Wednesday, January 14, 2015
Kelly starts with the assumption that the stock market is a zero-validity environment, what is commonly known as a random walk. Outcomes are unpredictable, and both expert and amateur stock pickers are wrong about half the time. Market timers face even tougher odds. In a 1975 study William Sharpe found that “timers need a 74 percent accuracy rate to beat a passive portfolio taking on the same amount of risk.” (p. 25)
Is there any way to beat the market? Yes, the author claims. His solution is the 3% signal. It has six components: “the growth vehicle where we keep most of our capital during our working years; the safety vehicle where we keep a smaller portion of our capital; the target allocation of capital between the growth and safety vehicles; the safety vehicle allocation at which a rebalance back to its target is triggered; the timing of our growth signal; and the growth target.” (p. 37) Although the investor can define his own permutations of these components, the default plan is “a small-company stock fund as the growth vehicle; a bond fund as the safety vehicle; an 80/20 target allocation between the stock and bond funds; a 30 percent bond allocation threshold that triggers rebalancing back to 80/20; a quarterly timing schedule; and a 3 percent growth target.” (p. 38)
As you may gather, what sets this system apart from and makes it superior to most rebalancing plans is the 3% signal. At the end of each quarter you rebalance based on how much your stock fund grew or didn’t—more than 3%, sell the extra profits and put them into your bond fund; less than 3%, use bond proceeds to bring your stock fund up to its target 3% quarterly growth rate.
The author’s research indicates that 3% per quarter is the outperformance sweet spot. This quarterly performance yields an annual return of 12.6%, 26% better than the market’s annual performance of 10% over the past ninety years. (p. 56) And we know how that extra performance compounds.
Kelly carefully describes how investors can put this outline of a plan into action—what kinds of funds they might use, how they might opt to adjust the default allocation as they age, how they can survive market crashes. He even follows three hypothetical investors as they try to navigate the stock market from December 2000 to June 2013. It should come as no surprise that the one who used the 3% signal fared best.
We often hear, and have come to believe, that models beat experts. Kelly offers the individual investor a simple, mechanical model that instills discipline, removes a lot of self-sabotaging emotion, and has a good track record. Will it continue to outperform? Actually, it just might.
Monday, January 12, 2015
I’m going to touch on three of these skills: drive for daylight, fly the OODA loop, and fail wisely.
The “drive for daylight” concept is borrowed from race-car drivers who say that “the trick to managing speed at 200 miles per hour is to drive for daylight. They go too fast to navigate by the lines on the pavement or the position of their fellow drivers. Instead, they focus on the horizon and, at high speeds, their hands follow their eyes.” Similarly, creators “navigate around immediate obstacles by keeping their long-term mission in mind. … creators don’t benchmark themselves against the competition or focus on industry norms. … they set their sights on the horizon, scan the edges, and avoid nostalgia.” (p. 49)
Integral to the “drive for daylight” mindset is a “to-go” way of thinking. That is, a person doesn’t focus on how far he’s already come but on what remains to be done. “To-go” thinking, researchers have found, accelerates momentum. “Motivating yourself by thinking about how much of the marathon remains before you cross the finish line can inspire you to run harder, faster, more competitively, and with greater enthusiasm.” (p. 55)
The notion of the OODA loop comes from John Boyd, an Air Force fighter pilot who “crafted a framework for making rapid decisions that would ensure success in fast-changing environments. Boyd’s ‘OODA loop’—observe, orient, decide, and act—is as pertinent to business [and to trading] as it is to aerial combat.” (p. 68) Since there’s a fairly extensive literature on the OODA loop, I’ll not say more about it here.
Finally, let’s look at the failure ratio. We’ve all read the advice to fail early and often, but how much failure is acceptable? The author found that “a surprising number of creators decide that ratio ahead of time. They aim not for perfection but to ensure that they take enough risk.” (p. 94) This is, I think, an important metric to consider. Entrepreneurs worry if they experience too few failures. As LinkedIn cofounder Reid Hoffman said, “Frankly, if you tune it so that you have zero chance of failure, you usually also have zero chance of success.” (p. 96) Just think of that beautifully over-optimized trading system that crashes in real time.
Traders focus on minimizing their risk by setting stops or keeping their position size small. But the other side of the equation is equally important. Their portfolio can grow only if the risk they assume is large enough. Institutions have metrics to look at both sides of the equation. Individual traders rarely do, and then they wonder why they come up short.
