Seems to make much more sense than the index-chasing, asset-driven investment approach that everyone’s buried their heads in for the past couple of decades. The concept is not new, and was first introduced to satisfy asset-liability match in large pension plan metrics. Vanguard talks about it (pdf) here in a 2008 paper. When it comes to your personal pension savings, why not invest according to anticipated liability that is specific to your age, risk tolerance, and expected liability profile?
Picks & Ideas
Conventional wisdom should be challenged and tested occasionally. Most of the time they stand the tests, but sometimes they crumple under the weight of new variables. None is too apparent than this financial crisis, where many old adages no longer apply, or can only be applied with footnotes. At a time when most persona finance and investment magazines spew out more of the same, don't you wish there are more ideas out there? Some can be found below.
Yesterday I talked about how the market is far, far from efficient. Today, I want to point you in the direction of a Wharton interview with Robert Stambaugh and Jeremy Siegel, who discuss the idea of stock volatility in the long run.
In the long run, instead of falling volatility, we are in fact faced with more trend uncertainty that compounds the short-term volatility problem. Uncertainty about the trend itself becomes more important than the actual volatility itself. More specifically:
That uncertainty about the trend itself becomes more important the further into the future you project investment outcomes. […] to an investor with a long horizon, stocks actually are riskier per period. That is, the rate at which risk grows over the horizon such that it makes the investment riskier over the long run.
The other feature of the stock market that contributes to uncertainty is the fact that at some points in time we think the expected rate of return is higher than at other points in time. In other words, over time the rate of return that you can expect to earn over the short- and intermediate-terms fluctuates. The fact that the expected return fluctuates also adds to uncertainty because we do not know — for example — if expected returns are currently high, which many of us would guess they are. We don’t really know how long they’re going to stay high.
Using global warming as an example of uncertainty a long term horizon is subjected to:
It provides an interesting analogy to this concept because we might be very uncertain about how quickly the Earth is warming, but that uncertainty doesn’t much impact our uncertainty about crop output and economic output next year. But if we look 50 years down the road, uncertainty about the rate [at which the Earth is warming] has a much bigger impact on our overall uncertainty.
Don Coxe is one of the godfathers of commodities investment. His recent investment letter highlights some market developments over the past half year, and is delivered with some commentaries.
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Interbank lending heading back to normalcy: TED spread had fallen from 110 to 72.
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The Chicago Volatility Index (VIX): high of 86 on October, 48 in mid-March, now at 32.
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Commodities as measured by CRB Index: low of 200 in February, down from 460 last June, now at 232.
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On the surprising performance of copper: not likely to see strong correlation between copper and industrial activity as some would suggest.
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China is stockpiling on industrial metals as a result of low LME prices. Even with copper’s sales surge, copper inventories on the LME has not shrunk. Investors are advised from drawing broad conclusions, instead, watch for decisive recovery of Baltic Dry Index.
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Base metals and steel stocks are the most economically sensitive group, followed by energy and agriculture; precious metals are responsive to fears of dollar or banking collapse, and inflation.
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Agriculture stocks are driven by demand on the ground. The economic slowdown has reduced demand for wheat and feed grains, but it will not to the same level as the fall in metals and oil.
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Skepticism on Obama’s initiatives on Clean Energy: jobs (estimated 4 million) will be created in universities and laboratories, but other than political goodwill, it’s far from certain his investment will provide good returns.
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Long gold, short bond, short the dollar.
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Once economic outlook improves, may boost base metal exposure and return to more exposure to oil refiners.
Some other things that caught my attention today:
- The Dutch becoming “euro-skeptics” (opens to video): I live in the Netherlands, but this is news to me. The Dutch do not seem overly political, and are painfully aware of the symbiotic, and highly dependent relationship it has with greater Europe. The pragmatists are truly concerned over money (and really, that is the one unwavering theme that will always bring the country together), and the populists are throwing the usual immigration, insecurity and border issues around. Not sure why the FT focus is on the Netherlands this time, perhaps there are French and German segments coming up also?
Water is perhaps the most scarce resource on earth. Yes, there is water everywhere. But most of the water is not drinkable, not accessible, nor is the resource evenly distributed. It’s not unlike the oil situation, where a small percentage of the earth holds the majority of crude. But unlike oil, water is not replaceable.
So how bad is it?
