How much of your accumulated wealth can you comfortably spend each year in retirement?  This depends on your likely longevity and market rates of return.  If your primary allocation is in fixed income, then in today’s environment your prospective after-tax rate of return is probably no more than 1%.  Given 1% rate of return, how much can you spend each year?

Well, that is a time value of money question that is easily handled.  All you need to know is when you are going to die.  Here are a few computations

So, let’s suppose at age 65 you have accumulated a fortune of $1,000,000.  The table says that at 1% rate of return you can spend $55,000 per year for 20 years, or $39,000 per year for 30 years, or $30,000 for 40 years.

If you are pretty comfortable you will die in 10 years, you can spend $106,000 each of those glorious years.  If you are not certain of dying in 10 years, then spending $106,000 each year would be very risky.

A more conservative strategy would be to spend $30,000 per year; you will run out of money only if you live past 105.  But you can do a lot better than this.

A nice way to eliminate the risk of living too long is to invest in life annuities.  An attractive seller of life annuities is TIAA-CREF, the investment company that handles college educator pensions.  TIAA-CREF is a very highly rated company (which is very important if you are buying a life annuity) that seems to favor transparency and simplicity.  You can go to their website and easily determine the “yield” or spending rate that is offered by a life annuity.  For readers not familiar with life annuities, the simplest version means that you receive a constant monthly or annual payment stream until you die.  This is called a straight annuity.  There are much more complex variants that offer protection against dying too early, or partial participation in equity market advances, but I’m focusing here on the basic product.

Naturally, the cost of a life annuity depends heavily on your age.  According to the TIAA-CREF website, the upfront one-time cost of a $1 lifetime annual payment stream for an adult male is as follows:

Age                                      60                         65                         70                         75                         80

Cost of $1 Annuity           $20.00                 $18.20                 $16.00                 $12.50                 $10.00

Today, a 65-year old male can purchase a $1 payment stream for life for an upfront cost of $18.20, or a “yield” of 5.5% (1/18.20).

Thus, assuming this fellow had $1 million, he could purchase a lifetime stream of $55,000 per year.  If he is in good health his life expectancy is probably 25 years.  Compared to the time value of money calculation above, this looks like a pretty good deal.  Naturally, his heirs will get none of the $1 million, even if he dies very soon after purchasing the annuity.  But if the chief concern is maximizing lifetime consumption and eliminating the risk of running out of money, the life annuity could be a winner.

What about the individual who aims to build family wealth?  That individual would surely not be interested in allocating 100% to life annuities, but perhaps a partial allocation would be sensible, particularly in light of the current low level of bond yields.  Consider an individual with a $5 million portfolio and desired annual spending of $100,000.  This spending goal could be achieved by devoting a fairly small portion of the portfolio to a life annuity and then allocating the remainder largely to equities.

Given the annuity prices above, we can calculate what percentage of wealth is required to purchase an annuity that covers 100% of the spending goal.  Since the cost of an annuity declines with age, the percentage of your portfolio required to produce a given income stream also declines with age.

Age                       Percent of wealth required to purchase a 2% of wealth annuity

60                                                                      40%

65                                                                      36%

70                                                                      32%

75                                                                      25%

80                                                                      20%

To see the logic of this table consider the 60-year old.  The “yield” on a life annuity at age 60 is 5.0%.  In order to achieve an annuity equal to 2% of wealth, the 60-year old would have to allocate 40% of wealth (.02 = .05*.40) to the annuity.  Similarly for the other ages.

The “100-Age” Rule would suggest an equity allocation of 20% for an 80-year old.  However, using annuities and assuming 2% of wealth is the spending goal, purchasing a life annuity would enable an 80% equity allocation.  80% at 80!  Even at age 65 the annuity looks like a decent deal.  You can lock in your $100,000 spending goal with just 36% of your wealth, leaving a large fraction of the portfolio available to be invested in equities, hopefully to appreciate greatly in future decades.

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Emanual lays out an extensive rationale for this position.  At 75 he will have lived a full live.  He will have seen his children grow up and his grandchildren born.  After 75 the process of mental and physical deterioration will accelerate.  He wants his friends and family to remember him as vibrant and healthy, not weak and decrepit.  Although there are exceptions, in general one does not make significant professional or artistic contributions after the age of 75.  He believes we spend way too great a proportion of health care costs prolonging the aged for a few years, instead of concentrating resources on addressing illnesses affecting children or younger adults.  He is not saying this position is right for everyone, but for him it is the way to go.

Not surprisingly, Emanual’s wife and children are not supportive of his position and continue to attempt to dissuade him.  Indeed, it will be interesting to see if he changes his mind as his 75^th birthday approaches.

There are fascinating financial issues raised by Emanual’s argument.  One is the effect on health care expenditures if many people adopted this approach.  This effect could be huge.  Data suggest that a very sizable percentage of lifetime medical expenses is incurred in the one or two years preceding death.  If lots of people chose to forego those expenditures the entitlement budget picture should improve dramatically.

Another financial issue is the effect on financial planning.  If you were planning on ending your life quickly (like the Old Stag in Bambi), that would make the financial planning process much easier.  Life insurance would be a good deal.  There is little need for life annuities.  You could comfortably maintain a high spending rate.  As of normal retirement age at 65 you could easily spend 10% of your retirement wealth each year.

On the other hand, if you are simply going to let nature take its course (which appears to be Emanuel’s approach), things are more complicated.