Wednesday, January 7, 2015
Overweighting bonds is not an intuitive asset allocation strategy, so Shahidi takes pains to explain its rationale. He sets the stage with a description of Ray Dalio’s economic machine, more vividly shown in Bridgewater’s 30-minute animated video. He then explains why a 60/40 portfolio is not well balanced. First, “the impact of an asset class on the total portfolio is only dependent on two factors: (1) how volatile the asset class is, and (2) how much of the total portfolio is weighted toward it. … The more volatile asset class should get a lesser weight to make up for the fact that it is more volatile. The less volatile segment should receive a higher allocation so that its impact on the portfolio matches that of the higher-volatility asset class.” Second, “the traditional 60/40 allocation is 99 percent correlated to the stock market!” (p. 24)
Instead of viewing an asset class as something that offers returns, the Bridgewater model looks at it as “something that offers different exposures to various economic climates.” (p. 26) Some sources of volatility, such as the future cash rate and risk appetite, are not diversifiable. But the most hazardous risk to investors--shifts in the economic environment--can in large measure be neutralized through proper asset allocation.
A simple two-factor model (growth and inflation) shows the economic bias of each major asset class. Equities want growth but not inflation, treasuries want neither, commodities want both, and TIPS want inflation but not growth.
With these basic pieces of the allocation puzzle in place, Shahidi explains each in more detail. TIPS, the most unlikely candidates for a major role in a balanced portfolio, are, according to the author, “possibly the most influential of the asset classes.” (p. 97) Their economic bias is opposite that of equities, so an outperformance in equities is normally matched with an underperformance in TIPS. In 2013, for instance, TIPS suffered big losses as equities soared. Bridgewater’s All Weather fund ended the year down 3.9%.
Shahidi admits that his basic portfolio is oversimplified, that other asset classes can be added to a portfolio and asset classes can be more narrowly defined—as long as you identify the environmental bias and overall volatility of each. For instance, your balanced portfolio can include global equities, emerging market bonds, commercial real estate, or small-cap stocks.
The bottom line is that a portfolio manager should weight asset classes to balance the economic exposure of the portfolio, not simply to equalize the risk of the asset classes (what has come to be known as risk-parity). If a portfolio is well constructed, it should be able to withstand future economic shocks.
Readers who want to emulate Bridgewater’s approach to asset allocation—professional portfolio managers as well as individual investors—will find a lot of useful information in Shahidi’s book. Just don’t expect miracles.
Monday, January 5, 2015
In Private Wealth Management: The Complete Reference for the Personal Financial Planner (McGraw-Hill, 2015) G. Victor Hallman and Jerry S. Rosenbloom, both affiliated with the Wharton School, lay out a daunting curriculum. The wealth manager should be skilled in investment planning and financial management, income tax planning, financing education expenses, retirement planning, charitable giving, insurance planning and risk management, estate planning, and planning for business interests.
In over 600 pages the authors cover a head-spinning number of topics. Unless you’re a masochist, this is not a book you read straight through. Even I, usually a conscientious reviewer, picked my way through it, choosing some areas in which I felt competent and others about which I knew next to nothing. The reason for this strategy was to see whether the authors did a good job with material with which I was familiar and whether they presented the unfamiliar in a way that was easily understood. They scored well on both fronts, which is probably one reason this book is now in its ninth edition.
Private Wealth Management is a reference/textbook that should be in the library of every financial planner.
Thursday, January 1, 2015
Tuesday, December 30, 2014
These billionaires (or Producers, as the authors call them) may be wired differently. They certainly think differently. They balance judgment and imaginative vision, a daunting mental task since “for most people, judgment and imagination sit on opposite ends of a mental spectrum. The more skilled one is at seeing things as they are (judgment) the harder it is to see things as they might be (imagination).“ (p. 4) Not only do they “revel in bringing clashing elements together,” “they seamlessly hold on to multiple ideas, multiple perspectives, and multiple scales.” (pp. 16, 15)
Since they “cannot predict the exact time to make an investment, … they are willing to operate simultaneously at multiple speeds and time frames. They accept that timing is not under their control, and so they work fast, slow, super slow, or in all these modes at the same time. They urgently prepare to seize an opportunity but patiently wait for that opportunity to fully emerge.” (p. 19)
Self-made billionaires are strict managers of their own time. “They appear far less busy than most executives… They intentionally guard their time, doing away with extras, distractions, and nonessential activities…. By guarding their time preciously billionaires are able to constantly cultivate and grow their innate curiosity. It gives them the time to read or converse widely on the subjects that let them make remote connections.” (p. 76)
They also have a different attitude to risk from most people, who “overestimate the risk of failure and underestimate the risk of missing out on a gain.” (p. 115) Self-made billionaires are willing to risk failure but not the chance to capture an opportunity. Contrary to myth, they don’t take irrational risks. They always want to be able to make the next investment if the first one doesn’t pan out. And, unlike most people, they have the emotional resilience to do just that.
