Financial Professionals Spring 2025

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!

In June, I’m speaking at a NAPFA symposium in New York on Financial Planning Urban Legends. I think it’s a fun topic, and I’d love to see some of my readers there. (The working title was Things You’re Wrong About, but that seemed a little rude!)

First, there were some good posts on longer-term (230 years!) financial history and market data. Part I, Part II, and Part III.

Second, here’s the abstract of a paper on wealth persistence:

Is the top tail of wealth a set of fixed individuals or is there substantial turnover? We estimate upper-tail wealth dynamics during the Gilded Age and beyond, a time of rapid wealth accumulation and concentration in the late 19th and early 20th centuries. Using various wealth proxies and data tracking tens of millions of individuals, we find that most extremely wealthy individuals drop out of the top tail within their lifetimes. Yet, elite wealth still matters. We find a non-linear association between grandparental wealth and being in the top 1%, such that having a rich grandparent exponentially increases the likelihood of reaching the top 1%. Still, over 90% of the grandchildren of top 1% wealth grandfathers did not achieve that level. [Emphasis mine.]

Third, just a reminder that stock returns are unpredictable:

Fourth, risk management mantras for CPAs (though they apply to financial advisors of all types).

Fifth, I received a reporter inquiry on SPY vs. VOO, and thought you might find my response a little educational – I don’t think most people know how SPY is structured:

I wouldn’t choose either one. The S&P 500 is essentially an actively managed fund; it isn’t a mechanical, rules-based, approach – a committee chooses the investments. I prefer VTI. But VOO is better than SPY, not only because of the expense ratio, but also because SPY (being old) was set up as a UIT, so dividends are not invested. They are held in cash until distributed to shareholders each quarter. Both the expense ratio difference and the cash drag are very small effects, but if you are going to pick one you might as well pick the one that is slightly better.

Sixth, I read a few things on AI and skills applicable in the future. I agree with Sam Altman (source):

There will be a kind of ability we still really value, but it will not be raw, intellectual horsepower to the same degree. Figuring out what questions to ask will be more important than figuring out the answer. 

I also agree with this comment in the article as well: “You can also find defenders of rote memorization who point out that it’s hard to connect dots you don’t recall exist or that you can conceive of only hazily without time-consuming googling.”

As I wrote a long time ago (here): “Information is cheap, wisdom is dear.”

There is a four-level hierarchy that I think is worth remembering:

1. Data – unstructured facts
2. Information – structured (and perhaps cleaned) data
3. Knowledge – relevant information to a question at hand
4. Wisdom – thinking about what question you are really trying to answer, whether it is the right question, and whether the knowledge you have is the best way to answer it.

AI (and Google before that) mostly provides #1-3, but we get paid (or should be getting paid) mostly for #4.

(See also Decision Making and Decision Making (again).)

An example may help:

• Data: U.S. GDP is about $27 trillion. The U.S. population is about 341 million. The U.S. market cap is about $60 trillion.
• Information: the country rankings of those figures are #1, #3, and #1. Yay us!
• Knowledge: as a percentage of the global total it’s roughly 25%, 4%, 60% - it’s really good to be us!
• Wisdom: perhaps those ratios are not sustainable over the long term? Perhaps it would be important to know that first percentage roughly matches the peak of the British empire in 1870 (source)? But who would think to ask the LLM (or Google) that question without broad background knowledge, curiosity, and (ahem) wisdom? (The British Empire at its peak was about 25% of world GDP, population, land area, and market cap. Today those percentages are, roughly, 2%, 1%, 0%, and 3% respectively.)

People could (justifiably) quibble about where the lines are between each bucket, but conceptually, I think you get the idea.

(See also some speculation on What fully automated firms will look like. OTOH, see The Generative AI Con.)

Seventh, since we’re on the subject of wisdom, here’s some on the good life.

Eighth, a paper came out last fall on the conduct of financial advisors, and there were a few interesting facts in it.