What is life expectancy at the age of 75?  That depends on many factors.  I have found a calculator at www.blueprintincome.com that provides estimated life expectancy as a function of about a dozen variables including gender, age, sex, race, income, marital status, education, smoking, BMI, alcohol consumption, and existing conditions.  The most significant factors, i.e., the ones to which life expectancy is most sensitive, are smoking status, BMI, exercise frequency and chronic conditions. Inserting the most negative answers for a 75-year old male, I get a life expectancy of just two years.  Inserting the most positive responses, I get a life expectancy of 20 years.  Quite a range.  There is no question along the lines “will you forego any future medical treatment?”

Emanuel points out in his article that he is healthy, unaware of any chronic condition, and recently climbed Mr. Kilimanjaro with his two sons.  Thus, he is likely to have a lengthy remaining life expectancy when he reaches 75, even with the commitment to avoid medical care.

Even so, Emmanuel’s financial planning is much simplified relative to those who aim to stay around as long as they possibly can.  For one, there is little need to budget for major medical expenses or long-term care.

I commend Emanuel for his thoughtful argument.  It would surely be beneficial for the federal budget if others followed suit.  I look forward to seeing if he chooses to modify his view as he approaches his 75^th birthday.  I will be watching closely.  I am six years older than Emanuel so I have to hang around to 81 in order to find out.

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According to Forbes Magazine, the threshold for the top one hundred richest people in the U.S. is $5 billion.  I call this group the “mega-billionaires.”  They have total wealth of approximately $1.5 trillion.   Under the Sanders tax, these mega-billionaires would pay approximately $80 billion during the first year, for an effective tax rate of just over 5% (ranging from 7.7% for Bezos down to 3.6% for the poor fellow with just five billion).  Subsequent year revenues would vary depending on the rate of return on capital.  If we take 5% as a reasonable assumption for the average annual rate of return, I calculate that over the next 25 years total wealth for these mega-billionaire families will decline by more than 60% under the Sanders Tax.  Tax proceeds will also decline, but probably not as much because successful entrepreneurs will create new fortunes that will be subject to the tax.  The likelihood of declining revenues over time suggests that this is not a particularly useful tax for funding new spending initiatives, like the Green New Deal or Medicare-For-All.  Again, the real reason for the tax is No More Mega-Billionaires!

Economic Consequences

As the fortunes of extremely rich people recede, some measures of wealth inequality will probably decline (for example, the share of total wealth owned by the richest .0001%).  Some commentators see this as unambiguously positive for a variety of reasons.  French economist Thomas Piketty has warned of a dark future in which increasing concentration of wealth results in undue political influence and an “heiristocracy” whereby undeserving offspring of billionaires become the dominant class.  In Piketty’s story, fortunes more or less automatically increase over time.

I don’t see this happening.   There is significant downward mobility among the .0001%.  For example, it has been reported that among the many descendants of Cornelius Vanderbilt, the richest man in the world in 1870, there is not a millionaire in the bunch.  It is almost as hard to remain in the .0001% as it is to get there in the first place.

Meanwhile, rich people make significant contributions to the economy.  For one, first generation billionaires are generally entrepreneurs who came up with new products or innovations that were highly valuable to millions of customers.  Second, billionaires generally have high savings rates.  They provide a large share of the funding for real investment by new and existing companies.  Third, they support new industries by being the guinea pigs to buy new products with marginal capabilities at outrageous prices (think of the 1980s cell phone that cost $3,000, was one foot long, weighed three pounds and had very few capabilities).  Similarly for electric cars, solar panels and smart watches.  Finally, many billionaires fund useful research projects and charitable giving.  Think of the Gates Foundation efforts to kill malaria and to develop clean and safe nuclear power.  Or James Simons, founder of Renaissance Capital, funding research into pure mathematics.

The real question, it seems to me, is whether you believe that the capital amassed by mega-billionaires is better managed by them or by bureaucrats and politicians.

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Is there a good reason to choose market cap weighting over equal weighting or other fundamental weighting?  Financial theory, as developed in Modern Portfolio Theory (MPT), the Efficient Markets Hypothesis (EMH) and the Capital Asset Pricing Model (CAPM), supports market cap weighting.  In theory, the optimal portfolio is the “market portfolio” comprised of market cap weighting of all risky assets.  Another nice feature of market cap weights is that it minimizes the need for rebalancing the portfolio.  After all, if you held the world wealth portfolio, there would be no need to change weights at all, except for the introduction of newly traded assets, like Initial Public Offerings and the like.

Recently, some economists have asserted that portfolios based on non-market cap weights are likely to outperform market cap weighted portfolios.  The reason is market inefficiency.  Suppose that the EMH does not hold, and that observed market prices include fair value plus or minus a random error.  In this scheme, a market cap weighted portfolio will tend to overweight the stocks that are priced too high (have a positive error term) and underweight the stocks that are priced too low (have a negative error term).  An equal weighted portfolio would not display this bias.  On the assumption that pricing errors are not persistent, then it would seem that “low” priced stocks would tend to outperform “high” priced stocks, so the EW portfolio might well outperform.  According to economist and portfolio manager Robert Arnott, proprietor of Research Associates, a family of fundamentally weighted portfolios, this prediction is borne out in the historical data.

One downside to equal weighting, or other fundamental weighting, is the need for rebalancing.  Typically, fundamentally weighted funds are re-balanced at least quarterly.  This may entail substantial transactions costs, including commissions and bid/ask spreads.  Naturally, if you create a fundamentally weighted portfolio and subsequently do not re-balance, the portfolio will gradually move away from the initial weighting scheme.  In particular, the weights of strongly performing companies will grow and the weights of weakly performing companies will shrink.  That may be a feature, not a bug.  After all, the same phenomenon occurs with market cap weighted portfolios.

