As wealth managers, we are frequently asked some variation of the question “So, what do you think the market is going to do?” or “What do you think of XYZ stock?” Those are difficult questions to answer, and this month’s post is an attempt to explain our perspective.

The reason that those questions are problematic is because no one knows. Certainly there is no shortage of prognosticators who pretend (or may even believe) they know, but the current price of a security, and by extension the market, generally incorporates all of the information possessed by millions of investors, most of whom are institutions. These market participants are intelligent, informed, and motivated. Thus the odds that any individual will consistently be able to find mispriced investment opportunities are extremely small. (Many excellent books have been written on this topic.  I heartily recommend Winning the Loser’s Game by Charles Ellis as an excellent introduction.)

In light of that, the answer I want to give to the first question is, “It will fluctuate.” (Credit to J.P. Morgan, possibly, for that bon mot.) and to the second, “It is probably correctly priced.”

This doesn’t mean that there is nothing that can be done to try to increase our client’s odds of success, but rather than the futile exercise of stock picking, here are the main things we focus on:

Risk Management. There are two aspects to this. First, the portfolio should be positioned so that the amount of risk is not greater than the client can bear. In a bad market we expect the value of risky assets (e.g., stocks) to decline by approximately half. Thus, most clients should not have all of their investments in risky assets. Second, the portfolio should be diversified among a variety of risky assets, not all of which will go up at the same time or by equivalent amounts. (Risky assets do have the unsettling tendency to all decline together however.)

Behavior Management. Keeping clients invested in an appropriate asset allocation during times of euphoria (the late 1990’s) or panic (early 2020) is probably the most important function of a good wealth manager. One of the differences between a salesperson and a quality investment manager is their willingness to go along with (or even encourage) client’s emotional investing impulses.

Even worse, some advisors are themselves not temperamentally suited to investing and get caught up in the emotion of the market. When I say behavior management is important, I don’t just mean the client’s behavior. I mean the advisor’s too.

Asset Class Opportunities. While individual securities tend to be correctly priced relative to similar securities, occasionally entire areas may be mispriced because of widespread emotion. This is one of the most difficult areas to exploit because while the mispricings are blindingly obvious in hindsight, they are almost impossible to see in real time. They also don’t exist all the time, so as an investment strategy this has low “breadth.” If a mispricing seems to be occurring, a small adjustment to a portfolio rather than a large adjustment is generally appropriate because of the level of uncertainty.

Costs. The outperformance of asset classes and active investment managers may come and go, but expenses are permanent. Controlling costs (both explicit and implicit) is crucial over time.

Factor Tilts. There is substantial evidence that some factor tilts can be advantageous. For example, value stocks are likely to outperform growth stocks over time (particularly in small companies and at current valuations).

To recap, “Is my porfolio constructed soundly to meet my long-term financial goals?” is a much more pertinent question than, “What’s the market going to do?”

Many people have prepared for the future and prepared a will, powers of attorney, etc.  A letter of instruction is not a legal document, but simply a letter that tells survivors where to find things, who to contact for various things, and any other information they will need that they may not know.  This may be particularly helpful in families where one person has managed most of the financial and administrative tasks and others may not be as knowledgeable in those areas.

Since letters of instruction are not legal documents, they do not have to follow any particular form.  You can include as much or as little information as you think necessary and change it at any time.  It would be best if it were signed and dated and stored in a safe place.  Also, be sure to let your loved ones know where it is.  Following are some typical sections you might include:

1. Contact Information

In the event or your death or incapacity, your friends, family, and perhaps other people in your life will want to know.  You should list phone numbers with the names as well.

Primary contact.  Choose someone to be contacted first plus an alternate or two in case the primary person is not available.

Secondary contacts.  You will probably want to include your friends, relatives, employer, attorney, accountant, clergy member, etc.

Tertiary contacts.  If your executor or trustees do not fall into one of the categories above, they should be contacted as well.  These individuals will be selected through your will or trust document, listing them here does not alter those decisions.

2. Documents

Appropriate people will need to know where to find crucial documents.  If these are in a safe deposit box, a safe, or are stored electronically, they may also need to know how to access them.  Essential documents typically include:

Personal Documents – birth certificate, Social Security card, marriage certificate, naturalization documents, last will and testament, any trust documents, etc.

Financial Documents – deeds, vehicle titles, credit card statements, investment and bank account information, insurance policies, pensions (including VA or other similar benefits), tax documents, and any other important financial documents or information.

3. Financial Information

A list of when bills need to be paid and when income is expected will be helpful to your executor.  In addition, you should prepare a list of each financial account (bank account, credit card, investment, loan, etc.) that includes the name of the financial institution, the account numbers, titling, any TOD/POD (transfer on death, or pay on death) or beneficiary instructions.

4. Property

Real property.  Identify any real estate you own and the location of related documents.  Include how that real estate should be cared for (including any lawn or pool services that may be in place), when property taxes and other bills must be paid, and landlord or tenant information.

