Modern Portfolio Management: Moving Beyond Modern Portfolio Theory
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About this ebook
Get a practical and thoroughly updated look at investment and portfolio management from an accomplished veteran of the discipline
In Modern Portfolio Management: Moving Beyond Modern Portfolio Theory, investment executive and advisor Dr. Todd E. Petzel delivers a grounded and insightful exploration of developments in finance since the advent of Modern Portfolio Theory. You’ll find the tools and concepts you need to evaluate new products and portfolios and identify practical issues in areas like operations, decision-making, and regulation.
In this book, you’ll also:
- Discover why Modern Portfolio Theory is at odds with developments in the field of Behavioral Finance
- Examine the never-ending argument between passive and active management and learn to set long-term goals and objectives
- Find investor perspectives on perennial issues like corporate governance, manager turnover, fraud risks, and ESG investing
Perfect for institutional and individual investors, investment committee members, and fiduciaries responsible for portfolio construction and oversight, Modern Portfolio Management is also a must-read for fund and portfolio managers who seek to better understand their investors.
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Modern Portfolio Management - Todd E. Petzel
Modern Portfolio Management
Moving Beyond Modern Portfolio Theory
TODD E. PETZEL
Logo: WileyCopyright © 2022 by Todd E. Petzel. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.
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ISBN 9781119818205 (ePDF)
ISBN 9781119818199 (ePub)
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To Kate, Sarah, Rebecca, and all the grandchildren who give support and joy in countless ways.
Preface
This book arose from a frustration over how the broad investment industry and specific funds and products are sold to the public. Having mostly been on the receiving end of these sales pitches for over 25 years, too often they are wrapped in a scientific mystique. People who are collectively responsible for trillions of dollars of assets are regularly told that they may not grasp the minutia, and they should trust those assets to fund managers who rigorously apply the science of finance to create superior risk-adjusted returns. While our understanding of finance is today far better than it was 50 years ago, it is far from complete and it never will be. Investing is a human endeavor, and because humans react to events and change behaviors, it will never be as orderly as the experiments in a high school physics lab. Managers pretending otherwise are guilty of hubris or deception. Unfortunately, many targets of these pitches are ill equipped to evaluate them carefully. The goal here is to provide the tools needed to better even the playing field.
Knowledge of a subject comes at different levels. At the most basic level one simply memorizes a formula, say for the Sharpe Ratio, and can parrot it back. The next level of understanding allows one to apply those learned principles to different situations to help analyze new problems. Level three allows one to teach others using everything on the first steps to bring new students along. The final level is when one does original research to move the knowledge frontier out. This book breaks little new research ground, but hopefully will help the interested reader to improve their understanding of portfolio construction to at least level two of the knowledge ladder. If it is successful it is because many people over many years have helped me better understand this fascinating and ever evolving process.
Acknowledgments are never complete as the people who contributed directly or indirectly are too many to count. This book is the product of more than 30 years of studying and participating in markets. Finding a single, good investment idea is not easy. Building effective portfolios is even harder. The challenge in producing this book was to distill all of that so that some of the many lessons learned could be passed on. Colleagues at Commonfund, Azimuth Partners, and Offit Capital expanded my understanding. Thirty years of market events etched lesson after lesson into my memory. A decade of teaching the course Endowment Institute
with Bill Spitz and Andre Perold not only expanded my understanding of the topic but also honed the communication of that knowledge. These two colleagues and friends will see their fingerprints on many parts of this book.
Every major project has easy stretches and sticking points. As this manuscript was coming together, the sticking points were the many graphs and charts throughout. In the summer of 2019, Offit Capital was blessed with three interns: Jesse Rosenblatt, Jared Rosenbaum, and Brandon Rosenbaum, who came ready to do anything that was asked of them. This trio downloaded data, created figures, and updated charts for weeks on end. They took a book that was at the five-yard line, and like a great offensive line, made it easy to go in for the score. They did this with curiosity about the subject, enthusiasm, and good cheer. They deserve credit and great thanks.
Nobody can be effective in the investment world living on an island. The world changes too fast for that. Great partners and colleagues challenge you regularly and welcome your challenges. Ned, Dan, and Morris Offit invited me to join Offit Capital at its inception, and fourteen years later we, with our other partners and colleagues, still engage continuously in the process of trying to improve the investment experience of our clients. The Offits appropriately strive to build a great and lasting business, but they also understand that is achieved by putting client results first. This ethos runs deep and anyone who has met Morris Offit over his 80-plus years knows this is at his core. I am grateful and privileged to call these gentlemen my partners and friends. They created the world that allowed this book to be written.
One person that deserves particular mention is Peter Bernstein. He had nothing to do directly with the production of the book, but he had everything to do with its content. Peter was the ultimate scholar and skeptic when it came to investing. His descriptions of the market were never promotional. He sought the truth, which often placed him in the position of saying the emperor had no clothes. His communications were crisp and he rarely equivocated. He set the standard for a generation of investment professionals. There is nothing in this book where I did not ask myself how Peter could have made it better. There is no doubt this effort fell short, but aiming at his standards improved it.
Family members always sacrifice, mostly silently, while these projects incubate. Blessedly my daughters, Sarah and Rebecca, are far enough along on their own paths that they did not feel the impact of this task too severely. They were, however, a strong motivation to see it through, and hopefully they will take from this that no project is too ambitious to consider or too big to make real. The final acknowledgement goes to my wife, Kate, who no doubt wondered what I must be thinking, spending hours sitting in front of the computer with no apparent end in sight. Her unwavering support and encouragement made it so much easier to get back at the effort when the simplest course would have been a strategic retreat. Thank you all.