The real question, it seems to me, is the extent of transaction costs.  It might seem that in today’s world of heavily discounted commissions transaction costs are minor.  If this is your view, consider the following story.

Renaissance Technologies

Renaissance Technologies is the top performing hedge fund in the world.  Founded by mathematician James Simon, the fund has compiled over the past thirty years a 39% annual compounded return (after fees).  The main fund, Medallion, has been closed to outside investors for years.  The fund is maintained at $10 billion by an annual disbursement of all gains to investors (nearly all of whom are Renaissance employees).  The staff is comprised of world class mathematicians, statisticians and computer scientists.  The strategy is purely quantitative.  According to economist George Gilder, Renaissance is the global leader in applying Markov Chains, the key analytical tool underlying a variety of famous applications including Google’s search algorithm, speech recognition, machine learning and AI (artificial intelligence).  A Markov Chain is a mathematical model that describes how a random process evolves over time.  At each point in time, the process may take on a number of different values, or “states.”  The key feature of the Markov Chain is that the probability of moving from one state to another is dependent only on the current state, the prior history is irrelevant.  To implement a Markov Chain, one must estimate something called the “transition matrix” which is a collection of the probabilities of moving from each state to every other state.  Given a set of estimated (and constantly updated) transition probabilities, the chain can be used to forecast future evolution of the process.  Since the number of variables and states may be quite large, the computational facility required to continuously roll out forecasts and test for forecast accuracy is immense.  This gives a large advantage to entities that deploy huge computational capabilities, maintain massive data bases, and employ the smartest STEM people on the planet, as does Renaissance.

The Renaissance strategy involves a large amount of very short-term trading.  If you tend to trade a lot, you might well be on the other side of the Renaissance strategy.  That is not a good place to be.  In general, for most investors it is a good idea to minimize the number of transactions.

Deploying an Equal Weight Portfolio

Let’s suppose we want to avoid establishing a market cap weighted portfolio.  Is there a way to obtain the benefits of fundamental weighting without extensive trading?  Sure, deploy the strategy at time of purchase and then forget about it.  For example, establish your portfolio by purchasing N stocks, spending 1/N dollars per stock.  If you believe you have some skill in stock selection, then N should be small, say less than ten.  If you do not believe you have skill, then N should be large, say more than fifty.  Once the portfolio is up and running, and assuming the portfolio is generating cash (cash inflows exceeding cash outflows), make additional purchases on market setbacks.  If you buy individual stocks you will pay no management fees and if you don’t sell you’ll incur no additional transaction costs after the initial purchases.

Is there any evidence that this would be a good strategy?  Consider the “coffee can” portfolio story told by former Capital Guardian CEO and equity money manager Robert Kirby.  Kirby advised a wealthy woman whose husband managed his own portfolio.  After both husband and wife died, Kirby was named trustee for each estate.  Once he had the opportunity to review the husband’s portfolio, Kirby was annoyed to find that the husband had “free-ridden” on Kirby’s advice to the wife – every time Kirby recommended to the wife a stock to buy, the husband bought it for his portfolio.  However, the husband ignored every Kirby sell recommendation.  After being annoyed, Kirby was chagrined to find that the husband’s portfolio had far outperformed the wife’s.  He concluded that it is easier to make smart buy decisions than smart sell decisions.  Kirby named the husband’s strategy the “coffee can” (aka “buy and forget”) portfolio, and suggested that this may be a better way to manage portfolios but would not be economically feasible for a company like Capital Guardian to offer such a product to customers.

The investment management company with which I am most familiar is SAM (Speakes Asset Management).  SAM deploys a strategy we call the Equal Weight Large Cap Value Coffee Can (EWLCVCC).  The initial portfolio for each SAM client (so far there is only one) consists of 1% of portfolio value invested in each of 100 more or less randomly selected individual stocks.  A few years ago, the commission cost of establishing the initial portfolio would have been $495; today it is zero (except for the risk of being on the other side of a trade with Renaissance Technologies).  Subsequent changes to the portfolio consist of investing in one new security (again, randomly chosen) each time the following occurs:  a) cash accumulates to at least 1% of portfolio value and b) the market has declined at least 10% relative to the prior market high or prior purchase point.  This is the “rebalancing strategy” for falling markets.  What about the rebalancing strategy for rising markets?  SAM has a plan for this. The plan is to cut in half the position in any of the 100+ individual stocks should that position grow to exceed 10% of the entire portfolio.  Should this occur, SAM will attempt to offset the taxable capital gain by taking losses on underwater positions.

Is the SAM strategy preferable to a broad-based market cap weighted index fund?  Maybe yes, maybe no.  It does offer less diversification, but on the other hand it entails lower transaction costs, is more tax efficient, and is not much more difficult to implement.

The post Indexing appeared first on Center for Economic Research and Forecasting.

Phil’s son Ken started his investment management company, Fisher Investments, in 1979.  Ken began by following in his father’s footsteps.  He managed a concentrated portfolio of individual stocks and wrote a widely read book on stock valuation, Superstocks, in which he proposed using the price to sales ratio (PSR, measured as market capitalization divided by annual revenue) as a key analytical tool.

Fast forward forty years and we find Fisher Investments to be one of the top investment management firms in the industry.  Assets under management today top $100 billion.  While it might be feasible to run a concentrated portfolio of $100 billion, this would necessitate focusing only on very large capitalization stocks.  After all, if the average holding is $20 billion, and you want to keep your ownership position in any individual company below 10%, your entire universe of potential stocks is the seventy-five stocks with market cap greater than $200 billion.

