I am frequently asked by financial advisors what trade publications I read and what organizations are worthwhile.  Below is a list of my current subscriptions that I would consider most valuable:

• Financial Analysts Journal – free with membership in the CFA Institute
• Financial Planning – free for financial advisors
• Investment News – free for financial advisors
• Investments & Wealth Monitor – free with membership in IMCA
• Journal of Financial Planning – free with membership in the FPA
• Journal of Investment Consulting – free with membership in IMCA
• Wall Street Journal – subscription required
• Wealth Manager – free for financial advisors

If you are trying to narrow it down, I would recommend Financial Planning magazine for basic technical information and Investment News for industry information.  I would also join the Financial Planning Association (FPA) which comes with a subscription to the Journal of Financial Planning.  I also subscribe to a number of other publications (or pick them up on the newsstand), but I don’t find them all that valuable.

Joining the following organizations is highly recommended as well:

• Financial Planning Association (FPA) – for all financial professionals with private clients.
• CFA Institute – primarily for Chartered Financial Analysts (CFA).
• Investment Management Consultants Association (IMCA) – primarily for Certified Investment Management Analysts (CIMA), and Certified Private Wealth Advisors (CPWA).
• National Association of Personal Financial Advisors (NAPFA) – for all fee-only advisors.

I am frequently asked for a recommended reading list, so I looked through my library and created the list below.  It is by no means comprehensive, yet in some respects it is undoubtedly redundant.  Some books are out of print and attempting to read it all would be daunting; so think of it as a menu of options you may want to try.  To keep it to a somewhat reasonable length, I restricted myself to only one title per author and excluded textbooks.  Also, due to my predilections it is tilted toward the areas of behavioral finance, efficient markets, and historical perspective.

• Against the Gods – Peter L. Bernstein
• All About Asset Allocation – Richard A. Ferri
• Asset Allocation – Robert D. Arnott & Frank J. Fabozzi
• Asset Allocation – Roger C. Gibson
• Asset Management: A Systematic Approach to Factor Investing – Andrew Ang
• Behavioral Investing – James Montier
• Beyond Greed and Fear – Hersh Shefrin
• Book of Investing Wisdom, The – Peter Krass
• Common Sense of Money and Investments, The – Merryle S. Rukeyser
• Devil Take the Hindmost: A History of Financial Speculation – Edward Chancellor
• Efficient Asset Management – Richard O. Michaud
• Efficiently Inefficient – Lasse Heje Pedersen
• Extraordinary Popular Delusions and the Madness of Crowds – Charles MacKay
• Fooled by Randomness – Nassim N. Taleb
• Fortune’s Formula – William Poundstone
• Happiness – Richard Layard
• History of the Theory of Investments, A – Mark Rubinstein
• Intelligent Investor, The – Benjamin Graham
• Investment Management – Robert L. Hagin
• Investor’s Manifesto, The – William J. Bernstein
• Management of Investment Decisions, The – Donald Trone, et al.
• Manias, Panics, and Crashes: A History of Financial Crises – Charles Kindleberger
• Millionaire Next Door, The – Thomas J. Stanley & William D. Danko
• More Than You Know – Michael J. Mauboussin
• Myth of the Rational Market, The – Justin Fox
• New Wealth Management, The – Harold R. Evensky, et al.
• Only Guide to a Winning Investment Strategy You’ll Ever Need, The – Larry E. Swedroe
• Only Yesterday – Frederick L. Allen
• Plungers and the Peacocks, The – Dana L. Thomas
• Portable Financial Analyst, The – Mark P. Kritzman
• Portfolio Selection – Harry M. Markowitz
• Psychology of Investing, The – John R. Nofsinger
• Random Walk Down Wall Street, A – Burton G. Malkiel
• Reminiscences of a Stock Operator – Edwin Lefèvre
• Thinking, Fast and Slow – Daniel Kahneman
• Signal and the Noise, The – Nate Silver
• Stocks for the Long Run – Jeremy J. Siegel
• Where Are the Customers’ Yachts? – Fred Schwed
• Winning the Loser’s Game – Charles D. Ellis
• Wisdom of Crowds, The – James Surowiecki
• Your Money and Your Brain – Jason Zweig

 

This is primarily for my fellow financial advisors and those entering the industry and is intended to encourage us all toward higher standards.  There is (in my humble opinion) a difference between simply working as a financial advisor and being a professional.  In my experience the professionals in our industry are rare.  What makes a financial professional different from other advisors?