The Self-Made Billionaire Effect is not intended to be a how-to manual for the budding billionaire. It’s written for corporate executives who have done a poor job of recognizing Producer behavior, knowing what to do with it when they find it, and figuring out how to grow the number of Producers in their firm. Even so, it provides individual entrepreneurs with a useful catalogue of attributes, habits of mind and action, they should cultivate. With a new year right around the corner, see what you can add to your list of resolutions that, this time, you’re definitely going to keep.
Monday, December 29, 2014
Gabriele Oettingen, a professor of psychology at New York University and the University of Hamburg, has done extensive research on the power—and impotence—of positive thinking. Her findings in Rethinking Positive Thinking: Inside the New Science of Motivation (Current/Penguin, 2014) undercut the view that positive thinking can transform dreams into reality. Instead, “the obstacles that we think most impede us from realizing our deepest wishes can actually hasten their fulfillment.” (p. 8)
Positive thinking can sometimes be perilous, especially when it comes in the form of collective positive thinking. The author analyzed articles in the financial pages of USA Today dating from the beginnings of the financial crisis during 2007-2009. Using a computer program that extracted all words that dealt with the future or that carried a positive valence as well as all words that were negative or dealt with the past, they created a “future positive” index. They then used this index to explore whether positive thinking in the media correlated with movements in the Dow. Contrarians won’t be surprised to learn that they “found a clear correlation: the more positive newspaper reporting was in a given week, the more the Dow declined in the week and month that followed.” A similar finding: “the more positive the inaugural address for a given presidential term, the lower the GDP and the higher the unemployment rates were in the following presidential term.” (p. 25)
Returning to individual self-sabotaging, Oettingen found that dreaming, or positive fantasizing about something, relaxes us. It even lowers our blood pressure. That’s a problem. “In dreaming it, you undercut the energy you need to do it. You put yourself in a temporary state of bliss, calmness—and lethargy.” (p. 44)
So how do you actually accomplish your dream? First, it is important that your dream is feasible. Dreaming that next year you’ll turn a $10,000 portfolio into a $1 million portfolio is not feasible, so you should just let that dream go and move on to something more realistic.
Oettingen introduces a tool with the acronym WOOP to move people from dream to accomplishment. The “W” stands for a wish or concern you might have, “something that is challenging but that you think is possible for you to achieve in a given period of time.” (p. 104) The first “O” is the outcome: “What is the best thing that you associate with fulfilling your wish or solving your concern?” Moving beyond the standard recommendations of positive thinking, the author introduces the second “O,” the obstacle. “Find the most critical, internal obstacle that prevents you from fulfilling your wish or solving your concern.” (p. 105) Finally, the “P” represents the plan. “What can you do to overcome or circumvent your obstacle? Name one thought or action you can take—the most effective one—and hold it in your mind. Then think about when and where the obstacle will next occur. Form an if-then plan: ‘If obstacle x occurs (when and where), then I will perform behavior y.’ Repeat this if-then plan to yourself one more time.” (p. 106)
“And that’s it. You’re done.”
Before I say I’m done, here’s an amusing anecdote about dreams that aren’t feasible from Joan Didion’s Blue Nights. In her seventies, thin and frail, she was told to gain weight and devote a minimum of three hours a week to physical therapy. She writes:
“I find, … somewhat to my surprise, that I actively like physical therapy. I keep regular appointments at a Columbia Presbyterian sports medicine facility at Sixtieth and Madison. I am impressed by the strength and general tone of the other patients who turn up during the same hour. I study their balance, their proficiency with the various devices recommended by the therapist. The more I watch, the more encouraged I am: this stuff really works, I tell myself. The thought makes me cheerful, optimistic. I wonder how many appointments it will take to reach the apparently effortless control already achieved by my fellow patients. Only during my third week of physical therapy do I learn that these particular fellow patients are in fact the New York Yankees, loosening up between game days.” (p. 78)