No need to worry!

I recently came upon an article entitled “What You Can Do About The Upcoming Stock Market Crash”.  The title was tongue in cheek and perhaps unfortunately so given recent events.  Nevertheless, it made a number of important points about the difficulty of knowing when a market is at its peak and when a market is at its lows, and of knowing in which direction and by how much a market is going to move at any given point in time.  Much of this I agreed with, but not all:

When you think about it that risk and fear will always be there no matter how far the market goes up, down, or sideways. So what can you do?

Be prepared for a crash at any time. If you need to withdraw money in the next few years or you want to cushion the blows, then you need to diversify your portfolio with enough bonds, cash, or other assets that won’t fall along with the stock market.

Once you figure out what is right for your current situation you don’t have to worry about what happens because you are controlling the risks instead of letting them control you. That means you are safe to invest your money today and start earning your way to the freedom you want for yourself and your family.

Points 1 and 2 noted above are more or less correct, but the last point I have emboldened is where I diverge.  You are never ”controlling” risk, just diversifying it relative to return, and if possible, its covariance, itself a function of risk.  You cannot control risk, only minimise its impact through structure.  You are certainly not safe to invest your money today and there is no guarantee that you will earn your way to freedom. 

Return is an important consideration when accepting risk and many today who use simple mean variance models assume that expected returns are invariant and that risk is only volatility around this return.  In a general equilibrium, random, independent price movement model it does not pay on average to delay or defer investment (any benefit is purely attained by chance), but even here you are hostage to the probability distribution since the expected return in Monte Carlo land is only the average of many outcomes, some of which turn out to be quite disastrous from any level.

But expected returns do matter and while timing your investment to maximise your returns and minimise your losses is impractical and impossible for the market as a whole to do, making value judgements about market valuations and economic cycles to inform you of the boundaries of return and its significance is I believe worthwhile if you possess the expertise..  Where people run into trouble is where they either lack the knowledge and expertise to make the type of judgements needed to define the boundaries of expected return, and its impact on structure, as markets and economic cycles mature or react to market falls and meteoric rises as if one is the end of the world and the other its never ending bliss.

Deferring new risky investment at high market valuations is a value call and a discipline, but it is an act which relies on knowledge of the significance of valuation differentials.  It is one of my concerns that “we” have been taught that we should invest in markets at all times irrespective of the valuation, the cycle and the specific characteristics of either.  One of the reasons the world has been through innumerable crises since the late 1990s is because we have ignored significant accumulating structural economic and financial imbalances and the differential between asset valuations and economic fundamentals.  In a well balanced world we could probably ignore valuations and invest at will, ignoring volatility. 

But then again context is everything.  While one may not invest/sell at cyclical highs/lows there is little reason to sell all (high) and then attempt to reinvest all (lows) at perceived key turning points.  Portfolios should adjust to the relationship between valuation risks and the time frame of their liability profiles and it is here where we need to pay attention to valuation risks since these do have material impact.   As markets rise returns fall and the risks to the ability of assets to meet future needs increases, and vice versa.  When returns and risks pass barriers of significance that is where changes at the margin need to be made.  It is therefore not a question of timing but of tangible discipline and its benchmarks.

And, of course, I believe we are in the middle of a very long period of global economic and financial fragility, so safe is a word I would eschew for some time.

Is the greatest risk to investors’ portfolios really longevity…?

A recent article in the Journal of Portfolio Management argued that longevity is the greatest risk to returns.   It also argued that investors should be moving along the risk horizon towards unconstrained portfolios.  

There were some aspects that I agreed with – I agree that portfolios should at the core be focussed on lowest cost allocation vehicles- but I disagreed with much of the following:

the rock-bottom interest rates of the past few years have forced risk-averse fixed-income investors to find ways of generating income without taking on too much volatility: as a result, many have turned to unconstrained, multi-asset strategies….The single biggest challenge facing investors remains how to pay for longer lives. Achieving that goal will require some adjustments—moving into nontraditional strategies, letting go of benchmarks, and, for many investors, taking on a higher level of risk throughout their investment horizon—both by holding higher levels of equity and, in many cases, through investments in alternative asset classes.

The biggest challenge is the low prospective returns from all asset classes and the much higher than historical risks to those returns.   Moving out along the risk spectrum throughout their investment horizon effectively entails reducing liquidity and certainty of return over the key short to medium time horizon of the portfolio.  It would also likely increase costs, especially at the short end of the horizon where once upon a time direct allocations to lower risk government bonds would have provided yield and capital security.  This needs to be planned for….

So the portfolio is increasing long term allocations to enhance long return at the cost of greater short term risk.  This essentially means that individuals are going to be more highly exposed to short term expenditure deficits…taking more risk to enhance returns means taking greater short term risk to returns…short term financial security has to take the hit.  I am not so sure that I am confortable with this.

