Financial Professionals Winter 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, an excellent example of correlation vs. causation:

Second, there is widespread belief in what is sometimes called “time diversification.” I debunked some of it here and here but I have had follow-up questions so I’ll elaborate further.

The question is really: is there mean reversion in the equity risk premium (ERP) over time? If so, if you have a bad ERP experience early it reverses later so that if you have enough time you capture that and get back to (better-than) even over a more conservative allocation. There is some evidence of that but it’s pretty small. Your risk does not decrease with time. Samuelson made this point 60 years ago, but for some reason most people still think it works.

That paper was the first time (I think) the “myth of time diversification” was debunked. I.e. stocks do not get less risky with more time. The probability of loss decreases, but the magnitude of shortfall grows proportionally. (Again, there is an argument that longer-term stock returns are somewhat mean reverting so that the volatility/risk does not increase quite as much as theory would predict – i.e. with the square of time. I would actually tend to agree with that.) Most people misunderstand the concept because they confuse “very unlikely to happen” with “can’t (or won’t) happen.” Mark Kritzman wrote a clearer explanation on this topic here, but you may not have access. It’s also in his wonderful book which I highly recommend.

The point Samuelson and Kritzman are both making is that diversification only works cross-sectionally, not serially. If you invest all of your funds simultaneously in 100 risky ventures (1/100th in each) of which most have decent returns, a few have spectacular returns, but a few also become worthless then you win. However, if you invest all your funds in 100 risky ventures one-at-a-time, rolling gains into the next venture, if any one has a negative 100% return then you are wiped out.

Also, you may have seen this from me last fall.

Third, I can’t believe this was a HBR article. Doesn’t every adult know these? (We may not always do them, but they aren’t exactly secrets!) As financial advisors, listening should be a core competency, but it frequently isn’t (certainly it isn’t for me) and that was a recent article too. Is the HBR getting more banal?

Fourth, the most and least valuable college majors (according to analysis by Bankrate) are:

Top five:
1. Architectural Engineering
Median annual income: $90,000; unemployment rate: 1.3%
2. Construction Services
Median annual income: $80,000; unemployment rate: 1%
3. Computer Engineering
Median annual income: $101,000; unemployment rate: 2.3%
4. Aerospace Engineering
Median annual income: $100,000; unemployment rate: 1.9%
5. Transportation Sciences and Technologies
Median annual income: $86,000; unemployment rate: 1.8%

Bottom five:
155. Clinical Psychology
Median annual income: $49,000; unemployment rate: 3.8%
156. Composition and Speech
Median annual income: $42,000; unemployment rate: 4.9%
157. Drama and Theater Arts
Median annual income: $41,000; unemployment rate: 4.5%
158. Miscellaneous Fine Arts
Median annual income: $38,000; unemployment rate: 5.6%
159. Visual and Performing Arts
Median annual income: $35,500; unemployment rate: 3.6%

Also, see this.

Fifth, the paper here is from a liberal perspective about what “loopholes” should be closed to raise revenue. Consequently, it is also a great guide to those loopholes! Many of these will undoubtedly be closed if/when this Congress gets a tax bill done, but it’s a good guide for now to help our clients. Here’s the list of strategies:

• Zeroed-out GRATS
• IDGTs
• Minority interest discounts
• Gifts over bequests (tax exclusive vs. tax inclusive if done more than three years before death)

Also, see this. While it is also written from a liberal perspective, the wealthy can take it optimistically: punitively high taxes have always been avoidable and avoided.

Sixth, Anitha and I have been using the phrase “work-life harmony” for a while as a description of how we want to arrange our lives, but I didn’t remember where I got it from. I recently read Invent & Wander ($3.05 for hardback and free on Kindle on Amazon!) and I think I stole it from Jeff Bezos.

He’s talked about it a lot elsewhere too, see this for example.

Anyway, I agree with his perspective.

Seventh, apparently you can buy S&P 500 index inclusion (at least at the margin) – who knew!

Eighth, this list of 10 truths about the stock market is good. Not new, but good.

Ninth, many of the problems with social media existed for radio as well. I don’t know that the policy prescriptions of this article are correct, but the history lesson is worthwhile. It starts slowly and doesn’t finish strongly (to me), but the middle portion (starting with the “Into the Ether” heading) is excellent. Modernity is not uniquely depraved!