• Financial advice is a “credence good” – I knew the concept, but didn’t know that term for it.
• “The total number of financial advisers, including both brokers and Investment Adviser Representatives, has remained steady at around 700,000.”
• “A large majority (89 percent) of financial advisers are registered as brokers, with roughly half of them also dual-registered as Investment Adviser Representatives. The remaining 11 percent are exclusively registered as Investment Adviser Representatives.”
• The median wage for those advisors is $95,000.
• “Advisers in the top decile of the wage distribution earn nearly four times as much as those in the bottom decile ($196,000 vs. $54,000).” (See Figure 3 on page 201.)
• Old news, but: “[Advisors] tend to engage in frequent trading, chase past returns, and underdiversify—even in their own portfolios (Linnainmaa, Melzer, and Previtero 2021).”
• OTOH: “Evidence from robo-advising shows that, even when algorithms manage portfolio decisions, human advisers continue to add significant value for households (Greig et al. 2024).”
• “Approximately 6.6 percent of currently registered advisers in the United States have a history of misconduct.”
• See Table 3 on page 204 for the top ten bad large firms. (Naming and shaming appears to cause those firms to hire less problematic advisors.)

Ninth, the WSJ had an article on valuations a while back. (non-paywalled)

I think the ERP (Equity Risk Premium) is better measured vs. TIPS rather than nominal bonds, but still.

You can find the PE here, and the TIPS yield (and nominal Treasurys too, FWIW) here.

I did this at the end of January using the inverse of the PE (to get an earnings yield) and the 10-year TIPS to get: 1/25.75 = 3.88% vs. 2.13%.

I thought 175 bps was a very skinny ERP! Of course, now stock prices are down, and earnings are less predictable, so YMMV.

Tenth, a good reminder that tech bubbles aren’t new here.

Eleventh, are you diversified? (non-paywalled)

Twelfth, Elm Wealth wrote on long/short direct indexing here. (I think the strategy they are talking about is probably AQR’s.)

Thirteenth, I would have titled this piece “Nine Lessons the Market Re-Taught in 2024” (rather than “taught”) because none of what Larry says here is new (as he admits right up front), and I’ve harped on many of these items myself (as you know), but it’s always good to be reminded.

Fourteenth, I suspect few of you have heard of 351 conversions/exchanges yet, but they will (IMHO) be an increasingly popular alternative to exchange funds.

No single stock can make up more than 25% of the contribution, and all positions over 5% must not total more than 50% of the contribution though, which makes it much less interesting than a first impression might indicate.

The minimum portfolio holdings then would be 25% in each of two stocks, and then a bunch of stocks under 5% weight each to make up the other 50%.

Fifteenth, “Among lower income individuals, optimism is more strongly associated with saving.” (source)

This is interesting because you could easily imagine it going the other way – being optimistic that things will be just fine, so no need to save.

Sixteenth, some interesting data on the housing stock:

But prices are still below their peak in real dollars:

Seventeenth, recent market volatility makes me think of what is known as the politician’s syllogism:

1. We must do something.
2. This is something.
3. Therefore, we must do this.

It feels better to “do something” with your investments, even when it isn’t clear what should be done, but almost always we should follow this adage: “Don’t just do something; stand there.”

Remember Investing 101: “Avoiding stupidity is easier than seeking brilliance.” – Shane Parrish, summarizing Charlie Munger

Eighteenth, some Deep Finance Thoughts from Ben Carlson.

Nineteenth, something I read recently made me think of this quote from Michael Dalcoe: “If you don’t come from a wealthy family, a wealthy family needs to come from you.” I’m not sure if I agree with it though. I think Epictetus might have had better advice: “Be careful to leave your sons well instructed rather than rich, for the hopes of the instructed are better than the wealth of the ignorant.”

Twentieth, back in 2016, I wrote, “From a historical perspective, everyone reading this lives in unbelievable opulence, with comforts unheard of just a few short years ago.” We Live Like Royalty and Don’t Know It makes the same point (but with details).

Twenty-First, there was a question on the FPA message boards recently about how much to spend for a home, and I thought my contribution to the discussion might be interesting to you:

Thought I’d share a few thoughts on this. You have already had people point to calculators and share the 30% of gross income for PITI guideline. There are two more ways I would look at it.

First, I wouldn’t spend more than 2-3x gross earned income for the home (and closer to 2x is more prudent, IMO). That breaks down (as does the 30% of gross for PITI) when people are retired as the “earned income” isn’t relevant. (The 2-3x is also off for lower-income folks.) I like the 2-3x better because it keeps the real estate exposure more reasonable in low-rate environments or when people have small mortgages relative to the property value. To take an extreme example, someone with a low income could buy a multi-million-dollar home with a tiny (proportionally) mortgage (fitting within the 30% rule) and the entirety of a large-ish inheritance (for example). That wouldn’t be prudent even though the 30% rule was satisfied. Of course, if the inheritance is really large, it looks more like the retiree situation – earned income isn’t really relevant. You’d do MCS calculations in all cases, of course.

