If you’ve been paying attention you probably know that investment fees will reduce the value of your retirement portfolio over time.
For example, Questrade argues that by switching to a lower cost investing platform you could retire 30% richer.
All this is true. Essentially, whatever you pay in fees is foregone wealth. I.e. if your annual fees are 2% and your gross return is 8%, your net return is reduced to 6% after fees.
Remember: fees can be layered (often covertly) into your portfolio in multiple ways – advice fees, investment management fees, tax, operating expenses, and so on. Sometimes the fees are bundled, sometimes they’re charged separately. Buyer beware.
Unfortunately, high fees will do much more damage than leave you ‘less well off’ at retirement. High fees could mean the difference between going broke or not.
Check out the following example for Joe Smith retiring at age 65 with a $1,000,000 portfolio. Sounds like plenty of money for retirement, right? Well, the level of fees mean the difference between Joe eating ham sandwiches and cat food for lunch.
Start with the following assumptions for Joe:
Requires a frugal annual income of $40,000, adjusted for inflation
Will live until age 95
Builds a balanced growth portfolio consisting of 80% stocks and 20% bonds
Has a 10% average tax rate
What are the odds Joe goes broke before he dies?
Calculation methodology for the data geeks: Using data made available by https://engaging-data.com/ , the probabilities are calculated by using stock and bond returns between 1871 and 2016. For example, if an investor expects to be live for 50 years in retirement, all historical 50 year periods are analyzed. One historical cycle would be from 1871 to 1922, another one from 1872 to 1923, and so on until 1965 to 2016. Thus 95 different historical cycles are considered (in this example).
The chart below shows the portfolio failure rate, based on historical precedent, for Joe Smith at various fee levels. “Portfolio failure rate” essentially shows how often during the historical periods the portfolio ran out of money before the end of the period (in Joe’s case 30 years).
Investment fees have a significant impact on the portfolio failure rate. In Joe Smith’s case, the portfolio failure rate rises from 18% when the investment management fee is 0.30% to a whopping 42% when the investment management fee is 2.50%.
Hold up…think about what this really means. Imagine what it would be like to run out of money as a senior citizen.
This is a deadly serious issue and a catastrophic failure of the wealth management industry. The average retiree is getting screwed out of their money leaving them completely broke during retirement. This creates massive hardship, as a broke retiree often has no way of recovering and has to rely on the state, charity or family for food and shelter. Dignity and independence, however, are lost forever.
While the difference between 0.30% to 2.50% sounds very wide, this is the realistic range for investors in Canada.
For example, Cambridge Canadian Equity Fund charges an MER of 2.48%. AGF Global Strategic Balanced Fund charges 2.63%. Mackenzie Canadian Growth Balanced Fund charges 2.29%.
Meanwhile, at the other end of the spectrum, Questrade provides all-in portfolio services for 0.38%. Finally, a DIY investor can combine Vanguard’s FTSE Canada All Cap Index ETF, which has a 0.06% fee and Canadian Aggregate Bond Index ETF, which has a 0.09% fee.
Investors who do a little investigating will better understand their costs and be able to shift from one end of the spectrum to the other.
Bottom line: Pay close attention to fees, as this is one of the few parts of investing that is totally within your control. Over the long run it will have a huge impact to your standard of living and independence.
If you’re like most people, you listen to the experts: Economists and investment managers. If there’s anything these folks are good at it’s making predictions about the future and then eloquently explaining why their predictions didn’t come true.
Economics is a pseudoscience that relies on unrealistic models that tend to be completely detached from reality. In case you don’t believe me, below is a list of projections made by various economists and investment managers over the past decade. All of these predictions proved false.
So next time you read a headline or hear a soundbite about the near-term direction of the economy or markets, treat it as background noise.
So who should you listen to? There are good economists and investment managers. They are the ones who are skeptical about their own conclusions. They tend to have a long view that ignores the day-to-day and week-to-week fluctuations. Instead of making overconfident predictions, they provide a framework for decision making by observing the world around them.
