Financial Professionals Summer 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 good article on firm culture is here that discusses three key elements:

• Giver vs. Taker
• Learner vs. Knower
• Meritocracy vs. Aristocracy

Second, you can find a good reminder about the dangers of hindsight bias and extrapolation here.

Third, desmoothing Private Equity returns is discussed here, and Private Credit returns are discussed here. From the abstract of the latter:

[A] typical private debt fund produces an insignificant abnormal return to its investors. However, gross-of-fee abnormal returns are positive, and using only debt benchmarks also leads to positive abnormal returns as funds contain equity risks. The rates at which private debt funds lend appear to be high enough to offset the funds’ fees and risks, but not high enough to exceed both their fees and investors' risk-adjusted rates of return.

Which is exactly what you would expect. Returns flow to the scarce factor of production: capital (money) is abundant, while the ability to generate alpha is scarce. Thus, excess returns are extracted entirely by the managers. Frequently they extract even the apparent (not actual) ability to generate alpha. We’ll see in the next credit crisis!

Fourth, I saw an old quote that I think somewhat captures today’s zeitgeist:

There is a cult of ignorance in the United States, and there always has been. The strain of anti-intellectualism has been a constant thread winding its way through our political and cultural life, nurtured by the false notion that democracy means that “my ignorance is just as good as your knowledge.” – Isaac Asimov, column in Newsweek (January 21, 1980).

Plus ça change, plus c’est la même chose!

Fifth, I have talked about planning and forecasting before (see this, for example), but this is good (if a little NSFW). The portion near the end also reminded me (again) of this: The Pretense of Knowledge

Sixth, the consistency of the amount of household outside (i.e., paid) labor over time is remarkable.

Seventh, this news came out just after my last quarterly email so it’s not new now, but thought I’d include it anyway with some commentary on optimal strategy:

The IRS has again waived the annual RMD once again for folks who have inherited after 2019 (source).

10-year rule is still in place though. So, if the IRA is huge you may want to start chipping away at it. Here’s an example: Suppose someone inherited a $1mm IRA in 2020 and has $100k left in the 24% tax bracket. You might want to do at least the $100k each year.

Here’s another example: Suppose someone inherited a $1mm IRA in 2020 and is still working so they are in the 37% marginal tax bracket. They anticipate retiring at the end of this year (2024) and being at the very bottom of the 32% bracket at that point. You would want to take nothing this year and then you have six years to work with. $1mm/6 = $167k/ year (ignoring growth for simplicity). So, you might want to take 1/6 of the balance in 2025; 1/5 of the remaining balance in 2026; 1/4 of the remaining balance in 2027; etc. You should also (to the extent possible) have the portion of the asset allocation with the lowest expected return in this account (probably investment grade bonds). You could also just take the limit of the 32% bracket for a few years and then the limit of 35% for the last few – that’s mathematically a little better, but the current tax brackets are scheduled to increase so it’s not crazy to do that anyway. We’ll have more info (hopefully!) next year, but if history is any indication, it might be 12/31.

If the IRA is smaller, say $50k and taking that in one year would not move the bracket you would just wait as long as possible.

Basically, you are trying to preserve the deferral as long as possible without crossing into a higher marginal bracket at any point.

Eighth, another good quote to remember as you invest (particularly in alternatives):

In good times investors focus on stories; in bad times they focus on balance sheets. – My paraphrase of Steve Eisman (Neuberger Berman)

Ninth, if you are trying to understand why large groups of Americans seem to be incomprehensible to each other, this summary of Three Languages of Politics may help (source):

Progressives organize the good and the bad in terms of oppression and the oppressed, and they think in terms of groups. So, certain groups of people are oppressed, and certain groups of people are oppressors. And so the good is to align yourself against oppression, and the historical figures that have improved the world have fought against oppression and overcome oppression. The second axis is one I think Conservatives use, which is civilization and barbarism. The good is civilized values that have accumulated over time and have stood the test of time; and the bad is barbarians who try to strike out against those values and destroy civilization. And the third axis is one I associate with Libertarians, which is freedom versus coercion, so that good is individuals making their own choices, contracting freely with each other; and the bad is coercion at gunpoint, particularly on the part of governments.

Tenth, the NYT had an article on the FIRE movement (here). There were errors however:

“[E]mploying your children starting from the age they are able to do household chores, which offers a double benefit of reducing a parent’s taxable income while building an investment-accruing tax shelter for the 7-year-old” is obviously bogus tax advice. Hiring someone to clean your home is not a tax-deductible expense but income the child legitimately earned (market rate for services provided) could be put into a Roth.