One simple way to think about it would be to consider to whom you would send your mother or your spouse for financial advice if you were unable to advise them.  I believe most of us would find it difficult to think of more than one or two people in whom we would have confidence.  Following is my view of the differences between a true professional – a professional that I could confidently tell my spouse to go see with the death benefit from my life insurance – and the average advisor.

Competence.  The first thing I would look for in an advisor is competence.  A true professional, though extremely knowledgeable in his field, constantly strives to learn more.  Conversely, many (most?) advisors in our industry have not read a book in their field in the past year (excluding books on how to sell or market more effectively), struggle to meet their continuing education requirements, and are not members of any professional associations.

Credentials are an essential part of competence.  Unfortunately, it is difficult, understandably, for clients to know whether an advisor’s credential is “good” (one that is respected in the industry and means something) or if it is one a salesperson may get by paying a fee for a weekend seminar.

The last time I checked the figures, close to 650,000 financial advisors were practicing in the United States.  Obviously, all would say they give personal financial advice, yet fewer than 6% were Certified Financial Planners.  And most CFP designees specialize in advising people on their investments, yet only 2.3% of them reported being CFA charterholders.

In addition to earning professional designations, advisors seeking to be true professionals can increase their level of competence by joining organizations such as the Financial Planning Association and attending their meetings.  I would also encourage reading trade publications with deeper content than the publications aimed at mere sales people.

Comparing financial professionals to medical professionals may illuminate the differences in competence among professionals:

• Most advisors would be analogous to a LPN or maybe an RN – they can be helpful to folks with very simple needs.
• A CFP designee would be analogous to a doctor who is a general practitioner – he or she is ideally positioned to recognize problems and solve minor issues while making referrals to appropriate specialists for more complicated situations.
• An advisor with designation such as the CFA would be analogous to a surgeon or other specialist.

While all these practitioners have their places, you certainly don’t want your nurse or GP performing your brain surgery!  The following designations are both meaningful and in widespread use:

Specialty Area	Best Designations	Other Quality Designations
Personal Financial Planning	CFP	CPWA, ChFC, MBA, PFS
Insurance	none	CLU or CPCU
Tax	EA, CPA*	none
Estate Planning	JD*	AEP
Investments	CFA	CIMA

^*With a specialty in the respective field.

Product.  The typical advisor in our industry is still focused on selling products or transactions.  The professional sells wisdom, a subtle but crucial difference.

Frequently, companies (and individuals) aren’t clear about what business they are in, and it leads them into trouble.  A classic example of this is the railroad industry about a century ago.  They thought they were in the railroad business, when in fact they were in the transportation business.  Failing to realize this caused them to be decimated by the emerging trucking industry – which did realize they were in the transportation business.  Most companies in financial services act as though their business is selling financial products – mutual funds, stocks, bonds, annuities, insurance policies, etc.  I believe this improper focus leads to problems.

Someone shipping gifts to loved ones at Christmas buys the delivery of the gift not the vehicle that transported it.  The clerk behind the counter did not explain about the trucks and planes that would deliver it, nor did he or she extoll the experience and track record of the drivers and delivery people.  Instead, the customer chose the desired delivery timeframe, and the company simply delivered the package.  If the desire was unrealistic, the clerk wouldn’t guarantee that delivery date.  If the customer wanted better outcomes (within limits), he or she had to pay more.

If we aren’t in the financial products business, what business are we in?  I believe we should be in the business of dispensing wisdom to help people maximize their happiness (not their portfolios – though the two are certainly related).  While it is generally necessary to use financial products, it should not be the focus of the relationship.  Note that the business is the provision of wisdom not information.  Information is freely available on the internet, in the newspaper, etc.  Those facts are emphatically not wisdom (and in many cases they are more like anti-wisdom).