A study by the University of New Hampshire shows that some 41% of the world population live in river basins under “water stress” – meaning the region is subjected to frequent shortages.
The most readily consumer able source of water, the freshwater variety, occupy less than 1% of the earth surface, yet it plays vital roles in agriculture, industrial productions, and our domestic lives. Over 70% of water is used for agriculture, making population increase a squeeze on all aspects of our natural environment, particularly water.
The need and the necessity of water
On top of basic agricultural needs, the rise of a genuinely more affluent class in the developing worlds are consuming more meat. As we know, animals require much more water to raise than its caloric equivalent in grains. Additionally, industrialization and mass urbanization have placed unprecedented strains on infrastructure. Thus, the accessibility of clean water has been compromised by rapid growth in many parts of the world.
High pollution and habitat degradation makes clean water increasingly inaccessible to the poorer regions. Many demographers, geologists and political scientists have attributed the root of war and violence in conflict regions to the lack of resources, particularly water availability.
Businesses stepping in
If there’s demand, then the market will find a way to meet the need. And it is hardly difficult to point to the existing challenging global eco-system, draughts and the ensuing human devastation to see some potentially lucrative opportunities. The explosion of bottled-water businesses is only the start. Up and down the water security chain, from bottling rights, purification and treatment, to distribution of the product, the water business is big.
When it comes to investing, the general public has been steadily moving away from the old adages that called for set allocation between the (perceived) safe bonds/cash and the (supposedly) more risky stocks. Nowadays, we have all become heavy investors in the stock market, whether it’s outright ownership or group purchasing through our work-sponsored pension plans.
Last week, I talked about the importance of market timing, particularly when it comes to market entrance or exit points. When we choose to enter or exit have the largest impact on overall portfolio return, much more than the year-on-year growth, diversification, asset allocation and all the detailed balancing and fine-tuning. Today, I want to continue the thought on market timing, and address the issue of long-term riskiness of stock market investment.
We have been conditioned to believe that in the long run, the market goes up consistently. Certainly, there are occasional dips, but many of us have probably heard of the success stories achieved by market-illiterate pensioners that retired comfortably by holding steadfastly to their basket of stocks for decades. Does this much-embraced truism still ring true in face of such market carnage? In addition to my guest post at GenX, here are more thoughts on what we can learn from the market bust.
Imperfections of diversification
One of the major cornerstones of modern portfolio theories is the benefit of diversification. Most of the time it worked. This time it didn’t, at least when applied to the stock market. There are many reasons why it didn’t. But unless you’re an octogenarian and a historian with a succinct understanding of the intertwined global financial and consumer market, and foresaw the implication of mass de-leveraging and forced liquidation, and allocated a substantial portion of your portfolio in non-stock investments, you probably didn’t benefit from diversification this time around.
In fact, long-term, buy-and-hold, value investor guru Warren Buffet, had gradually shaved his 73.5% stock holding in his portfolio in 1995, to just 25% in June, 2008. Because even he didn’t believe that diversification offered him any protection when the overall market was massively over-valued.
This might seem like a pretty out of the character subject for me to discuss, since I write about sensible, non-hype, and long-term investing principles. Those would be exceedingly prudent and timely given the market onslaught. If you are at all familiar with general investing terms, then you would most likely associate technical analysis with the image of someone hunched over multiple LCD screens, fixated by indecipherable charts and graphs in a range of neon colours, and occasionally yell “Buy!” or “Sell!” with a touch of craziness into the phone. Needless to say, your average value investor would not approve of this behaviour. In fact, Warren Buffet famously dismissed technical analysis and quipped, “I realized technical analysis didn’t work when I turned the charts upside down and didn’t get a different answer.” So far not great, then why am I talking about it?
But first, what is technical analysis and why the bad rep?
It all depends on what you believe in.
Belief numero uno: Efficient market
At the crust of the matter, technical analysis is deemed the opposite of fundamental analysis. Where fundamental analysis make buy or sell decisions based on intrinsic value of a stock compared to market valuation; technical analysis disregards intrinsic value (since it assumes the market is efficient enough) of the stock, and focuses purely on supply and demand in the market.