Second, I would do a gross asset allocation view of it. For simplicity suppose someone has $1mm 60/40 portfolio and an 80% LTV mortgage on a $1mm house.

They are long $600k of stock, long $400k of bonds, short $800k of mortgage, and have $1mm in real estate. Netting the fixed income exposures, they are:

In other words, this situation would be a much more aggressive allocation than they probably realize. Of course, with the mortgage you won’t get margin calls, but still. I tend to think of things as risky (stocks) and less risky (investment grade bonds and cash). As a really rough estimate, you can consider real estate half risky and half less risky (beta of 0.50), so this simplifies into approximately an asset allocation of:

(You can also consider the present value of human capital as a mix of risky and less-risky, but the mix depends on their occupation. For most people it’s probably in the vicinity of 40% risky and 60% less risky. I.e., most people’s human capital is more bond than stock. Finally, you should do the present value of pensions and maybe Social Security also as fixed income. The Social Security is a little flaky because you don’t really have a property right in it, but the PV seems pretty TIPS-equivalent for folks already drawing or who will shortly.)

Someone is about to argue that in the case above they only have $200k – the equity – exposed to real estate, but that’s not true, even in the very unusual case where the mortgage is non-recourse. They are long $1mm of real estate and short $800k of fixed income, but if non-recourse they also have a put option on the real estate with a strike price at the value of the mortgage, or $800k in this case.

(You don’t often see advice on how much to spend on a car but the White Coat Investor just covered it here.)

Twenty-Second, summarization of the point here: “Belief in yourself is overrated; generate evidence.”

Twenty-Third, in a new paper, McQuarrie (unsurprisingly) finds that bonds should be located in tax-sheltered accounts and (low-turnover) stocks in taxable accounts. Which we already know, but you may not have considered just how detrimental the combination of taxes and inflation is since taxes are paid on nominal, not real, returns. (I talked about it here as well.)

Twenty-Fourth, I’ve written on most of the content in Michael Mauboussin’s Probabilities and Payoffs paper, but it is a very good, comprehensive, recap and he’s always worth reading.

Twenty-Fifth, in times like these, remember (source):

• Market prices already reflect probabilities of future outcomes.
• It’s okay to be disappointed, but it’s not okay to be surprised.
• The market is never “going down” – it only has gone down and may go down further.

Twenty-Sixth, I have told people forever that buffered strategies are stupid suboptimal. Cliff Asness takes them apart with some data.

As I wrote back in 2018 (about equity indexed annuities, which are the same sort of silliness): “As Milton Friedman (among many others) observed, TANSTAAFL. The investor should simply admit they are investing in fixed income and just buy it directly instead of complicating it to pretend they have stock exposure.”

Twenty-Seventh, it seems to me that low-quality advisors (who typically have less wealthy and less sophisticated clients) mostly bet (i.e., position portfolios for what they believe will happen), while high-quality advisors (who typically have wealthier and more sophisticated clients) mostly hedge (i.e., position portfolios for what can happen). For those of us in that second camp, the goal is to maximize the sum of happiness across all potential futures, keeping in mind the declining marginal utility of wealth since the first dollars are more valuable (have higher “utility”) than the last dollars. Going from a retirement income of $60,000 to $70,000 increases happiness much more than going from $160,000 to $170,000 because the next dollar to someone making $60,000 is more valuable than the next dollar is to someone making $160,000.

In other words, quantify the happiness in one possible future and multiply it by the probability of that future. Then, do that for every possible future. The plan that has the highest sum of happiness across all futures is the optimal plan. This is simply an expected return calculation using happiness instead of dollars. The best plan has the highest expected return in terms of happiness. This is a gedankenexperiment, of course, since you can’t generally quantify very precisely. But I think it is helpful to pay attention to the concept and make sure we are spreading out our risks over a range of possibilities, and not betting on the one future we think will occur.

I post this now because I fear that many advisors (and clients) are trying to predict the future and positioning portfolios based on their political beliefs in particular. The political situation has almost certainly widened (increased the variance of) the outcomes much more than it has changed the expected mean outcome. And, of course, folks will have differing opinions on whether that mean expectation is slightly higher now (from deregulation, etc.) or lower now (from chaos, etc.). But remember, as Harry Markowitz explained: “A good portfolio is more than a long list of good stocks and bonds. It is a balanced whole, providing the investor with protections and opportunities with respect to a wide range of contingencies.” (emphasis mine)

We certainly do seem to have, ahem, “contingencies” at the moment, but remember the range is high and we (as humans, I do it too) have way too narrow an estimate of the possibilities the future could hold. (See, for example, What’s the Market Going to Do?)

