Following is an analogy to explain how to think about expected return and what actions might be prudent if that expected return changes.

The Magic Box.  Imagine there is a magic box and at the end of each year a dollar mysteriously appears inside.  Suppose you pay $10 to acquire this box.  At the end of the first year, it produces the aforementioned dollar as it always has.  What is your expected return on your investment?  Well, if you continue to receive $1 per year on an investment of $10, then you have a 10% return ($1 return divided by a $10 investment).  At the end of the first year, after collecting your dollar, you sell the box to someone else for $20.  What has been your actual return?  You received 10% from the dollar produced, and an additional $10 (100%) from your gain on the sale, so your total return was 110% ($11 total profit divided by $10 cost) for the year.

So far, so good, but now it gets a little more complicated.  What is the expected return for the person who bought the magic box from you?  One way he or she might look at it is that the box has “always” produced 110% return per year for as long as we have historical data.  Therefore, we should expect 110% each year in the future.  Many people do this with the stock and bond markets and simply look at the historical total returns that have been achieved to arrive at an estimate of future returns.

Some analysts go a step further and suggest that price appreciation (P/E multiple expansion) may not continue as it has, so we should remove the 100% appreciation from the total return leaving us with 10% expected return.  This seems plausible until we realize that the person who bought the box from us paid $20 and will likely receive $1 per year for a 5% return.  Of course someone may in the future purchase the box for $30 or $10, we simply don’t know in advance.  Historically, the stock market has paid about $15 for a dollar of earnings; currently it is slightly higher than that.  That does not necessarily imply that the market must go down, but it does imply some probability of lower returns in the future.  In general, I believe that markets work, and current prices are the best estimate of future prices.

Two Boxes.  Now let me change the example slightly.  Suppose there are two types of magic boxes.  One works just like the one in the previous example.  It magically produces $1 each and every year like clockwork.  We will call that box the “bond box.”  The second box type on average creates $2 per year, but it is highly uncertain.  Some years there is nothing, some years there is more than $2, but on average it has been about $2 per year.  We will call this box type the “stock box.”  Due to the uncertainty of the stock box, both of these boxes cost the same amount.  In other words, you can choose to purchase a bond box and get $1 per year or purchase a stock box and on average receive $2 per year but at irregular intervals.  Given this scenario, suppose you choose to buy equal numbers of each box to reduce your risk a little but get returns higher than $1 per year.  On average, you will receive $1.50 per box with some uncertainty due to the stock boxes.

Now suppose that it appears that the stock box, instead of producing $2 per year on average, is only producing $1.50 per year on average.  It may be hard to tell due to the irregularity of the pattern, but suppose we are convinced that it is now $1.50 and not $2.00.  What should you do?

As with many questions, it depends.  If you absolutely, positively must average $1.50 per year return as you always have, you have no choice but to sell all of your bond boxes and buy stock boxes.  That is the only way to get $1.50 on average.  Of course, you will have a lot of risk given the irregularity of the payments, but on average (a very important caveat) you will receive the $1.50 you always have.

Another option is to look at it another way.  You previously received a premium of $1 per stock box for taking the risk that in any given year you might get nothing at all.  Now you are only getting $0.50 premium for taking that same risk.  It would seem logical to have more bond boxes in that case since you aren’t getting as much compensation for that risk.  Looked at from this perspective, it would be rational to have fewer stock boxes and more bond boxes.  Of course your expected return is lower than it would be otherwise, but so is the risk.

Which adjustment to make (more risk or less risk) will depend greatly on your individual situation.

A while back I was having a discussion with a colleague about the mindset of a particular person and I commented that they were essentially a “poor person with money.” In the context it made sense (they grew up poor, but had subsequently done very well), but I realized that locution would seem odd to many people. It has to do with the psychology of money and I thought it would be a good topic to discuss here. There are exceptions of course, to the generalizations I make below, but I think they are at least somewhat apt, though anecdotal.

I’m going to use the more emotional terms “rich” and “poor” rather than the more neutral “wealthy” and “non-wealthy” to describe subjective psychological states. For example, Mike Todd (an American theater and film producer) back in 1953 said:

I’ve never been poor, only broke. Being poor is a frame of mind. Being broke is a temporary situation.

Rich people (particularly several generations down the line) typically have an abundance mindset. Money is just there and will always be there and certainly isn’t something to be anxious about. They usually exhibit equanimity about their finances.

