenue) or harder to do so (it only hits really rich people – who don’t plan early enough) but we should realize that it would not be unprecedented (actually it would be perfectly normal) for it to be at about $1,000,000 rather than either just under $13,000,000 or the half of that it is scheduled to revert to.

Third, delayed Social Security claiming is better today, according to a recent paper. Here is a portion of that paper:

Three factors have contributed to the increase in gains from delay over the past two decades. First, the delayed retirement credit – the increase in monthly benefit from delaying beyond a person’s full retirement age (which has ranged from 65 for those born in 1937 and earlier to 67 for those born in 1960 and later) – has become more generous. Cohorts born in 1933-1934 could receive a benefit increase of 5.5 percent of their primary insurance amount (PIA) – the benefit an individual would receive if they claimed at full retirement age – for each year of delay. In contrast, cohorts born in 1943 or later receive a benefit increase of 8 percent of their PIA for every year of delay. Second, mortality has improved. Finally, real, safe interest rates have been at historically low levels. The interest rate on 10-year Treasury Inflation Protected Securities (TIPS) hovered around 2 percent in 2003. However, since 2011, this interest rate has consistently been below 1 percent. Thus, the internal rate of return from delaying Social Security – an inflation-indexed obligation of the United States government – looks attractive compared to the return on equivalent investments like TIPS. Due to the combination of these three factors, delay has become actuarially advantageous for many people. While there has been an increase in real interest rates in recent months – the 10-year TIPS rate was 1.36 percent on November 25, 2022 – it remains to be seen whether this recent increase will represent a new trend. Even if real interest rates return to their historical average, the first two factors will be enough to make Social Security claiming a high-stakes decision for most people.

TL;DR: “[E]mpirical evidence suggests that many people who claim early are making mistakes.”

Fourth, I wrote at least several dozen emails to our consulting clients about ChatGPT and other Large Language Models starting in January. (I’d been following it for almost a year at that point.) But it is all old news to you now, I’m sure. If you haven’t experimented with it yet though, I encourage you to.

Fifth, I have mentioned this before (here for example), but Charles MacKay, of Extraordinary Popular Delusions and The Madness of Crowds fame, missed the Railway Mania that happened right in front of him. The FT just had a good article on it: What the poet, playboy and prophet of bubbles can still teach us

I think the primary lesson should be humility (and diversification)!

(The bicycle bubble and other lesser known manias are also interesting.)

Sixth, some quotes:

One sign that determination matters more than talent: there are lots of talented people who never achieve anything, but not that many determined people who don’t. – Paul Graham

A safe investment is an investment whose dangers are not at that moment apparent. – Peter Bauer

For the simplicity on this side of complexity, I wouldn’t give you a fig. But for the simplicity on the other side of complexity, for that I would give you anything I have. – Oliver Wendell Holmes Sr.

That last one I think this applies particularly to investment strategy: You start out ignorant and thus have a very simple asset allocation, then you learn more and complexify the portfolio enormously, then you learn even more and simplify it again.

Seventh, how do active managers view passive investing? From this paper:

[W]e conclude that financial markets should be understood as characterised by slowly evolving communities of practice whose habits, routines and ways of knowing can be difficult to shift, even when faced with overwhelming evidence that what they are doing doesn’t work most of the time. Whereas behavioural approaches might explain this defensiveness in terms of irrationality, the conceptual approach advanced here emphasises the epistemic opportunism (convoluted and self-serving attempts to demonstrate superior knowledge) that communities engage in to justify their position.

Eighth, I had a question from a colleague about arithmetic vs. geometric returns and I thought I share with you all as well.

I used this example in classes back in the day:

Client gives you $100,000 and it goes up 100% in period 1 so the balance is $200,000.

Client is excited then and gives you $1,000,000 more so the account has $1,200,000.

Account then goes down 25% in period 2 so $1,200,000 becomes $900,000.

You tell the client – we’re doing great! The average annual return has been 22.47%!

