Friday, May 21, 2010

5/21/2010 On the Premium Puzzle, Quoting Yields, Dividends, and Investing in Real Life

A.S. over at the economist leads off a new post on the equity risk premium with the following:

EQUITIES just aren't what they used to be. It was once gospel that equities out-perform low-risk bonds. But if you invested in the stock market around 1999 the balance of your portfolio probably suggests otherwise. During the post-war era equity returns have been positive. Enough so that the equity-risk premium, the return equities generate in excess of the risk-free rate (which is normally short-term Treasuries), is often assumed to be between 5% to 8%.

Now, Aleph Blog and others are probably much more suited to discuss the finer points of the Equity Risk Premium, other than to say David Merkel usually uses longer term bonds in order to decide whether there is a risk premium for debt versus equity in general. A.S. here refers to the risk free rate, generally 3 month treasuries.

The first thing that strikes me is this theoretical person who dumped a boatload of money into the stock market in 1999, held it for 11 years, and is thus our layman's proof of the lack of an equity risk premium. Theoretical set and forget investors like this are wonderful rhetorical points, but would have most likely sold out in 2003 and not jumped back into the market until, say 2006. The classic "buy high/sell low" investor. But individual investor irrationality and inexperience doesn't prove or disprove the equity risk premium. Additionally, the problem with this type of data point, like Felix's advice and belief in zero equity risk premium, is that the way it is said begs interpretation from the lay person to stay away from equities entirely. Equities are risky, there is no equity risk premium, and oh look if I had just kept my money in cash I would be doing so much better than I would be doing now. Investing in hindsight is a wonderful way to lose sleep and otherwise confuse your strategies for the future planning.

Moreover, is A.S. taking into account just the price level of the index, or also including dividends? A $10,000 investment in the S&P 500 would have, with dividends reinvested, yielded $11,656 by April 1st 2010. A similar investment in T-bills would have grown to $13,674.

So, if we are going to assume an investor, why does A.S. assume a fully invested, maximum risk taking investor, taking no dividends? Well, convenience, surely. I spent most of the morning looking for monthly returns for the Lehman Aggregate Bond Index fruitlessly, and while Robert Shiller and Kenneth French keeps their data nicely updated, William Sharpe does not.

So, putting aside the likelihood that "real" investors are more likely to be bad trend followers, get nervous and try to market time, and otherwise engage in a whole host of poor investing decisions, what does a "real" investors portfolio look like?

First, lets assume that this investor is investing on a regular basis, through something like a 401k. Thus, a newly minted grad in 1999 (which A.S. may have been, who knows with the Economist's anonymous blogger policy) gets their first job in Jan 1 1990, and puts aside $1000 per month into their company sponsored Defined Contribution Plan. Next, let us also assume that this investor does not invest entirely in stocks, but also elects to invest some money in bonds (I used VBMFX as a proxy for the bond market, see above for the dearth of monthly LABI returns online). What do the different portfolios look like for an investor who is "in the market" versus one who puts their money into the three month t-bill each month?

From January 1, 1999, an investor who invested regularly on the first of month, every month, invested 100% in equities (represented here by the S&P 500), would have invested, over time, $136,000 and on April 1, 2010 have $155,864.79. This is a simple return of 14.61%, and a yearly geometric return of 1.37%.

For the same period, an investor who invested regularly on the first of month, every month, invested 100% in 3 month treasuries, would have invested, over time, $136,000 and on April 1, 2010 have $155,301. This is a simple return of 14.19%, and a yearly geometric return of 2.81%.

Geometric returns doesn't take into account the amount invested during the time period. If we look at the Dollar Weighted Returns (using IRR), we see the that the Market portfolio yields 2.51% versus a 2.45%.

If we add bonds into the portfolio, the returns of the portfolio during the period increase even more (3.98% dollar weighted average for the time period for a 60/40 stock/bond portfolio).

All of this is to say that the academic question of the risk premium may or may not be related to the way that portfolios are (or should) be constructed in real life, and that even cherry picking the sample size of recent data can mask the differences in the way that returns are quoted. Obviously how well each investor slept with each portfolio is different, but that is a different post.

Alternately, past performance is no guarantee of future returns.

But seriously, if anybody has monthly bond index returns going back as far as Shiller's data, please email me.

Who do you follow?

Oddly, I have missed, until this week, the "follow others" feature in google reader. I first discovered it when Henry Farrell noted that his "shared items" is a repository for things that don't quite make it into a post over at Crooked Timber.

Following other people's Google Readers also popped up when Chris Blattman recommended to follow Rajeev Ramachandran.

I have added these three people to my reader, and am amazingly happy with the results. Each acts as a curator for a different area of interest, and I reap the rewards (which I suppose makes this project second order curation, as we get more and more recursive).