CHAPTER 1
Introduction
There are countless books that try to explain how to manage portfolios of stocks, bonds, real assets, and virtually every other investment opportunity. An obvious question is, Why does anyone need another one now?
In the past 15 years there has been a gut-wrenching liquidity crisis and stock market crash followed by one of the least loved bull markets in history. Then a booming economy and market was laid low by the COVID-19 pandemic. As people stumble through this minefield, it seems at a basic level either that previous books do not have the right prescriptions or that few investors have learned enough from them.
There are two distinct reasons a new discussion is timely. First, the investment world has shifted dramatically toward more analytically based approaches over the past 40 years, but these models are either defective or were applied incorrectly, leading to the great financial crisis. The second reason regards significant institutional change in the investment world. The old approach had a broker assemble securities into a portfolio. Profits from the old way of managing portfolios have shrunk dramatically because of negotiated commission and other basic competitive forces. To replace those profits, firms have turned to financial engineers to construct customized structured products and more exotic, scientifically grounded
investment funds for their sales forces. These products appear straightforward on the surface but can have hidden risks and costs that can meaningfully erode investment performance. Today's investor simply must acquire a basic knowledge of how securities, derivatives, and other investment vehicles work before they can make informed portfolio decisions.
Some believe that before the 1970s investing was something of a folk art, full of quaint habits that produced inferior performance. As modern portfolio theory (MPT) developed, the science
of investing was refined. Investments could be systematically evaluated in terms of risk and combined to produce optimized
portfolios. By the time the twenty-first century arrived, portfolio management had become highly dependent upon, and some would say dominated by, quantitative methods and financial engineers. The fact that many markets around the world almost melted down in 2008 and early 2009, destroying years of wealth creation and catching legions of quants off guard, suggests that currently accepted portfolio management practice has some serious flaws.
More than a dozen years after the financial crisis, many of the old, bad habits of selling financial products based on their promised analytical superiority have crept back into everyday use. Sadly, few of the deficiencies have been repaired. The structure and precision of our portfolio modeling have been grossly oversold to investors.
Models rely on expected returns, risks, and correlations that are estimated from thousands of data points. Before the widespread use of computers, these calculations took days and weeks to complete. Early finance pioneers like Bill Sharpe and Harry Markowitz would spend considerable time gathering data and carefully thinking about the construction of a problem before rolling up their sleeves and actually cranking out their complicated estimates. Today, finance professionals routinely download data sets in seconds and complete countless calculations in the blink of an eye. Unfortunately, one of the downsides of this is that the cost of poorly specified models to the researcher is almost nil. To the investor, however, the costs have been massive.
Too many people believe that investing can be reduced to a science. Today, portfolio models are based on data sets too large to have been collected or analyzed just a few years ago. Statistics teaches that as the number of observations in the sample grows, greater confidence can be placed on the model, but many of the basic foundations of statistics are not present when dealing with market information. New data are piled upon old, and the models are reestimated. Few critically ask whether the unstated assumptions behind the statistical models truly apply to the markets being studied.
Economics in general and finance in particular are not physical sciences. They are behavioral disciplines, and the difference is profound. A chemist can try to duplicate a complicated physical reaction hundreds of times, each time carefully observing the outcomes. The more tightly the experimental environment can be controlled, the closer the outcomes should cluster. When the data do not fit the model being tested, it is likely due to some error in the model specification. That is how science advances. When the data fail to match the predictions of the model, the scientist rethinks the interaction of the variables, sometimes rearranging them or sometimes discovering that new variables need to be introduced.
In contrast, consider the economist. They may have a collection of thousands of market prices or returns to examine, but unlike the chemist's data set, these observations came from real life and not from any experiments. Each day may bring a new set of market data; however, it was not produced by a controlled experiment, nor can the researcher ever control the environment. Today, economists are being asked to model the impact of exploding federal deficits on interest rates, inflation, and real economic growth. How large and lasting will the impact of COVID-19 be on incomes and wealth? While these are important thought exercises, there is nothing in the history of the United States that provides data on which to build a precise model with these conditions. An examination of other nations that have experienced huge national debt may be suggestive, but none of these countries have had the same population, technology base, or government structures, to name just three of innumerable variables that cannot be controlled. Economic models are simply suggestions about what might happen, and the range of actual outcomes can and does vary widely.
When financial engineers travel the modeling path, the problems are similar. Despite attempts to account for all the factors that play a role, no database drawn from market data can possibly have the statistical rigor of a set of physical science experiments. Not only do the histories fail to reflect all the possible outcomes, but there is also the basic problem of markets: people who invest react to their environments, and the environments, in turn, change because of these actions. An example will show the difference.
Suppose you walk into a casino and notice that everyone around the roulette wheel has bet on 13 black. This could mean one of two things: either the crowd has figured out that the wheel is defective or rigged and 13 black has a higher-than-average chance of happening, or it is a superstitious bunch with a common bias. If the wheel is fair, there is a 1 in 38 chance of the spinning ball landing in 13 black. It does not matter how many people bet on that number in any turn of the wheel; the probability stays the same.
Markets are different.
If large numbers of market participants try to buy Chinese stocks, gold, bitcoin, mortgage securities, or any other traded good, the market price will change. And as seen in the near financial meltdowns in the second half of 2008 and March 2020, when those traders suddenly turn to sell, prices can change in ways that seemingly defy the probabilities. Whenever enough other participants join an investor in the same trade, the price of the trade changes, and the probability of any given subsequent outcome shifts, sometimes in completely unanticipated ways.