Ken has deviated significantly from a concentrated portfolio.  According to an SEC filing, in 2018 the total number of stocks held by Fisher Investment accounts was 922!  This is almost one-third of all the stocks in the Russell 3000, one of the broadest indexes of the U.S. equity market.  Given this breadth of ownership, it is likely that Fisher Investment portfolio returns are very close to market averages.  Assuming the Ken has extraordinary ability to identify stocks that are likely to do well, is he diluting that skill by running such a giant portfolio?

I think the answer surely is yes.  Why would he do this?  From the point of view of maximizing his own personal wealth, this does not seem like the best strategy.

Suppose the overall market returns 10% a year on average.  Suppose that a concentrated portfolio run by Ken would earn double that, 20% a year on average.  Suppose further that Ken feels obligated to invest his own portfolio (currently about $2 billion) exactly as he manages client accounts.  In terms of wealth accumulation, would Ken be better off earning 20% on his own portfolio and foregoing outside accounts, or earning the fees from running $100 billion while earning just 10% on his (and his clients’) portfolios?  Due to the magic of compounding, the answer surely is that Ken would eventually be far richer by foregoing outside clients and focusing on his own, concentrated, portfolio.

In recent interviews, Ken has revealed an outline of his philosophy.  He has characterized Fisher Investments as a “taxable non-profit” that is seeking to provide investment management services to the broadest client base.  By “taxable non-profit” Fisher appears to mean that he plows back all earnings into the company, hiring more advisors and marketing people, and paying them more.  Aggressive advertising and reasonable realized returns have produced steady growth in the total number of clients and total assets under management (AUM).

Ken does not believe that his company has become too big.  In fact, in one interview, Ken explained that his “market share” of the investable universe is very small, only about 0.08% (suggesting the relevant universe is $125 trillion).  This provides him lots of room to grow.   He is a great believer in the contribution of the role played by saving and investing in the capital market in financing new ventures and promoting innovation and economic growth.  He seems to feel that his mission is to assist in the magic of the “capital market pricing mechanism” by expanding his own AUM and maintaining a substantial allocation in equities.  Ken even feels bad about making charitable contributions because it entails extracting funds from the capital market process.

It has always seemed to me that the natural course for a successful portfolio manager with the ability to generate extraordinary returns would be to eventually stop taking outside money and focus on investing his/her own portfolio along with portfolios of close friends and family members.  Ken Fisher is a major counter-example.  Even as his wealth has skyrocketed, Ken continues to invest heavily in expanding his clientele and asset base.  While Ken may well be able generate a higher average rate of return on a smaller asset base (like Warren Buffett, who has stated that he could 50% a year today if he was only managing $1 million), it appears he believes his economic contribution is larger with greater AUM.

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John C. (Jack) Bogle graduated from Princeton University in 1951 and founded The Vanguard Group, Inc. in 1974.  In 1975, Vanguard introduced the first so-called “Index Fund” based on the Standard and Poor 500 (S&P500) stock index.  The S&P500 is a market capitalization weighted average of 500 of the largest stocks that trade on the New York Stock Exchange or NASDAQ.  Since the total market capitalization of these 500 stocks represents more than 95 percent of the entire market value of stocks traded on American exchanges, the index return is a good proxy for the overall “market” return.  The purpose of the fund is to come as close as possible to emulating the return on the index.  This is accomplished by purchasing and passively holding a portfolio of S&P500 stocks.  Since there is no effort made to time the market or to pick winners and losers, there is no need to hire expensive economists or security analysts.  The strategy can be deployed by a single manager equipped with a smart computer.  Thus, the expenses of running the index fund are quite small.  In fact, Vanguard’s annual fee today for running the fund is six basis points (that is, .06 percent) of fund assets.  This compares to approximately 150 basis points for the average actively managed stock funds.

The rationale for creating the index fund was a growing suspicion or awareness that actively managed equity funds produce returns before fees that were no greater on average than market returns.  Naturally, in this case the return after fees (the net return to the investor) would lag behind the market return (by, roughly, the amount of the fee).  Thus, Bogle identified an opportunity to create a product that should be very appealing to the typical investor – getting market returns at very low expense.   Surely, this was an important financial innovation.

It is interesting that Warren Buffett views Bogle as favorably as he does.  For years, Buffett made fun of passive investing and the financial theories, notably Modern Portfolio Theory and the Efficient Market Hypothesis, that lie behind it.  Representative examples:  “Diversification means you don’t know what you are doing” and “I want to thank the Business Schools of America for teaching generations of MBA students to not compete with me.”

Yet, Buffett has also directed that any money left in his estate after giant gifts to the Bill and Melinda Gates Foundation is be invested in Vanguard index funds!  How can we reconcile these views?  Maybe the answer is that Buffett understands that the portfolio management business is extremely competitive and that it is very difficult to beat the overall market return.  However, thanks to John Bogle, it is quite easy to match market returns.  Thus, most people, including Buffett descendants, would be better off a passive strategy.

In his Shareholder Letters over the years, Buffett has explained in some detail the key elements in his own investment approach and the lessons he learned from his primary mentors, Ben Graham and Phil Fisher.  Ben Graham wrote the definitive text on analyzing bond and equities (named, appropriately, Security Analysis) and a more readable treatise The Intelligent Investor aimed at the serious layman.  In one sentence, the essence of the Graham approach is to estimate a range of “intrinsic value” for an individual issue and then wait for the market (the mercurial “Mr. Market”) to provide a market price sufficiently below the intrinsic value that the investor has a suitable “margin of safety.”  The defensive investor should aim to compile a diversified portfolio of thirty or so companies matching the criterion, and the overall allocation to equities versus safe investments should be no more than 75%.