Knowledge is important, but generally it isn’t what you don’t know that will get you into trouble, it is what you don’t know you don’t know, and what you do know that isn’t so.

During the late nineties, people tended to forget they didn’t know where the market would go next.  It seemed obvious – up!  Students of history, however, were familiar with past bull markets and similar feelings among the populace.  This was perhaps exemplified best (and infamously) by Irving Fisher, Professor of Economics at Yale University, in 1929 when he said:  “Stocks have reached what looks like a permanently high plateau.”  In hindsight he looks foolish, yet that was mainstream opinion, not only in 1929 but even just a few years ago in tech stocks and more recently in housing.

A vital component of wisdom is to know what we don’t know.  We don’t know where the market will go in the short run.  While it would be comforting to our clients to pretend we can call market direction, it would be dangerous.  Anyone can design a plan that works if their predictions are correct; the challenge is to design a plan that works even in cases where the forecast is wrong.  We need to know what we don’t know.

Leonard Read, who founded the Foundation for Economic Education in 1946, had a great illustration.  Imagine this page (screen) is all knowledge.  Here is a representation of the knowledge of one person:

•

Similarly, here is the knowledge of a more experienced, more educated individual:

●

Obviously, relative to all possible knowledge both individuals are fairly ignorant.  There is a lot of the page (screen) that isn’t within the dot.  More important is the difference in the circumference of each dot.  The first person with less knowledge has less contact with the knowledge he doesn’t know.  The more educated person has a larger circumference.  He or she has much more contact with what isn’t known.  Paradoxically, the more a person learns the more ignorant they feel as they come in contact with more and more they don’t know.

Thus, it has been my experience that the wisest, most knowledgeable people are those who frequently sound the most uncertain about what will happen next, while those with the least knowledge and experience are the most certain and dogmatic.

Perhaps this explains why, as one wag said, all the people who know how to run the country are driving cabs and cutting hair.  The more ignorant a person is on a particular topic, the more likely they are to think they know plenty about it.  (In other words, “A little knowledge is a dangerous thing.”  The original quote is from An Essay on Criticism written by Alexander Pope in the 18^th century:  “A little learning is a dangerous thing; drink deep, or taste not the Pierian spring: there shallow draughts intoxicate the brain, and drinking largely sobers us again.”)

Knowledge per se obviously isn’t bad, but the person who wields it undoubtedly believes he has more knowledge than he really does.  Overconfidence is one of the most pernicious and systematic errors we make as human beings.  It is easy for us to think we know the answer to a problem (and that it is not that complicated) when we know only a little about the subject.

Process.  Quality advisors realize their value is in their process.  For example, the investment process should look something like the following:

1. Identify the client’s specific goals, resources, and constraints.
2. Develop the capital market’s assumptions (which asset classes should be used, the expected return and risk of each class, and the correlations of each class not only to the other classes but also to other risk exposures the client may have).
3. Run a Monte Carlo simulation or similar analysis combining the previous two steps to determine the optimal solution. (If there isn’t one, start over on step one and help the client adjust his expectations).
4. Implement the allocation using the most efficient and effective vehicles.
5. Monitor the situation for any changes to the assumptions in steps one and two and, if any, repeat the process.

Unprofessional advisors all too frequently start by explaining which product is the solution without going through a process to gain adequate knowledge of the client’s goals and current situation.

The Objective.  The objective of the typical advisor is to find clients who need what he or she has.  The broader objective of the professional is to help the client achieve financial success and remain financially successful in an uncertain world.  (Financial success is simply having more than needed.)

The professional advisor reviews the client’s situation with the goal of developing a strategy that both maximizes the probability of success in reaching the goals and minimizes the shortfall in cases where they won’t be met.  Difficulties arise as a result of tension between these two objectives.