The world has too often seen the response to such seismic shifts. The quantitative fund manager, who has frequently just lost a great deal of other people's money, proclaims complete shock that these virtually impossible events occurred. Then they race back to the computer with the new data in hand to try to fix the flaws in the model. At the most basic level, however, it is not the model that is broken; It is the entire premise behind it.
This is not to suggest that quantitative methods do not have a place in portfolio management. However, the pendulum may have swung too far, resulting in inflated expectations for their benefits. Moderation and skepticism, which are very useful tools for investors, have often been pushed aside. When a manager is on a winning streak and gathering investors, it is often hard to ask what can go wrong or to question whether an approach that worked with $100 million under management is likely to work with $20 billion or more. Investors want to believe that a successful manager's historical record is a product of skill and not luck and that skill is as reliable as identifying the true odds on the roulette wheel. This is rarely the case.
The complexity of quantitative approaches to trading and portfolio construction only adds to this mystique for some. If the lay investor cannot comprehend the trading model, it must be profound. But the frequent market disasters that can be linked to these quants, almost always losing great sums of other people's money, should suggest otherwise. A theoretical chemist might be able to recite incomprehensible formulas about how egg protein reacts to heat, but that does not mean they make an edible omelet.
It is time for the pendulum to swing back toward the art of investing to find an appropriate balance. Throughout this book, models will be questioned. Are all the variables considered? Are the estimated models drawn from a broad enough experience? Does the game change if many are looking at the world in a similar way? What can go wrong outside the model? That is why this book is subtitled Moving Beyond Modern Portfolio Theory. It is foolish to completely reject the quantitative advances of the past 50 years. It is equally foolish to believe that pushing further down the same quantitative path today can totally solve the problems in portfolio management.
This book suggests a middle ground. It starts with a quantitative foundation, but there is no promise of completeness or any easy solutions. Nothing will be optimized. To suggest there is a single best approach is total hubris. The living, breathing organizations we call markets will continue to evolve and react to the steps and missteps of their participants. Investors must embrace this uncertainty and incorporate dynamism into their approach to succeed.
There are four main sections in this book. The first is designed to explain modern portfolio theory in a way that is accessible to most readers. Chapter 2 focuses on the key question of setting objectives. If you do not know where you are going, how do you expect to get there? Chapter 3 digs into the key concepts and may be a somewhat challenging discussion for those who are bit removed from their time in the classroom; the principles are important all the same. So many fund managers and brokers use and misuse these concepts in their sales pitches that the only way any investor evens the playing field is to have at least a basic knowledge of this material.
Chapter 4 returns to shallower analytical waters, where we shall stay. Here the building blocks of portfolio construction are described and the process of asset allocation developed.
The second section is devoted to the steps of building portfolios. The many practical challenges to executing any asset allocation are presented in Chapter 5. Chapter 6 sorts out suggestions regularly presented to investors to earn an enhanced return. Spoiler alert: most are not worth trying.
It has been more than a decade since the financial crisis, but the memories of those events still shape our investment thinking. Chapters 7 and 8 dig deeper into the topics of tail risk, bubbles, and crashes. The third section consists of three chapters (Chapter 9–11) that can be viewed as reference material to be drawn on as needed. The goal is to give you informative descriptions of the vast array of investment vehicles regularly included in modern portfolios. Traditional securities, derivatives, and a wide array of structures and packages are explained and compared.
The final section covers four chapters (Chapter 12–15) that are both practical and philosophical in nature. What is the nature of decision-making around investments? How are investments regulated, and how does that affect your decisions? How is the investment world likely to evolve, and what does that mean for us? And finally, what are the major lessons we can take from throughout this book? It was not easy to keep the list to 10, but if the reader wants a handy reminder of things to keep top of mind, Chapter 15 is the one to bookmark.
As we create this foundation, we will regularly challenge many parts of accepted wisdom. An aggressive marketer might assert that their book is all any investor needs. This is never true. Most people will not build their portfolios without help. This book will prepare you to ask the right questions of investment managers, brokers, or advisors and then to appreciate their answers. When finished, you should have a framework to grow capital through time, avoid major pitfalls, and be able to adapt to worlds not yet seen or even imagined.
SECTION A
The Foundation of a Modern Portfolio
CHAPTER 2
Setting Goals and Objectives
It is quite remarkable to see how often individuals or committees pursue investments before they have firmly established their objectives. They may have gotten what seemed like a good idea at a cocktail party. They may have heard from a friendly rival that their alma mater's endowment grew faster last year than their own. They may have simply been overwhelmed by all the investment advice available 24 hours a day in our media-rich world.
This book starts with the hope that all of those sources of confusion can be blocked out for a while. The two most important questions to ask before anything else are, What do you want to try to achieve with your investments?
and How much risk are you willing to take?
We shall learn that neither of these questions can be answered with certainty, but without an honest effort to address them, everything one does in investing devolves to emotion and luck.
The already wealthy, multigenerational family may have very different goals than the newly married couple who were the first people in their families to go to college. Both of these are likely different than a perpetual college endowment, a liquidating foundation, or a pension plan. The starting point of any portfolio discussion has to be:
Where am I now?
Where would I like to be at different points in the future?
What happens if it doesn't work?
After the wealth destruction of 2008 and early 2009, too many individuals and groups were scrambling in damage control. They may have carefully thought about the first two questions before setting up their portfolios, but the third was often missing. The new generation that has begun investing after the crisis has no real concept of how bad things can feel in a severe market.
Beginning with the first question, one's starting point is not only the current level of assets but also any anticipated flows. Consider a 30-something couple who are both Lehman Brothers mid-level executives in the spring of 2007. Everything about their foreseeable earnings stream was dependent upon Lehman. The largest part of their assets was likely split between a house (with a mortgage) and Lehman Brothers stock. Earnings at Lehman were strong. The stock price was high. The home was appreciating at a good enough clip to take out a second mortgage to remodel the kitchens and bathrooms. Life was good.
