My latest quarterly ramblings to my Financial Professionals list are out: Financial Professionals Fall 2019

If you have a good portfolio – i.e. did the “right” things and diversified internationally, tilted to value, etc. it hasn’t worked well recently.  This is where the mettle of quality advisors is tested. Can we keep clients on-board and on-track, continuing to do the right things even when it hasn’t worked for a while?

Of course, there is a difference between perseverance and stubbornness, but I think this is perseverance. Diversification and value have too much evidence – evidence that is pervasive (in lots of markets and asset classes), persistent (in lots of time periods), robust (to various specifications), and economically meaningful (makes you money, not just a statistically significant t-stat).

This is similar to the late 90’s in a way, but there the pain was brief and acute (huge underperformance for about four years), here it is more of a chronic and dull pain – it just goes on, and on …

I thought it would be helpful to everyone if I walked through how to think about it. This will be a little long, but hopefully useful.

First, assume we have two asset classes, Stocks and Bonds. Assume there is no serial correlation in the returns (i.e. no momentum or reversals). Bonds have a lower expected return than Stocks, but less risk too. The mix in that case will entirely depend on risk tolerance – the psychological risk tolerance, the time horizon doesn’t matter. Remember in our set-up I specified no serial correlation. In reality there is negative serial correlation in the short run (i.e. reversals in daily returns), positive serial correlation in the medium run (i.e. momentum over a year or two) and negative serial correlation again in the longer run (i.e. reversals in the five to ten year period). The first and last of those are not tradable (transaction costs kill daily unless you are a market maker, and after a run up stocks may have lower long-run expected returns but it will still almost always be higher than bonds). So, suppose we settle on 60% Stocks and 40% Bonds.

For the 60% stocks suppose we have two options:

• US Stocks
• Int’l Stocks – same expected return as US Stocks, same risk as US Stocks, but not perfectly correlated.

If we are merely trying to maximize risk-adjusted return, it is clear we should split Stocks 50/50 between US and Int’l. But there are two reasons not to:

1. Most people benchmark (at least partially) off of their family/friends/neighbor’s returns. And those folks are overweight US. So going 50/50 won’t maximize happiness since a shortfall compared to others will be more painful than a surplus compared to others would be pleasurable. This is the psychological reason (Kahneman and Tversky’s Prospect Theory combined with Framing).

2. This is subtly different from the previous point. We are competing against others for retirement resources so having a portfolio different from everyone else increases the risk of being able to obtain those resources. In other words, suppose my neighbor Bob will invests in US only and at retirement will be buying assisted living services. I invest 50/50 US and Int’l and will end up with either more or less than Bob at retirement. If I “win” I can buy more assisted living than him, but if I lose I get less. But here’s the subtlety, since the “Bobs” in the US outnumber me when US wins it will push up the prices of assisted living (more competition and more willingness to pay on the demand side) so it is entirely rational to partially hedge (since “not losing” is more important than “winning”). This is the objective reason.

So, given that, in my hypothetical example it might make sense to be 40% Bonds, 40% US Stocks, and 20% Int’l Stocks. (This isn’t an asset allocation recommendation, just an exposition of the thinking.)

Now, let’s take it one step further.  Suppose we have two choices for our US Stocks:

1. US Core

2. US Value – higher expected return than US Core, same risk as US Core, and perfectly correlated (in reality the risk is actually lower, and the correlation isn’t perfect, but I’m making a point)

In that case, from a purely mathematical perspective you should invest all of it in US Value. Time horizon is irrelevant – do you want higher expected returns or lower ones? Everything else (in my set up) is the same! There are three reasons not to be so extreme however:

1. Periods of underperformance are likely more painful than periods of outperformance are pleasurable. So, it would make sense from a psychological perspective to not go 100% US Value.

2. In reality, since US Value is also lower risk, we should do even more US Value (potentially even if we had to short US Core to do so).

3. In reality, since the correlation isn’t perfect having some US Core makes sense from a diversification perspective.

Those last two issues are offsetting and in practice not as big a deal. (Russell 3000 Value is 95% correlated to Russell 3000 – that’s not perfect correlation but it’s pretty close.)

Make sense? Time horizon is irrelevant except for from a psychological perspective where people are benchmarking off of undiversified (US) or untilted (no factor exposure) portfolios. Which they are. But I can’t easily provide a mathematical answer to a psychological question. It is a function of how well we can manage client expectations (and maybe how sophisticated the clients are). So that’s why I said, “This is where the mettle of quality advisors is tested. Can we keep clients on-board and on-track, continuing to do the right things even when it hasn’t worked for a while?”