Phil Fisher wrote the classic text on growth stock investment, Common Stocks and Uncommon Profits.  He proposed that the active investor run a very focused portfolio, no more than five stocks, and that each candidate for purchase must satisfy detailed scrutiny of size of market, quality of management, extent of research and product development skills, marketing strategy and salesmanship, ultra-competitive cost structure, and so on.  Most of the information for this assessment should come from detailed conversations with suppliers, consumers, competitors, and even management itself (Fisher called this process “scuttlebutt”).

Buffet took from Graham the ideas of estimating intrinsic value, letting the market come to him, and seeking a substantial margin of safety.  From Fisher Buffett absorbed the value of building and holding a concentrated portfolio of high quality companies.

Both Graham and Fisher managed investment partnerships and lectured on investments (Graham at Columbia and Fisher at Stanford).

Are there lessons for the ordinary investor from Graham, Fisher or Buffett?  Can you be a successful stock-picker?  You can certainly build a diversified portfolio of individual stocks that has zero ongoing management fee.  You can use a number of free, or nearly free, services that allow you to screen for stocks that have features suggested by the masters:  threshold profitability, decent value, steady growth, conservative balance sheet.  Are you likely to come up with a portfolio that beats the overall market?  No, but so long as you own at least thirty stocks from a number of industries, you are unlikely to deviate widely from market returns.  And, you will have saved the annual management fee.

John Bogle may even have approved.  Apparently, for fun, he liked to do a little stock-picking himself.

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Finance professors have had a hard time explaining the BRKA performance.  Under the Efficient Market Hypothesis (EMH), it is impossible to outperform the overall market over an extended period of time.  This is so because all available information is rapidly captured in stock prices.  This means that companies with excellent prospects are priced up so that a new investor can only expect a market return.  Similarly, downtrodden companies are priced down with the same result.  Unless an investor has non-public information, sustained out-performance is not possible.

So, how to explain fifty-plus years of out-performance?  For many years, the standard explanation was luck.  Suppose there were one million monkeys repeatedly flipping a coin.  By the laws of statistics, it is likely that at least one monkey would get 20 heads in a row.  Warren is that monkey.  Unfortunately for the argument, it was first made about 30 years ago and yet the monkey has continued to come up with heads (beating the overall market) year after year.

Recently, a new explanation has been proposed.  Through massive data mining, finance professors have found that Warren’s stocks had greater expected return than the overall market.  What?  Does that mean the academics now agree that Warren is a genius?  No.  The academics have found (through data mining) that certain classes of stocks have greater expected rates of return (and greater risk as well).  These classes include so-called “value” stocks and “quality” stocks.  Value stocks are stocks with high ratios of earnings, cash flow, dividends or book value to price.  Quality stocks have greater profitability than the average company, steadier growth and more conservative balance sheets.

All this time, Warren has been buying high quality stocks at low prices.  Combining this clever factor strategy with modest leverage (through his insurance companies, Warren is able to generate cash for investing at very low financing cost), finance professors have now been able to explain 50 years of 21% growth.  See, it was as easy as that.

Actually, I’m being a little facetious.  The academics didn’t begin with Warren’s portfolio.  Instead, the research design was, first, search for factors that predict historical returns and second, test to see if the predictions hold outside the original sample period.  It took decades of research to identify a set of factors that appear to be predictive (value, quality, etc.).  The recent step has been to comb through the BRKA portfolio and realize that Warren apparently independently discovered these factors several decades ago.

The academics acknowledge that it was clever of Warren to have identified and taken advantage of these factor opportunities long before they were discovered by the professors.  But they are excited that they have been able to show that BRKA’s performance does not violate the EMH.  Not surprisingly, there have been quite a few investment management companies started by finance MBAs and PhDs that attempt to achieve out-sized returns by utilizing factor investing.  Perhaps the most notable of these companies are Dimensional Funds Advisors (DFA) and AQR Capital Management (AQR), both founded by finance graduates of the University of Chicago.  These companies build highly diversified portfolios that capture one or more of the predictive factors.

Since there are now competing portfolios that mimic the BRKA portfolio, is there any reason to prefer BRKA?  One positive is that Warren is still in charge; he may still be capable of identifying investment themes well before empirical research catches on.  On the flip side, he is 88 years old today and may not have another fifty-year run.  Another positive is fees.  For a retail investor to enjoy the benefits of DFA funds, she must pay the DFA fees plus the fees of a personal financial advisor (DFA only distributes its funds through financial advisors).  The total of these fees is probably around 150 basis points or 1.5% of assets, per year.  Meanwhile, owning shares in BRKA means owning shares in a diversified portfolio and paying zero annual fees.  Yes, you must pay a commission to purchase your shares, but this represents a very small fraction of one basis point, and is paid only once.  This is an enormous advantage in favor of BRKA.  Finally, don’t forget about the low-cost leverage provided by BRKA’s insurance businesses.

All in all, it looks to me like BRKA is likely to continue to be a winner compared to the academics’ portfolios.  EMH supporters would say that these benefits are built into the price of the stock.  Perhaps they are correct.  The total market capitalization of BRKA is $500 billion and the book value of equity at the most recent reporting date was $375 billion.  You might conclude that BRKA is overvalued by 33%, but you’d probably be wrong because the equity number reflects the purchase price of wholly owned acquisitions, not the current market value.  While it is difficult to estimate the size of this difference, it does not appear that BRKA is significantly over-valued.