“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
Let’s say you’re 20 years old and have 40 years until retirement. If you’ve been reading this blog you know that you need to start saving and investing early to get time on your side.
You’ve also probably seen growth charts – like the one below – showing how an annual contribution of $10,000 to a portfolio that returns 6% would grow over the years. This illustrates the simple concept that time + return on investment provide exponential growth over the long run.
This is the power of compounding
Compounding describes how an investor gets returns on their initial investment plus returns on the returns on that initial investment. Returns on returns – that’s when your money starts really working for you. That’s when it takes a life of it’s own.
When contributing regularly to a retirement nest egg, there is a point after which your portfolio learns to fly on its own.
In the early days, your portfolio is small. So most of your portfolio’s growth is dependent on your contributions. During this time, investing feels like an uphill battle – it’s more an exercise in saving than generating returns. This is frustrating for many, as the dollar value of annual portfolio returns are small during this period. The vast majority of annual portfolio growth comes from your contributions.
However, over time this eventually changes. At an average annual return of 6%, portfolio returns outpace contributions by about year 13. As you can see in the chart below, once this point is passed, the portfolio becomes self-funding in a way, with the dollar value of annual portfolio returns increasingly outpacing the value of annual contributions. Of course, it is best not to think of the portfolio as self-funding, and you should keep contributing to accelerate future growth.
It isn’t until these later stages that you truly start to see the benefits of compounding.
The chart below shows the same thing as the previous chart, except it shows annual portfolio return and annual contribution as a proportion of portfolio growth. I think this really highlights why people get frustrated in the early years of investing. You can see how in the early years, the only growth is due to your own personal sacrifice. Your friends are spending their paychecks on BMW payments, while you suffer in silence to fund your portfolio with little to show for it.
However, while your friends have a negative net worth 13 years later, you’ve built a portfolio that has really started to take off.
Jeff Gundlach, CEO of DoubleLine Capital predicted the election of Donald Trump and the 2007 housing crash. He is now providing insights into the next economic collapse.
In 2011, he was featured as “The King of Bonds” in Barron’s, and named one of “5 Mutual Fund All-Stars” by Fortune Magazine. In 2012, he was named one of the “50 Most Influential” by Bloomberg Markets magazine. In 2013, he was named “Money Manager of the Year” by Institutional Investor.
When Jeff Gundlach speaks, people listen. Unlike most investment managers, he doesn’t hold back and is willing to tell it like he sees it. Listening to Gundlach is like getting a bucket of cold harsh reality poured on your head.
He was recently interviewed by a Swiss newspaper on what the next recession might look like. Gundlach warns investors to prepare because it will lead to big changes in the market. He argues investors need to reduce risk and own their house free and clear. (in fact, he says anyone with a mortgage should not own stocks.) While there might still be market gains over the near term, when the downturn does come people will be “overwhelmed by problems” with their investments. In particular, he sees big problems with the US corporate bond market.
“This time the liquidity is going to be very challenging in the corporate bond market. The corporate bond market in the United States is rated higher than it deserves to be. Kind of like securitized mortgages were rated way too high before the global financial crisis. Corporate credit is the thing that should be watched for big trouble in the next recession. Morgan Stanley Research put out an analysis about a year ago. By only looking at leverage ratios, over 30% of the investment grade corporate bond market should be rated below investment grade. So with the corporate bond market being vastly bigger than it’s ever been, we’ll see a lot of that overrating exposed, and prices will probably decline a lot once the economy rolls over. Furthermore, central bank policies have forced investors into asset classes that they usually would be a little bit more hesitant to allocate to.”
Gundlach also sees major problems with the US stock market, arguing it will be the worst performing equity market in the world. Why? Partly because it is currently the strongest.