Tenth, some retirement savings stats (source):

• Half of American adults between 32 and 61 have less than $6,500 in retirement savings (IRAs, 401(k) plans, etc.).
• 43% had no retirement savings.
• “The average age at retirement in the United states [sic] is just shy of 60 (with a median – and mode – of 62)” That means there is negative skew. (I.e. people retire more years shy of 62 than they do later than 62.) Assuming age 62 for retirement in financial plans might be prudent (although for HNW folks in white collar jobs – i.e. our clients – that might be too conservative).

Eleventh, why do we diversify broadly? This is why.

Twelfth, curiosity is a superpower.

Thirteenth, EV stock investing is the new bicycle mania. If you aren’t familiar with the 1890’s bubble in the UK see this for example.

Fourteenth, I’ve been thinking about advice for younger professionals so I’ve been reading a few networking books. (I thought I had read them a long time ago, but apparently I picked up the essence without ever actually reading the books. I have corrected that now.) Anyway, I highly recommend, Give and Take. A related book is The Heart and Art of NetWeaving which is similar to Give and Take, but not as good. However, it does have a few very good questions that can be used in business networking situations to get past superficiality and see how you can really help someone (my paraphrases/versions of the questions):

1. Some version of, “How do you make money?” We all tend to ask people what they do, but if you can get to how they actually get paid it’s much more insightful.
2. “What’s your biggest problem/obstacle/need/opportunity?” As I envision a networking situation, I might ask, “What’s the hardest thing about what you do?”
3. “What’s your strategic/comparative/differential advantage (aka USP)?” Again, as I envision this, I would probably ask, “What makes you different from your competitors?”

He also throws in a personal one which is perfect for a financial planning discussion with clients or prospects: “If you weren’t doing what you are today, and money were no object, what would you be doing (and why)?” This is a more concrete version of, “What’s your passion?”

Both of those books reflect our approach to business: Be helpful to folks and you will be successful. I didn’t say be helpful to be successful. This isn’t mercenary or strictly reciprocal. But I think if you just try to maximize total societal outcomes it works. Let me see if I can explain that better. Some people see the pie size as fixed (and sometimes it is): if your portion is bigger, then mine is necessarily smaller. But often you can increase the size of the pie and everyone can win. I go a small step further and will have my piece a little smaller if it makes the whole pie much larger. Let me give a few examples:

• Fixed-pie situation: I can help someone, but they can help themselves/do it themselves as easily as I can (and we are equally busy, etc.). I’m not doing that. There is no net win. I lose, they win by exactly the same amount.
• Grow-the-pie situation: I can help someone easily and they can help me easily. We help each other and both win. This might be undefined. I might help a co-worker right now and then they sort of informally owe me a favor to be used later. This is usually really loose, but assuming conscientious folks, it works out fine. This might be just being neighborly outside the workplace. Here’s a few real-life examples that occur to me:
• The grass was dead in front of our house between the sidewalk and the street. The dead area continued in front of the neighbor’s house for about 15 feet too. When I get it fixed, I don’t have them stop at the property line, I get it fixed all the way along. That’s so much better than my neighbor having to try to get someone to do a very small sod job. Probably this comes back in good relations. (The neighbor is the new Woodstock mayor so who knows I might need a favor someday. But I didn’t do it so that I could call in a favor someday. And I’m not fixing the sod in front of all the houses in the neighborhood either!) Almost exactly the same situation, but at the office, we got the sidewalk in front of the office power washed. We did the offices on either side too so the whole building was done. It would look weird to just have in front of our section done. They offered to pay a portion, but we declined. It was a very small cost and the goodwill of the neighbors is probably worth more. (I had my nephew do it so it was pretty inexpensive.)
• In the office, there are things that are easier for me to do or easier for Anitha to do or easier for Kaitlyn to do. In general, whoever can do it the easiest should do it. (Exceptions though for levels of busyness, compensation, learning experiences, etc. The compensation one just means that even one person can do everything better if it is the highest paid person in the office, they should almost certainly be doing the highest value things. See Ricardo’s comparative advantage.) At home, spouses frequently divide up responsibilities this way too (though research shows the women generally get the short end of the stick on this). Sometimes I reach out to peers with a question or something and they are always very generous with their time. Of course, when they reach out to us, we are too.
• This newsletter is free. It has been suggested to me many times that I charge for it, but I think it’s worth more to have 3,000+ people feel warmly (and perhaps slightly indebted) toward me.

