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« Currency Warfare | Main | Don't Listen to Anybody over 50 »

October 04, 2007


Bond investor

ZB, your blog has moved to the "must-read" section of my bloglines account. I only have a hard copy (and it's at work, not here at home), but you should check out Edward Chancellor's "The Case For Cash" in the July (I think) issue of Institutional Investor.

A couple thoughts on "a better risk-free rate." It's too bad that TIPS auctions are not that big and usually only occur every couple months or so. Otherwise I'd advocate the use of a short TIPS bond yield as a better risk free rate, so we can disaggregate the real rate of interest from inflation. Then we can start getting over this lousy notion that stocks are better inflation hedges than real assets or even quasi-financial assets like commodity futures contracts.

Too many of the brokers-turned-planners' Asset Allocations only use mean-variance optimization and Markowitz Portfolio Theory. They assume a normal distribution of returns. The better planners use Monte Carlo simulations to calculate a Chance of Plan Failure. Why is this better? Because Jeremy Siegel can tell you the long-run average return on stocks, but can't tell you the *timing* of those returns. Try putting someone who retired March 10, 2000 in a room with someone who retired March 10, 1995, both with 100% stock allocations, and see if they're both happy with they're outcomes.

This is also why lifecycle funds are risky -- a recent Financial Planning magazine article showed that the average lifecycle fund with a 2010 retirement target date was just over 50% in stocks. Shouldn't that decision be dependent on the *size* of the nest egg as well as the time horizon? A multi-millionaire can afford to have more stock exposure than someone with $250,000.

Zero Beta

Thanks for the thoughts and I appreciate your loyal reading and commentary. I enjoy writing this blog and at times it can be very difficult to balance that with work and life, so I am delighted when people like yourself are actually interested and inspired to comment and/or criticize what I post because my intent was to bring a different perspective to others.

I will try to get my hands on that article. I know a few people who subscribe to the publication. Stocks are only a good inflation hedge in the current environment that we are in. I think this has to do with a multitude of factors, some of which I have thought about during my response to this and may post on a little later. Essentially outsourcing and low interest rates along with growing consumer credit has created an inflationary storm that has made stocks a great investment for inflation hedging over this time period. I am skeptical as well as I know this is a phenomena that is not sustainable. Companies benefit from being able to keep input costs low through outsourcing and globalization. At the same time the cost of capital is low because of low interest rates, essentially. Meanwhile, large amounts of consumer debt has enabled companies to be able to raise prices and grow earnings. Consumer debt has replaced real income growth and has flowed through into earnings. If consumers did not have access to the debt, companies probably would either not be able to raise prices like they have unless they also paid there employees more - since many of their employees are also consumers of their products - in aggregate. Since extending credit increases the money supply it is no surprise that stocks have been a great inflation hedge over the past 10 or 20 years. What is scary however is that stock gains recently have mostly been inflation. Regardless of what exact principle you believe in, most exchange rate theory rests heavily on expected inflation. Todd Harrison over at Minyanville always reminds people that an investor in the S&P 500 would have lost money if he put money into the market in 2003, because currency losses outweighed the equity gains. I think this is beginning to unravel as debt is becoming more elastic and our inflationary measures are causing soaring prices all over the world.

As per the modeling, most big brokerage houses use Monte Carlo these days, but my argument is that it doesn't matter if you tell someone that we ran 10,000 trials and these are your odds, because the last 20 years of returns data is still introduced into the model, which happen to be the best 20 years of asset returns in the history of time. If you run a simulation model that simulates good times, you will get good times. Adding to that, these models take some sort of randomly generated numbers and then use them in some equation that gives investment performance based on the normal distribution, which Taleb and Mandelbrot (among others) have shown to be a poor proxy for past market returns. When I design a plan for a client or potential client, I make it as conservative as possible, putting in very modest return estimates, inflation expectations, and life expectancies. In my opinion, I believe this is going to be a huge deal for the industry in 10 or so years if things don't go well for the markets. I don't believe that these plans are however bad. I think they are a very good way to get people to think about the future, but are much more dangerous for both the clients and the industry if used improperly.

I hate the lifecycle funds as well. I tell everyone in them to get out of them. The allocations are arbitrary and usually are put out for a mutual fund to introduce a new product to put investors in their worst funds, and at an extreme, where everyone was in those funds, they would solely be driven by demographics. They also lull an investor into a false sense of security.

One asset allocation that I have been thinking about lately is what Taleb proposes in The Black Swan. Basically investing 80% of your wealth in safe investments like short to mid term treasuries and using the other 20% to make very speculative and very risk bets utilizing options or derivatives in some cases - arguing that people shouldn't try to get the average return - they should let their risk free capital be absolutely safe and their risky capital to be invested in very risky investments. As part of his Black Swan theory argues that it doesn't matter how good you are about picking it but by doing that you will put yourself into the position to profit from black swan events. It is interesting and alleviates risk perversion in general because people know what risks they are taking.

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