“The late 1980s saw Japan as invincible with the Nikkei tremendously outperforming every other market to the point where there was incredible overvaluation of Japanese real estate when the recession came in the early 1990s. The Japanese Market was the worst performer. It never made it back to that level. In the advent of the Euro, there was a lot of enthusiasm about the economic prospect of the Euro area, and the stock market in Europe was incredibly strong in 1999, outperforming every other market. When the recession began, it was the worst performing market and never made it back again, broadly speaking. This time US stocks are crushing every other area. It’s due to some fundamentals like the better economy, but also due to tax cuts and share buybacks. In the next recession, corporate bonds will collapse, and buybacks will stop. The dollar has already topped. It may begin falling in earnest during the next downturn and US equities will lose the most. They will probably not make it back to the peak for quite a while. When the US market drops, it will drop a lot.”
The next recession will see deficit spending balloon. The US is already running $trillion+ deficits and this is supposed to be the best economy ever. The next recession could put upward pressure on interest rates, as demand for funding rises. Of course, the Fed will do everything in its power to combat this, but possibly not until after a crisis emerges. The firefighters don’t show up until the house is ablaze.
“Powell said he’s going to use large scale asset purchases to fight the next recession. That’s what he said at his last press conference. He could introduce negative interest rates, but I think Powell understands that the US cannot introduce negative interest rates without the entire global financial system collapsing. Because where’s all that capital going to go? Which markets are big enough? Negative rates are the worst thing that could happen in the US. You can see what negative rates have done to the banking system of Japan and Europe. All you’ve got to do is look at the relative performance of bank stocks. The underperformance of European banks is correlated to the yield of the 10-year German Bund. I don’t know if the politicians understand that negative rates are fatal. It’s fatal to Deutsche Bank and insurance companies in Switzerland.”
So what happens post recession when US public debt levels skyrocket due to massive deficit spending? Suddenly, the problem everyone has ignored could smack the US right in the face, and the US government will look for solutions.
“You could create inflation through universal basic income. That would debase everything. Or you could default on Social Security benefits and welfare benefits. These are the options. We’ll do some combination, maybe raise the eligibility age from 65 to 75. I don’t know what’s going to happen, but what we have now is unsustainable. The debt is unsustainable. Interest rates are unsustainable. The wealth inequality gets worse every minute. It’s already beyond the point of sustainability, and when the next downturn comes, there will be a lot of anger and unrest. …the misery is going to be apparent for a considerable fraction of the population. It’s going to be pretty intense, and the response will be money printing. When Ben Bernanke said, we’ll never have deflation because we have the printing press and when he used the word helicopter money, people thought it was some euphemism, some joke. People thought that that could never happen. Now we have candidates running on it. Kamala Harris has a version of it, Cory Booker has a version of it. And for Andrew Yang it’s the centerpiece of his campaign.”
Gundlach is not talking about a garden variety recession. This situation – massive debts, slowing growth, rising wealth inequality – has been building for decades and the world is approaching a point at which seismic shifts will occur.
“This situation has taken since 1945 to develop. And it really got going with US-President Ronald Reagan. So I started in this business when the scheme was starting. And we used to think that 8% interest rates were set to last forever, and it was unthinkable that the Fed would buy bonds, inconceivable! And now it’s normal. And free money used to be unthinkable. What people got themselves fooled by was feeling somehow that there’s real stability to societal institutions because they’ve experienced it most of their life. Some still think they’re experiencing it. But they’re not.”
So what does normal look like?
“In 1970, there were no credit cards. In 1970, there were no car loans. People saved money and bought things. That was normal. The debt-to-GDP ratio was stable. Economic growth was real. It really happened. In 2018, the dollar growth of nominal GDP was less than the dollar growth of the national debt. That means that there is no growth. We’re having an illusion of growth. It means that we’re issuing IOUs and spending it, and it shows up in the calculations as growth. But spending is not growth.“
Image: George Catlin, Cabane’s Trading House, 930 Miles above St. Louis (1832)
The sooner you realize you suck at investing, the sooner you’ll become a successful investor. Unfortunately, many people believe they are the exception. The truth is, most people barely achieve ⅓ of broad market returns due to their emotional decisions.
This isn’t simply about stock picking or choosing a fund manager who will outperform. It’s about swimming against powerful market tides.