Good portfolios lose regularly!

“The best way to measure your investing success is not by whether you’re beating the market but by whether you’ve put in place a financial plan and a behavioral discipline that are likely to get you where you want to go.”

“In the end, how your investments behave is much less important than how you behave.”

Both of those quotes are from The Intelligent Investor by Benjamin Graham (1965 edition).

Recently Anitha and I were talking about whether someone we knew was “good with money” and we disagreed. We were momentarily confused until we realized our definitions of that phrase were different.

When I said “good with money,” I meant behaviorally. For example, we know a couple who are a perfect example of the point I’m trying to make. For several years when they were young, the wife stayed home with their first child while the husband worked a blue-collar job that was seasonal. Since he was going to be laid off for four months every year, they saved half his pay during the months when he was working steadily. (If you are doing the math and thinking that doesn’t work out – to levelize spending they should save a third of the income – you are correct, but that is what they did.) Then, during the four months of no income (aside from odd jobs), they still never touched the savings. In other words, they had enough left over from the “spending” half to make it through the four months of little or no income without touching the half they had put away for that purpose!

Conversely, when Anitha used the phrase, “good with money,” she meant technically. In other words, does someone have the knowledge to invest the funds wisely in a well-diversified, low-cost portfolio, take advantage of tax-advantaged retirement vehicles such as IRAs and 401(k) plans, etc. And the folks in the example above left their savings in a bank savings account for decades – imagine if it had been invested! They were not “good with money” in a technical sense.

But of course those folks are doing just fine in retirement because of their frugal lifestyle.

Conversely, if someone possessed all the technical knowledge to optimize their financial planning, but they stayed perpetually in debt and never saved, their retirement would probably be a disaster.

So, there are two versions of “good with money”:

1. Behavioral – which is mostly the ability to delay gratification (i.e. have income exceed outgo by a reasonable amount).
2. Technical – efficient portfolio construction, optimal tax strategies, etc.

In other words, simply increasing savings is clearly a more effective road to financial success than conducting an in-depth analysis of the investment choices offered in a 401(k) plan while not contributing.  Far too many people focus on improving their finances by the second definition without realizing the first is usually much more important to their financial future.

It sounds trite, but not spending is a prerequisite to wise investing.

My latest quarterly ramblings to my Financial Professionals list are out: Financial Professionals Summer 2019

ESG investing (avoiding investments with “bad” Environmental, Social, or Governance aspects) is becoming more popular but has been around a long time. The approach was previously known as SRI (Socially Responsible Investing) or colloquially as avoiding “sin stocks”.

A quick note on terminology first. If I talk about a “good” or “bad” investment, it isn’t clear whether I mean in the moral sense or in the risk-adjusted-return sense, so I am going to use good/bad to refer to the expected risk-adjusted returns and virtuous/evil to refer to moral qualities. I’m also going to avoid scare quotes even though in many (perhaps most) cases reasonable people could disagree about the virtuousness or evilness of an investment. Of course, when I say “evil investor” I merely mean one that invests in companies that fail the ESG screen – not that they are literally evil people. With that out of the way …

There are a few issues with ESG investing, some of which may not be obvious:

1. There is no universally, or even widely, accepted definition of an evil company. One person’s “arms dealer” is another person’s “defense contractor.” So, it isn’t clear which investments should be avoided. Google’s motto was “don’t be evil” yet they are frequently considered evil by at least some people.

2. ESG investments are screened, not weighted. In other words, if it is evil it gets zero investment. If it is “not-evil” (which is different from virtuous) it gets full investment. So, rationally, companies should be a little evil – little enough not to be screened out, but as much as is consistent with high returns otherwise.

3. Evil investors will get higher returns. As virtuous investors avoid evil investments the price declines, which is simply another way of saying the expected return rises.

4. There is a temptation to think that by investing in virtuous companies the returns will be higher – virtuous investors can have their cake and eat it too. It is easy to imagine that evil companies will have higher costs or lower sales (or both) because of their practices. But if that is true, they are not just evil, they are stupid. An evil businessman might not particularly care about the environment or women’s rights, but he is unlikely to actually reduce earnings to try to harm either! Thus, the argument that virtuous stocks are good investments, can ignore the ESG part. Unless, somehow, you believe the market is not pricing the expected returns of evil investments correctly. This seems unlikely.  My guess is that management errs more frequently the other direction – a CEO would actually give up some shareholder return to be seen as virtuous and this is actually an agency cost problem, not a benefit.

If you want to make the world a better place, it is far more efficient and effective to do it through direct contributions of time or money to charities and causes you support than to try to indirectly help through your investment portfolio.