No one is “keeping score” (at least I’m not) on any of that, but it probably all comes out at least even, but I think in aggregate everyone probably wins.

• Grow-the-pie with karma situation: I can easily help someone a lot but they almost certainly can’t do anything at all for me. I probably help anyway. Examples:
• Pro-bono advice for people with low incomes and trivial net worth, no connections to any prospective clients, etc.
• Coffee with young people needing career advice or connections, etc.

I’m pretty happy to help with all of that even though there is a small cost (primarily time) to me. The help to them is (hopefully) very large so the total pie is still bigger (my slice is a little smaller, but theirs is so much bigger it’s larger at the aggregate level).

Regarding, the fixed-pie vs. variable-pie views above, Paul Graham also wrote an excellent piece on this topic years ago. I highly recommend that motivated young people read this and internalize the key factors of leverage and measurement.

Fifteenth, two good financial planning (or just life) questions here.

Sixteenth, I am not a fan of tactical allocation, but this version from the eminent William Bernstein I actually endorse. But it is very, very, very hard. Rarely – very, very rarely – the market goes on sale and provides the buying opportunity of a lifetime where I would hopefully be able to pull the trigger and increase my asset allocation risk (perhaps from 60/40 to 80/20), tap a portion of a HELOC to invest, etc.

What is that “sale” level? To me it’s when the market gets to a 10 PE or so. That may never happen for the rest of our lives, but (since 1900) it happened in 1907, 1916-21 (so pretty painful if you pulled the trigger in 1916), 1923-26, 1941-42, 1947-1953, 1974, and 1977-82 (plus a few other random months, but those are the major periods). No opportunities in about the last 40 years!

We can look at this another way. To get to those levels, with the market at a current 29 PE, it would have to fall by about 2/3. That’s if the E stays constant. Any trigger that would prompt a 2/3 drop in the P probably hit the E pretty hard too. So my guess is that we could easily have an 80% drop in stocks. Or not. This isn’t a prediction! It’s merely an elucidation of what can happen – and why William Bernstein is right about dry powder. But I’m not sure if we had an 80% drop that folks (including me) would be able to pull that trigger!

Seventeenth, I read an interesting paper on philanthropy: The Psychology of (In)Effective Altruism

Eighteenth, nothing new, but a good introduction to a few statistics issues here.

Nineteenth, I read a good article explaining the “The Intrinsic Futility of ES(G) Investing” (yet another by William Bernstein). The short Peter Lynch piece at the link in that article (also here) is well worth reading too.

It’s one of the reasons that value and profitability are good. But note that there is a difference between management of the company (I want all that profitability, boring, moat-having) and investing. In the investing case, I like those things if they are mispriced by the market, i.e. they are cheap. And they frequently are.

As I have observed before, there is a price at which the best companies in the history of the world are a terrible investment, and there is a price at which the worst companies in the history of the world are good investment.

Twentieth, I’ve always admired the wisdom of Michael Mauboussin and I liked his answers to the last three questions in this interview:

Where do you see economies and markets going for the rest of the year and early into 2022? No view.

Same question about inflation, tapering and interest rates? Same answer.

What are some key metrics and events we should be watching for? Beyond the obvious, there’s nothing I can add.

I wrote a newsletter with a similar point back in 2018:

I was thinking about what goes into quality wealth management. The goal, in our view, is to use wealth management to maximize long-run client happiness in the face of an uncertain future.

I think there are three inputs into the process:

1. Quantitative and Qualitative Data – you have to know the facts about the client, about the tax code, about capital market return history and drivers, etc. You also need to know the “soft stuff” about the client to maximize their happiness.
2. Analytical Ability – you have to be able to “do the math” to calculate whether or not a mortgage should be paid off, an IRA converted to a Roth, how Social Security or a pension should be claimed, etc.
3. Wisdom – exposition below.

The first two items I think are (or should be!) just “table stakes” – they aren’t a differential advantage, a unique selling proposition, or whatever you want to call it. But I think wisdom is what separates the high-quality advisor from the typical one. The Socratic paradox is the statement (based on Socrates, but not a direct quote), “I know that I know nothing.” Supposedly this made him the wisest man in Athens. Another great observation (attributed to many sources, but probably from Josh Billings originally) is, “It ain’t what you don’t know that gets you into trouble, it is what you know for sure just ain’t so.”