Looking at that same couple 18 months later, a different picture emerges. Lehman is bankrupt. Its stock is worthless. If lucky, the young executives have found other positions on Wall Street, but future income projections are probably reduced. The value of their home has already tumbled and is about to enter a period of meaningful decline with few opportunities to sell it for more than they owe on their mortgages.
While the above story is stylized, anyone in the New York metropolitan area in 2008/2009 knows too many real examples from financial professionals who previously worked at Lehman, Bear Stearns, or any of a myriad of failed hedge funds. The 10% of the labor force generally unemployed in America at the end of 2009 had stories with many similarities. So, what happened?
In the case of the Lehman couple in 2007, the problem can be seen as a classic failure to diversify. Not only were the couple's resources concentrated, they were in assets that were highly correlated to their earnings power. This is often viewed as a good thing from the employer's perspective. It keeps the employees focused and motivated to do the right thing for shareholders. But there is a major disconnect in this logic when applied to major corporations with thousands of employees.
It is virtually impossible for a single employee to materially improve a corporation's bottom line (Michael Milken at Drexel Burnham in the 1980s might be an exception). It is however possible for a single person to destroy that same bottom line (e.g. Milken later in the Drexel story, Nick Leason at Barings, and others throughout history). It is undoubtedly good to encourage all employees to work hard and enhance share prices. But, should anyone expect employees to concentrate their wealth to a point where the acts of a handful of people at a firm could destroy their family's future?
The importance of the above parable may seem limited to the reader anxious to dive right into the portfolio construction process, but it holds several guiding principles:
Never assume good performance is going to persist. Always ask what can go wrong and prepare for it.
Correlations are important across more than just portfolio assets. If one's regular income is completely linked to one's current portfolio, the outcomes are likely to be binomial, either very good or very bad.
Most people understand that correlations can shift around dramatically through time. Experience shows, however, that in bad times correlations almost always increase, magnifying the impact of any shock.
Creating a sleep-well-at-night pool of assets against extremely negative outcomes allows one to maintain the most important elements of one's lifestyle or business plan at the primary cost of missing out on higher returns when that safety is not needed. Everyone can choose how big a cushion provides peace of mind, but ignoring the possibility of a severe downturn does not make the risk go away.
2.1 SETTING THE OBJECTIVES
Objectives across investors can vary widely. Examples of how four distinct types of investors might set their objectives will demonstrate the general principles that can be applied in virtually any circumstance. In turn, we shall discuss:
The high-net-worth family looking to provide for the future of several generations.
The young family looking to grow wealth to provide education and retirement resources.
The perpetual endowment or foundation.
The insurance company or pension fund with reasonably well-defined future liabilities.
2.1.1 The High-net-worth Family
A familiar story in America is the entrepreneur who spends many years building a successful business. He or she may have experienced lean years in the beginning, but probably enjoyed a strong income stream as the business grew. As welcome as that income was, the real wealth of the family was building within the business. At some point there is a realization that the entrepreneur is mortal, and that the future of the business must be planned for without the founder. Some transitions pass the business to other family hands. Others may experience a liquidity event like an initial public offering (IPO) that opens the firm to outsiders. Some founders simply sell their businesses and move on completely. The effect on the entrepreneur of such a transition is to transform locked-up, embedded wealth into more liquid assets that need to be managed in a completely different way than the original enterprise.
While the bulk of the wealth was tied up in the business, there were not many decisions to be made. The entrepreneur was completely married to the illiquid investments. Diversification was not an option. The business either succeeded or it did not. There may be cash flow questions to be managed along the way in these stories, but there is little in the way of portfolio management to consider.
Everything changes with the liquidity event. Suddenly decisions need to be made and multiple objectives considered:
How much safe money do we need to maintain our desired lifestyle?
How much of our wealth do we want to leave to the next generations? What are the most efficient ways to do that?
Are there charitable causes that we want to support? How much and over what period of time?
The first question can be answered reasonably precisely, as long as the cost of living remains stable. If inflation or deflation enters the picture unexpectedly, the most carefully estimated goals might be woefully in error. Truly safe money is insulated from these forces, which means putting those assets into short-duration, highest-quality funds like T-bills (Treasury bills) and top rated municipal bonds. If unexpected inflation appears, nominal interest rates rise, as will the yield on the short-duration portfolio.
Note that the answer to the first question is not expressed as a percentage of overall wealth. This is a strict dollar calculation and has nothing to do with whether the stock market is rising, falling, or holding steady. Once this calculation is made, then one can turn to the growth
part of the portfolio.
The second two questions on the list defining the major goals are the kinds of issues, along with an investor's fundamental tolerance for risk, that shape the investments in the growth portfolio. Chapter 4 discusses investment choices, the trade-offs between liquid and illiquid securities, and other practical considerations in setting one's asset allocation targets that are relevant to the goals.
2.1.2 The Young Family
The biggest difference between the couple just starting out and the high-net-worth family mentioned above is the form of their wealth. Assuming that they do not have inherited assets, the young couple's wealth is primarily in the form of human capital, or simply their capacity to generate earnings through time. Fundamentally, smarter and more educated people tend, on average, to have more human capital, but other skills are important as well. Leadership, emotional maturity, entrepreneurial talent, and ability in the arts or athletics are all forms of human capital that have the potential to be translated into an income stream and ultimately financial wealth.