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Does this mean that buy and hold strategies are doomed to failure?  Not necessarily.  Rapidly growing companies typically pay no dividends, but as they mature and the rate of growth slows, they tend to begin paying out cash to shareholders in the form of dividends and/or stock buybacks.  Even if the value of the stock eventually reaches zero, the rate of return for the poor fellow holding on the bitter end may not be disastrous.    For example, suppose Amazon is able to continue growing operating cash flows at a rapid rate (25% per year) for the next 30 years, at which point the company fails and the stock price goes to zero.  Further, suppose that 10 years from now Amazon begins paying out half of cash flow each year in dividends and continues doing so for the subsequent 20 years.  The internal rate of return to an investor buying the stock today at $1,600 per share would be nearly 15%.  That means that the investor would enjoy a doubling in value roughly every five years.

Perhaps this is an extreme example.  Rapidly growing companies generally do not pay out dividends or buy back stock because internal investment offer higher returns.  It is only after internal opportunities begin to wane, and growth begins to slow down, that companies typically begin paying out cash.  Thus, the assumption that Amazon begins paying out 50% of cash flow while growth remains robust is a bit of a stretch.  Still, the point is that returns can be substantial even for companies that eventually fail.

Generally, failure rates are greater for young companies with potentially greater growth rates.  Thus, if you seek to participate in the monster potential gains of young startups, you’ll have to contend with a very high failure rate.  If you go for large mature companies, the failure rate is smaller but likewise is potential growth.  What is an investor to do?

Some insight into these issues is provided by Hendrik Bessembinder, a professor of finance at Arizona State University.  The professor has compiled the monthly returns for every stock that has traded on US exchanges since 1926.  He has used this database to calculate lifetime returns for each stock.  His overall conclusion is while that most individual stocks do not generate returns exceeding Treasury bills, there is sufficient positive skew in the return distribution such that broadly diversified portfolios do generate excess return (that is, return over Treasury bills).  The lottery-like feature (high probability of failure of individual stocks) is much greater for small stocks – specifically, the probability that a small stock (first decile of market capitalization) will outperform T-Bills is less than half the probability that a large stock (top decile of market capitalization) will do so.

It appears that a key lesson is this:  diversify!  While important for any sector, the importance of extensive diversification is much greater for small growth companies than for large dividend paying companies (unless, of course, you like to play the lottery).  One way to achieve extreme diversification is to invest in one or more broad passively managed index funds.

While index funds provide an excellent way to obtain market returns at low cost, I prefer what has been termed the “coffee can” approach.  The coffee can idea is to purchase a diversified portfolio of individual stocks (not funds) and then hold on forever.  What are the advantages of the coffee can?  No fees, possible tax benefits (the ability to sell individual stocks to secure tax losses as needed), and the possibility of giant gains on one or more of the individual securities (such gains might never be realized in a fund due to rebalancing).  But the coffee can approach seems particularly vulnerable to the phenomenon noted by Bezos.  If you reinvest the cash flows from this portfolio into the same stocks, and they all eventually fail, then you will have secured the ignominious result of minus 100% return.  To avoid this outcome, it may be necessary to use cash flows from the original coffee can portfolio to build additional such portfolios.

To examine the viability of coffee can portfolios, I set up a simple experiment wherein I simulate portfolio returns for two sectors:  large, dividend paying companies and small growth companies.   For each sector, I assume a dividend payout (that is currently being paid for large companies and is deferred for small companies), a growth rate of cash flow (modest for large companies and quite high for small companies) and an annual probability of failure (low for large companies and high for small companies).  I calibrate the assumptions so as to be consistent with the historical individual stock returns reported by Bessembinder.  Given the basic assumptions I simulate lifetime returns for portfolios of 1, 10 and 100 stocks (the simulation proceeds by randomly drawing, for each company in each year, from a binomial distribution representing probability of default; once a company “defaults” all cash flows cease).

As expected, the returns on 1-stock portfolios are hugely variable, for each sector.  The same is true for 10-stock portfolios.  However, for the large company sector, 100-stock portfolios exhibit small variation in lifetime returns.  Thus, a 100-stock large cap coffee can be viable.  This is not the case for the small company sector.  Even portfolios consisting of 100 stocks show lottery-like returns.  This suggests that even in up markets, your 100-stock portfolio is likely to exhibit significant underperformance.  If small caps or startups is your sector of choice, you should seek the greatest diversification you can find.  One implication is that so-called “Angel Investors” – that is, affluent people that support a small number of startups – are likely to experience extreme variation in results.  To me, this is yet another reason for all of us to applaud the rich people who are willing to take on the huge risk of investing in new companies.  A great example of this is Bezos himself.

The post Amazon Will Fail appeared first on Center for Economic Research and Forecasting.

Economist Lawrence Ball challenges the Fed’s position.  In his book The Fed and Lehman Brothers, Ball argues that Lehman did have sufficient collateral to support Federal Reserve lending in an amount that would have prevented bankruptcy and that, by choosing to let Lehman fail, the Fed exacerbated the financial crisis and economic downturn that had been going on for the prior year or so.

