Financial Professionals Spring 2024

This is my quarterly agglomeration, intended primarily for my fellow financial professionals. It’s simply a way to share things of possible interest that I have read or thought about this quarter. Enjoy!

First, a very good, funny, (though NSFW) take on the FIRE movement here.

But at the same time, you should probably: “Save more money than you think you need. Life is unexpected and your future tastes will likely be more expensive. Not worrying about money tomorrow is worth more than whatever you could buy today.” (source)

Second, the FT had an excellent potted history of factor investing here. It included this visual on the recent pain of value investing:

Third, I had missed this change to SIMPLE plans (source):

For SIMPLE IRA plans, starting in 2024, both the under-50 limit and the catch-up limit will increase by 10% above the $16,000/$3,500 limits – but only for businesses with 25 or fewer employees. So, for those very small companies, the 2024 under-50 limit is actually $17,600 ($16,000 x 10%), and the catch-up limit is $3,850 ($3,500 x 10%). Businesses with 26-100 employees can elect the extra 10%, but only if they provide a 4% (instead of 3%) matching contribution or a 3% (instead of 2%) across-the-board contribution. [emphasis mine]

Fourth, my third item last quarter (here) was on the possibility of Alpha from Ugliness?. but see this. (TL;DR: apparently there is a correlation between looks and intelligence, which removes the effect..)

Fifth, there is a good piece on private credit here and on private equity here.

Sixth, in this post on college funding, the author talks about splitting the 529 equally between students, but I don’t know why you wouldn’t split it unequally. Keep more of the balances in the younger children’s plans – assuming those kids are not entering college yet. You can always transfer funds between siblings (keeping in mind gift limit issues).

Assume college is $50k per year and nothing can be paid out of pocket, but there are lavishly funded 529 plans for two children who are 4 years or more apart in age. Since the current gift limit is $18k/year and (I think) the lookback period on the FASFA is two years (on income, not assets, you can transfer assets just before you fill out the FAFSA). I would put $50k for year one, $50k for year two, $32k for year three, and $32k for year four ($164k total) in the oldest child’s plan and everything else in the younger one’s. I am oversimplifying of course because I am ignoring growth in both the account and in college expenses. Then when the first child has finished school, reverse it, and start transferring (within the gift limit probably) from the younger to the older child to reduce the balance of that younger student who is about to enter college. Then you gift back from the older to the younger in the junior and senior years.

In fact, you could go further. Assuming two grandparents plus that younger (or even an older, out-of-college) sibling, or some other relative, (an aunt, uncle, grandparent, etc.) you could do $50k for year one, $50k for year two, ($100k total) and nothing else. Then put $16,667 times two in each of those other people’s plans. If you transfer $16,667 from three relatives each year, that is $50k.

That may not be clear so let me spell it out. Assuming $50k need each year for college, and no siblings, you could (over time, because gift limits) put funds in 529s so that you have:

  • $100k in the student’s account
  • $33.3k in “aunt’s” account
  • $33.3k in “uncle’s” account
  • $33.3k in “grandma’s” account

Any “extra” money should be in the accounts that are not the student’s. Only $100k shows up (and as a parental asset) on the FAFSA. In years three and four, each of the other relatives gifts half the balance to the student which covers the need for those years. (The other relatives don’t actually make the gift, the account owner – presumably mom or dad – make the actual transfer, but it is considered a gift for transfer tax purposes from the relative to the student.)

I’m not sure this is going to come up much though. A case where income is low enough that aid may be available it wouldn’t seem that there would be lavishly funded 529s in existence, but maybe occasionally – from rich grandparents probably. But those grandparents probably shouldn’t be too rich. If the grands have estate tax issues, it would be better for them to pay all the college tuition (but not room and board) to get the assets out of their estates (40% savings right there) rather than try to optimize the financial aid. In that case you would only use the 529 for room and board. The rest of the funds in the 529 could be rolled down to subsequent generations (at $18k per year).

Seventh, levered bitcoin! From the FT (here):

ProShares this week disclosed plans to launch five ETFs, including one that would offer twice the daily exposure to a bitcoin-tracking index and others to provide inverse bitcoin returns, paying out up to double any decline in an underlying index, according to filings with the SEC. The extra leverage in the ETFs — which are not designed to be long-term investments — would amplify swings experienced by the already volatile bitcoin price.