The young family's objectives should start with the same discussion of sleep-well-at-night money. Protecting against a calamity trumps every other wealth-building idea. While it is hard to lose human capital, it is not impossible. Specific job skills become obsolete, young athletes are injured, and start-up businesses commonly fail. Setting aside enough to protect against those unexpected events can make the difference between a lifestyle well below one's desires and expectations, and one that can bounce back from setbacks to ultimately reach one's goals.
Those goals likely include children and their educational needs, a certain target lifestyle along the way, and ultimately retirement at a similar standard of living. The growth portfolio for the young family should reflect those goals, their risk appetite, and the fact that distant goals allow additional latitude when it comes to shorter term market volatility.
2.1.3 The Endowment or Foundation
In many cases an endowment or foundation starts with the goal of living forever. A secondary goal is often to provide intergenerational equality,
where today's students or grant recipients receive roughly the same benefits as those coming after them. While some foundations are built to be self-liquidating after a specific mission is achieved, many more envision their good deeds going on through time.
One might think that the perpetual orientation of these pools eliminates the need to have sleep-well-at-night funds. One of the many lessons of 2008 was that even carefully constructed perpetual asset pools could hit crises of such magnitude that the mission of the organization is permanently impaired. Trustees of these organizations need to confront these risks and set aside safe money as well. If one's immediate programs are eliminated because of a market crash, today's endowment beneficiaries feel a disproportionate impact of the crisis. Sleep-well-at-night funds are as important for trustees and organizations as they are for individuals.
The other challenge in setting the goals of an endowment or foundation is the less defined nature of future needs. Often trustees are hard pressed to articulate the goals of the investment program. Growing the endowment in real terms after spending and expenses, at some ill-defined rate, is often the stated goal. A common unstated objective is growing faster than one's archrival. The lack of a well-defined liability stream and precise growth targets has led many institutions to poorly designed and riskier investment portfolios than they needed to reach their objectives.
One sometimes hears the argument that the perpetual nature of endowments and foundations allows them to set loftier growth goals and achieve those goals by investing more in illiquid assets. On the surface this makes some sense, but every rule has its limitations. Too many endowments and foundations entering 2007 underappreciated the risk attendant with illiquid investments. As the recovery from the financial crisis reaches 10 years there are signs that some of those hard-learned lessons may already be fading.
2.1.4 The Insurance Company or Pension Plan
The biggest advantage insurance companies and pension plans have over individuals and endowments or foundations is the more defined nature of their liabilities. One can estimate with high precision how many people are likely to retire each year and how long they will subsequently receive benefits. These actuarial assumptions stake out fairly clear goals that can be a meaningful advantage in planning investment portfolios.
Unfortunately this advantage is sometimes squandered. At the peak of the bull market in late 1999, many pension plans were meaningfully overfunded because of the rapid appreciation of the plans' equity holdings in the previous decade. Some could have liquidated every stock they owned, purchased Treasury bonds, and been secure in meeting all their future liabilities with virtually no market risk.
Few did. Instead of keeping sight of their liability goals, they became enamored with the idea of peer comparisons. How did your pension plan stack up to all the other corporate or public sector peers? Which CIO was just featured on the cover of Institutional Investor? Investment goals silently shifted from meeting the needs of future beneficiaries, to racing against other funds. The first decade of the twenty-first century showed the folly of that behavior.
Today the problem facing these plans is completely different. Major central banks pursue zero interest rate policies to support lagging economies suffering from echoes of the Great Financial Crisis and the COVID 19 pandemic. With such low rates, plan sponsors struggle to come up with any asset allocation that has both a comfortable level of risk and an ability to reach target returns. The environment matters when setting portfolio allocations. Just because a firm or individual has particular needs is no reason to believe the market will always provide a means to achieve them.
2.2 SLEEP-WELL-AT-NIGHT MONEY
If an individual or an organization has not asked the following question, it should become one's highest priority:
How much money do you need to allow you to maintain your lifestyle or business plan for an extended period in the absence of current income or investment gains?
If one sets aside this amount, which we shall call sleep-well-at-night money, there are funds available to see you through unemployment, business disruptions, and severe market downturns. The most important feature of these reserves is that they need to be ultimately safe and available under all circumstances.
Determining the answer to the critical question depends greatly on one's degree of risk tolerance. Does an individual need six months' expenses? Twelve months'? Three years'? What about an endowment or a not-for-profit organization? Individual circumstances matter. Diving into this puzzle will be done in Chapter 4.
A young person employed in a high-demand sector may believe that there are few possible disruptions that could befall him or her. Barring the proverbial event of being run over by a bus, income should be reliable and current obligations covered. But while the probability of a disaster may be small, the impact of such an event could be devastating and should be taken into account.
Any organization, whether for-profit or not-for-profit, should go through a similar exercise. Events from 2008 and 2009 show vividly that assuming ready access to liquidity through credit channels is a serious mistake. Sleep-well-at-night money does not depend on the kindness or abilities of bankers at a time of crisis.
How long a period of crisis should the sleep-well-at-night money target? This depends on the individual's or the organization's ability to adjust spending or revenues. One not-for-profit might conservatively want to have a year's worth of expenses set aside on the belief that if disaster strikes a year would be long enough to change programs or develop new sources of revenues. Another organization might think six months' reserves are more than adequate.
Individuals will want to assess which current expenditures are mandatory and which are more discretionary. Adjustments to lifestyle or programs are rarely pleasant, but much can be done if the runway is long enough.
The key discussion involves asking the hardest questions about what can go wrong. Even small probability events happen sometimes, and modeling what they might mean allows one to plan against the worst contingencies. Setting aside reserves that allow one to get through the worst of times is the true definition of sleep-well-at-night money.