Personal property.  While your will or trust control how assets are distributed after death, a LOI is frequently used to address personal items with little or no monetary value, but which may have significant emotional value.  These items typically include family heirlooms, sentimental items, family photo albums, and anything else that may have special meaning to someone.

Private property.  If you have anything of a personal, sensitive, or embarrassing nature, you can include instructions on disposing, protecting, or otherwise handling them.  If discretion is crucial, you can include a section or instructions that can only be read by your attorney or someone you trust completely.

5. Digital Assets

Your letter should include an updated list with your passwords, subscriptions, along with how to access them, and what you want to happen to them.  Some online and social media platforms have policies and procedures for the transfer of these assets after the owner’s death or incapacity.  Online subscriptions, such as Netflix or Spotify, should be canceled.

You should also share the location of any photos, videos, or documents that may be on your phone, tablet, computer, external hard drive, memory stick, cloud storage, etc.  If you have private or personal photos or documents, be sure to identify these and be clear about how you want them handled.

If you have digital assets with substantial value, such as domain names, websites, e-commerce storefronts, etc., you should explain how these should be managed until they can be transferred to new owners.

6. Children, Dependents, and Pets

If you are a parent or guardian for a minor, or you have adult children or other dependents with special needs, there is information the subsequent caregiver needs to know.  (I will use the term “child” for simplicity, but it could be a disabled sibling or other dependent.)

Child Support and Finances.  Record child support or other payments you’re receiving or making and the location of any related court documents.  Also supply the details if the child is the beneficiary of a trust, a custodial account, life insurance, or has (or is expecting) any other significant assets.

Education.  Information about the school, schedule, teacher, contact information, and coaches.  Also include information about extracurricular activities such as sports or music lessons.

Medical.  List any medications, care requirements, and medical needs as well as the name and contact information for their doctor, dentist, and any other health care providers.

Personal.  Information about your child, such as what activities they enjoy, food preferences, allergies, habits, fears, passions, and anything else a subsequent caregiver should know.  You might also include special messages to the child.

Documents.  Note the location of birth or adoption certificates, medical records, school records, etc.

Pets.  You may want to record similar information as above for any pets as well.

7. Funeral Wishes

If you leave funeral wishes in your LOI, place the LOI in an easily accessible place.  Locations such as safe deposit boxes are usually not able to be accessed quickly enough for funeral and burial wishes to known to those making relevant decisions.  Clear instructions will help your family and loved ones in a time of stress and grieving.

Funeral Service Plans.  If you have already purchased funeral or cremation services, a burial plot, etc.  provide those details.  Even if you haven’t, list any preferences for a funeral home, services, and final resting place.

Donations.  If you desire monetary donations to a charity or something other than sending flowers, include that information along with the name and address or website of the charity.

Ceremony, Music, and Speakers.  Include desires for the funeral service or ceremony, such as location, music, and who you would like to speak at your service.

Personal Details.  Speakers and others may need details about your life, such as where you were born and where you went to school.

Photos and Personal Items.  List any photos, special items, or anything else you wish to be displayed or available at the funeral service, as well as where to find these items.

8. Obituary & Epitaph

Include an obituary for publication purposes, as well as an epitaph for your final resting place.  If you want a photo published, provide that (or the location) as well.  Detail where you want your obituary published.  You may need different length versions of your obituary depending on the publication requirements.

9. Personal Messages

You may want to leave behind personal messages or wishes to the significant people in your life.  This may take the form of individual letters just for them, or words to be read in public at the funeral.

You should update your LOI as you experience life changes.  Reviewing it annually, perhaps using the beginning of a new year or your birthday as a reminder, is usually easiest.  As you change it, follow the same instructions that were given regarding signing, dating, etc.

My latest quarterly ramblings to my Financial Professionals list are out: Financial Professionals Summer 2024

I used this example in classes for financial advisors back in the day:

Client gives you $100,000 and it goes up 100% in period 1 so the balance is $200,000.

Client is excited then and gives you $1,000,000 more so the account has $1,200,000.

Account then goes down 25% in period 2 so $1,200,000 becomes $900,000.

You tell the client – we’re doing great! The average annual return has been 22.47%!

[((1+1)*(1-0.25))^(1/2) – 1= (2*0.75)^0.5 – 1 = 1.5^0.5 – 1 = 22.47% (for geometric – i.e. time-weighted – you add one to each return, take the product, then the nth root (the number of periods) then subtract 1)]

The client responds, “Are you smoking something hallucinogenic? I gave you $1,200,000 and you turned it into $900,000 and you have the audacity to tell me you made money?

The problem is the client’s. He/she should have given the advisor all the money up front! Since managers generally don’t have control over cash flows it is unfair to penalize (or reward) them for the timing. So that’s why all standard reporting is CAGR (Compound Annual Growth Rate) which doesn’t account for cash flows.

The client’s compound return is -13.40%

[What you got divided by what you paid for it to the nth root, minus 1, or ($900,000/$1,200,000)^(1/2) – 1 = 0.75^0.5 – 1 = -13.40%]

That’s still a compound (geometric) return, but it’s dollar weighted.