If I focus only on maximizing the probability of my client’s success, I probably would not, for example, recommend my client purchase any type of insurance at all.  In such a case, the client could apply the premium savings to reaching his retirement goals.  Depending on the case, that would likely increase the probability of an adequate retirement.  But, should my client’s house burn down or should he die at age 45, that family would really be in trouble.  It would not comfort them to know they would have been slightly better off because of the premium savings had they not suffered those calamities.

So, I do want to encourage my clients to purchase insurance and otherwise address those small (in probability, not in magnitude) risks – but not in all cases.

For example, insurance generally excludes coverage for acts of war.  A client could obtain custom coverage from Lloyd’s of London or another company for that, but it would be very expensive and thus detract from reaching goals in scenarios where there weren’t losses from acts of war.  Similarly, there is a very small chance that the stock market will be down over a 50-year period.  That particular risk may be avoided by not putting any money in stocks, but the opportunity cost would be so high that even though that one possible (though extremely unlikely) future was “fixed,” the results in all the other futures would be suboptimal.

The goal is to maximize the sum of happiness across all potential futures, keeping in mind the declining marginal utility of wealth.  In other words, the first dollars are more valuable (have higher “utility”) than the last dollars.  Going from a retirement income of $30,000 to $40,000 increases happiness much more than going from $130,000 to $140,000 because the next dollar to someone making $30,000 is more valuable than the next dollar is to someone making $130,000.

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.

An example may help explain that more concretely.  Suppose an individual has no fire insurance, and the odds of the home burning down in a given year are 1 in 1,000 (I made up the odds).  99.9% of the time, the house doesn’t burn down this year and the few hundred dollars of savings from the premium can now be spent on something else.  There is probably not a large increase in happiness in those 99.9% of cases. Call it 1 unit of happiness.  In the 0.1% of cases where the house does burn down and there is no insurance, there is a loss of say 1,000 units of happiness. So, in this case the sum of happiness is 0.999*1 + 0.001*-1000 = -0.001 units of happiness.  Thus purchasing the insurance increases happiness by an average of 0.001 units.

Obviously in reality it is hard to quantify happiness, but the principle holds and provides a very useful framework for thinking about financial planning and tradeoffs that must be made.  The primary objective is not to maximize portfolio value, but to attempt to maximize happiness given imperfect knowledge and an uncertain world.

Collaboration.  Professionals works with other professionals to help their clients.  Too many advisors see relationships as adversarial and only work with other professionals if something is in it for them (referral fees, quid pro quo, etc.).  The true professional “knows what he doesn’t know,” as mentioned earlier, and gets advice and help in those areas from experts.  A typical financial planning and investment management practice will likely need relationships with at least one quality professional in the following fields:

• CPA and/or tax preparer
• Estate planning attorney
• Mortgage broker and/or banker
• Property and casualty agent
• Life/Health/Disability/LTC agent (these may be different people)

Risk focus.  The world is risky.  This simply means more things can happen than will happen.  The professional focuses on what could go wrong, tries to mitigate risks appropriately, and explains them thoroughly.  The non-professional focuses on the upside and downplays risks.  The professional stresses the fluidity and uncertainty inherent in many decisions; the non-professional strives to have the client believe the advisor knows exactly what will happen and how the future will unfold.

Experience.  If the product is wisdom, it is hard to sell it without experience.  Experience isn’t merely a function of time, however.  Many people who have been financial advisors for 20 years don’t have 20 years of experience; rather they have had one year of experience 20 times.  As much as possible, professionals strive to learn new things and work in new areas.  Charlie “Tremendous” Jones said, “You will be the same person in 5 years that you are today except for 2 things: the people you meet and the books you read.”  We can learn from other people’s experience and from history.  This reading list may help.

Ethics.  Immanuel Kant’s categorical imperative is a good guideline for our actions.  One formulation of his imperative stresses that people should always be treated as ends in themselves, never simply as a means to an end.  (The advisor helps them reach their financial goals rather than the client helping the advisor reach production goals.)  Thus, a professional does not manipulate people through fear or greed to make decisions – even ones that are “good for them.”  Such behavior does not treat people as ends but rather as means.  Additionally, whether an advisor is legally a fiduciary or not, the professional always acts as a fiduciary would.