Twenty-Eighth, I have updated some of the resources on our web site with 2024 data, etc. The updated ones are in bold:

White Papers
Ruminations by Other People
Ruminations on Investment Philosophy
Ruminations on Being a Financial Professional
Ruminations on Paying Off the Mortgage
Ruminations on Roth vs. Traditional IRAs

Charts
Ranked Asset Class Returns

Spreadsheets
Alpha for Confidence Spreadsheet
Black-Scholes Option Pricing Spreadsheet
Converting Arithmetic to Geometric Averages Spreadsheet
Duration Calculator for Stocks, Bonds, & Mortgages
Efficient Frontier Spreadsheet
Historical Market Downturns Spreadsheet
Investment Return Matrix Spreadsheet
Itemized Deduction Bunching Calculator
Joint Life Probability Spreadsheet
MCS Spreadsheet for Foundations
MCS Spreadsheet for Private Clients (instructions)
Merton Share Calculator
One-Person Retirement Plan Comparison Spreadsheet
One-Person Social Security Breakeven Spreadsheet
Pension Option Analysis Spreadsheet
Russell Indices Spreadsheet
Stock Market Trend Spreadsheet
Stocks vs Bonds Spreadsheet
Tax Treatment Comparison Spreadsheet

Twenty-Ninth, a few years ago I got the CAIA (Chartered Alternative Investment Analyst) designation, and I attend alternatives conferences periodically to be well informed. A recent conference prompts this note.

The attendees at this conference (like all the others) were very enthusiastic about alternative investments, and I was frequently asked about our usage. I usually responded, “I got the CFA to mostly index and the CAIA to own no alternatives at all – it’s a severe level of overkill.” I also sometimes just said we didn’t use them, but I was “alt curious,” which usually got a laugh. Here I thought I would set forth in detail my reasons for avoiding alts.

Though some of my reasons may apply to them as well, in what follows I am not talking about alternatives that have no current or prospective cash flows (other than from selling someday) and are impossible to value mathematically. Proponents will argue with me about that impossibility, but, in my opinion, they are merely grasping for rationalizations to own the investments – particularly since I have never seen anyone do a mathematical analysis on them that concludes they are overvalued.) Those alternative investments are frequently called “collectibles” and would include art, wine, stamps, coins, watches, antiques, beanie babies (at one time), NFTs (more recently), rare cars, trading cards, gold, cryptocurrencies, etc. (That last one, crypto, people would argue isn’t a collectible, but outside of the narrow use of facilitating crime there is no significant current use case for crypto despite a lot of hype. Blockchain, yes. Stablecoins, yes. Bitcoin, et al, no.) Some of those are more ridiculous than others as investments, of course, but all of them share the property that the investment case boils down to, “I think it will go up.” That opinion could, of course, turn out to be right, but it’s vibes-based, not empirical, and since they were first issued in 1997, TIPS are a far better option for protecting wealth against the ravages of inflation.

With those preliminaries aside, let me explain why I am unpersuaded to invest in currently popular alternative investments such as Venture Capital/Private Equity, Private Credit/Debt, and Real Estate (Hedge Funds too, though those are less popular today because the returns have been relatively abysmal for a while).

The trivial (and well-known) reasons are:

1. The fees are very high (compared to traditional investments). Indeed, in economic theory the returns will flow to the scarce factor of production. Supplying capital is not that factor. You would expect (and I do) that more or less all of the excess returns flow to the managers of the funds to the extent they have skill. (You may wonder about the “more” – many, probably most, managers are better at purporting to have skill than they are at having skill. They charge a lot either way.)

2. There is a hassle factor to investing in these. The investment process is onerous. The redemption process is onerous (frequently on purpose). They generally produce K-1s rather than 1099s, and those K-1s are notoriously produced very late – often running up against the extension (not regular) tax deadlines. These things aren’t terrible, but they do tend to annoy the investors. In addition, the work to research and perform due diligence is substantial, which would require us to increase our fees to cover researching and managing them.