Longevity needs to be planned for and for many it may require a downward adjustment of expenditure over lifetimes.  But if overly optimistic return assumptions are used to model expected withdrawal rates it will not matter what your investment strategy or your adjusted expenditure profiles are.   I am concerned that people are seeing low IRs on the one hand and normal expected cash flows on risky assets on the other.  I also express concern that longevity risk may be the lure towards higher cost more remunerative more complex structures for the sake of chasing return while the tide is in the asset manager’s favour.

Underfunded pensions..not such a slam dunk

I picked up the link to the following report on twitter: THE FUNDING OF STATE AND LOCAL PENSIONS: 2013-2017

The report stated that the funding status of state and local pension funds was at some 72% of liabilities and would likely rise further assuming a return to historical returns.   The report did look at current funding liabilities under a range of equity return scenarios none of which were as low as many pundits (Hussman, GMO and myself) would model.   The lowest return figure of 4% (all assets combined) would yield a liability with a net present value of $3.8trn or circa 22% of current GDP or 32% of personal consumption expenditure ….this translates into my vague assumption that if future GDP rates are based on current consumption, then future return assumptions would need to incorporate pension fund liability shortfalls.  

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“The future is now”

I have stolen a line from John Hussman’s most recent market commentary.  Like most who are focussed on valuation, Hussman is not concerned about how much stocks can rise or fall at any one point in time, but to what extent, or not, prices have discounted future earnings growth.  This is translated into an estimated total return that is likely available from stocks based on current valuations, expected future growth in earnings and an assumption regarding an appropriate valuation range. 

All decisions today are effectively based on an assumption about the future, so the future is always now, but when valuations are at extremes, inappropriately structured portfolios are exposed to the future.

There are three portfolio management mechanisms that need to be borne in mind as markets and risks peak and these are a) the return assumptions you use to project asset/liability modelling and management planning and decisions going forward, b) the extent to which your asset and liability management is impacted by the longer duration of short term economic and market risks to return and c) the extent to which you adjust asset allocation to take account of the longer duration of short term risk and the narrower margin of return on risky assets.

I do not believe that any of a, b or c are market timing exercises per se because our view is not now but the future – in other words the future is now.  I also believe that managing risks to return and the ability of assets to meet future and especially near term liabilities as markets peak to be a natural economic mechanism for managing consumption/production and savings/investment balances.    

The portfolio allocation should match the economic allocation!

A brief thought on market valuations

As I work my way back into the mental state required to hold the data points I just wanted to make one key point.   Many have commented on the pointlessness of market timing and therefore the pointlessness of listening to those who believe that a large negative market movement is around the corner.  I have never been one for wholesale market timing transactions, but I do believe that high market valuations impact one critical dimension of the portfolio and need to be treated with respect.   The higher a market is valued, in an out of equilibrium world, the lower the future expected returns.  Therefore, without an adjustment for future returns the liability demands  on the portfolio (which have likely been revised higher due to higher portfolio values) will place undue and increasing stress on the portfolio’s ability to meet those returns, especially in the event of an eventual market adjustment.   As markets rise and as the time frame of significant market risk extends, for a given level of liabilities, it makes sense to adjust asset allocation towards lower risk/fixed return asset classes.   We cannot ignore valuations and we cannot ignore their impact on the management of income and capital liabilities over time.    

The lost world of asset allocation Part 3: Risk Premium Differentials and Liability Frames.

One of the most important determinants of asset allocation is the risk premium on risky investments. 

The lower the risk premium on risky assets the less rationale there is for their inclusion and the longer the time frame of “risky asset risk” that a portfolio will need to manage.  Asset allocation decisions that involve allocating to longer term higher risk growth assets to provide the differential expenditure (income and capital liabilities less portfolio dividend, interest and other income) are about capturing differences in risk premiums.

But this also requires that asset allocation is also framed in terms of units of liabilities as opposed to just units of assets, such that risk management uses size and timing of liabilities as the primary determinant of rebalancing transactions and asset allocation decisions.   The time frame of risk for risky assets is framed likewise in liabilities.

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Long run predictability of asset prices..

Robert Shiller and Eugene Fama were two of three academics who won the Nobel Prize for economics for different accounts of asset price predictability: the former regarding its bounded long term predictability and the latter regarding its short term unpredictability.

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The lost world of asset allocation–part 2, the liability profile

This post is in response to a recent article by Rob Carrick on “conventional” asset allocation approaches, titled Longer lives, new investing approaches. It commented on asset allocation rules of thumb to give you your equity allocation and bond allocations.

The trouble is these rules of thumb are meaningless in terms of deriving optimal asset allocations.  How you construct a portfolio should depend on a number of things.  One of the most important determinants of of asset allocation is the liability profile, which in layman’s terms is income and capital needs as a % of the portfolio value.

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