In modern finance, this rests in something called the efficient market hypothesis (EMH). Most economists believe in a weak version of EMH, which is to say that the market does a pretty ok job when it comes to incorporating public information into the stock prices. But it’s not perfect, since insider information may still exist. On the other hand, technical analysts assume the market is perfect in incorporating valuation related information as well as market psychology into the stock price, or at least accurate enough for its purpose. The rest of the market movements are determined by more immediate demand and supply, as well as market psychology.
Belief numero dos: History tends to repeat itself
Given the present market bloodbath, there are many ongoing discussions on what the sensible investment strategy should be going forward, and whether one should still be investing in face of economic uncertainties at all.
Most solutions favour an old-school approach. Many personal finance writers have gone back to basic principles of investing such as dollar-cost averaging, diversification, looking at the long term, be calm when the market is fearful, etc. Many are viewing investment through a mostly unchanged framework as what we have become accustomed to. But my question is, in a time when the corporate world, government bodies, and media complex have abdicated or neglected to perform their roles, why aren’t investors moving towards a different paradigm?
Here are some ways that I see the rules of investing change in the coming decades.
Long-term sustainability. Once a successful business becomes a publicly traded company, the management team willingly subjects themselves to continual scrutiny by the market. Dozens of analysts pore over the company’s quarterly and yearly forecast and issue their own estimates. After each earning call, those whiz kids compare and contrast their estimate to the actual numbers and company forecast, and issue their “buy” or “sell” recommendations. The market then reacts, sometimes violently, if the quarterly numbers greatly exceed or disappoint the analysts.
As a system, we have a stock market that rewards short-term gains and profits. By doing so, we inadvertently create unsavory incentives for the management team to maximize short-term profits at the expense of pretty much everything else.
Remember Chainsaw Al? A self-proclaimed turn-around artist, Al Dunlop infamously presided over Sunbeam over a decade ago. Within three months of his installation as CEO, Sunbeam had cut over half its employees and eliminated 87% of its products. Employees saw working for him akin to trench warfare, many exhausted from having unrealistic goals imposed on them. Upon his firing, it became clear that massive accounting fraud had taken place. Revenues had been padded through various dubious or outright illegal revenue recognition techniques. The company was cash strapped. Share prices shot up from $12 to $53, before falling back to $11.
Thank you to The Penny Daily for including this article as its “Editor’s Pick” in Carnival of Everything Money #5.
We set out to see what the experts are saying about 2009. What we didn’t realize was how the art of providing financial outlook has become a game of “one down-manship.“ How else would you explain the boom in competition for the title of Dr Doom?
So it would seem that the Rapture is upon us, are you ready? Yeah, we feel the same way.
Here’s our survey of what some of the bigwigs in the investment industry have said about 2009 in recent months. In our mock* roster, we have Warren Buffet the sage; Nouriel Roubini aka Dr Boom/perma-bear, or our favourite, the playboy Professor; Nassim Taleb aka Black Swan; Peter Schiff who’s-laughing-now; Jim Rogers my-kids-speak-Chinese-and-that-is-my-investment-hedge; Marc Faber the original-Dr-Doom; Don Coxe via Basic Points; and John Embry the Canadian goldbug.
Outlook for 2009
Investoralist: So how bad is 2009 looking? Don’t hold back now, give it to us straight-up!
Warren Buffet: We have lived in one way in one type of economy. And we’re now deleveraging that economy. We’re gonna have to live without the same impetus from credit expansion that really helped propel the economic engine for a long period of time. That wind will not be at our back.
The economy will be in shambles throughout 2009, and, for that matter, probably well beyond, but that conclusion does not tell us whether the stock market will rise or fall.
Nouriel Roubini: The worst is yet to come. I don’t want to name names, but many [banks], given the housing bust, will become insolvent. Their losses are mounting because they have written down only their subprime loans so far. They haven’t started writing down most of their consumer-credit losses, and reserves for losses are much less than they should have been. The banks are playing all sorts of accounting gimmicks not to recognize them. There are hundreds of millions of dollars outstanding in home-equity loans that eventually could be worth zero, too.
Thanks to the Skilled Investor for including us in its Carnival of Financial Planning for Mar 7.
Really? Yes. And I’m not talking about the less stress, better health, more me and my family-time kind of perks.
Let’s rewind.
For months, we have been pounded in the head over and over again on the evils brought on by the recession. Let’s recount the havoc wreaked.
- Retirees have seen their savings significantly reduced or wiped out, some even going back to work to alleviate the cash problem.