3. Alts are illiquid, and more illiquid precisely when you don’t want them to be. This illiquidity is frequently touted as an advantage in the sense that you earn an illiquidity premium, but it isn’t clear why that would be so. Suppose you own shares in a partnership that invests in real estate, for example, that underlying property is illiquid, so it’s purchased at X% off some “true” value. You will also sell at X% off some true value on the back end. Consequently, on the price appreciation there is no advantage whatsoever (though the cash flows from the investment would be higher as a percentage of the amount invested). Even aside from that, it appears that today many investors will happily pay an illiquidity premium because in poor markets they can pretend the value of their investment has not declined when it really has. (Cliff Asness has eloquently made this point here.)

4. The purported low volatility and low correlations with traditional investments are simply not true (or at the very least greatly exaggerated). It’s merely a function of the assets not being appropriately marked to market, which makes the apparent risk and correlations seem low as a matter of pure mathematics. Further, many investors (and advisors) give these factors far too much weight. The return of the proverbial cash stuffed in your mattress has zero volatility and zero correlation with all other investments – but it’s still a terrible investment. (Lottery tickets are also completely uncorrelated to the rest of your portfolio.)

So far, so banal. I think there are four other substantial reasons though:

1. There is extreme positive skewness in the distribution of returns of the investments. This means most of them do poorly, but you are “saved” by the very few that do extremely well. This means you need to own a lot of them, but you would have to be extremely wealthy to afford to do so. This can be partly mitigated with funds-of-funds, but those produce another layer of high fees causing investors to start even further behind.

2. The “good” funds won’t let you in. As Marx (Groucho, not Karl) said, “I refuse to join any club that would have me as a member.” That should be your attitude toward alternative investments unless you are (again) extremely wealthy or a very large institutional investor. The funds with excellent track records are not only closed to new investors, they may also be returning capital to outside investors and converting into family offices for the owners and employees. The capacity of any very lucrative strategy (if you can find one) is very limited. If they need capital from you (or me!) that is a sign that it probably isn’t a great investment. Many remember David Swenson (of the Yale endowment) for his enormous success with alternative investing and writing Pioneering Portfolio Management touting that approach, but fewer realize he subsequently wrote Unconventional Success: A Fundamental Approach to Personal Investment for individual investors telling them not to do that – they aren’t the Yale endowment!

3. You can’t differentiate luck from skill because you will never have a long enough track record. To know whether a portfolio manager who has been beating the market by 2% annually (which is enormous) has skill would require a track record 56 years long. (This is a difference of means test assuming a normal distribution, 2% alpha, 20% standard deviation, and 90% correlation with the benchmark.) Thus, realistically, you will never know with any high degree of confidence whether a portfolio manager is skillful. I wish it were otherwise, but it simply isn’t. With alternative investments it’s even worse. The “uncorrelated” nature of them means the time horizon needed goes up even more. Returning to the earlier example, if the correlation is reduced from 90% to 85%, the time horizon necessary increases from 56 years to 83 years! And keep in mind that many alternatives promise zero correlation (if that were true, the time horizon needed to know with 95% confidence that the alpha is positive, not 2%, simply not a negative number given the other listed parameters, is 543 years). The investment industry, particularly in the alternatives space, is almost entirely faith-based rather than evidence-based.

4. Proponents of alternative investments will tell you to be very careful in what you purchase because one alt is not like the other – even in the same sub-type. (And, of course, their company sponsors the good ones.) With traditional index funds, there are advantages and disadvantages of full replication vs. sampling (though full replication seems better). With alternatives you definitely need full replication, which is impossible because of investment minimums. (It’s impossible for access reasons as well, but I’m focusing on the minimums here.) In academic theory you would start with a market-cap weighting methodology and then deviate from that based on the strength of your belief in the investment. How much belief do these alternative investments require us to have? The market cap of the U.S. stock market right now is roughly $60 trillion. Suppose you are contemplating investing in a real estate limited partnership that owns property worth $60 million. For every $1 million invested in U.S. stocks, how much should you put into the partnership? One dollar. But, of course, the investment has a $100,000 minimum (minimums vary, but that’s typical). So, suppose I have $10 million in U.S. stocks, I should invest $10. But the promoter requires me to be 10,000 times overweight that holding to access it. I’m sorry, I will never have enough confidence to overweight something by that much in my portfolio! Obviously, this is just one example with made-up numbers, but you will always be massively overweight the holding and thus should have confidence approaching certainty that it will have a high return. Arguably, you could also use the Merton share calculation.

TL;DR: Friends don’t let friends buy alts! (IMHO, of course.)

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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