According to Section 13(3) of the Federal Reserve code, the Fed can, “in unusual and exigent circumstances” lend freely against good collateral at a penalty rate.  Unlike the situations of Bear Stearns a few months earlier, or insurer AIG a few days later, in the Lehman case the Fed determined that there was no legal basis to provide financing.  Basically, the Fed’s position was that Lehman was insolvent.  Insolvency may be defined in different ways, but the basic idea is that cash flow from assets is inadequate to meet debt obligations as they become due.  A simple criterion for insolvency is that the market value of assets is less than the book value of debt, in symbols:

Insolvency Criterion:       MV(Assets)<BV(Debt)

Using Ball’s numbers, Lehman was very close to being insolvent on this criterion.  The stated value of assets in the most recent accounting report (August 31, 2008) was $600 billion.  Total liabilities were $572 billion, leaving equity of $28 billion.  However, it was widely believed that the true market value of assets was less than $600 billion.  Ball reports a range of estimates made by Lehman lenders and potential buyers, with the median estimate of fair value of $568 billion.  This would put the value of equity at negative $4 billion, and the company would be insolvent.  However, Ball argues that these valuations were based on stressed market conditions at the time and that “fundamental” values were surely higher.  Ball also challenges the validity of Criterion 1.  Ball notes that $115 billion of Lehman liabilities had maturities greater than one year and therefore were not subject to near term runoff.  He proposes a second rule for adequacy of collateral to support short-term finance.  This rule is that the market value of assets must exceed the book value of short-term debt:

Collateral Adequacy Rule:             MV(Assets) > BV(Total Debt) – BV(Long-term Debt)

On this basis Lehman had “excess” collateral of $111 billion ($568-($572-$115)).  Ball believes that the Fed and Treasury dropped the ball (pardon the pun) in the Lehman case, perhaps to set an example, and by doing so sharply worsened the crisis and associated economic downturn.  The Fed’s primary role is to act as lender of last resort in a crisis environment and this they failed to do.

Had the Fed stepped in to stop the bleeding, Ball believes, the subsequent economic downturn would not have been as severe.  He thinks it is very important to set the record straight, that the Fed failed to perform its critical mission of lender of last resort.

I think it is uncertain whether Lehman was insolvent or not in the summer of 2008, but surely they were pretty close to it.  The reason for that is that the company followed an extremely risky strategy of holding a highly leveraged portfolio including long-term and/or illiquid securities funded by volatile wholesale short-term funding.  Although it may be true that it took a fairly serious negative event to trigger it (a “ten-year storm”), Lehman was a ticking time bomb.

We would hope that the lesson people take from this and other 2008 debacles is that the basic business plan was flawed.  Lehman was highly exposed to a modern day “run” – a refusal by lenders to roll over short-term collateralized loans. That does not appear to be Ball’s primary takeaway.  His main point is that the Fed should act in extreme circumstances to provide liquidity and enable gradual wind-downs of troubled financial companies (provided they are big enough to warrant concern).

Ball’s chief worry is that events subsequent to the crisis have reduced the Fed’s ability to step in as lender of last resort in a crisis.  In particular, the Dodd Frank Act requires the Treasury to agree with the Fed to provide assistance and eliminates the authority to structure tailored deals for specific situations (like those extended to Bear Stearns, Fannie Mae, Freddie Mac, AIG, etc.).

How to stop a run?

Certainly one way to stop a run is for the Fed to back stop everyone’s liabilities.  Mervyn King (former Governor of the Bank of England) proposes a variant of the current model wherein the Central Bank is obligated to lend against good collateral (be the “pawnbroker for all seasons”).  In his proposal, the Central Bank designates the percentage of funding that it will provide against each class of a bank’s pledgable assets.  By adding up the percentage of funding multiplied by asset value across all assets, you get the maximum amount of Central Bank lending available to the bank (this is the Effective Liquid Assets or ELA).  The bank is then responsible for ensuring that the aggregate of “runnable” liabilities (deposits plus short-term borrowings) is smaller than the ELA.  This would generally require greater reliance on long-term financing than is the case today.  In this regime, a run still could occur in which private lenders back away, but this would not lead to a crisis since the Central Bank would step in to provide liquidity.

Economist John Cochran proposes to eliminate the risk of runs in a very different way.  He proposes a “narrow bank” concept in which any institution that accepts insured deposits is constrained to invest only in very low risk assets, like Treasury securities or bank reserves.  The funding for risky assets would be entirely equity or long-term debt, not insured deposits or short-term borrowings.  Cochran’s solution would surely prevent runs.  Some argue that the volume of financial intermediation might be subdued with negative consequences for economic growth.  Perhaps, but the flip side is that the likelihood of massive financial market disruption and its sizable negative consequences for growth would also be sharply reduced.

Whatever the merits, there is little evidence of support for the Cochran proposal.  If we continue down the current path, perhaps the King proposal deserves consideration.  In order to establish the ELA for a given bank, the Fed would estimate values for all the asset classes that could serve as collateral for a Fed loan.  How would it set these values?  Generally, lenders are willing to lend a certain percentage of the current market value of an asset.  The more liquid the asset, the greater is the lending percentage (one minus the lending percentage is called the “haircut”).  For cash, the lending percentage is 100% (and the haircut is 0%).  For illiquid assets like commercial real estate, the haircut might be 50% or more.  In a financial crisis, asset prices tend to decline.  If the ELA amounts are established by applying pre-specified haircuts against current asset values, then the ELA will be declining in a crisis and there would be no assurance that Fed lending would stop a run.  On the other hand, if the ELA is based on pre-specified haircuts against book asset values, then there is no assurance that the Fed loans will be properly secured.

I think financial regulators should aim to be counter-cyclical, not pro-cyclical.  However, much of the current regulatory structure is pro-cyclical.  One example is deposit insurance premiums that are often waived in good times (because the insurance fund is flush) and increased in bad times (when banks are suffering losses).  Other examples include market value accounting and loan loss provision rules.  In order to ensure that King’s proposal is not pro-cyclical, the ELA should be based on book asset values.  In order to ensure that Fed loans are properly secured, the haircuts should reflect stress or “worst case” economic scenarios.  I suspect that rigorous application of these principles, had they been in place ten years ago, would have significantly constrained or curtailed the Lehman business and portfolio strategy.