It may seem obvious that these reserves should be invested in as close to risk-free funds as possible, but this common-sense notion is often violated. Not-for-profit organizations should hold these assets in short-duration sovereign debt of the country where their liabilities reside. This largely eliminates interest rate risk, currency risk, and inflation risk, as short-term interest rates typically adjust quickly to changes in inflation. Taxpayers will follow a similar strategy, but adjusted for their effective tax rates. The goal is to squeeze as many market risks as possible out of these portfolios. A side benefit is that these highest-quality assets tend to be in great demand during crisis periods. You want to own enough of them before the crisis happens.
Such investment standards are incredibly rigid and lead to the lowest rates of return of all the choices. As such, people have historically tried to cheat by relaxing one or more of the criteria. Auction rate securities, structured notes, and collateralized deposit obligations (CDOs) were all advertised as highly secure ways to earn extra returns on one's cash. Each was too clever in different ways, and when investors discovered their flaws, all fell dramatically in price and liquidity. "Almost safe" is a far cry from safe. Any time one receives a higher return than the risk-free rate, there must be one or more incremental risks attached. There is a good chance that the extra risks can stay hidden for months or even years, but they will eventually surface and are likely to destroy the notion of sleeping well at night.
The investor must reconcile the fundamental difference between genuine minimum risk investing for one's reserves and appropriate risk in the long-term growth portfolio. The lines between the two tend to blur when times are good and risk appears slight. As individuals or organizations age there may be many valid reasons for changing the size of the sleep-well-at-night liquidity reserve, but there will be few good reasons to compromise on its investment guidelines.
2.3 LONG-TERM GROWTH PORTFOLIOS
If you begin with $5 and your goal is to have $1 million by the end of the year, the best growth portfolio you might be able to create is a lottery ticket. Such a portfolio is almost certain to fail, but there are no other imaginable portfolios that have any probability of success. The point is that goals and portfolios have to be consistent. One just might have to lower one's sights if a realistic portfolio cannot be constructed.
Start with a reasonable set of goals. Once you set up your safe assets, the rest of the portfolio should focus on growth. But not all paths to growth are created equal. Chapter 4 goes into detail on how to combine different investments to shape both risk and return, but how does one gain confidence that any set of investments will achieve one's goals? There are three fundamental rules that no investor should forget:
Compound interest is one of the greatest forces in investing. Small differences in return, if they can be maintained through time, produce massive differences in ultimate outcomes.
Additional returns should never be expected without the assumption of additional risk. Risks translate into volatility in the value of one's portfolio. How each individual reacts to that volatility is highly subjective.
If an investment loses 100%, no amount of future return can help you. Zero principal, compounded at any rate of return, is still zero.
2.3.1 The Power of Compounding
Allowing today's investment returns to build upon previous profits, or compound, increases wealth exponentially through time. Compound interest is the force that separates superior long-term performance from mediocre results, and mediocre returns from losing ground.
The power of compounding surprises most people who haven't thought carefully about the concept. As a case study, consider Investor A, who was evaluating his portfolio in 2010. He had invested $1 million with an active large-cap US stock manager at the start of 1985. Twenty-five years later, which included three major stock market drawdowns, his account stood at $8 million and he concluded the manager had done a solid job increasing his wealth eightfold.
But how well had the manager really done? From the start of 1985 to the end of 2009, the S&P 500 had an average total return (price appreciation plus dividends) of over 10.6% annually. Investor A's $1 million dollars invested in an index fund and left untouched so returns could compound for that 25 years would have grown to more than $12.4 million!
There is a simple rule of thumb to demonstrate the power of compound interest that is called The Rule of 72.
¹ If an investment earns X% through time, compounded each year, it will take 72/X years to double one's money. That is, a 2% rate of return will double one's capital roughly every 36 years. A 7.2% rate of return will do the trick in a decade. The 10.6% rate earned by the S&P 500 from 1985 through 2009 doubled an investor's money, on average, every 6.8 years.
The most powerful part of the calculation is the doubling. $1 million in 1985 became $2 million by the third quarter of 1991. That $2 million was $4 million in 1998, and $8 million by 2005. If the calculation date had not been the start of 2010, but only a little more than two years later, and the average rate of return had not changed, the investment would have doubled again to $16 million.
Small differences in average rates of return can mean massive differences in end values. Figure 2.1 shows the growth of a dollar over 25 years at different rates of growth. In the first example above, Investor A's manager seriously underperformed the index, creating a third less wealth over the period. But the manager's average rate of return for the 25 years was less than 2% per year behind the index. Because of compounding, even minor slippage can be costly through time.
In Get Rich Slowly, a wonderful book with a title sure to discourage enthusiastic and impatient investors, Bill Spitz describes the many dimensions of this important principle.² Small differences in return mean a lot, which translates not only into seeking the right portfolio mix but also on shaving away every cost that cannot be justified by incremental return. Time is just as important.
In a dramatic example of how important both time and return are, the Chicago Tribune reported in March 2010 on a $7 million gift to Lake Forest College by Grace Groner, who made her donation when she died at age 100.³ The incredible part of the story is that the gift started in 1935 when Ms. Groner purchased three $60 shares of specially issued stock in Abbott Labs. Ms. Groner never sold any shares, even after many stock splits, and dutifully reinvested any dividends she received. Over the 75 years her $180 investment grew to $7 million, a seemingly near impossible achievement. In fact, if one calculates the average compound rate of return for the investment, it turns out to be just over 15% per year.