[((1+1)*(1-0.25))^(1/2) - 1= (2*0.75)^0.5 - 1 = 1.5^0.5 - 1 = 22.47% (for geometric – i.e. time-weighted – you add one to each return, take the product, then the nth root (the number of periods) then subtract 1)]

The client responds, “Are you smoking something hallucinogenic? I gave you $1,200,000 and you turned it into $900,000 and you have the audacity to tell me you made money?

The problem is the client’s. He/she should have given you all the money up front! Since managers generally don’t have control over cash flows it is unfair to penalize (or reward) them for the timing. So that’s why all standard reporting is CAGR.

The client’s compound return is -13.40%

[What you got divided by what you paid for it to the nth root, minus 1, or ($900,000/$1,200,000)^(1/2) - 1 = 0.75^0.5 - 1 = -13.40%]

That’s still a compound (geometric) return, but it’s dollar weighted.

The arithmetic return is just the average like you learned around fifth grade or so. 100% + -25% = 75%/2 = 37.5%.

To recap:

  • If you want to know how the manager is doing over time (particularly with investments that have different volatilities), you want the geometric return without any cash flows.
  • If you want to know how the client is doing over time you want the geometric return with cash flows.
  • If you want to know the shape of the annual distribution of returns (the bell curve) as input to an MCS, or to tell the client what to expect in a single year, it is best described as the arithmetic mean and a standard deviation (not getting into higher moments here, but the skewness and kurtosis also matter for investments such as hedge funds).

Over time, the arithmetic return compounds into the geometric return as demonstrated here: Converting Arithmetic to Geometric Averages Spreadsheet

See the second tab for actual historical data, the market’s arithmetic average from 1926-2022, 97 years, was 12.01% but the geometric average was 10.12%. If you invested $X in 1926 you would have $X*(1.1012^97) at the end. But your expectation of next year (or any single year) would be a bell curve with a mean of 12.01% and a standard deviation of 19.77%.

Finally, given a high enough volatility, a positive arithmetic return can be a negative geometric return. This is the problem with extremely levered investments like the 2x, 3x, and -2x, -3x funds (and, again, some “hedge” funds).

Ninth, if you ever have a client who thinks Cramer is anything more than a carnival barker, you can direct them to this.

Tenth, the Ten Traits of Top Teams from Capital group is pretty solid, but I would have titled it, “Top Ten Traits of Successful Advisory Teams.” It’s not about teams in general.

Eleventh, I got the CAIA a few years ago to make sure I wasn’t missing something important, but I don’t think I disagree with anything Larry Siegel wrote here about liquid alts.

I’ve also been attending alternative investing conferences just to know more about the space. The pitches sound compelling, but it’s just words. There is little reliable data. The other thing that occurred to me was that they talk a lot about the size of the alternatives market (i.e. everything privately owned and not traded) and how if you don’t own them you are missing out. But the size of the investments being pitched is pretty small and I think the risks are fairly idiosyncratic. In other words, sampling to get exposure to the asset class probably doesn’t work all that well. Sure, an opportunity zone investment has compelling tax features, but it’s really making a big dollar (otherwise you wouldn’t bother) commitment to a very tiny company for a decade.

In theory, the optimal portfolio is the market-cap-weighted ownership of every investment – public, private, debt, equity, etc. in the world. All of it. You can’t do that of course and people use the S&P 500 as a proxy. That’s pretty bad tracking error!

But it occurred to me I could look at the very largest of the alternative investments and see just where it ranked compared to stocks. The largest interval fund (source) is about $10 billion market cap. The size goes down very quickly from there. The total market cap of the U.S. stock market is about $40 trillion. So, simplistically, I should weight the largest interval fund to be 1/4,000th of that. So if I have $1,000,000 in U.S. stocks, I should have $250 in that fund.

