Applied Capitalism - Part IV
True Wealth Management
This series began with five economic fallacies that are widely accepted in American culture and the asset management industry. It continued with the social and political ideas that foster those fallacies and originate in the academic world. And Part III discussed five “best practices” of the investment advice industry that are the natural consequence of the faulty ideas that are popular.
To summarize, “market failure” and “externalities” lead to hyper diversification as a remedy for capital market uncertainty. In addition, antitrust and climate change activism leads to conservative market forecasts to accommodate the massive government intrusion in free markets.
Inevitably, the “beat the market” mentality of GDP metrics and economic protectionism leads to money manager selection determined by their beat the market track record. And like stimulus spending and income taxes are widely accepted for their “good intentions,” risk tolerance suitability forms document the good intentions of an advisory firm’s “stay the course” recommendations.
And when the State convinces people that government is best suited to control your money through the central banks and your mind through public education, you get equilibrium as the economic ideal, equality as the social ideal, conformity as your duty to the common good, and reversion to the mean as investment strategy tool. In other words, mediocrity worship. Never mind that the mean moves toward the current price as the current price moves toward the mean.
In other words, no one is accountable to anything that is defined. This is where the conclusion of Applied Capitalism Part III meets Part IV:
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. Defining your important values, goals and aspirations is the most challenging part, the most important element, and the one that meets the most resistance.
Goal-Directed Action
Human life is the only form of life that is capable of thinking into the future and arranging its affairs to the achievement of abstract goals. In fact, this ability is existential, but it also requires mental effort. Therein lies the rub. The choice to think takes more effort than choice to avoid thinking - and for a poetic dramatization of this essay’s theme, I will turn to the lyricist of progressive rock band Rush, the late Neil Peart and their 1980 hit titled Freewill:
You can choose a ready guide in some celestial voice/If you choose not to decide, you still have made a choice/You can choose from phantom fears and kindness that can kill/I will choose a path that’s clear, I will choose free will.
Whether those phantom fears are of the supernatural or secular variety, they both lead to kindness that can kill. That is the consequence of the economic and social humanitarians who deny the virtues of money, information of prices, elegance of markets, and justice of earned profits. But for the objective investor, we disregard all of that.
The rational alternative is to apply reason to reality, control what you can control, define the goals that give your life meaning, assign a reasonable time and monetary commitment when necessary, and balance all of that against uncertain markets.
First, fire the scouting department. Parts I - III summarized the work of the macroeconomists, market strategists, and research analysts who have been trained by the State university system. They are beholden to the policy prescriptions of professors and punditry, but objective investors are focused on microeconomics at their personal level.
Second, take a “values inventory.” I realize the term “values” is overused, but like any important concept, it gains traction when it is clearly defined, and there is no one better to do that than philosopher and novelist Ayn Rand:
“Value” is that which one acts to gain and keep, “virtue” is the action by which one gains and keeps it. “Value” presupposes an answer to the question: of value to whom and for what? “Value” presupposes a standard, a purpose and the necessity of action in the face of an alternative. Where there are no alternatives, no values are possible.
A good place to start your “values inventory” is to ask yourself: who or what do I do now that delivers satisfaction, happiness, or exhilaration? And then ask: why or how this make me feel good? Then think about major categories: Family and Relationships, Business and Career, Health and Recreation, and Wealth Building. What is available or out there and might deliver the emotions of satisfaction, happiness, or exhilaration?
Of course, these are abstract concepts - and like fine art is the concrete form of the artist’s value judgments, your happiness depends on your ability to conceptualize the material goods and experiences that give your life its meaning and purpose.
Wealth vs. Return Management
To help with that, the values inventory may include house and home, children or grandchildren, travel and vacation, recreation and sport, the arts and reading, civic and professional groups, legacy and charity, or health and retirement. However, this is a generic list and you may have more specific and important aspirations. The key is to treat all of them as important before deciding what is realistic.
When your values inventory is reasonably complete, the next step is to give each goal a time frame - and if it requires money, assign a dollar amount to the values and their timing. But that is basic financial planning. The Moneyball Method adds an essential feature to help you balance competing goals with time, money and the uncertainty of the future.