And:

“[S]tudies have shown that global happiness tops out at income levels of about $75,000 a year” which is not true. Happiness increases with the log of wealth (i.e., there are decreasing amounts of happiness to the same dollar – not percentage – increases, but it never flatlines).  I wrote on this last year here.

Eleventh, good (and short) memo from Howard Marks on risk here.

Twelfth, good article in the FT on Small Cap here (or here if you have paywall issues).

Thirteenth, the conventional wisdom has long held that summer has particularly low returns, as indicated by the popular adage, “Sell in May and go away.” The specific origins of this saying are murky, but the original version was “Sell in May and go away, stay away till St. Leger Day.” St. Leger Day was the final horse race of the season in Great Britain. Today the ending event is Halloween, but it doesn’t rhyme as nicely so the saying has been truncated.

Larry Swedroe said this about it:

Sell in May and Go Away Is the Financial Equivalent of Astrology
One of the more persistent investment myths is that the winning strategy is to sell stocks in May and wait until November to buy back. It's true that stocks have provided greater returns from November through April than they have from May through October. However, there has still been an equity risk premium from May through October. [Emphasis added.]

I agree with him.

On a monthly basis, October is considered particularly risky, and this belief is attributed to the 1929 and 1987 plunges (and validated perhaps in 2008). It is interesting that October apparently had a bad reputation well before 1929 though. In 1894 Mark Twain observed:

October: This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August and February.”

I find the lowest returning month to be September though, and investigated whether any month is statistically different from all months (Welch’s Difference of Means Test for Unequal Variances). September has a mean that is different from all months (it’s statistically significant); the other months do not.

I also looked at the “sell in May” data again. The Equity Risk Premium (CRSP 1-10 minus 5-year Treasurys) for six-month periods:

The November to April is highly significant (100% chance the ERP is positive); but the May to October isn’t (78% chance that you have a better result than going to bonds). Using just recent data, the conclusions are similar though the IR (Information Ratio) for the summer is a little better now. You certainly wouldn’t want to switch from stocks to bonds and back every six months in a taxable account since the gains (if any) would be short-term.

Using Welch’s test (again), the probability that the November to April returns are different from May to October returns is 98% though.

Fourteenth, retirement savings by age:

Fifteenth, it’s important to know whether you are playing a pricing game or a valuation game (click image for larger version, source):

Also, see this on why you probably shouldn’t attempt market timing.

Sixteenth, who owns the stocks? Raising cap gains taxes doesn’t help a lot when much of the market is held by non-taxable entities (source):

Seventeenth, the LA Times reports, “An eye-opening Sports Illustrated study in 2009 that included interviews with athletes, agents and financial advisors found that 78% of former NFL players had gone bankrupt or were under financial stress within two years of retirement and 60% of NBA players were broke within five years of retirement.” The whole article is filled with cautionary tales.

Eighteenth, interesting article about a financial psychotherapist.

Nineteenth, you may wonder why I distribute items on happiness. It’s because our goal is not to maximize the client’s portfolio, minimize their taxes, etc. – it’s to maximize their happiness. Those things can be related, but are not identical. How to Be Happy.

Twentieth, I just read Think Again and recommend the first section (Individual Rethinking) for portfolio managers; the second section (Interpersonal Rethinking) for folks who interact with clients (or others really), and chapters 9-10 for teachers (including informal teachers in a business environment) and chapter 11 for students (or those early in their careers). I have also had Barking Up the Wrong Tree for a while, but just got around to reading it. I think it is going to be our default gift for new college graduates from now on.

Twenty-first, since I am a Friedman acolyte, I liked this and this. YMMV.

Twenty-second, I have linked to Edward F. McQuarrie’s research previously and he has some excellent comments about some misconceptions here.

Twenty-third, I thought I had written about Danish mortgages years ago, but I can’t find anything on it. It was just a theoretical point then, but it has real-world impacts now. See this to learn about a better system.

Twenty-fourth, interesting paper (here) finds that a person’s credit score decline is a leading indicator of dementia. Abstract:

We examine the effect of undiagnosed memory disorders on credit outcomes using nationally representative credit reporting data merged with Medicare data. Years prior to eventual diagnosis, average credit scores begin to weaken and payment delinquency begins to increase, overall and for mortgage and credit card accounts specifically. Credit outcomes consistently deteriorate over the quarters leading up to diagnosis. The harmful financial effects of undiagnosed memory disorders exacerbate the already substantial financial pressure households face upon diagnosis of a memory disorder. Our findings substantiate the possible utility of credit reporting data for facilitating early identification of those at risk for memory disorders.

Twenty-fifth, we never learn, zero-down mortgages are back!

Twenty-sixth, read about some excellent customer service.

Twenty-seventh, nice data from Chicago Booth on Which Americans Are Happiest.

Twenty-eighth, interesting post here on BREIT.

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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