Applied Capitalism - Part III
Good Theory is Good Practice
In Part I of this series I discussed five economic fallacies that have become priorities in economic research reports, market analysis and forecasts, and the investment advice industry: Gross Domestic Product, Market Failure, Externalities, Stimulus Spending and Money Supply. Part II revealed the political and social ideas that support those fallacies: Protectionism, Antitrust, Climate Change, Income Tax and Government Schools.
Briefly mentioned were the rational alternatives to all of them. Those will be discussed at the end of this essay and they will be integrated with the principles of objective investing. And as promised at the end of Part II, the application of personal finance procedures will be in the context of diversification, risk tolerance, market projections, mean reversion and manager selection.
This way, the elegance and complexity of capitalism can be understood in concrete terms that mean something to you, and when you put those terms into practice, they will have a dynamic impact on your life. And that epiphany happens when true wealth management replaces the rate of return mindset.
Market Projections
One year-end ritual is for investment banks to publish their rate of return forecasts for the ensuing year and sometimes longer. These are known as forward-looking projections - and they can be rationalized with complex calculations that include global GDP forecasts, currency movements, inflation expectations, central bank action, the yield curve and volatility trends.
In other words, they have no idea what to expect, but the rate of return forecasts for equities will always be lower than the historical averages, sometimes sharply. This is convenient for managing investor expectations and looking good if their asset managers outperform their canned predictions.
However, it is not likely that the risk profile of those asset classes will be reduced accordingly, which contradicts the normal risk and reward relationships.
Another version of market projections is to use the historical data, but only for the last twenty-five years or some other arbitrary cut-off that represents the firm’s definition of “things are different now.” For software companies that do this for their random simulations of potential market behavior, the data sets are updated quarterly - as if the identity of the asset classes somehow changed in the last three months.
To that, they add regime-based systems using lower return assumptions for near-term (2 - 5 years) outcomes, higher rates of return for long term trial runs, and this complexity serves no purpose. Never mind the fact that extreme market volatility - up or down, can happen tomorrow, next week, or last for the next several months.
Although “externalities” can be anything not booked in the accounting records and climate change models can be manipulated with inputs for desired outcomes, the identifying characteristics of financial asset classes must not become infected with contrived numbers. Furthermore, broad-market indexes own the most reliable data sets, are inclusive of every subcategory, respect the price mechanism of efficient markets and are the best application of capitalism for objective investors.
Diversification
Like “capitalism,” this term has broad implications, means different things to different people, and is overused. And because this blog is meticulous about definitions, I will begin with Merriam-Webster’s second entry that applies to finance: “the act or practice of spreading investments among a variety of securities or classes of securities.”
This is where the problems begin. In this case, the dictionary definition offers no objective purpose for diversification - and that allows for any collection of securities or asset classes to be branded as “diversified.” In fact, nearly all pension funds, trust departments and balanced SMAs (separately managed accounts) will make this claim.
Certainly, there is truth in the fact that their securities have different risk profiles and correlations to each other, but for the purposes of The Moneyball Method, that is far from good enough. For an investment strategy to be properly diversified, it must have the highest, long-term expected return for the level risk being assumed. That is known as portfolio efficiency.
Just as important, the “expected return” must be determined by the most reliable objective evidence - and that is the long-term historical price data. And for a number of reasons, forward-looking projections are a really dumb idea.
Not only is it impossible to determine the efficiency of a strategy and its diversification benefits with subjective forecasts, adding more securities or asset classes does not necessarily improve diversification. But it does increase the potential assumption errors for each one’s median return, standard deviation, and correlation coefficients. All of that for the sake of more complexity.
Ultimately, markets do not fail, antitrust prosecutions against successful companies do not diversify an economy - and the only way to truly diversify an investment strategy is with low or negatively correlated asset classes that prove themselves under the pressure of large deviation events. The anticipation of extreme markets - to the upside and downside - and having a contingency plan is how applied capitalism works.
Risk Tolerance
Risk management can be interesting once it’s understood, but risk tolerance is a psychological myth when applied to your investment strategy decisions. It is subjective because it is not integrated with your net worth, values and goals, cash flow expectations, and will change depending on the recent performance of stock and bonds markets. But if maximum risk tolerance did exist, who would want it imposed on them anyway?
Regardless, risk tolerance questionnaires gained wide acceptance in the retail investment world as a seemingly objective way to decide on market risk exposure. And to their credit, they use historical range of return data to illustrate the possible effects of different allocation strategies among broad-market asset classes. At the same time, the questionnaire’s responses are possible evidence for defense counsel in the event of an arbitration claim for suitability against a brokerage firm.
More recently, they are used by robo-advisors to help do-it-yourselfers come up with their “optimal” asset allocation strategy and then choose a packaged, model portfolio. Those model portfolios are pretty good, but for objective investors, there is something missing: the well-defined objectives. But that’s not all. A worthy discussion includes aspects of risk evasion, avoidance, and risk aversion.
Or an objective discussion will include: 1) the idiosyncratic risks included in the price mechanism, 2) the probabilistic risks of sequence of return, longevity, and markets themselves, and 3) the controllable risks of underperformance, overspending, concentration, and liquidity.