You Suck in Bear Markets
Bear markets are a form of psychological torture. Believe me when I tell you that even seasoned investors are tempted to sell everything when markets are pummeled. The relentless and pervasive barrage of negativity goes on for months leading even the most resolute to question their own beliefs.
Whether you invest in stocks, index funds or active funds, do you have the intestinal fortitude to buy when the entire market is dying and everyone is screaming ‘sell’? It is easy to say ‘yes’ from the comfort of your armchair when unemployment sits at record lows and markets are near all-time highs. But it isn’t as easy when your friends and family are losing their jobs and people are going bankrupt. At that point in time, self preservation becomes paramount and one can easily rationalize selling underwater investments to protect what’s left.
You Suck in Bull Markets
It is just as difficult to do the opposite (sell) when everyone around you is getting rich off the last vapors of a bull rally. The conservative investor that misses the final months (or even years) of a bull market is made to feel stupid. Meanwhile, your friends and family with sub-par IQs are rolling in dough as they plow every penny into risky assets.
These are precisely the emotions you need to combat even if you simply want to passively buy and hold low cost index funds to match market performance. Investing is simple…until it’s not. It’s simple until you start paying attention to the noise around you. Unfortunately, the noise is hard to ignore.
These emotional decisions cause investors to lock in losses and miss out on gains. Consequently, the average investor vastly under-performed the broad stock market over a 20 year period.
“The performance of the typical investor over this time period is shockingly poor. The average investor has under-performed every category except Asian emerging market and Japanese equities. The average investor even under-performed cash (listed here as 3-month t-bills)! The average investor under-performed nearly every asset class. They could have improved performance by simply buying and holding any asset class other than Asian emerging market or Japanese equities. Thus, their under-performance suggests investors’ timing of asset allocation decisions must have been particularly poor, i.e., investors consistently bought assets that were overvalued and sold assets that were undervalued.”
BlackRock made similar comments back in 2012:
“Volatility is often the catalyst for poor decisions at inopportune times. Amidst difficult financial times, emotional instincts often drive investors to take actions that make no rational sense but make perfect emotional sense. Psychological factors such as fear often translate into poor timing of buys and sells. Though portfolio managers expend enormous efforts making investment decisions, investors often give up these extra percentage points in poorly timed decisions. As a result, the average investor under-performed most asset classes over the past 20 years. Investors even under-performed inflation by 0.5%.”
How to Become a Better Investor
So what can you do? Perhaps the more appropriate question is ‘how can you do less?’. Because it is the ‘doing’ – the unplanned activity – that causes investors to fall behind.
The best way to avoid unnecessary and detrimental activity is to build a plan for how you want to invest, in good times and bad. Perhaps the simplest plan is to invest a percentage of your paycheck every month into a pre-selected set of investments that align with your risk tolerance and objectives. Your plan can be more elaborate if you choose – e.g. creating trading rules such as stop losses – but for most the simple approach is best because it doesn’t require expert knowledge and is easy to execute.
Most importantly, make the decision today about how you plan to behave when markets are plummeting or irrationally exuberant. Because when you’re in the heat of a bear market or bubble economy, emotions will take over and you won’t be able to make rational decisions.
“Record year for stocks, as S&P 500 up double-digits”
…and so on.
The problem with these statements is that they’re using the S&P 500 as a proxy for the overall market. I’ll be the first to admit that no index completely represents the market at all times. But in this article, I’ll point out some of the issues with the S&P 500.
The S&P 500 index is a market-capitalization weighted index made up of 500 of the largest publicly-traded companies in the United States. The stocks within the index represent a significant portion of value of all companies in America.
I am a big fan of low cost index investing. So why am I shit-talking the S&P 500?
First, the index is arguably actively managed. All indices have a pre-programmed set of rules to determine its constituents, weightings and rebalancing frequency. An index and its characteristics need to be defined – like everything else in life – and that definition is the creation of a human being (or team of humans) making some sort of decisions. The activity undertaken to create these rules (and the activity in executing these rules) means that indices (like the S&P 500 index) may not be as passive as investors believe. While an investor can make a passive allocation to an index, that investor must first understand and believe in how that index is constructed.