Graph depicts 25-Year compound growth of $1 for different Interest rates.FIGURE 2.1 25-Year Compound Growth of $1 for Different Interest Rates
Now 15% per year is a fine rate of return, but just a few percent higher than the stock market in general did over that period. An equally important push came from the passage of time. At 15%, Ms. Groner's investment doubled on average every 4.8 years (72/15 = 4.8). Over 75 years this meant that the investment doubled 15 times! Each dollar grew by a factor of two raised to the 15th power, which is 32,768 times. Clearly, the surest way to turn $180 into $7 million is to start when you are 25, earn a good rate of return, and live to be 100.
Like most principles, the guiding light of compound returns can be pushed too far. The trend among endowments in the first part of the twenty-first century was to devote large proportions of their portfolios to illiquid partnership investments. There was a basic belief that the expected incremental return would allow their funds to grow a little faster, and given the perpetual nature of the endowment, sacrificing short-term liquidity for additional compounding would be an attractive strategy. The liquidity-driven crisis of 2008 and early 2009 showed that there are risks beyond market volatility that can threaten one's capital and enterprise.
The Tribune story also noted that Ms. Groner led a modest existence despite her considerable wealth, apparently never placing herself in a position where a downturn would threaten her lifestyle. Staying power is what counts in the world of compounding. One must be able to maintain one's portfolio throughout any market cycle to achieve the ultimate investment goals.
2.3.2 Incremental Expected Return = Greater Risk
The most fundamental truth in investing is that to get higher rates of expected return one must assume higher risk. If this were not true every risk-averse investor would opt for the higher yielding, lower risk choice and improve both the expected return and the risk profile of their portfolios. While this appears on the surface to be straightforward, there are in fact several subtle dimensions that are easily missed.
The first is that at any given point in time current projected yield is not a perfect indicator of risk. There is no better example of this than highly rated structured securities based on mortgages widely sold in 2006 and early 2007. These structures certainly offered a higher yield than Treasury notes and bonds of comparable maturity, but they offered nothing close to the return necessary to adequately compensate investors for the inherent risks.
History suggests that current rates of return reflect the market's perception of risk. Bonds with large spreads to treasuries are perceived to be riskier than those with small spreads. On average the market does a decent job of getting these relationships correct, but there are times when either errors in judgment or other factors move market prices and forecast returns away from reasonable reflections of true risk. Quiet market periods tend to lull investors into a sense of security that leads to underpricing of risk. Similarly at times of market stress, interest rate spreads and option volatilities extend well beyond historical norms and may overstate future risk.
In theory, even if the price of overall market risk is too high or too low, there should be a consistent relationship across investment alternatives. Unfortunately, even this is not always the case. Periodic enthusiasm for a specific investment (e.g. railroad bonds in the late nineteenth century, silver in 1979–1980, or Dutch tulip bulbs in 1637) can produce distorted prices and risk patterns. While the market usually is a reasonable guide to the relative riskiness of investments, it is ultimately the investor's obligation to determine whether today's expected returns are adequate compensation for the full array of risks actually present, but perhaps lurking.
The second complication comes from how any particular investment contributes to risk in a portfolio. Before there were advances in the theory of portfolio construction (discussed in more detail in Chapter 3), each investment was examined individually. Is the bond yield steady and reliably paid? How much does the stock price vary day-to-day or month-to-month? Most investors still think of risk in this way. The missing dimension is how any investment varies in return relative to all the other investments in the portfolio.
A simple example of this effect can be seen with car theft insurance. Each month that one's car is not stolen, there is a 100% loss of premium. Only if a theft occurs while the policy is in place is there ever a payoff, but that payoff is many times the size of the monthly investment.
In fact, if one compared the payoff pattern of auto theft insurance to that of a lottery ticket, they would look remarkably similar. Both, on a stand-alone basis, are highly risky. But car theft insurance is not bought on a stand-alone basis, but in conjunction with the ownership of a car. The portfolio
in this case is the car and the insurance, which has a lower risk profile than either the car or the policy taken separately.
The same thinking should be applied to traditional investment portfolios. A specific investment may be risky on a stand-alone basis, but could be much less of a problem within the portfolio. Investors should not expect to get paid much of an extra return for risk that can be diversified away.
The final complication is that risk comes from many directions. Market price volatility is simply the most obvious one of many risks. There are other risks, including liquidity risk, for which one should reasonably demand a higher expected return before investing. These risks too may be mispriced at any point in time, but every effort should be made to incorporate them into any valuation.
As will be discussed in Chapters 5.4 and 5.5, there are a myriad of operational and fraud risks that impact investors all too often. In theory, one should be compensated for taking on these risks, but in practice no fund manager ever offers a higher rate of return while warning investors they have shoddy business practices. Risks of this nature are not correlated in an advantageous way with any other investments. Diversification is vital here simply to contain any possible loss; there is no other portfolio advantage to pooling operational and fraud risk.
2.3.3 Losing 100% Is Game Over
The obvious sometimes needs emphatic restating. Investors focusing on the power of compound returns sometimes reach for incremental return without realizing that they are meaningfully increasing the chance of losing all of their investment. One of the most fundamental rules of investing is to strive for enough true diversification, which will likely include an appropriate allocation to sleep-well-at-night money, so that a 100% loss of portfolio is as nearly eliminated as possible. A portfolio's average rate of return over a long string of time periods is relevant only if none of those period's return is −100%. Once the investment corpus is lost, nothing after that matters. Zero compounded at any rate of return is still zero.
The reader may believe that this is an academic discussion without practical importance. After all, if one owns a diversified portfolio of stocks, a few might fail, but the market, as a whole, still exists. Such an attitude can lead to trouble. After the 1929 stock market crash, too much leverage produced many complete wipeouts for individual stock investors.