In spite of the sensational press stories about some advisors – I believe that most advisors are ethical and do have integrity.  However, those with problems seem to fall into one of the following three categories:

• They are consciously trying to swindle people. Fortunately (notwithstanding prominent recent examples) this type of person is rare, and there is a criminal justice system designed to accommodate them.

• They just want to make their clients happy. This is the largest problem I see.  The advisor isn’t “evil;” he or she just doesn’t want to deliver bad news and make clients unhappy.  The advisor attempts to smooth things over, put a positive spin on the situation, or cover things up – just until things get better.  Since most advisors are optimists by nature, this is understandable.  But quality advisors contact clients quickly with bad news; a true financial professional is proactive, not reactive, in communication with clients.

• They live above their means. Some advisors get into trouble (particularly in poor markets) because they are straining to keep up appearances.  Truly successful people, advisors or not, live well within their means and see their wealth merely as a tool to better their families and communities.

One last aside on the topic of integrity – as we have seen in the news over the past few years, many firms are conflicted in their relationships with their clients and sometimes don’t have their best interests at heart.  While many quality advisors work at those firms and try to do what is right, increasingly they are leaving for smaller companies or starting their own firms.  True professionals only work where they are permitted to act with integrity in dealings with clients.

(I have written a longer post on ethics that can be found here.)

Full disclosure.  The professional fully discloses potential or actual conflicts of interest, method and amount of compensation, and all material facts about their recommendations.

It is also important to note how the advisor is compensated.  While no compensation method is perfect, awareness of the potential conflicts of interest that exist is crucial.  Obviously, a good advisor should be adequately compensated.  On the other hand, the specific products used should generally be relatively inexpensive.  Too many advisors continue to use products that have high fees in spite of research indicating this leads to poor performance.  In addition, many advisors do not pay adequate attention to (or are ignorant of) tax implications and transaction costs of their decisions.  While these costs are not obvious, that does not make them any less real to the client.  Products where the commission earned by the advisor is not visible to the client are particularly prone to improper or excessive use.

Conclusion.  The financial advisor I would recommend to my family has these attributes.  My hope is an increasing percentage of practitioners in the financial services industry will as well.

An article I wrote in May of 2006 is interesting now in light of what subsequently happened in the markets, but I also think the advice remains pertinent.  The entire rest of this post is that article:

As you may have noticed there has been some turmoil in the markets lately and I wanted to let you know my thoughts.  I think most (all?) of our clients trust us implicitly and don’t need detailed explanations of what is going on, but we always want to err on the side of over-communicating.  If you take the position that you pay us to worry about your investments so you don’t have to, feel free to ignore this.

Over the past few years returns have been so good and volatility so low that we are no longer accustomed to even the minor (from a historical perspective) volatility we have seen recently and some folks might understandably be anxious.

As you know, our focus is long-term and we don’t attempt to time the markets, but rather to maintain appropriate long-term allocations.  We believe history has shown that is a superior strategy to attempting to predict market moves.  At the same time however, we have certainly recognized for some time that wherever we looked investment opportunities appeared at least fully valued and we have attempted to set expectations knowing that corrections were not unlikely.  To quote from a recent letter [April 2006] to our clients:

I am running out of ways to say “we are doing well but please keep expectations low.”  Many commentators have been predicting the end of the small and value outperformance, but it continues apace, rewarding our relatively large exposures to those areas.  Real estate continued to do well also…

In spite of all this good news in returns, we continue to maintain prudent allocations to short-term, high-quality fixed income as protection against possible downturns.  Alan Greenspan expressed it perfectly (though in his typical inscrutable manner) in a speech to economists back on August 26^th [2005]:

“[T]his vast increase in the market value of asset claims is in part the indirect result of investors accepting lower compensation for risk.  Such an increase in market value is too often viewed by market participants as structural and permanent.  To some extent, those higher values may be reflecting the increased flexibility and resilience of our economy. But what they perceive as newly abundant liquidity can readily disappear.  Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher asset prices.  This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums.”  [Emphasis mine]

In other words high current prices imply lower future returns.  People are willing to accept low returns on assets; therefore it may be that people now consider these traditionally risky areas safe.  Historically, that has been unwise.