So, the question becomes: Who do you follow on your reader? Who else should I follow?

Tuesday, May 11, 2010

5.11.2010 A Conversation about the Goldman Sachs Hearing

This is a conversation (spell checked and minor grammatical corrections) between a friend of mine who works in the business of Politics. As I have helped him in the past understand the arcane uses and abuses of CDOs, MBS, and other methods of saying one thing and doing another in the financial world, I hope that my 4 readers* will find the following exchange insightful. I apologize for the profanity. People with jobs in politics tend to swear.

T***: Also, they adopted the Sanders (modified) amendment, but rejected a more fulsome audit of the Fed

Me: ah.

More fulsome?

It is really just despair. I think this expresses it well:

T***: The Sanders audit is limited to info on who they gave money to in the last 3 years

The rejected Vitter amendment is a full audit, including minutes

Me: I mean, it isn't rational, insofar as I have no evidence for this, but I just feel that data points will be used as cudgels, either against the central bank or against specific banks, while leaving the bigger picture/necessary adjustments unaccounted for.

T***: That is a f****** stupid article

Me: I mean, the Goldman senate hearings were a laugh

Look, I like Barney Frank as much as the next guy

But he is more the exception, imho

T***: Seriously, absolutely pig ignorant about how hearings work

No, seriously, that is f****** retarded

Those questions were literally all written by public interest groups

And the audience sure as f*** wasn't Wall Street analysts

They were all political questions made for a political point

Me: right

A political point which purposefully missed the fundamental purpose of the financial system.

T***: Using them to gauge the knowledge of the market among senators (and really, about Senate staff because who gives a f*** what senators know?) is retarded

The writer of this is far more ignorant about how Congress works than the average senator is of the market

It is garbage

Me: I mean, I suppose it is silly for me to expect that a hearing should actually be an attempt to inform and clarify, let alone that the tone and tenor of the hearing will influence the crafting of legislation

T***: Yes

That is absolutely ridiculous to expect

Me: so you are saying that I should ignore the hearings? and that anyone involved has no input on the financial regulation in the pipe, and that the knowledge level that their questions implied in no way represents the knowledge level of the people actually crafting the regulation of the financial sector?

T***: Pretty much! You should basically treat them with the importance that you would treat a company’s press release regarding upcoming litigation

It is all posturing

And again, the questions don't come from the members about 90% of the time

They come from lobbyists

We do that all the time

Writing questions for hearings

T***: The analog between CEOs and Senators and their relevant expertise relative to their respective staffs is apt, except that Senators have more accountability, more diverse backgrounds and a higher level of personal achievement. Considering how s***** senators are, collectively and individually, that is the harshest f***ing burn of CEOs I can muster.

Me: zing

5.11.2010 More on risk and volatility

Crossing Wall St has a further meditation on the Volatility = Risk implication of Felix's most recent statement.

On further contemplation, I want to clarify my previous statements.

I worked with mid to high net worth individuals for most of my professional life before school, creating financial plans to provide for retirement, college education, and other goals. Determining the appropriate exposure to stocks is probably the most important thing that we did as advisers. Some clients are younger, less risk averse, or have higher income; some clients are older, more risk averse, and have less income flexibility. These metrics, amongst others, are the critical things to evaluate the risk tolerance, and thus the proper allocation of stocks.

Maybe this is a moment of delayed Upton Sinclair*, but risk tolerance shouldn't change because the market is volatile, and so an individuals portfolio shouldn't change because the volatility of the market has quickly changed (as it is wont to do). An individual's risk tolerance is in relation to the volatility of the market in general, not the volatility of the market on a daily basis. If an adviser has done his or her job right, they understand their client's psychology and will be conservative with their estimation of a client's risk tolerance when the market is bullish, and aggressive with their estimation of a client's risk tolerance when the market is bearish. Indeed, this is what we attempted to accomplish with our practice in 2006 to 2007, where the standard analysis suggested a 80/20% stock/bond portfolio, we moved clients to 65/35 stock/bond portfolios.

The implication of Felix's advice is that daily volatility is a reason to shift the allocation of a portfolio. If you've done your job right, the volatility that a client is exposed to is the volatility that they can stand. This means in low volatility time periods, they want to take more risk; in high volatility time periods, they run for the exits. A client should be unhappy with you in bull markets, but happy in bear markets.

Your investment allocation strategy shouldn't magnify the behavioral irrationalities of a retail investor.

* "It is difficult to get a man to understand something, when his salary depends upon his not understanding it!"