While the United States has been blessed by a stock market that has operated continuously for over 200 years, there are few other countries that can say that. Wars, revolutions, and hyperinflations have each destroyed entire asset markets. The investor that says, Such things can't happen to me,
should instead say, I suspect a complete wipeout is a small-probability event, but if it happens, how will I cope?
It is not just extreme political events or irresponsible borrowing by individuals that can cause a complete loss. Fraud and fund leverage are very real considerations as well. Too many Bernie Madoff victims had all their eggs in one basket. Investors in Long Term Capital Management (LTCM) in 1998 and many other hedge funds in 2007 and 2008 also suffered almost complete losses when seemingly reasonable trades became toxic because they were highly levered and then lost more per trade than the fund managers or investors had ever experienced before.
2.4 BETA AND THE POWER OF THE MARKET
Less experienced investors tend to want to jump to specific investment ideas right away when thinking about their portfolios. The Internet retailer, the property in Florida, or the cult status hedge fund manager all make for great cocktail party conversation. They do not, however, really help address the portfolio construction problem. Collections of individually selected investment ideas, even ones that are better than average, do not typically make a strong portfolio. After one decides on the right amount of sleep-well-at-night money and sets one's long-term growth goals, the next step is to sketch out the amount of money to be invested in each asset class. Bonds, stocks, real assets, and alternative investments are the broad categories available to virtually any investor. In Chapter 4 we shall go through the process of establishing a policy portfolio.
If there were no expected rate of return to investing, there would be no point in taking on any risk. Having said that, how does one estimate what any particular investment is likely to earn over time? Before the rise of modern portfolio theory and the collection of massive data sets of investment returns, there were few complete answers to that question. In the first half of the twentieth century, the common wisdom was that cautious investors only dealt in bonds. Stocks, whose prices could fluctuate widely on the basis of rumor, inside information and manipulation, were only to be traded by people seeking a speculative thrill. Nothing from the experience of the Roaring 20s and the subsequent Great Depression helped dispel such impressions.
After Harry Markowitz's and Bill Sharpe's pioneering efforts to model the behavior of a portfolio of stocks, the world recognized that each type of investment was driven by multiple factors.⁴ For example, any particular stock's daily price would be affected by the following three influences:
Particular information about the company (e.g. new customer contracts, a new patent awarded, the size of the CEO's pay package or his recent Tweets).
Information about the sector (e.g. trade tariffs affecting the industry).
Forces at work on the stock market as a whole, which is everything else not included in the first two points.
Notice that at any point in time all the factors working on individual companies or sectors aggregate up to contribute to the movement of the market as a whole, but they are not the whole story. If the Administration publicly announced a plan to double the capital gains tax, there is an excellent chance the stock market would take a dive even in the absence of any company or sector news.
Concentrating primarily on returns from individual stocks and bonds runs the risk of attributing too much to the skill, or lack thereof, of the security analyst. Anyone who bought a specific stock for their retirement account on 13 October 1987 got a rude shock when the entire market tumbled 8.9% in the next three days, only to fall another 22.6% on Black Monday, 19 October. That did not make them a bad stock analyst. The fortunes of the company whose stock was purchased had probably not changed materially in less than a week. This was a case where the vast majority of stock price change resulted from market-wide forces including a large dose of panic.
Beta is the extent to which any stock price moves with the market as a whole. This term is often misused in the investment lexicon, being sometimes confused with correlation.⁵ It is always a term used in comparisons such as The stock's beta with respect to large-cap US stocks taken as a whole is 1.2.
One can calculate the beta of any security with respect to any other single security or group of securities, but some comparisons make no sense. Claiming that a US tech company's 10-year bond has a beta of 0.4 with respect to an index of Chinese stocks may be accurately calculated from the simple statistics between the two series, but one would be hard pressed to explain why there should be any connection. More importantly, blindly relying on such calculated betas can lead to serious errors in judgment.
Figure 2.2, shows the path of three hypothetical investments, demonstrating the concept of beta.
Graph depicts visualizing beta.FIGURE 2.2 Visualizing Beta
Choosing among the three investments A, B, and C clearly involves different risks. Investment A (light gray line) fluctuates between +0.5 and −0.5, Investment B (medium gray) between +1 and −1, and Investment C (dark gray) between +2 and −2. If one assumes that the relationships across the investments can be expected to persist through time, what is the beta of each investment?
The right answer is to first ask another question, The beta with respect to what?
If Investment B is the benchmark asset, A moves in every period exactly half that of B, so A's beta with respect to B is 0.5. Similarly since C moves twice as much as B every period, it has a beta of 2 with respect to B. The beta of B with respect to itself is always equal to 1, by definition.
If the beta calculation was performed relative to A, Investment B would have a beta of 2 with respect to A, and C's beta would be 4. Beta always captures the ratio of movements between two investment options and the choice of the reference investment is entirely arbitrary. When an investment manager states that his portfolio of stocks has a beta of 0.95, one needs to determine to what that beta refers.
Notice that in the stylized example in Figure 2.2 all three investments move in lock step. That is, they are perfectly correlated. Changing the proportions of A, B, and C in a portfolio will alter the total risk, but only because of the different underlying volatilities. There is no directional benefit from having a portfolio. If one investment makes money, they all do, and conversely. This is the first of many demonstrations in this book that high positive correlation is the enemy of the portfolio investor.
All three of the investments in Figure 2.2 are perfectly correlated to each other. Correlation tells the investor nothing about the size of an investment's calculated beta. It is generally true, however, that investments that are highly correlated produce more reliable beta estimates than those that are not.
If one expects an economy to grow through time, and there is an active stock market to support that growth, it is perfectly reasonable to expect that owning a broad portfolio of stocks should also produce a