In light of this situation, for some time we have been directing clients to the more conservative choices where they could afford potentially lower returns.  Of course, we also have maintained very broad diversification.

I want to explain further why we don’t attempt to market time (get in and out of the market on a short-term basis).  One of the primary problems with attempting market timing with traditional investments – even assuming some people have skill – they don’t get to exercise it often enough.  To illustrate, suppose I have a coin that has a 60% chance of coming up heads and a 40% chance of coming up tails.  Would you bet $1,000,000 on one coin flip that it would be heads?  If you win you get $1,000,000; if you lose, you pay $1,000,000.  The expected return is ($1,000,000 x 0.6) – ($1,000,000 x 0.4) = $200,000.  I assume the answer would be no, even though on average you would win $200,000.  However, you would almost certainly be willing to bet $1 on that coin flip and do so 1,000,000 times, even though the expected return is the same.  The difference is the outcome becomes practically guaranteed because of the volume of wagers.  You will almost certainly have a profit of close to $200,000 at the end.  [The 95% confidence interval is $198,080 to $201,920 which is 1.959964 standard deviations of (1,000,000*0.6*0.4)^(1/2).] Even presupposing superior skill, many transactions are necessary to eliminate bad luck and evidence that skill with high certainty.

In addition, knowing investments are overvalued (or undervalued) isn’t enough.  As John Maynard Keynes remarked, “Markets can remain irrational longer than you can remain solvent.”  Assume for a moment that we recognize that a particular investment is “too high”.  If there are other investments that appear more reasonably priced we could sell the one that appears expensive and purchase the ones that appears more fairly valued or even cheap (we do this on an ongoing basis in your portfolio by maintaining tilts to value stocks and away from growth stocks and rebalancing to the target allocation for example).  That isn’t what we have seen lately.  We have seen investments across the board all appear expensive (or at least what we would call “fully valued”).  In light of that, what could we do?

That is not a rhetorical question, but rather one we have thought through and revisited frequently.  Recognize that even if investments are “too high” that doesn’t necessarily imply a crash or even a correction.  It probably means that returns in the future will be lower, but how we get those lower returns is unknown.  For example, suppose an investment would be fairly valued today at $5 and given its growth rate and fundamentals is expected to be worth a fair value of $10 in 10 years.  That is about a 7% annual growth rate.  Let us further suppose we have perfect knowledge and we know that it will be exactly $10 in 10 years.  Now suppose the investment is currently valued at $7.  Given our analysis we would determine that it is “too high” and overvalued by $2 (since it is really worth $5).  We have three options, 1) sell it because it is overvalued, 2) hold it but realize that we will probably only earn just over 3.6% per year (as it grows to the $10 fair value), 3) recognize the risk and trim back a little, but continue to hold it to some extent.

Which is the superior strategy?  Well, as with most things in financial planning, it depends.  The investment could crash tomorrow to its $5 “fair” value (or even go lower as markets frequently overshoot – in both directions).  However, there is another possibility.  The investment could shoot up to $10 immediately.  There is nothing that says that an overvalued investment can’t get even more overvalued – remember not only what Lord Keynes said (above) but also the late 1990’s!  Markets can and do go from overvalued right on to “irrationally exuberant”.  If you sold your investment at $7 and it went up to $10 and stayed there for the next 10 years, you would have given away a decade of returns (admittedly low returns, but returns nonetheless) from attempting to profit in the short run.

Thus our dilemma is that even if we know the distant future, we would also have to know the short term path to successfully trade.  In light of the uncertainties, we continue to counsel broad diversification, relatively conservative allocations (“conservative” is different for different situations obviously), and focusing on things we can control like transaction costs, advisory fees (ours are lower than most), diversification, taxes, saving and spending, etc.

