1. The reason to diversify internationally is not because expected returns are higher on foreign^* investments, but because they will be different. Diversification is about risk reduction, not return enhancement.
2. Hedging currency risk is optional in equities but essential in fixed income.
3. The belief that foreign holdings are unnecessary because domestic companies have large foreign sales, operations, subsidiaries, etc. is a canard. You could also only invest in every other stock in the S&P 500 – but why?
4. In (academic) theory portfolios should be market cap weighted (currently 54% US, 34% foreign developed, and 12% emerging markets).
5. Reasons for US investors to hold less than market cap weights in foreign stocks:
   1. Diminishing marginal benefit from diversification – the biggest “bang for the (diversification) buck” is from the initial exposures
   2. Maximizing happiness (i.e. minimizing tracking error) – US investors are typically “benchmarking” off of the S&P 500 (or off of people who are doing so)
   3. Hedging – competitors for (retirement) resources are generally overweight domestic equities
6. Reasons for US investors to hold more than market cap weights in foreign stocks:
   1. Other exposures (real estate, human capital, pensions, SS, etc.) are generally domestic
7. In our experience, knowledgeable and prudent portfolio managers typically allocate 20-30% of the equity portion of a portfolio to foreign equities.
8. Our foreign allocation is 25% of investment grade fixed income and 25% of equities (20% of “risky”) but with a more concentrated dosage than typical in the equity positions.

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^*The investment industry for some inexplicable reason uses the term “international” to mean “foreign” and are then are forced to use “global” to mean “international.”  I will use “foreign” when I mean “foreign.”

Financial Professionals Summer 2018

The title of this piece is “guaranteed” to make financial regulators hyperventilate and plaintiff’s attorneys salivate, but I think you will find it hyperbole-free. Of course, as Benjamin Franklin famously observed, “in this world nothing can be said to be certain, except death and taxes” but I think these rules come very, very close.

Before we get to the rules, two initial items need to be clarified. First, we need to define “financial success.” As I have noted before (here) financial success can be defined as simply having more than you need. With these rules I’m thinking more along the lines of lifetime consumption smoothing (which Milton Friedman, among other economists, showed maximizes happiness). Second, these rules get you “guaranteed” and they may seem extreme. Many people will be successful doing less than suggested here, but the further you are from following these rules, the less certain your financial success.

So on to the rules…

The first rule is to start young. These rules will help at any age, but for “guaranteed” financial success starting young is imperative.

The second rule is to maximize all tax-advantaged retirement plans such as your 401(k), 403(b), SEP, SIMPLE, IRA, Roth IRA, etc. There are two pieces to this, 1) make the maximum permitted contributions while working, and 2) take only the required minimum distributions upon retirement. (If you don’t have access to a plan through your employer, or your income is high, you may need to save in a taxable account as well. The idea is to have about a 25% savings rate – just for retirement, other saving, such as for children’s higher education, would be in addition to that. Note that in reaching 25%, principal payments on a mortgage count as savings, as do Social Security contributions.)

The third rule is to never borrow money for a depreciating asset. A depreciating asset is one that declines in value over time such as a car, consumer goods, etc. For this rule it is easier to explain the things that it is acceptable to borrow for. I think there are only three:

1. A prudent education. Prudent in two ways – the field of study and the cost. For example, borrowing $60,000/year to go to an exclusive private university for a bachelor’s degree in theater arts is likely to be a terrible investment for most students. Borrowing $20,000 to go to the state university for an engineering degree is likely to be a very good investment for most students. Obviously not borrowing at all is optimal, but if it is the only way to get the degree it can be a good use of debt.

2. A primary residence. Obviously homes can decline in value, but assuming you make a reasonable purchase (purchase price no more than 2x gross income) this can be a “good” debt.

3. A low-risk investment. Many businesses appropriately borrow money to fund expansion or for seasonal working capital. Borrowing conservatively to purchase a rental property can be prudent as well.

The fourth rule is to hedge all the risks you reasonably can. This would include buying appropriate amounts of life, health, and disability insurance, as well as liability insurance. Also, avoid concentrated stock and business investments and further diversify your portfolio between stocks and bonds, domestic and foreign holdings, etc.  Finally, realize that divorce is one of the biggest risks of all.

It may be possible to follow these four rules and still end up a financial failure, but I can’t think of a way.

This is an excellent list of how to evaluate scientific evidence.  Almost all the issues are applicable to evaluating whether a manager or investment approach will demonstrate outperformance in the future.  To wit:

• Differences and change cause variation – that outperformance is subject to a very high level of sheer randomness.
• Bias is rife – particularly given the huge rewards to finding (or claiming to find) an edge.
• Bigger is usually better for sample size – a 3-, 5-, or even 10-year track record is essentially meaningless.
• Correlation does not imply causation – self-explanatory.
• Regression to the mean can mislead – just when a manager or effect looks great (or terrible) performance will become much more typical.
• Extrapolating beyond the data is risky – it may have worked before, but the future is out-of-sample.
• Beware the base-rate fallacy – given the rarity of true alpha, historical alpha is probably meaningless.
• Controls are important – and you generally don’t have a control in investing.
• Randomization avoids bias – and again you generally don’t have this in investing.
• Seek replication, not pseudo replication – rolling periods are not separate tests because of the overlapping data.
• Scientists are human – and product providers are even more prone to bias given the enormous incentives.
• Significance is significant – if you try 20 things, one, on average, (by sheer randomness) will appear to be significant at the 5% level.
• Separate no effect from non-significance – the sample sizes (track records) are probably too small to find the effect even when the manager or strategy in fact does have true alpha.
• Effect size matters – differentiate between results that are statistically significant and those that are economically meaningful (generally not a problem in investing, if it is significant  it will generally be meaningful)
• Study relevance limits generalizations – the market/economy/etc. isn’t the same now as it was in the historical data.
• Feelings influence risk perception – self-explanatory.
• Dependencies change the risks – we rarely have independent factors.
• Data can be dredged or cherry picked – and in our industry it will be not just dredged or cherry picked, but tortured to death.
• Extreme measurements may mislead – lots of things led to the performance, not just the factor you are focused on.

In my head I have had a hierarchy of items I disseminate:

1. Quick simple thoughts or forwarding of things to my coworkers via email.
2. If it is a little more interesting also share (via email) with my consulting clients. (These are other RIA firms that have me on retainer for my perspective.  If you are interested in this let me know.)
3. If it is an item worthy of even broader distribution, email it via my “financial professionals” list at the end of the quarter.
4. If I think it is a useful analysis of a topic, flesh it out into a blog post.
5. If I think it is a really useful analysis of a topic, do a whitepaper (pdf) on it and put it on our web site.

In other words, I have always felt that a white paper is more important and permanent than a blog post, which in turn is more weighty than an email.  I never felt most of my random musings and comments were blog-worthy, but rather reserved them for (ephemeral) emails.

But Michael Kitces has been bugging encouraging me for a long time to put the content of the quarterly Financial Professionals email on this blog.  So I have (finally).  That email goes out the 15th of the month (or the next business day, if the 15th isn’t one) after the end of each calendar quarter (so January, April, July, and October).  From now on I’m going to post that missive here too (on the first of the month following that date).

So, this being May 1st, here is the first one.  I have uploaded the ones back to the beginning of last year as well.  They were never intended to be permanently available on the web, but I hope you find them worthy!

Financial Professionals Winter 2017

Financial Professionals Spring 2017

Financial Professionals Summer 2017

Financial Professionals Fall 2017

Financial Professionals Winter 2018

Financial Professionals Spring 2018