Poor people (again particularly over several generations) are just the opposite and typically have a scarcity mindset. Money usually isn’t there and might not be in the future and absolutely is something to be anxious about. They usually exhibit worry about their finances.

For the objective state of whether someone has adequate resources to support their lifestyles I will use the more colorful terms (a la Mike Todd) “broke” and “loaded.”

So we have four possible combinations of folks:

1. Loaded rich people
2. Broke poor people
3. Broke rich people
4. Loaded poor people

The first two in the list are the expected cases, but the last two – where the mindset doesn’t match the resources – are more interesting.

Broke rich people are usually the heirs of the wealth creators who either alone or in concert with previous generations have squandered the family fortune. With their abundance mindset they don’t recognize (or are in denial about) the precarious state of their finances and adjust far too late to what used to be called “straightened finances.” As Hemingway is often said to have observed, they go broke slowly then all at once. (The actual quote from The Sun Also Rises, 1926, is “How did you go bankrupt? Two ways. Gradually, then suddenly.”)

Loaded poor people are usually first generation wealthy and they worry a great deal about becoming poor again. This frequently causes them to be poor investors as they either avoid risk (and the returns that come with it) or to flee risk at exactly the wrong times. In other words, they invest too conservatively (e.g. exclusively bank CDs) or invest appropriately but sell at inopportune times (e.g. in late 2008).

We can learn from both groups:

• The equanimity of rich people is good for investing, but bad for spending.
• The worry of poor people is good for spending, but bad for investing.

Over time you will be more financially successful if, like poor people, you watch your spending but, like rich people, don’t worry much about your short-term investment performance.

I was tempted to call title this post “Alternative Alternatives” but it seemed more confusing than clever.  In previous posts I have covered traditional asset classes, an overview of alternative investments, commodities & gold, real estate, and miscellaneous other alternatives.  In this post I will talk about investment opportunities that are generally not even noticed as investment opportunities.  Many of these I have written about previously so I won’t repeat that here, but will rather link to the other piece.

• Prepaid taxes.  If you are in a lower tax bracket now than you will be in retirement you can “invest” by prepaying some taxes now at the lower rate.  How?  Roth conversions and capital gain harvesting.
• Paying off (or down) debt. Paying off (or even down) debt is a very good fixed income investment.  This can even extend to paying off your mortgage.
• Delaying Social Security benefits.  Not taking Social Security until later is an investment.  The current foregone benefits purchase higher future benefits and the returns are extremely attractive.
• Life Insurance. We consider  a great deal of life insurance to be inappropriately sold, but there are opportunities.  Term insurance with a return of premium rider can be attractive in the right situation, as can permanent insurance, but those situations are fairly rare.
• Human Capital.  Investing in improving your skills or knowledge (particularly if you are young) can be one of the best returning investments of all.
• Market Guarantees. These are typically not good investments and should be avoided.  They go by the names of equity indexed annuities, Guaranteed Minimum Income Benefit (GMIB), Guaranteed Minimum Withdrawal Benefit (GMWB), etc.  These are very expensive and in reality the “guarantee” is that you will almost always have far less wealth than you would have by doing something else with your funds.  There is no free lunch and you cannot get market returns without market risk.  I wrote about a few similar products here.

 

Following is an overview of several alternative investments that didn’t warrant their own posts:

Convertible Bonds.  These are bonds that are convertible into shares of stock. They are mostly traded by hedge funds using sophisticated arbitrage strategies.  We do not use these in portfolios as they aren’t different enough from stocks to make the diversification compelling.  They are equivalent to having a bond portfolio combined with call options on the related stocks.  Because of the call option the yield on the bonds are lower than they would otherwise be.

Preferred Stocks. Preferred stocks are mostly owned by corporations due to the special tax treatment (there is a dividend exclusion for companies). While preferred stocks are senior to common stock in the capital structure, they are junior to all debt.  This means in the event of bankruptcy, there is likely to be little, if any, recovery.  These stocks are not typically a compelling investment for individuals.  While they are technically stocks, they more closely resemble bonds in most cases.