Over the last 36-months, the annualized standard deviation of the S&P 500 index was 17.54%. For the MarketVector Bitcoin index it was 68.12%. So, bitcoin is already 3.88 times as volatile as stocks, and ProShares thinks to themselves, “Hmmm, what we really need to do is to find a way to double that.”

Oh My God I Love Lucy GIF - Oh My God I Love Lucy Omg GIFs

Remember the difference between the arithmetic mean return (the average return) and the geometric return (the compound return, or what you get as an investor over time), is half of the variance. The variance is the standard deviation squared. So, using the numbers above, the difference for the S&P 500 is 1.5%, for Bitcoin 2.3%, and for the 2x levered bitcoin 7.5%. It’s called volatility drag and it’s not new information!

“The only thing new in the world is the history you do not know.” – Harry Truman

Eighth, there was a discussion on some message boards back in January on the optimal equity/fixed income mix, and I weighed in. Lightly edited:

The Merton Share (which is a version of the Kelly Criterion) is the important formula, but there is a lot more that impacts the decision – Social Security and pensions are long bond positions (with different inflation exposures usually), a mortgage is a short bond position, real estate is probably roughly 50/50, human capital is 50/50 at most (for say, people working in hedge funds or commercial real estate developing) but generally more bond-like for most people. And you should be thinking of the “portfolio” holistically and include all of that. (Perhaps not explicitly, we don’t do that math in a spreadsheet or anything, but we pay attention to those factors to get to what portfolio is appropriate. Ceteris paribus a client with a very large mortgage would have a more conservative portfolio than someone with no mortgage.)

In the Merton Share formula, you need to know:

  1. The ERP estimate. Siegel says this is 6.5%, but that has been debunked and the U.S. is an outlier (a little). I’ll use 4% here.
  2. The variance of the ERP. For mathematical simplicity, assume the standard deviation is an even 20% (that’s a little too high), then the variance is that squared, or 4%.
  3. A level of risk aversion. Most people have a risk aversion of around 2 so I’ll use that.

The formula is ERP/(Variance * Risk Aversion) = percentage allocation to equities.

So, using the assumptions above: 0.04/(0.04*2) = 50%.

If I take the S&P 500 (and it’s predecessor before 1957) for stocks and 5-year Treasurys for bonds from 1926-2023 inclusive, the standard deviation of the difference (annualized from monthly data) is 18.8%. If you start in 1946 it’s 15.0% and pretty stable around that (no real trend) regardless of what years you look at (provided it’s a long period).

But just because something hasn’t happened in a while doesn’t mean it won’t so I’ll use 18%. I’m not using that data for the return premium though. As mentioned above, I’ll use 4%. (Arguably it’s even lower. Right now, the inverse of the S&P 500 PE is 4.6% and TIPS are 2%-ish real yield depending on your maturity. So the ERP right now is maybe 2.6% on that simple comparison. But the S&P 500 is uniquely expensive at the moment, so for a well-diversified (esp. foreign stocks), factor-tilted (esp. value) equity portfolio, and because I think adjusting a little toward historical experience can make sense, I still like 4% for the ERP.)

So, let’s use 18% for the standard deviation (so 3.24% for the variance) and assume someone is not risk averse at all (1 for the risk aversion). The equity allocation should be 123%! At a risk aversion level of 2 it would be 62%. (Interesting that it comes out so close to the 60/40 allocation.) At 3 it’s 41%. At 1.5% it’s 82%. So I think that is justification (perhaps rationalization though!) for 80/20, 60/40, 40/60 mixes being used routinely (not 123%!).

All that said, the constraint probably isn’t going to be that math – it’s going to be the client’s ability to maintain their allocation in a severe downturn.

Precision in these matters isn’t available (the math above isn’t right because we don’t know the numbers), but as Carveth Read (not Keynes) said: “It is better to be vaguely right than exactly wrong.” (source)

Ninth, since bonds did so poorly in 2022, I was curious if a 60/40 portfolio actually did worse than in 2008. It didn’t.

