Financial Architects

by

Time Diversification

How should an asset allocation change over time? Most folks (financial professionals included) believe that the longer your time horizon the more risk you can take. That, as stated, is clearly wrong. Let me explain by way of an example. Assume an individual is 35 years old and inherits $1,000,000. He or she will not save any additional funds and at age 65 will annuitize for retirement whatever that sum has grown to. We will ignore taxes or other complications. Now, suppose that over the next 30 years, one year will have a positive 100% return (i.e. the portfolio doubles), one year will have a negative 50% return (i.e. the portfolio halves), and the remaining 28 years will each have a return of 6%. To maximize the ending value, what sequence of those returns would be best?

I have been asking that question of financial professionals in classes for about a decade now (I don’t remember specifically when I started, but it’s been a while). Almost never do I get the correct answer. Some just have no idea and guess, but most say you want the bad return first (when the portfolio is smallest), the 28 returns of 6% next, and the best return at the end (when the portfolio is largest). I then chide them (with a smile) for failing third grade math. It’s in the third grade that I think most students learn the commutive properties of addition and multiplication. Our problem may be stated mathematically as:

($1,000,000) x (2) x (0.5) x (1.06^28) = $5,111,687

The parenthesis are just there for readability. The point is that the answer doesn’t change if you rearrange the order of the terms (the items in parenthesis)! A x B x C = C x B x A! It also doesn’t matter what the returns are – any 30 returns will give the same ending value as the same 30 returns that simply occurred in a different order.

In other words, if our investor can’t afford the risk of a 50% loss the year before retirement, he or she also cannot logically afford to take such a risk at age 35 either – it’s the same risk! In the absence of cash flows, the time horizon is utterly irrelevant to the asset allocation decision.

Nonetheless, it seems intuitively correct to change the asset allocation over time to a more conservative one. And I think that is right, but it is for a different reason than commonly assumed. Few people have a lump sum as used in the example above. They are actually converting their human capital to financial capital over time. So we don’t have two buckets (stocks and bonds) but three (stocks, bonds, and human capital). A young person’s human capital (the present value of future wages) will significantly dwarf their financial capital in the early years. Assume for simplicity that human capital was equivalent to bonds (more on this below). Further assume that to reduce risk we want half our assets to be kept safe. But we don’t have human capital in cash and can’t implement this allocation in practice. Rationally, a 35 year old should borrow against future earnings to reallocate human capital to stocks. There are significant constraints to doing so however. What we can do is “borrow” by reducing the bond position much lower than we would if there were no human capital in play. Selling bonds is equivalent to borrowing. We can take the proceeds and invest in stocks to improve our allocation. So, because of borrowing constraints our hypothetical investor should perhaps be 100% stocks in their financial portfolio at young ages and this is not risky because of the enormous allocation to human capital that still exists. (Of course it’s still prudent in most cases to have an emergency fund – or perhaps a HELOC, a wealthy parent, or something similar.)

This assumes that human capital is bond-like. It probably depends on the career, but research indicates that human capital is generally more bond-like than stock-like. Traditional stock brokers and big-ticket luxury goods workers are correlated in their wages with stocks somewhat (but perhaps not ultra-luxury goods which may be uncorrelated or small dollar luxuries which may be negatively correlated), securities attorneys (who litigate) are negatively correlated with a lag (and I think high-quality advisors are too) but most folks are relatively uncorrelated in the short run (though in extreme cases such as the great depression equity markets and human capital may suddenly become highly correlated). In the long run if the economy grows 4% per year both pay and stocks will do much better than if the economy grows 2% per year. In addition, things like Social Security are more sustainable if the economy has been growing at a faster rate. So there may be very valid reasons not to lever up to extreme levels to buy stocks even when young, but overweighting stocks seems very prudent.

In short, time horizon doesn’t matter to your asset allocation, but your human capital certainly does.

by

Bitcoin and Other Cryptocurrencies

There is no way to value Bitcoin or other cryptocurrencies (since there are no cash flows from it) so we are in the realm of uncertainty, not risk. Gambling has known odds (more or less, depending on what you are betting on) and a negative expected return (house gets a cut). Investing has estimable odds (again, more or less) with a positive expected return for bearing risk. Bitcoin has no assessable odds at all, just guesses (and hype and wishes). That’s not to say it won’t skyrocket (sometimes gambles pay off), there’s just no way to know or even estimate any odds or values.