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Major diseases have been nearly or completely wiped out.  Access to clean water, indoor plumbing, refrigeration, heating and air conditioning is commonplace.  Violence is down, education is up.  The median income guy in the developed world has enjoyed roughly a 20-fold increase in standard of living.

What?  The median guy is up 20x (that would be 1900%!).  How can that claim (fact) be reconciled with the oft-told assertions that median household wages have flat-lined over the past several decades, middle class jobs are being eliminated or sent overseas, the next generation will be worse off than the current generation, and economic insecurity is prevalent?

It may be useful to get some more perspective.  In another recent book², Hans Rosling (famous for his TED talks and beautiful graphics displays that may be found at www.gapminder.org/tools) laments the lack of understanding of important global trends, even among the economic and educational elite.  Rosling, a former doctor and health professor, has for decades attempted to assess general knowledge of global economic and health trends by posing to audiences simple multiple choice questions about global trends in wealth, poverty, health, violence, the environment, education, literacy, vaccination, and climate change.  Compiling the percentage of correct answers, he has found the responses not only incorrect, but much worse than would be expected by random chance (as he puts it, the respondees are ‘dumber than a chimpanzee’).  The direction of error is, invariably, people are too pessimistic.  Consider one question reported in his book:  How did the number of deaths per year from natural disasters change over the past 100 years?  A.  More than doubled, B.  Remained about the same, C. Decreased to less than half.  Most people answered A while the correct answer is C.

So, one major reason for the “millennial malaise” suggested above is simply pessimistic bias.

Rosling shows that the primary driver of how people live is their income, expressed in dollars per day.  He distinguishes four levels of income:

Level I                   Daily income = $2 per person

Level II                  Daily income = $8 per person

Level III                 Daily income = $32 per person

Level IV                Daily income > $64 per person

People at Level I are extremely poor.  People at Level IV are affluent.  People at Levels II and III are, obviously, in between.  As you can imagine, living standards across these four groups varies immensely (see examples at www.dollarstreet.org).  As recently as 1960, 50% of the global population was at Level I.  Today, this number has declined to less than one billion people, or about 10% of the global population.  Another billion live in the rich world (Level IV), and rest (a large majority) lie in the middle.  Rosling predicts that by the time the human population reaches its peak (at 10 billion) around 2100, the distribution will have again changed immensely, as is summarized here:

2017                       2100

Level I                   1 billion                Zero billion

Level II                  3 billion                2 billion

Level III                 2 billion                4 billion

Level IV                1 billion                4 billion

Total                      7 billion                10 billion

The interesting thing about the millennial malaise argument is that the majority of people in the U.S. today lie in Level IV, and nearly everyone else is in Level III.  By global standards, we are already rich!  The problem of material abundance has largely been solved.  And, it appears to be getting better.

This last statement is somewhat controversial.  Economists Thomas Piketty and Emmanual Saez (PS) claim that real household median income has increased by only 3% in the past three decades.  This amounts to just 0.1% per year!  However, economist Richard Burkhauser (RB) and colleagues argue³ that the PS analysis overlooks or ignores several critical issues including changes in the number of people in the average household (this has been declining for several decades) and the effects of progressive taxes and transfer payments (the PS analysis looks at pre-tax income before transfer payments).  After making suitable adjustments, RB finds that median real income has actually increased by 36% over the past thirty years.  This is close to the long-term rate of increase in per capita standard of living, and therefore does not support the notion of a declining middle class.  This conclusion is supported by studies that examine consumption patterns.  The consumption “basket” of the poverty line family in 2010 appears to be greater that the consumption basket of the median family in 1970.

Some go so far as to suggest that the median guy in the U.S. today (maybe even the poverty level guy) is materially better off than the nobility of one or two centuries ago.  Certainly, the median guy (poverty level guy) today enjoys many products that didn’t exist or were very expensive in the past.

What about the future?  Is the next generation going to be worse off?  Of course, it is impossible to say for sure, but certainly there is little evidence of a trend in that direction.

But there is one area that is concerning.  Data suggest that about half of households today do not have sufficient cash on hand (or easily available) to handle even a modest emergency.  Thus, economic insecurity is widespread.  This may be the primary reason for the malaise (to steal a term that, apparently, Jimmy Carter never used) that appears to have settled upon many economic commentators.

There are two fairly obvious solutions – one is fragile (likely to fail), the other is robust (likely to work).

The fragile solution:  expand the government safety net.  This could include programs such as jobs for everyone, a living wage for everyone, free college for everyone.  The problem with this solution is unintended consequences.  Providing jobs for everyone is useful only if doing these jobs results in development of useful skills.  This is unlikely.  A living wage for everyone sounds great, until you realize that it might induce low-skilled workers to not try and work at all, with the result of never developing useful skills.  Finally, free college for everyone is not meaningful unless the curriculum is reduced sufficiently that everyone can reasonably hope to get through.  Once that is done, the value of having achieved a college degree will have declined.

The robust solution:  save more.  After all, if you are 20 times richer than your great-great-great-great- great-great grandparents, then saving 10-20% of your vastly higher income seems to be not that much of a stretch.  While it may be painful to do this, the result will be elimination or at least sharp reduction in the economic insecurity that is the bane of modern mankind.

¹Steven Pinker, Enlightenment Now, 2017.

²Hans Rosling, Factfulness, Flatiron Books 2018.

³Richard Burkhauser, Jeff Larimore, Kosali Simon, “A ‘Second Opinion’ on the Economic Health of the American Middle Class,” NBER, 2011.

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