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!

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.