What is the Ideal level of spending for this objective? What is the minimum Acceptable? What are the Ideal and Acceptable time frames for getting there? The Site Map in Chapter Eight, page 182 of The Moneyball Method is the starting point for taking your inventory of values - and the Timing of Cash Flow decisions from page 191 are the transition to True Wealth Management. The introduction to Applied Capitalism - Part III explains it 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.
Third, with a healthy respect for the virtues behind money and the elegance of free markets, objective investors will explicitly define their cash flow expectations, assign Ideal and Acceptable levels, and do it with a reasonable number of classifications for income, expenses, major purchases, and significant events. Naturally, it makes sense to connect goals and aspirations with those that produced the money you have earned.
Of course, these are abstract concepts - and The Moneyball Method reverses everything. Instead of historical rates of return and forward-looking market predictions, objective investors use long-term data to anticipate the behavior of markets and take ownership of their futures with their defined cash flow strategy.
Reliable Data
This includes the relevant variables you know and control: financial assets by tax category from page 188, non-financial assets, saving and investing habits, baseline living expenses, intermediate and long-term spending goals, pension and trust income, liquidity events, gifting and legacy plans, taxes and management fees, etc. This information is then modeled against the uncertainty of capital market performance for any investment strategy you care to test.
Fourth, simulate the potential outcomes of different asset allocation strategies. With your values inventory given clarity and your Ideal cash flow objectives assigned dollars and deadlines, the Ideal objectives are likely underfunded. As it should be. If not, new consideration is needed for what those can be. After all, the overall objective is to live the one life you have with confidence.
With the power of today’s financial technology (fintech), nearly all registered advisors can do this, but nearly none of them know how to do it for reliable outcomes. What if the majority of advisors and investors believe in some combination of economic fallacies, social responsibility, market projections, fund track records, and rate of return benchmarks? If so, what is the likelihood their capital market inputs are conservative projections? And what is the likelihood that “probability of success” will be their language for their simulation outputs?
The test results will lead to unnecessary investment risk or lifestyle sacrifice. More specifically, conservative return assumptions will cause investors to become more aggressive with their investment strategy or too conservative with their cash flow strategy because higher expected returns are needed to meet their spending goals.
And “probability of success” conclusions will necessarily include test run results that overfund the investor’s plans. Trial runs in the top decile of outcomes mean the investors was overly aggressive with their investment strategy or too conservative with their spending goals.
Fifth, only use the most reliable, long-term historical data - and the Center for Research in Securities Prices (CRSP) is the place to start. They are the best indicators for anticipating the future behavior of each asset class - and the indexes for broad market US stocks, intermediate US Treasuries, and core international stocks include nearly everything except commodities and have the longest histories.
Philosophically speaking, this is the law of identity and the law of causality. And because asset classes are man-made concepts, those assumptions are subject to change, but only when there is convincing evidence.
Of course, these are abstract concepts - and true wealth management measures success in the concrete terms of money-weighted performance driven by your explicitly defined goals and aspirations.
Integration
The Applied Capitalism series began with economic principles that are worth repeating here: Production creates wealth. Supply creates demand. Supply lowers prices. Prices are information. Markets reward efficiency. Profits attract capital. Capital finds talent. Talent obeys reality.
And for most people, the reality of investing success has two primary components: the timing of their cash flow activities and the sequence of their investment returns. The investment strategy decision is third.
Put another way, those top two components represent everything we know about and can control balanced with the uncertainty of the future. The first half is the whole of life approach to your values, time, money and capitalism. The second half is to control market risk exposure according to your values, time and money. The tool for that is the Facts and Values Matrix in Chapter Nine, page 220.
Using the Matrix, each of your important cash flow goals can be weighed with each of the others - and that includes market risk exposure as an objective. And with your hierarchy of values established in such a manner, the Ideal and Acceptable levels can be balanced with every relevant factor to arrive at the optimal cash flow strategy and investment strategy.
Bear in mind, cash flow supersedes investment strategy. Dollars of future wealth replace backward looking rates of return. Historical data replaces forward-looking projections. Efficient markets replace economic analysts. Risk capacity replaces risk tolerance. And not discussed yet - dynamic rebalancing replaces “stay the course.”
Please stay tuned. Part V in this series will address the practical application of extreme markets, probability analysis, risk and spending capacity, contingency plans, and dynamic rebalancing.