Sunday, May 9, 2010

5.09.2010 On the peculiar advice of Mr. Salmon

Felix had some interesting advice the other day, which he updated tonight. Suffice it to say, I think a fair summary is something along the lines of "OH GOD SELL HOLY SWEET JEBUS WE'RE ALL GOING TO DIE" or something similar. Or at least that is, I am reasonably sure, the take away that people will have who read the Huffington Post as they log onto their eReaders and eTrade accounts after reading the weekends news, given my short tenure in the field of explaining the incomprehensible market volatility to nervous retail investors.

Nevertheless, my curiosity was piqued when Felix said:

With all those inputs, the Samuelson Share output is 78%: you should have 78% of your investments in stocks, on average, over the course of your investing life.

But now what happens if you change the 18% value for the VIX to its actual closing level on Friday, which is 40.95%? Suddenly, the Samuelson Share plunges to just 15%.

SURELY the “Felix Salmon Investment Advice” isn't saying that we should adjust our market exposure DAILY based off the closing VIX price? That would lead to CRAZY volatility and leverage in the portfolio, not to mention silly things like transaction costs. Perhaps it would be better to take a yearly average of the VIX, and adjust accordingly there, rebalancing the portfolio.

So, I charted the "Samuelson Share" based off the Daily close of the VIX and then took the 1 year moving average trend line. I also threw the daily close of the S&P500 on to get a better idea of what the market was doing during each allocation point:

So, the Felix/Samuelson approach would have you buy more and more (with leverage) as the bull markets increased, and sell into the bear markets. Buy high (with leverage), sell low.

I don't know if this strategy would have actually beat a buy and hold strategy since 1990 (as this is just the quick excel work I could piece together over 3 innings of the Sox/Yankee's game) let along longer time periods, but I suspect that this isn't really a winner, in the long term strategies for allocation of assets to produce satisfactory risk adjusted returns.

Saturday, May 8, 2010

Tuesday, May 4, 2010

5.08.2010 On the Rorscharch test of pretty charts...

Recently, the blogosphere has been a flutter about this post by Mike Mandel. It contains this chart:

He observes:

This one fact explains much of the fiscal stress at the state and local level—why states such as New York, New Jersey, and California are in such a mess. State and local governments pay more than $1 trillion in compensation annually (actually, that’s an astounding number–I had no idea it was that high). If compensation is 5% higher than it should be, that’s $50 billion in excess pay costs for the state.

And lo and behold, that $50 billion would roughly cover the total size of the state budget gaps. For example, in February a survey found that the combined budget gap of all 50 states was $55 billion for the 2011 budget year and $62 billion for the 2012 budget year . (The survey was done by the National Governors Association and the National Association of State Budget Officers)

Of course, this chart doesn't actually tell us this. It does show that somewhere around 2006Q01, something happened where public and private wages started to diverge (or perhaps nothing happened, and this is a common event in the business cycle). Whether private wages were held low to where they should be or public wages were inflated higher than where they should be is unanswered by the chart. Indeed, the chart merely confirms a belief already held by the viewer, as we see in the comments where LP2 states:

Yes, the arithmetic IS very clear. Just eyeballing that graph, virtually all of the difference comes from stagnation in private sector pay between 2004 and Q1 2008. The recession started in December 2007 by most measures.

This graph doesn’t show higher wages for public workers “while the private sector struggles;” it shows the private sector sticking it to private sector workers.

Same chart, diametrically opposed conclusions.

So both sides partake in a thesis in search of data, and nothing looks more like data than a nice chart with some squiggly lines on it.

This is, of course, the opposite of what we should do. Upon observation of a divergence from either a historical relationship or a seeming identity, we should avoid the temptation to immediately shoehorn it into our existing world view. Rather, we can and should attempt to build a model of items in question, and from that we can see if, at the inflection point, what, if anything, changed.

Much of this is informed by my professional career in retail asset management. When faced with a market that swings every day and with clients calling wanting to know why their portfolios are having intraday swings greater than your Adjusted Gross Income, the temptation to declare something over or under priced, to declare the collective wisdom of everybody else in the market as wrong, is great. Indeed, the entirety of the asset management business is based off of being smarter than the market. But I felt it was always hubris to, in my small office in Los Angeles, declare myself smarter than every blowhard on TV. What we did better than they did, in my opinion, was to be more humble, to know what our clients wanted, and to know the limitations of our experience. We levered the information that we had and where our knowledge failed us, we had the humility to trust the collective knowledge (market).

The creation of useful knowledge - which is the primary unit of investing and economics - requires a willingness to embrace not knowing an answer. This requires work, and lots of it. If you are going to accuse the collective wisdom of a multitude of actors of making a mistake, your reasons should be better than your reading of Atlas Shrugged or A People's History...

Which is to say I'd love to look at Mr. Mandel's data and method backing this up, and see what this relation looks like going back further than 2001Q01.