As we observed several years ago, to reach any goal there are only four fundamental things you can do:

• Lower the cost of the goal (retire on less income; send the kids to State rather than Harvard, etc.)
• Put the goal off until a later time (retire at 65 instead of 62 for example)
• Save more to reach the goal
• Get a higher rate of return

Notice that the first three of these are completely controllable while the last is largely not (while you can have a more aggressive or conservative portfolio you don’t really get to pick the return).  In spite of this people spend about 90% (my estimate) of their efforts trying to impact the one factor they have the least control over!

So, as we have noted before, much of what you need to know about financial planning you can learn from the serenity prayer:

Lord, grant me the serenity to accept the things I cannot change,
[such as the stock market’s performance]
The courage to change the things I can,
[such as the amount and timing of my saving and spending, and the level of risk I am taking]
And the wisdom to know the difference.

Let’s move on now to determining the returns we should expect on our investments.  In the following discussion, I make no claim whatsoever to knowing what will occur in the short run, and in the long run these estimates will undoubtedly be wrong, but should give us the midpoint of a range of returns we should expect.  In particular, these exercises can be an objective yardstick when everyone seems either panicked or euphoric about the market.

Expected Returns on Bonds.  Calculating the expected returns on bonds is relatively easy; it is the yield to maturity less any expected defaults.  For investment grade bonds, the default risk can be mostly ignored, but for non-investment grade (aka junk bonds) the defaults can be significant.

Expected Returns on Stocks.  It is a mistake, in my view, to try to achieve some target rate of return.  It is far better to take an appropriate level of risk and accept the returns the market is currently offering.  Wanting or needing a particular level of returns doesn’t make it available.  But it is nice to know what types of returns are on offer.

When appraising a home, there are three ways to arrive at a valuation, 1) comparing the home to the sales price of other, similar, homes, 2) determining the cost to replace the home, and 3) determining what a fair price would be given what income the home could generate as a rental.  These three methods also apply to stocks.  Let’s take them one at a time.  (The astute reader will notice that past performance is not a factor in any of this.)

Comparables.  This is most useful when trying to determine if an individual stock is fairly valued.  Comparing the company to its peers on a variety of metrics including the stock price relative to fundamentals such as sales, cash flow, earnings, book value, etc. can be very useful.  It is less useful in trying to determine the return of the market as a whole, although since bonds compete with stocks for the investor’s dollar, comparing stocks to bonds can sometimes be useful.

Cost.  The value of a company in bankruptcy is the value of the assets net of the outstanding liabilities.  This serves as a lower bound on the value of the stock, because it should be worth at least the value of the stuff in the company.  There may be other intangible values as well.  For example, the Coca-Cola brand is of significant value as long as the company is a going concern.  If there isn’t a significant “goodwill” value (like a brand) then a company should be worth what it could be built for.  In other words, why pay more for an existing company than what it could be created for from scratch?  There is a ratio called Tobin’s Q that measures exactly this.

Tobin’s Q is the ratio of the value of the stock market divided by corporate net worth.  Using this metric is not easy since assets are carried on the balance sheet at their historical value, not the current fair market value.  Further, many intangible assets are not included.  Thus adjustments are needed and are difficult (indeed, there is divergence of opinion on exactly what adjustments should be made and how to do them).  In theory, a “correctly” valued market will have a q ratio of one, but historically the value has been less than one most of the time.  This is a puzzle since intangible assets should cause the ratio to be above one.  This may indicate that assets on the corporate balance sheets are being carried at values that are too high – i.e. not enough depreciation is being taken or write offs being done.  During the dot com boom, the q ratio was higher than it had ever been, portending the coming debacle.