Interestingly, there is still no significant use case for it still (blockchain technology, perhaps; cryptocurrencies, not really) which I find telling given the enthusiasm and efforts to do so. It’s like tulips (1636-1637) or Beanie Babies (late 1990’s) – you are betting that someone else later will pay more for it despite the intrinsic value being roughly zero, aka the greater fool theory. There are a lot of fools out there so a buyer might make money. It’s essentially a pyramid scheme (without the cash flows) – as long as the pool of buyers increases it works. There are a lot of people who don’t own it yet, so it could go on, but there are a lot of people who don’t own most things in the world and that doesn’t automatically make them good investments.

The supply of dollars increases at about 3% per year. Bitcoin at about 1.8%. So there is a little scarcity difference, but not a material one. Cash is enormously more useful. Yet you don’t see people suggesting that squirreling away $100 bills in your sock drawer is a good way to get rich. The objection to that argument would be that there is fear that central bankers could debase the dollar. That’s fair, but the supply of Confederate dollars has been fixed for about 150 years and it isn’t skyrocketing in value despite having historical value and few people owning them. The global gold supply also increases at roughly the same rate as dollars or bitcoin (precise numbers are harder to get), and it’s useful (jewelry, electronics, dentistry, etc.), yet the expected return is the inflation rate.

Buying a little bit (very little) to avoid FOMO, indulge YOLO, or whatever is fine, but realize that it’s much closer to gambling than investing. It’s also interesting to me that we only get questions about it when it has hit a new high, never at the lows. People are mostly just buying the momentum rather than anything fundamental – because there isn’t anything fundamental. Again, there are no cash flows to value, ever.

I did a somewhat related blog post about five years ago comparing gambling, investing, and insurance. You can find that here if you are interested.

by

Decision Making (again)

I did a post on decision-making years ago (here) but I wanted to share some more on it.  As financial advisors, our “product” is really wisdom (as I’ve said before), and it turns out we are wiser about other people’s situations than we are our own. This has two implications, 1) our clients (even our very wise clients) need us, and 2) we need wise advisors ourselves (or strategies to get distance on our issues) no matter how wise we consider ourselves to be.  (I’m blessed to have Anitha.) From Aeon:

… When inspecting the results, scholars observed a peculiar pattern: for most characteristics, there was more variability within the same person over time than there was between people. In short, wisdom was highly variable from one situation to the next. The variability also followed systematic rules. It heightened when participants focused on close others and work colleagues, compared with cases when participants focused solely on themselves.

These studies reveal a certain irony: in those situations where we might care the most about behaving wisely, we’re least likely to do so. Is there a way to use evidence-based insights to counter this tendency?

My team addressed this by altering the way we approach situations in which wisdom is heightened or suppressed. When a situation concerns you personally, you can imagine being a distant self. For instance, you can use third-person language (‘What does she/he think?’ instead of ‘What do I think?’), or mentally put some temporal space between yourself and the situation (how would I respond ‘a year from now’?). Studies show that such distancing strategies help people reflect on a range of social challenges in a wiser fashion. In fact, initial studies suggest that writing a daily diary in a distant-self mode not only boosts wisdom in the short term but can also lead to gains in wisdom over time. The holy grail of wisdom training appears one step closer today.

Related, here’s an excellent decision-making flowchart:

Also, you may be able to get the wisdom of crowds … without the crowd, as shown in this paper. Here’s the abstract:

Many decisions rest upon people’s ability to make estimates of some unknown quantities. In these judgments, the aggregate estimate of the group is often more accurate than most individual estimates. Remarkably, similar principles apply when aggregating multiple estimates made by the same person – a phenomenon known as the “wisdom of the inner crowd”. The potential contained in such an intervention is enormous and a key challenge is to identify strategies that improve the accuracy of people’s aggregate estimates. Here, we propose the following strategy: combine people’s first estimate with their second estimate made from the perspective of a person they often disagree with. In five pre-registered experiments (total N = 6425, with more than 53,000 estimates), we find that such a strategy produces highly accurate inner crowds (as compared to when people simply make a second guess, or when a second estimate is made from the perspective of someone they often agree with). In explaining its accuracy, we find that taking a disagreeing perspective prompts people to consider and adopt second estimates they normally would not consider as viable option, resulting in first- and second estimates that are highly diverse (and by extension more accurate when aggregated). However, this strategy backfires in situations where second estimates are likely to be made in the wrong direction. Our results suggest that disagreement, often highlighted for its negative impact, can be a powerful tool in producing accurate judgments.

Finally, from Annie Duke:

Investing is hard, because you need to answer these questions:

  • Am I being disciplined or stubborn?
  • Am I being foolish or staying ahead of the curve?
  • How useful is market history?
  • What if it really is different this time?
  • Do I have enough?

See also:

As Voltaire observed, “Doubt is an uncomfortable condition, but certainty is a ridiculous one.”