Second, the index is highly concentrated. The chart at the beginning of this articles shows that the largest 5 stocks of the S&P 500 accounts for the same market cap as the last 279 companies of the index. These five companies are Microsoft, Amazon, Apple, Alphabet and Facebook. While these companies may seem like behemoths that could survive anything – thus deserving their big weights in the index – one only has to go back as far as 2010 to see a completely different composition. In 2010, the largest five stocks in the S&P 500 included Exxon, GE and Berkshire Hathaway. Where are they now? This degree of concentration presents a risk to investors, as the success of index constituents waxes and wanes. Essentially, the performance of the S&P 500 is dependent on the success or failure of just 5 companies.
Third, the index is effectively a buy-high sell-low strategy. Put simply, to get added to the index a company needs to be meaningfully large. Companies aren’t born large, so by the time they are big enough to be added to the S&P 500 they have often experienced years of growth. In other words, companies are added to the index AFTER they have performed well and potentially already trading at elevated levels. In contrast, a company is removed from the index if it falls from grace and has shrunk considerably (or even gone bankrupt) due to years of weak performance. Ideally, investments should be bought BEFORE they perform well and sold BEFORE they start to underperform. The S&P 500 (and many other indices) does the opposite, and is effectively a buy-high sell-low strategy.
Takeaway: If you are looking for simple, diversified access to passive exposure to equities I would first look for indices that are well constructed. These well constructed indices may not be what you see in the newspaper headlines, and some are proprietary to mutual fund or ETF manufacturers. Look for investment products that provide ‘total market’ exposure while capping the weight of each underlying holding. Take a look at the top 10 holdings of whatever index ETF or fund you are researching to ensure they represent no more than 25% of the overall assets. Finally, also consider an index ETF or fund that includes small, mid and large cap stocks to provide exposure to all phases of company growth (i.e. not simply to companies that have already gotten big).
Thomas Boone Pickens Jr. (May 22, 1928 – September 11, 2019) was an American business magnate and financier. Pickens chaired the hedge fund BP Capital Management. He was a well-known takeover operator and corporate raider during the 1980s. As of November 2016, Pickens had a net worth of $500 million.
Before his death, Pickens wrote his last words to be published on LinkedIn by his foundation after he passed.
The entire post is much longer, but below is the key excerpt. In it, Pickens lists his secrets to success and building wealth:
– A good work ethic is critical.
– Don’t think competition is bad, but play by the rules. I loved to compete and win. I never wanted the other guy to do badly; I just wanted to do a little better than he did.
– Learn to analyze well. Assess the risks and the prospective rewards, and keep it simple.
– Be willing to make decisions. That’s the most important quality in a good leader: Avoid the “Ready-aim-aim-aim-aim” syndrome. You have to be willing to fire.
– Learn from mistakes. That’s not just a cliché. I sure made my share. Remember the doors that smashed your fingers the first time and be more careful the next trip through.
– Be humble. I always believed the higher a monkey climbs in the tree, the more people below can see his ass. You don’t have to be that monkey.
– Don’t look to government to solve problems — the strength of this country is in its people.
– Stay fit. You don’t want to get old and feel bad. You’ll also get a lot more accomplished and feel better about yourself if you stay fit. I didn’t make it to 91 by neglecting my health.
– Embrace change. Although older people are generally threatened by change, young people loved me because I embraced change rather than running from it. Change creates opportunity.
– Have faith, both in spiritual matters and in humanity, and in yourself. That faith will see you through the dark times we all navigate.
Over the years I have interviewed and questioned many, many investment managers. Early on, I discovered a disturbing pattern.
One of my previous roles was to perform due diligence on investment managers hired to run a variety of segregated funds (aka variable annuities) and group investment products. I essentially acted as a gatekeeper to decide which managers my company would use.