- Baby boomers see their expected retirement date stretched indefinitely into the horizon, investments portfolio reduced, housing worth shattered.
- Gen X are getting squeezed in the workplace in more ways than one, and feels more insecure in the job market.
- Gen Y, having just gotten their feet wet in the workplace, feels betrayed by the many promises dangled in front of them. Demographers have predicted speedy career advancements as a result of baby boomer exits. So much for that.
There has been considerable faults placed on the baby boomers, in their relative easy paths to success in America since the 1950s. There were no major war nor catastrophic financial turmoil, jobs were easy to come by, properties were cheap, and the infrastructures were there to service their every need. Many Gen Y and Gen X blame the “selfish” generation for their over-the-top consumption, excessive debts, degradation of the environment, mis-management of the social security and health care systems that will be defunct as soon as they have benefited from it, and falling asleep at the helm when it comes to financial regulation that plunged the nation, and perhaps the world, into the perilous position that we are in now.
Simplistic and over-dramatic? Indeed it is. But there is no denying that for the younger generations, the foreseeable future is an uphill battle. The workplace will only become more competitive, property prices are still steep in many parts of the country, health care and social security is broken, and country is bankrupt. Ouch.
Thank you to Penny Daily for including us in its Carnival of Investing Strategies #5.
What makes a successful long-term investor? Is it an exceptional understanding of the market? Is it a Blackberry full of Wall Street contacts that tip you on every insiders’ move? Is it a PhD in quantum-physics or mathematics?
No. Because if that was the case, then most investment funds with their well-paid, well-educated, and well-connected managers would not be walking around with their portfolios 50% lighter.
So what is it about the market that suckers in so many people? How is it that some investors are ruthlessly spit out, and others remain relatively unscathed in the long-run?
Knowledge.
But not just business knowledge. What has been taught in business school and other rudimentary business classes do little to improve one’s chances when it comes to investing. Why? Because the knowledge presented in those accounting and finance classes only give you a myopic look at the whole picture.
For example, say you are an accounting maven but know nothing of what’s going on in the mortgage market in 2006. You look at the balance sheet of banks, match up the debit and credit sides, check off the triple-A rated loans, and marvel at how the bank has managed to grow so quickly in the last few years. But any economists looking at the picture would be alarmed at the rate of growth, probe deeper into the loan ratings, gasp at the poor judgment exercised on part of the bankers, and issue a warning. Someone who is schooled in politics would take a hard look at the political contributions made to head of committees that signed off on the predatory lending policies and yell foul! And any Tom, Dick, and Harry, who’s been canvassed by sketchy pseudo-lending institutions would tell you that if it walks like a scam, and quacks like a scam, it is a scam.
It is little exaggeration to say that many people are losing their shirts (if not worse) through the ongoing financial turmoils. A few got caught up in some truly heinous swindles, but for the most of us, the losses came through our previous-thought conservative investments.
What happened? What happened to the smart experts that put out money into hyper drive for a fee, but came back with losses? Are all these letters behind their names truly worth their weight in paper?
In all fairness, in a year where even Warren Buffet’s having a tough time, we can ask for little more than a mere preservation of capital. But for millions of ready-for-retirement boomers, this is no consolation. The S&P Index is back to 1997 lows, the bloodbath continues on Wall Street and Main Street.
Troubled started brewing by the end of 2006, as many forecasted low growth for 2007. Yet the market defied expectations, and the naked emperor marched on.
Now in retrospect, the picture is so clear. The US and a number of European countries were experiencing massive real-estate led credit bubbles. Many banks were leveraged to the hilt on their sub-prime lending. Debts were piling up (residential, commercial and credit cards). But the general consensus, or should we call it wishful thinking, was that there would be a soft landing at worst.
Instead of heeding to a minority of economists and analysts’ pleas to exit the market, more individual and institutional investors poured money in, hoping to ride the ever-rising wave to riches.
The media outlets were of no help. The 24-hour squawk box provided little insights and meaningful discussion to the issue. Eager to fill out its screen time, so-called experts and analysts were brought in, each with their own agendas. The stage was set up for them to further confuse the public and fan the flame of speculation.
At a time when the only thing left to say should have been: we’re in trouble, how do we get out, and by the way, get the hell out of the market right now; the discussion on short-term profiteering and trading opportunities raged on.
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