My latest quarterly ramblings to my Financial Professionals list are out: Financial Professionals Summer 2020

The market’s estimate of inflation can be derived simply from the spread of “regular” (nominal) treasuries and TIPS (treasury inflation-protected securities). As I write this, the 30-year treasury is at 1.4% and the 30-year TIPS is at -0.2% (per Bloomberg). So, very simplistically, inflation is expected to average 1.6% (the difference). That is slightly off though in three ways:

First, it doesn’t matter much at the current low rates, but subtraction isn’t technically correct. The returns on nominal bonds are given by this formula: (1 + yield) = (1 + real rate) * (1 + expected inflation) * (1 + risk premium)

Since we are talking about treasuries, the risk premium is (supposedly) zero so that term drops out. We can rearrange the remaining terms thus: (1 + inflation) = (1 + nominal yield) / (1+ real rate)

Plugging in the current rates we have: (1 + inflation) = 1.014/0.998 = 1.0160

Subtracting 1, we are left with 1.6% as the inflation expectation. (As I said, very close to just subtracting at these low rates.)

Second, since TIPS are slightly less liquid than nominal treasuries we would expect a small liquidity premium (much like the difference between on-the-run treasuries and off-the-run treasuries). In other words, the TIPS yield is a little higher due to being less liquid which means expected inflation is actually a little higher than the spread would indicate.

Third, since TIPS eliminate inflation risk, buyers should be willing to pay a small premium to avoid that risk. In other words, the TIPS yield is a little lower due to having less risk which means inflation is actually a little lower than the spread would indicate.

My astute readers will have noticed that the previous two items go in opposite directions, so they offset each other. They are also difficult to estimate and are likely small in magnitude. In practice that means I ignore them.

Also, a note for data nerds, inflation is:

• heteroskedastic – the volatility of inflation is correlated to the level of inflation
• autocorrelated – the current level of inflation is related to the previous level of inflation
• positively skewed – high inflation is further away from the median than low inflation

There is a natural tendency for things to become increasingly adapted to their environments and with this adaptation to be more and more successful. These successful entities (organisms or companies) grow larger and larger – until.

Until the environment changes. There is a trade-off between specialization and adaptability. The more successful an entity is in one environment, the less successful it will be in another. The bigger the “bet” you make the better you do when it works, but the worse you do when it doesn’t.

The sweet spot is somewhere in the middle. You never want to go “all in” on the current environment, but neither do you (probably) want to maintain perfect flexibility.

This applies to career choices as well. One of the highest paid college degrees is petroleum engineer, one of the lowest is liberal arts (but philosophy majors do better than you might think). But what if the world changes? Again, there is a trade-off between specialization and breadth. The petroleum engineer’s career is high return and high risk like a stock portfolio, a liberal arts major is more like a bond portfolio, their career is likely to be (financially) unspectacular, but their downside is likely lower (given equal intelligence, etc. – I’m not sure the average liberal arts major has the same qualities as the average engineer, but in this analysis, I am assuming the same student merely selected one or the other and had the ability to be academically successful in either major). The best combination is probably a technical (STEM) degree with a minor in liberal arts. Or maybe a liberal arts degree with a technical graduate degree.

In portfolio construction, this means you overweight what has worked (equities, factor-tilts, etc.) but you always remember the future could be different, so you prudently diversify too (investment grade bonds, core holdings, etc.).

Probably the best way to hedge an unknown future is to use as little leverage as possible in your business, personal finances, etc.

People don’t seem to think enough about the possibility that the landscape can change. Survival of the fittest depends on the environment, being perfectly fit for an environment is better than fitness for lots of environments – until the environment changes. I would note that this overspecialization is a bigger risk for the young since the amount of future change that can happen is greater over a longer period.

Similarly, this article parallels how I think about financial planning and portfolio construction. Wealth management is an “infinite game” – survival is more important than getting the highest score. Thus, you should not (completely) optimize for the current situation because the current situation may not persist, and we don’t know in what ways it could be different.

My latest quarterly ramblings to my Financial Professionals list are out: Financial Professionals Spring 2020

We periodically get queries about how to invest in the latest hot area (3D printing a few years ago, blockchain and cannabis more recently).  We believe that fads (from tulip bulbs to blockchain) are generally poor investments.

To profit from new technology is harder than first appears. There are two ways to profit:

First, you can recognize the technology revolution – but if everyone recognizes it, then all the investment opportunities are already at least fully valued, if not overvalued (investors tend to get carried away). So you must recognize a new technology has enormous potential while others don’t see it. That is difficult to say the least.

Second, you can figure out which company is going to be the winner in the gold rush. Again, you must be better at predicting than everyone else. Another extremely difficult challenge.

History is replete with life-changing technologies, but in virtually every case, investors (in aggregate) lost money trying to pick the winners (though of course a lucky few made fortunes). Examples include the railway mania of the 19th century, the automobile industry in the early 20th century, the PC revolution in the early 1980’s, the dot com and internet boom of the late 1990’s, etc.

Railroads and cars might not seem like cutting-edge technology, but they certainly were at the time.

As Wikipedia notes, “There were over 1,800 automobile manufacturers in the United States from 1894 to 1930. Very few survived.” Even Henry Ford’s first attempt failed.

So, while we will probably agree that the current whatever is likely to be huge in the future, we would also recommend not investing in it. It is much more likely to be overvalued than undervalued.

One sign that the investment opportunities may be experiencing excessive enthusiasm is that you want in on the action!  FOMO is almost always a sure way to lose money.