Hedge Funds.  A hedge fund really isn’t an investment strategy, it’s a compensation method.  There are a wide variety of funds so it is difficult to paint with a broad brush, but in general:

• In the U.S. hedge funds are only available to accredited investors – those who have a net worth of over $1 million excluding their primary residence, or an income over $200,000 ($300,000 with spouse) for the last two years and expected for the current year.
• The fees are high (though worth it if in fact they are delivering alpha), and are most commonly “two and twenty” – two percent of the value plus twenty percent of any profits.
• They require minimum investments that preclude even relatively wealthy investors from owning enough of them to diversify properly.
• Hedge funds of funds solve the previous problem but at the cost of another layer of fees.
• It appears hedge fund outperformance may have existed when there were fewer of them, but it probably doesn’t exist any longer.
• To the extent there is (or was) outperformance it is (or was) concentrated in a very few funds that have such restricted access you (or I) are unlikely to be able to get in.  (Groucho Marx said, “I would not join any club that would have someone like me for a member.”  Similarly, you don’t want to invest in a hedge fund that would allow you to do so.)
• While ostensibly charging high fees for alpha (outperformance) it appears in practice they are delivering a great deal of beta (simple market performance) which should be nearly free.
• The strategies are opaque and illiquid.

We do not invest in hedge funds or encourage clients to do so either.

Master Limited Partnerships.

• These have historically been owned by investors in taxable accounts for the favorable tax treatment, but it comes with increased tax complexity (K-1s) that investors dislike.
• If the positions are large, it may cause the investor to have to file state income tax returns in states where the partnerships are located.
• If the positions are large and located in a retirement account, it could result in UBTI (Unrelated Business Taxable Income) which is taxed at trust (i.e. high) rates. Further, this does not create any basis in the account and thus will be taxed a second time when it is distributed to the owner.  This is very unfavorable.
• It would be difficult to diversify properly among individual MLPs given the very small weight it would have in even a relatively large portfolio.
• Recently Exchange Traded Notes (ETNs) and Exchange Traded Funds (ETFs) have been created that remove some of the favorable tax treatment (particularly with the ETF), but offer diversification and 1099 treatment.
• Like REITs, I think the best metric is the current yield.  Past total returns should probably be given little weight.
• They have very low correlation to stocks; higher than commodities, but less than high yield bonds, and high yield is also the asset class to which they have the highest correlation.
• MLPs should actually go up with inflation.

The returns on MLPs can be attractive relative to high yield and offer additional diversification.

High Yield Bonds.  These are also known as “junk bonds” or “non-investment grade bonds.”

• These are somewhat like covered call writing on an equity portfolio, and should produce high returns in moderate periods, little extra upside potential in good times, all the downside in bad times. In other words, the distribution has negative skew.

• These can be very good for “muddle through” markets. If the economy booms, stocks win. If the economy tanks, investment grade bonds (particularly treasuries) win.  But in a slow growth environment where companies are neither doing extremely well nor going out of business, high yield can do relatively well.

• Some analysts believe these are unnecessary in a portfolio of stocks and bonds as they are merely a hybrid of those two. I find a significant idiosyncratic element that leads to improved portfolios because of the increased diversification.

High yield bond funds can have a place in client portfolios, but in small proportions and as part of the stock (i.e. “risky”) portion of the allocation rather than the fixed income portion.

Directly-owned real estate is a popular alternative investment.  While there is no right answer for every situation and different people will weigh the factors differently, here are some items to keep in mind (in no particular order):

• People like real estate emotionally. The fact that it is tangible and substantive, gives them comfort.  The danger is, however, that these emotions will get in the way of an objective decision.

• Behavioral finance research has demonstrated that people tend to overweight recent data. Long-term returns on real estate (longer than the past few decades) have been just above inflation (0.4% above inflation according to one study), though this ignores income or expenses of the real estate.  Income-producing investments can have very high returns (similar to stocks) if unleveraged (no debt) and potentially even higher if levered (debt financed), but flipping is probably not a successful long-term strategy.

• Real estate is a good inflation hedge particularly when financed with a long-term, fixed-rate mortgage. Thus it can be a risk-reducing part of a prudent financial plan, though it is difficult to get proper diversification due to limited personal resources except for the very wealthy.  Also, people typically don’t diversify because of comfort with “known” types of real estate and the local area (e.g. they tend to buy single-family residential rentals in their area rather than warehouses in another part of the country).

• High leverage (debt) frequently used exacerbates cash flow issues if properties are vacant temporarily. (This is ameliorated of course by not using leverage.)

• There are some tax advantages to real estate as an investment.

• It can be more work than people realize, and they rarely factor the value of their time into their basis when computing their returns. It is also generally illiquid, and transaction costs are generally high.  Because of these factors, publicly traded REITs may be a more appropriate alternative.