The arithmetic return is just the average like you learned around fifth grade or so. 100% + -25% = 75% / 2 = 37.5%.

To recap:

• If you want to know how the manager is doing over time (particularly with investments that have different volatilities), you want the geometric return without any cash flows.
• If you want to know how the client is doing over time you want the geometric return with cash flows.
• If you want to know the shape of the annual distribution of returns (the bell curve) as input to an MCS, or to know what to expect in a single year, it is best described as the arithmetic mean and a standard deviation (not getting into higher moments here, but the skewness and kurtosis also matter for investments such as hedge funds).

Over time, the arithmetic return compounds into the geometric return as I demonstrated here: Converting Arithmetic to Geometric Averages Spreadsheet

See the second tab for actual historical data, the market’s arithmetic average from 1926-2023, 98 years, was 12.16% but the geometric average was 10.28%. If you invested $X in 1926 you would have $X*(1.1028^98) at the end. But, assuming the distribution of future returns is expected to be like the past (which is probably erroneous), your expectation of next year (or any single year) would be a bell curve with a mean of 12.16% and a standard deviation of 19.72%.

Finally, given a high enough volatility, a positive arithmetic return can be a negative geometric return. This is the problem with extremely levered investments like the 2x, 3x, and -2x, -3x funds (and, again, some “hedge” funds).

I had a conversation recently with a young adult who was focused on buying a home. It got me thinking about priorities, and while it was on my mind I wrote some general advice for young people:

---

While individual situations will vary, as a young adult there are some basic financial milestones that I think you should strive to achieve. These are listed in roughly the order I think they should ideally occur:

1. Complete your education.

2. Have the ability to pay your own living expenses from your earned income. For most people this means having a spending plan (aka a budget). This doesn’t mean you actually have to be paying your own expenses, but if you aren’t, then you should be saving the amount that you are being subsidized. In other words, if you are on someone else’s insurance/Netflix account/cell phone plan/etc., that’s fine, but you should be saving that amount then, not spending it.

3. Have appropriate amounts of the crucial types of insurance: health insurance, disability insurance, and liability insurance. (If you have people who are financially dependent on you then add life insurance to this list.)

4. Save in your employer’s retirement plan, such as a 401(k), each year to the extent of any match.

5. Have no consumer debt (i.e., credit cards, car loans, etc.).

6. Accumulate three to six months of expenses in an emergency fund.

7. Get estate planning done. This may move up (or down) the list depending on your individual situation, but at some point, you should get a:
   • Will (this is important if you have a minor child or assets that would pass through probate)
   • Durable power of attorney (specifies who handles your finances if you can’t)
   • Living will (specifies what life-prolonging actions you want taken, if any)
   • Durable power of attorney for healthcare (specifies who makes medical decisions if you can’t).

(In some states, such as Georgia, those last two are combined into one document called an Advance Medical Directive.)

8. Save to the maximum limit of retirement plans such as a 401(k) or IRA/Roth. This will be a financial stretch (or perhaps impossible) if your income isn’t high. For a younger person in 2024 the 401(k) limit is $23,000 and the IRA/Roth limit is $7,000 so this is $30,000 combined before you move to the next level.

9. Accumulate a 20% down payment for a home. There are two reasons for the 20% number. First, and most obviously, that is the level that saves you the private mortgage insurance (PMI) premium. Second, and more importantly, if you can save that then you probably have the financial habits and ability to handle the ongoing responsibility (and irregular expenses) of homeownership.

10. Buy a home. This is optional, but this is the spot on the list where it would go.

As a young person, that list undoubtedly seems daunting, but that’s why I put it in priority order, you just have to work your way down. The further you get down the list the brighter your financial future will be. (See also Four Rules for Guaranteed Financial Success.)

Happy adulting!

---

I want to expand a little on buying a home. Many young people have no idea how much home they can afford, and lenders will encourage borrowing more than I think is prudent. There are two rules of thumb for this:

1. Regular homeownership expenses should not exceed 28% of gross income. Those expenses are PITI (Principle, Interest, Taxes, and Insurance) plus any HOA/COA/POA fees. This ratio is frequently used by banks and other lenders.

2. The value of the home should not exceed 2-3 times gross income. This is my rule of thumb and is usually more conservative than the banks’ rule.

People tend to get excited about buying after real estate prices have risen quickly (they do the same with other assets too). Prices may continue to rise or they may not, but the long-term expected appreciation on real estate is roughly the rate of inflation. Total return on real estate is higher because of rental income, or imputed rent (the rent you don’t pay on your own residence), but of course there are expenses as well.

Furthermore, for a young person, flexibility is important. In the early years of employment, moving (even across town) to take a better job frequently changes the trajectory of lifetime earnings, and renters are much more willing and able to do that than homeowners are.

Finally, people often “stretch” to buy their first home and then are in a precarious situation if they lose a job or the HVAC system needs to be replaced. Waiting to buy until more financial resources are firmly in place is more prudent in many cases.