Another “alternative” fund that is huge and has been in the news is BREIT (it isn’t technically an interval fund – it’s a REIT that works like an interval fund). It has a market cap of $71 billion (source) so if you have (again) $1,000,000 in U.S. stocks you should allocate $1,775 to BREIT. If you do more than that you are making an active bet vs. other assets. The minimum investment is $2,500 ($1,000,000 for the institutional share class) so you shouldn’t buy it unless you have about $1,400,000 in U.S. stocks. Suppose you have a 40/20/40 portfolio (U.S. Stocks/Foreign Stocks/Fixed Income). Then your portfolio should be $3,500,000 to justify having $2,500 in BREIT!

I also saw an excellent literature review of PE here. This isn’t a point of the paper at all, but it mentions the average size of various types of funds (table, page 10), in millions:

  • VC is $247
  • Buyout is $1,331
  • Real Estate is $574
  • Private Debt is $868
  • Natural Resources is $914
  • Infrastructure is $2,067

(Medians are, as you would expect, lower.)

So, to extend the math above using those figures, to be market cap weighted, per each $1,000,000 of your portfolio in U.S. stocks, then you should have roughly the following amounts in the average PE fund of these types:

  • VC, $6.18
  • Buyout, $33.28
  • Real Estate, $14.35
  • Private Debt, $21.7
  • Natural Resources, $22.85
  • Infrastructure, $51.68

Note that that is the actual dollars, not in thousands or millions or anything!

Twelfth, I often tell people not to buy investment real estate in the same location where they have a huge chunk of current real estate investment (their primary residence). This makes that point with data.

Thirteenth, most of you know my opinion of forecasting; I agree with this: “[T]here is no Forecasters’ Hall of Fame. There is no one to induct.” More from that same piece:

Statistically the most accurate forecast is to say: “I have no idea. What I do know is that long periods, where you make few changes, have historically been extremely rewarding to investors.” We can also note, quite accurately, that something will happen which we could not predict.

Indisputably, compounding works if you do not interrupt it. Establish a set of habits and routines to minimize compounding interruptions and to avoid reacting to forecasts.

Ignore the forecasters. Their job is to sell clicks, eyeballs, and in the end, advertising.

Fourteenth, T+1 is coming on May 28, 2024. (When I started in this industry it was T+5!)

Fifteenth, a good paper on entrepreneurs here.

TL;DR: Smart, generalist, rule-breakers, with some mental health issues. Also, people who are undervalued in the marketplace because of background (college dropout or immigrant, for example).

Contrary to popular belief, age 42 is the average age to start a company.

Sixteenth, this explains both sides:

— Gurwinder (@G_S_Bhogal)

(See also this.)

Seventeenth, I may have shared before that CPI will be overstated for a while. It’s a well-known quirk because the housing costs are a survey which tends to lag the actual data. Anyway, paper on it here.

Eighteenth, a short article on better decision-making.

Nineteenth, a cautionare tale on Health Care Sharing Networks here. These are usually pitched as “Christian” but that could simply be affinity fraud.

Twentieth, unsurprisingly, Earnings Are Greater and Increasing in Occupations That Require Intellectual Tenacity. Abstract:

Automation and technology are rapidly disrupting the labor market. We investigated changes in the returns to occupational personality requirements---the ways of thinking, feeling, and behaving that enable success in a given occupation---and the resulting implications for organizational strategy. Using job incumbent ratings from the U.S. Department of Labor's Occupational Information Network (O*NET), we identify two broad occupational personality requirements, which we label intellectual tenacity and social adjustment. Intellectual tenacity encompasses achievement/effort, persistence, initiative, analytical thinking, innovation, and independence. Social adjustment encompasses emotion regulation, concern for others, social orientation, cooperation, and stress tolerance. Both occupational personality requirements relate similarly to occupational employment growth between 2007 and 2019. However, among over 10 million respondents to the American Community Survey, jobs requiring intellectual tenacity pay higher wages---even controlling for occupational cognitive ability requirements---and the earnings premium grew over this 13-year period. Results are robust to controlling for education, demographics, and industry effects, suggesting that organizations should pay at least as much attention to personality in the hiring and retention process as skills.