• It is a relatively inefficient market (i.e. mispricing can happen and can be large); so there is opportunity to outperform based on skill. Even assuming skill exists however, it is difficult to have the requisite number of transactions for it to evidence itself.  See the detailed explanation of this below.

• The riskiness of real estate is frequently not recognized due to artificial smoothing of prices reducing the standard deviation of the data as mentioned below.

I would like to dilate further on the last two points because they are important in areas other than real estate as well.

It is not enough to have skill; there must be adequate opportunities to evidence that skill.  This is 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 the flip comes up tails you pay $1,000,000 and if it comes up heads you get $1,000,000.  The expected return is $1,000,000 x 0.6 – $1,000,000 x 0.4 = $200,000.  Few people would be willing to make that wager, 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 (99% of the time you would be between $197,476 and $202,524).  In real estate, even presupposing superior skill, many transactions are necessary to eliminate bad luck and evidence that skill with high certainty.

Real estate may look less volatile than it actually is for two reasons:  First, properties don’t trade every day, so prices between trades are estimated.  These estimates tend to be based on the last transaction and/or the last estimate, which tends to smooth the volatility (hedge funds with illiquid holdings have this same artificial reduction of volatility).  Second, when prices “decline,” many people exhibit typical loss aversion, and pull the property from the market until it recovers rather than selling.  Thus, while the true price is a loss, volumes simply slow dramatically rather than showing up as a loss in the data.

On a related note, we occasionally have people ask about purchasing real estate in their IRAs (individual properties, not REITs).  We wouldn’t recommend buying real estate in an IRA for the following reasons:

• The fact that someone is using an IRA for the investment generally would indicate they don’t have the financial resources to buy it without using retirement funds. Since frequently the vast majority of an individual’s non-retirement assets are tied up in their primary residence (i.e. real estate), investing retirement funds in a similar asset in most cases would mean they are very undiversified (and possibly leveraged).

• Individually owned real estate (the buildings, not the land) can be depreciated for current tax savings and capital gains (above depreciation recapture) get a special (low) tax rate. Neither of these benefits are available within an IRA.

• Investors should avoid using leverage on IRA investments because it creates UBTI (Unrelated Business Taxable Income) which is taxed at trust (i.e. high) rates in the IRA. Further, this taxed income does not create any basis in the IRA and thus will be taxed a second time when it is distributed from the IRA to the owner.  This is very unfavorable.

• Investors cannot use any “sweat equity.” Doing work on the property is an IRA contribution and prohibited since IRA contributions may only be made in cash.

• Using the property personally constitutes an IRA distribution and is taxable.

• Enough liquidity must be maintained within the IRA for unexpected expenses. Because the investor needs to avoid debt and thus UBTI and because they can’t just arbitrarily contribute extra funds to an IRA when needed, an adequate cushion of liquidity must be maintained.

• A similar need for liquidity exists in retirement when RMDs (Required Minimum Distributions) must be taken. There must be enough cash or other investments to make the distribution, or the taxpayer has to distribute a portion of the property.  For example, suppose a house is worth $548,000 and the taxpayer turns 70 ½.  There is a 3.65% RMD so $20,000 of the house is distributed from the IRA and put into different (individual) ownership.  Every cash flow is now split 96.35% and 3.65% between the two entities.  Needless to say, this creates a great deal of complexity.

• Related to the previous point, since RMDs are based on the value of the IRA, each year a qualified appraisal will have to be done each year to determine the current value.

For most people Real Estate Investment Trusts (REITs) would be a better investment option.  Here I am discussing equity REITs as opposed to mortgage REITS or hybrid REITs:

• REITs invest in a variety of commercial real estate ventures and the correlation between commercial real estate and residential property (which many investors already are overexposed to through their residence) is trivial.

• REITs are most highly correlated with small value stocks and also somewhat correlated with high yield bonds.

• The tax-efficient REIT structure is now available in enough other countries for international REIT funds to exist.

• In theory, REITs should serve as a reasonable inflation hedge as they own real property and the duration of the tenant’s leases should be shorter than the duration of the mortgages giving them the ability to raise rents faster than financing costs increase.

REITs are among the most popular alternative investments but they are actually not strong alternative candidates.  Nonetheless, given their widely accepted position and the ability to invest in international REITs (which should give a great deal of diversification) they may have a place in portfolios.