Using monthly data for the S&P 500 and 5-yr Treasurys, here are the 10 largest independent drawdowns (had to get back to a new high to record another drawdown) of a 60/40 portfolio, in chronological order (losses in bold):

  1. In May 1932, a 60/40 portfolio was 62.1% off the August 1929 all-time high.
  2. In March 1938, a 60/40 portfolio was 32.0% off the February 1937 all-time high.
  3. In September 1946, a 60/40 portfolio was 13.4% off the May 1946 all-time high.
  4. In June 1962, a 60/40 portfolio was 13.0% off the December 1961 all-time high.
  5. In June 1970, a 60/40 portfolio was 17.6% off the November 1968 all-time high.
  6. In September 1974, a 60/40 portfolio was 26.4% off the December 1972 all-time high.
  7. In November 1987, a 60/40 portfolio was 17.3% off the August 1987 all-time high.
  8. In February 2003, a 60/40 portfolio was 19.0% off the August 2000 all-time high.
  9. In February 2009, a 60/40 portfolio was 29.9% off the October 2007 all-time high.
  10. In September 2022, a 60/40 portfolio was 18.6% off the December 2021 all-time high.

In order of magnitude, from the worst:

  1. In May 1932, a 60/40 portfolio was 62.1% off the August 1929 all-time high.
  2. In March 1938, a 60/40 portfolio was 32.0% off the February 1937 all-time high.
  3. In February 2009, a 60/40 portfolio was 29.9% off the October 2007 all-time high.
  4. In September 1974, a 60/40 portfolio was 26.4% off the December 1972 all-time high.
  5. In February 2003, a 60/40 portfolio was 19.0% off the August 2000 all-time high.
  6. In September 2022, a 60/40 portfolio was 18.6% off the December 2021 all-time high.
  7. In June 1970, a 60/40 portfolio was 17.6% off the November 1968 all-time high.
  8. In November 1987, a 60/40 portfolio was 17.3% off the August 1987 all-time high.
  9. In September 1946, a 60/40 portfolio was 13.4% off the May 1946 all-time high.
  10. In June 1962, a 60/40 portfolio was 13.0% off the December 1961 all-time high.

The most recent one was #6 in magnitude. No biggie!

Tenth, there is a good history of portfolio theory from Markowitz to the present here (sorry, it’s probably paywalled for most of you) and a good video on the history of options here.

Eleventh, things are generally better than you think, as explained here.

Twelfth, there are good thoughts on how to have better meetings here.

Thirteenth, you have undoubtedly been reading a lot on market concentration (i.e., the magnificent seven, or whatever). Jason Zweig provides us with a good history lesson (source):

This past week, the 10 biggest companies constituted just under one-third of the total market value of the S&P 500. The top three, Microsoft, Apple and Nvidia, account for 17.9% of the total. Nvidia alone is 4.6% of the total value of the index.

This isn’t the first time the U.S. stock market has been highly concentrated in a few giants, however.

In the boom years of the 1950s, the 10 biggest companies, including AT&T, DuPont and General Motors, regularly exceeded 30% of the value of all U.S. stocks. In July 1955, GM alone—up 78% over the previous 12 months—amounted to 6.8% of the value of the entire U.S. stock market, according to the Center for Research in Security Prices at the University of Chicago.

It’s also common around the world (source):

Fourteenth, last quarter I included some information on beneficial ownership reporting requirements for LLC clients (here). I wanted to let you know that subsequently a court has found this unconstitutional (see here).

Elsewhere, it was reported that it would be appealed and for the moment only members of the NSBA are exempt (because of the ruling). So no change yet, but I wouldn’t be in a hurry to get it done (though it isn’t hard) because it might just go away.

Fifteenth, I have updated the data in the following through year-end 2023 (or with 2024 tax numbers), or just updated in general, if the following are in bold (otherwise they are unchanged from last year):

White Papers

Charts

Spreadsheets

Sixteenth, there is an excellent paper on concentrated stock positions here.

I researched this a little over 20 years ago and came to this conclusion: If you are otherwise diversified and have less than 10% in a single position it’s fine. Between 10% and 20% consider selling that portion, particularly if you can do it tax-efficiently. Over 20% sell that portion immediately; do not wait to pass go and collect $200; don’t get cute; SELL. (Unless that portion – the entire concentrated position – of your portfolio can go to zero without consequence to you.)

I’m gratified that the paper came to basically the same conclusion (though Dr. Petajisto expressed it a lot more placidly).

Seventeenth, I saw this article, and their scaremongering is stupid. Here is the scary graph they use (click for larger version):

It’s bogus because it’s unadjusted for the population, or inflation, or size of the economy. Any of those would be better, but size of the economy is best. It takes about a minute to fix it, and you get this:

Different impression, no?

Eighteenth, if you are a professional, stop selling.

Nineteenth, there was a good post on cognitive dissonance here and hindsight bias & extrapolation 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 continues to publish valuable wisdom.

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

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Regards,
David

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