The problem is acknowledging our ignorance doesn’t make clients very comfortable – it might even prevent us from having any. Imagine if we re-branded Financial Architects like this:

Financial Architects, LLC
“Embracing ignorance since 2005”

But we are ignorant, particularly in our predictions of the future, whether that is the tax code, the yield curve, investment returns, etc. As the Danish proverb (not Yogi Berra!) says, “It is difficult to make predictions, especially about the future.” So, in light of our ignorance, here are a few things that I think are prudent:

1. Spend lots of time trying to become wiser by reading, writing, and thinking. See here for example. Schedule time for thinking, or, even better, empty your schedule like Charlie Munger and Warren Buffett. Bill Gates, and others, take “think weeks.” Leonardo da Vinci observed, “Men of lofty genius, when they are doing the least work, are most active.” I don’t know if any of us would qualify as “men of lofty genius” but I think having free time (like I do today so I can think about this and write this) is important.

2. Recognize that the best predictor of the future is frequently the present. The current yield curve is the best estimate of the future yield curve, the current tax code is probably the best estimate of the future one. I would be cautious about assuming reversion to some “normal” level of interest rates, equity risk premiums, PE ratios, profit margins, etc. – particularly over a short period of time. The exception to this would be if differences are profound, but even then, it is problematic. In 1995 the dividend yield of the market got lower than it had ever been in history, but it turned out to be much better to buy than to sell. In the spring of 2009, the earnings yield (the inverse of the PE) was also lower than it had ever been (due to minuscule earnings) just before the market soared.

3. Given the paucity of information, frequently the best we can do is equal-weight. Sometimes this is called the 1/n strategy. At best it looks unsophisticated, at worst, ignorant. But it is empirically grounded. If your asset allocation models have decimal points, I would (politely) suggest you are overfitting your data. If you have more than half-dozen or so allocations in your model you have probably sliced your asset classes too finely (you may have two or three holdings in each class, but you probably shouldn’t have all that many top-level classes).

4. Be very slow to make tactical changes to a portfolio. We rarely know as much as we think we do, and we certainly will almost always know less than the collective wisdom of all market participants. It is very hard to do nothing, but doing nothing is frequently the optimal move. As Warren Buffett has said, “Much success can be attributed to inactivity. Most investors cannot resist the temptation to constantly buy and sell.” He also stated, “Lethargy, bordering on sloth, should remain the cornerstone of an investment style.”

So, I don’t know about you, but I’m headed to Starbucks to try to remediate some of my ignorance with some reading…

Twenty-first, you now need to use this new Uniform Lifetime Table for RMDs.

Twenty-second, the college gender gap will become increasingly important, though it is hard to know exactly what the effects will be. Key points from that article:

• “There are roughly three women students for every two men”
• “The gap in graduation rates is even larger, because male undergraduates are less likely to complete their degree.”
• “[T]he career and financial benefits of a college degree have grown dramatically. Women largely have responded to this market signal, but men have not.”
• “[M]en are still a majority of students in some of the highest paying fields like business, computer science and engineering.”

Twenty-third, the 50 laws of investing are very good. (I did a similar list a while back: Advice to a Neophyte Advisor.) Also, these 35 Ideas from 2021 are outstanding.

Twenty-fourth, quote of the day: “Rich people have money. Wealthy people have time.”

Twenty-fifth, good paper on real estate investing here, my synopsis:

1. Investments in “superstar” cities have lower total returns (about 100 bps annualized) because they are less risky than investing in smaller and more rural areas.
2. Superstar cities do have higher levels of appreciation, but this is more than compensated for by higher starting prices compared to rental income. In other words, because people know that risk is low and price appreciation is likely to be high, the starting prices (compared to rents) are high which brings the realized total returns down.

Twenty-sixth, I assume this is the average crypto investor today.

Twenty-seventh, I don’t think people have realized the huge implications of ZPG (zero population growth) in the U.S.

This, for example, is about COVID, but what if the trend is permanent? I can see a devaluation of college degrees because they simply need the enrollment so begin to take those who really aren’t “college material.”

Also real estate will no longer have a tailwind from more people (though some regions – probably mostly urban – will still win at the expense of others – probably mostly rural – who will lose).

One trend that is likely to continue though is that people become more affluent over time so even if the population doesn’t increase you can still increase sales if your product is oriented toward higher income/wealth people (such as wealth management).

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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David

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