Present value of the cash flows.  In theory the value of a stock is the present value of the future cash flows you expect to get from that stock.  Thus, as a starting point the expected rate of return is the dividend yield.  Of course the company’s dividend may grow through time as well, so we should add to the dividend yield that growth rate.  The lower the dividend the company pays out, the higher its growth should be and vice versa.  If we are looking at the entire market however, we can assume to a first approximation that the capitalization of the stock market will grow proportionally with the overall economy.  That is, companies in aggregate will reinvest enough to grow at the same rate as the overall economy, keeping the ratio the same.  This is probably too high a growth rate for two reasons: First, management at public companies invest retained earnings suboptimally, i.e. the funds they don’t pay out are spent poorly.  This is either unintentional because of overconfidence in internal projects and acquisitions or intentional in building corporate edifices.  (This is an example of the “agency problem”; the manager’s desires – self-aggrandizement – don’t exactly match the owner’s desires – profits.)  Second, it seems reasonable to assume that privately held companies, which are generally smaller, might grow faster than publicly held companies thus leading to GDP growing faster than the public company’s market capitalization.  (IPOs plug the gap to keep the ratio the same over time.)  As I write this, the dividend yield on the market is just over 2%.

The growth of the economy (GDP) can be divided into “real” growth and inflation.  The real growth has been relatively stable over time at about 3%.  Since it has been lower than this recently, and many commentators think slower growth is the “new normal” it might be prudent to trim that by 0.5%.  Expected inflation can be determined by the spread of yields on nominal treasuries over TIPS.  Currently, that spread is well under 2% at all maturities and about 1.5% for the 10-year bonds.  So combining the dividend yield (2%), the expected real growth in the economy (2.5%), and expected inflation (1.5%), we arrive at an estimate of about 6%.  This sounds low (and it is), but in the context of 1.5% expected inflation and 1.5% (or so) yields on nominal bonds (10-year Treasuries), we are getting a 4.5% real return and a 4.5% equity risk premium.  That is certainly lower than what occurred historically, but not really a horrible return expectation.

The immediately preceding analysis used dividend yield as the starting point.  There is another approach where we begin with earnings.  In theory, if a company paid out 100% of its earnings it wouldn’t grow but it wouldn’t whither and die either (depreciation expense is taken out before earnings and, again in theory, would allow enough reinvestment to remain in a steady state).  The company would be able to raise prices with inflation though and costs would increase with inflation.  (This will vary for companies in different industries and with different capital structures and cost structures, but in aggregate it should be roughly true.)  Thus our estimated rate of return on stocks is the inverse of the PE ratio of the market (the earnings yield) plus expected inflation.  As I write this, the market PE is about 25, so the earnings yield is 4.0% (the inverse).  Adding the previously computed inflation of around 1.5% gives us an expected return of about 5.5%.  As in the previous method, this calculation is probably slightly high since earnings are far more likely to be overstated rather than understated in relation to economic reality.

There is also an issue with earnings varying over the business cycle.  When times are abnormally good, assuming those are the perpetual earnings is a mistake.  It is also a mistake to assume that in a recession, the current earnings are the correct ones.  Irrationally, PE ratios are higher in good times and lower in bad times – they are positively correlated with profit margins.  This is the opposite of what should be the case.  It appears people inappropriately assume that the current state of the world will persist rather than revert to a more normal state.

Benjamin Graham, widely recognized as the father of value investing, suggested averaging earnings over a period of time rather than using the current earnings.  Robert Shiller, professor of economics at Yale, maintains this data and refines the method by adjusting the earnings for inflation.

The current “Shiller PE” (also known as the PE10 because the earnings are averaged over a decade, or the CAPE for Cyclically Adjusted PE) is about 27.  The inverse of this gives us 3.7% – though it should be adjusted upward slightly because it is using the average of the last 10 years and there is inflation and growth over time.  Assuming 4.0% nominal growth over the past 10 years would make the current value about 4.5%.  Adding inflation again, we arrive at an estimate for future returns on the market of about 6%.

Using simple metrics like these can help you avoid overreacting to transient market conditions by focusing on the long-term expected returns and make you a more successful investor. With apologies to Rudyard Kipling, here’s my investor’s version of If:

If you can keep your head when all about you
Are losing theirs and trading like crazy people;
If you can trust your valuation models when all men doubt you,
But make allowance for their models too;
If you can force your heart and nerve and sinew
To maintain your asset allocation long after they are gone,
And so hold to your prudent portfolio when there is nothing in you
Except the Will which says to them: “Hold on”
Yours is the risk adjusted return and the alpha goes along with it,
And – which is more – you’ll be a successful investor my son!