Like “stimulus spending” and income taxes are imposed by economic “experts” to protect us from our collectively “unjust” economic decisions, risk tolerance is a tool of behavioral “experts” to protect us from our “irrational” reactions to market volatility. The rational alternative is the risk category that objective investors treat as a capital asset: your risk capacity expressed in dollars of future wealth.
Manager Selection
Fourth on this list is the subject that advisors and investors like to talk about first: picking the hot stock, mutual fund or ETF. And to help with that obsession, there are Morningstar ratings, heat maps, Lipper rankings, Seeking Alpha and all sorts of alpha seekers at every brokerage firm and trust department. And for all of them the goal is the same: beat the index, rank in the top peer group quintile, and pick the outperforming sectors.
Ideally, you only own the outperforming sectors, the manager who ranks near the top of that group, and somebody who sells before that style goes out of favor. Yet, as the pinnacle of the rate of return mindset, it guarantees nothing for wealth management success, and there are several reasons for that: 1) buying a fund based on track record does nothing if you didn’t own it during the hot streak, 2) the risk associated with the strategy must be discounted, 3) track record may be attributable to some years but not others, 4) percent returns are not dollar-weighted, and 5) the timing of cash flow may have a bigger impact on your success.
Ultimately, dollar-weighted performance is fundamental to true wealth management, but today’s best practices focus on methods that have nothing to with the investor living the one life they have with confidence: value, growth, active, passive, sector rotation, factor-based, target date, social responsibility, leveraged, buffered, hedge funds, income riders, funds of funds, private equity or credit.
There’s a lot of worthless complexity here, but at the same time, these can be accommodated by a skilled wealth advisor who knows how to model their capital market variables.
Whether its gross domestic product, protectionist trade policy, or superior money management, the premise is that credentialed experts are needed to make sense of their artificial complexity for us. Yet, applied capitalists disregard all of that in favor of what we can control: very high correlation, low cost fund managers for the asset classes with the most reliable data sets. Not only does that eliminate underperformance risk, it allows you to focus on the performance benchmark that matters: the dollars of future wealth that help give your life its meaning.
Mean Reversion
Proponents of efficient markets are aligned with the “random walk” hypothesis for stock price movements: future prices cannot be predicted by past price movements or trends. Conversely, those who subscribe to “mean reversion” believe that stock prices may be random in the short run but will move toward their historical averages over time. Most likely, either one is true about half the time.
Essentially, the Random Walk Hypothesis conforms to the idea that prices include all available information, the future is uncertain because of innovation and unpredictable events, and passive index investing makes the most sense. And the Mean Reversion theory tells us that price movements are predictable to some degree and active management can be more profitable depending on skill, timing and trading costs.
To the objective investor, not only are both ideas flawed, neither of them have anything to do with true wealth management. If you take the random walk to its mathematical conclusion, there is a high likelihood that you or your stock will end up very close to where you started. If you take mean reversion to its mathematical conclusion, all you have to do is change the time frame of the moving average to confirm that the current price is where you want it to be.
But in the event of stock market corrections and meltdowns, mean reversion becomes “stay the course, the market always bounces back, there is no loss unless you sell, it’s time in the market, not market timing.”
There is wisdom in some of that, but also pointless risk. Seat of the pants rules of thumb are not objective, but pretending to be proactive, rate of return advisors will recommend selling securities that underperformed, replace them with outperforming managers, and rebalance the accounts to the original asset allocation strategy. Usually, the one determined by a risk tolerance questionnaire or market projections.
You get the picture. Activity for the sake of activity could have been avoided by not owning the underperforming managers in the first place.
That is how the Federal Reserve and State schooled economists pretend to manage the money supply while investment banks and think tanks cheer them on with their artificial complexity. Back to reality, prices determine asset class identities, markets inform us about markets, risk capacity guides strategy decisions, correlation determines implementation, and applied capitalists take ownership of their futures. And they do it with objectively defined goals, cash flow strategy, forward-looking performance measurement and contingency plans.
Principled Action
That is the entrepreneurial mindset: create the vision, take calculated risks, learn from mistakes and measure success. Random walks and mean reversion may move in circles, but the proper course for human life is a forward moving line - and it begins with the Site Map that was introduced in Chapter 8 of The Moneyball Method:
In the context of the World Wide Web, a site map stores information about the pages, videos, images, files and relationships among them for that one website domain. For an investor’s goal-directed action, we need the same tool — a map of our domain. Furthermore, to become engaged with the elegant system of one’s own mind builds self confidence and a sense of self-worth.
Defining your important values, goals and aspirations is the most challenging part, the most important element, and the one that meets the most resistance. Not only is introspection difficult, but most people have conditioned themselves to believe that picking companies or industries or fund managers is a suitable replacement. After all, future cash flow needs are impossible to know and beating the market means more money for future spending goals.
Objective investing with applied capitalism is not for everyone, but if you can fog a mirror and cash flow is an important part of your livelihood and longevity, this is for you. Please continue with Part IV of Applied Capitalism to learn about efficient strategy, correlated managers, dollar-weighted performance, contingency plans and dynamic rebalancing:
The Moneyball Method is not primarily about investing, but about redefining success. It is not primarily about investing success, but about principled action. It is not primarily about achieving those goals, but about the emotional payoff from your newly perfected declaration of independence.