Surprisingly, the opposite seems true of social adjustment. (See charts on page 16 & 20.)

Twenty-first, research on income and happiness here. My summary:

  • Happiness rises with (log) income for all incomes.
  • Unhappiness decreases with (log) income only for low incomes.
  • The impact of income on happiness is not as large as you would think.

What I would like to see is quality research on the relationship of life satisfaction (rather than happiness) to wealth (rather than income).

There is also an interesting article on happiness and intelligence here.

Twenty-second, according to this, inheritance doesn’t matter much to the wealth gap, which also means “reparations” for economic harms done to ancestors isn’t logical.

Twenty-third, given the recent bank issues, I was curious about the historical limits of FDIC insurance – particularly real – and made a quick chart in Excel:

It seemed only logical to do the same for SIPC coverage:

As an aside, see Oklahoma Senator Lankford vs. Janet Yellen on the bank bailouts. His points are spot-on.

Twenty-fourth, with an unfavorable change in the yield curve blowing up the simple business model of SVB (and others), I thought this would be an opportune time to point out that the risk parity investment strategy (in its simplest form) is the same model (borrow short, lend long, collect the spread). In a risk-parity strategy, you bulk up your bond exposure by borrowing short (the portfolio is financed at t-bill rates) to lend long (you buy lots of long bonds to increase the bond risk to match that of stocks). It is not a free lunch!

Twenty-fifth, Stocks for the long run? This paper is an outstanding review of very long-term return data and shows it’s a lot more nuanced than is commonly appreciated. This is required reading if you want good perspective.

Twenty-sixth, a good run-down of IRA issues with Secure 2.0 from Ed Slott here.

Twenty-seventh, do you remember how it felt three years ago? See this.

From 3/23/20 to 3/23/23 the S&P 500 (total return) is up 85%. That’s 22.8% annualized. (source)

Twenty-eighth, I have updated the data in the following through year-end 2022 (or with 2023 tax numbers):

Ruminations by Other People
Ruminations on Paying Off the Mortgage
Ranked Asset Class Returns
Converting Arithmetic to Geometric Averages Spreadsheet
Efficient Frontier Spreadsheet
Historical Market Downturns Spreadsheet
Investment Return Matrix Spreadsheet
One-Person Retirement Plan Comparison Spreadsheet
Russell Indices Spreadsheet
Stock Market Trend Spreadsheet
Stocks vs Bonds Spreadsheet

Twenty-ninth, I wrote back in 2018:

[T]here is a topic on which I listen carefully to clients and then mostly ignore what they just told me…

Clients think that the fact that “Mom lived to be 98” or “the men in my family all die before 75” is relevant information for designing their financial plan. It isn’t. Socioeconomic class matters (largely because diet, exercise, and smoking are very correlated to class), but genetics don’t matter much at all. More evidence supporting that view just came out.

New research on this just came out (here), here is the abstract:

While there is substantial research on the intergenerational persistence of economic outcomes such as income and wealth, much less is known about intergenerational persistence in health. We examine the correlation in longevity (an overall measure of health) across generations using a unique dataset containing information about more than 26 million families obtained from the Family Search Family Tree. We find that the intergenerational correlation in longevity is 0.09 and rises to 0.14 if we consider the correlation between children and the average of their parents' longevity. This intergenerational persistence in longevity is much smaller than that of persistence in socio-economic status and lower than existing correlations in health. Moreover, this correlation remained low throughout the 19th and early 20th centuries despite dramatic changes in longevity and its determinants. We also document that the correlations in longevity and in education are largely independent of each other. These patterns are likely explained by the fact that stochastic factors play a large role in the determination of longevity, larger than for other outcomes.

How long “momma and daddy” lived doesn’t tell you anything useful! Clients probably won’t believe that though…

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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