This was a sweet job!
When you’re the ‘gatekeeper you get invited to a lot of ball games and fancy dinners. Of course, there was a lot more to the job than getting wined and dined.
On a quarterly basis, I met face to face with investment managers to better understand their philosophy, strategies and processes for managing money. I would also review their results.
Most meetings began with the investment manager walking me through their slide deck. Let me tell you, every single investment manager I met with was impressive. They all had great academic achievements, were articulate and had robust investment processes. Moreover, they possessed an unreal bank of knowledge about their portfolios and the markets.
Early into the job, however, what I repeatedly saw troubled me. Actual performance results – i.e. what these investment managers were hired to deliver – were usually left to the last slide of the deck. Performance results were treated as a footnote to an engaging story. It was plainly obvious that these managers were trying to dazzle their audience with fantastic – but subjective – insights, hoping to skim over the hard, objective facts.
Because the performance results were crap most of the time. More specifically, these investment managers were generally unable to outperform their benchmarks.
It was a consistent letdown. I would spend 45 minutes engaged in some of the most intelligent conversation one could have, only to discover it was all meaningless bullshit. Repeatedly.
When Academic Theory Becomes Reality
Through my academic work, I learned that the majority of investment managers failed to outperform their benchmarks after accounting for fees. However, this fact was academic until I started my ‘gatekeeper’ job. After some time in that role, it became clear: These smart, expensive, well educated, fully resourced managers couldn’t do what they were meant to do.
Today, I still enjoy intellectual conversations with people in the asset management business. I still listen to economists and portfolio managers discuss their outlooks. But I do so knowing there’s a good chance they’re wrong and that the information is of no practical use.
The asset management industry likes to make everyday individuals think investing is hard. This is partly because people want to trust their money with smart people. But it is also because asset managers don’t want individuals to think they could manage their own money.
Dumbwealth.com is here to tell you it is easier than the industry leads you to believe. I’m not saying you can beat the benchmarks. After all, if million dollar portfolio management teams can’t, the average person can’t either. But individuals shouldn’t pay for something they won’t receive. Instead, strive for market-average returns at the lowest possible cost. In the long run, this strategy may beat professionally managed funds.
As Warren Buffett once said: “By periodically investing in an index fund, for example, the know-nothing investor can actually outperform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.” (1993 Berkshire Hathaway Shareholder Letter)
August 30th was America’s most-loved business tycoon’s 89th birthday. He made his fortune (US$82 billion as of July 18, 2019) investing in and helping to build American businesses.
I won’t waste your time diving into Buffett’s background (Wikipedia does a good job), but I will say his wisdom on investing, money and business management is sought by many (including President Barack Obama, as you can see in the pic above).
Here are some of his best gems:
“Beware the investment activity that produces applause; the great moves are usually greeted by yawns.”
“Calling someone who trades actively in the market an investor is like calling someone who repeatedly engages in one-night stands a romantic.”
“The stock market is designed to transfer money from the active to the patient.”
“The business schools reward difficult complex behavior more than simple behavior, but simple behavior is more effective.”
“Forecasts may tell you a great deal about the forecaster; they tell you nothing about the future.”
“Opportunities come infrequently. When it rains gold, put out the bucket, not the thimble.”
“It’s better to hang out with people better than you. Pick out associates whose behavior is better than yours and you’ll drift in that direction.”
“You’ve gotta keep control of your time, and you can’t unless you say no. You can’t let people set your agenda in life.”
“The investor of today does not profit from yesterday’s growth.”
“Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value.” (Note: Interestingly, Buffett’s company, Berkshire Hathaway, currently holds about $122b in cash.)
“I insist on a lot of time being spent, almost every day, to just sit and think. That is very uncommon in American business. I read and think. So I do more reading and thinking, and make less impulse decisions than most people in business.”
“Be Fearful When Others Are Greedy and Greedy When Others Are Fearful”
“There comes a time when you ought to start doing what you want. Take a job that you love. You will jump out of bed in the morning. I think you are out of your mind if you keep taking jobs that you don’t like because you think it will look good on your resume. Isn’t that a little like saving up sex for your old age?”
“Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.”
The Global Financial Crisis of 2008-2009 was a shocking reminder of what risk looks like. Markets around the world plummeted and volatility skyrocketed. The banking system almost shut down and we came close to experiencing another Great Depression.
Despite the unusual nature of the financial crisis, market declines of 20-50% do occur somewhat regularly. (Another market decline of a similar depth occurred only six years before the 2008 crisis started.) Consequently, it is prudent to factor in these types of declines when examining the long term market performance track record of any mutual fund or ETF.
When investment fund companies display returns for mutual funds and ETFs regulators force them to show 1 year, 3 year, 5 year and 10 year returns (or since inception, if the track record is shorter than 3, 5 or 10 years).
Important note: Fund companies are not obligated by the regulatory bodies to show returns beyond 10 years. This means you might not be getting the full picture – especially if the longer track record looks weak.
Until recently, funds with a 10 year track record incorporated the period that included the Global Financial Crisis. The bottom of the crisis occurred in March 2009, so until March 2019 at least some of the crisis was captured. Now that March 2019 has passed, 100% of current 10 year performance data occurred during a bull market. In other words, despite a few market jerks along the way, 10 year data no longer includes a full market cycle and no longer illustrates the full range of what an investor might experience. Current 10 year time series is effectively a case study in the ‘best case’ investing scenario.
Chart 1 illustrates the impact the financial crisis had on long term returns calculations. The bars show the worst 1 year return for the preceding decade. Until recently, the worst 1 year return occurred during the financial crisis (-43%) and was captured in 10 year time series. With the financial crisis dropping off the 10 year time series, you can see the dramatic improvement in the worst 1 year return on the right side of the chart.
Chart 2 shows how rolling the financial crisis (and the worst 1 year return from Chart 1) off the 10 year time series impacted 10 year returns. The spike on the right hand side of the chart coincides with the worst 1 year period falling off the scale. Indeed, average 10 year return has risen from the high single digits to the mid teens.
This is a deceptive representation of long term returns since it is no longer grounded by a bear market – a normal occurrence during a full market cycle.
Chart 3 illustrates how the financial crisis impacted 10 year volatility as measured by standard deviation. Again, you can see how the 10 year volatility dramatically declines once the data that includes the financial crisis rolls off.
Losing the Global Financial Crisis off 10 year historical data means investors are no longer getting the full view of how a mutual fund or ETF performs during a market cycle. Not only is this misleading with respect to long term risk-return analysis, this potentially has an impact on how investment fund companies define the risk profiles of their products.
Regulatory documents require companies define the risk level of their products. While not perfect, standard deviation is the commonly accepted quantifiable measure of risk. The recent dramatic decline in 10 year volatility will probably mean that fund companies re-rate their funds as lower risk than before. Meanwhile, the fund itself hasn’t changed. This would be like saying a car is safer now because it hasn’t been in an accident in 10 years. Nothing about the car has changed…it is simply operating within a safer environment.
Same car. Same fund. But you can be sure as sh!t that fund companies will use this more attractive data to their advantage when marketing their products. Even fund companies that don’t purposely mislead will still inadvertently do their investors a disservice by under-reporting risk ratings for their products. After all, what company would voluntarily communicate the risk levels for their funds are actually higher than what the regulators force them to communicate?
Now – more than ever – the warning rings true: past performance is not indicative of future performance. And, if you can, try to evaluate your investments using data that captures a full market cycle.
This morning I saw a job posting for a Global Equity Portfolio Manager role in Toronto. The base pay was $200,000 with total compensation ranging up to $600,000.
Let me repeat that: Total compensation was up to $600,000. Per year. Every year.
What are the requirements for such a prestigious role, you ask? The ability to convert water into wine? The answer to the meaning of life? Or perhaps a more reasonable track record of outperformance versus a benchmark?
Nope. None of the above.
The right candidate simply needed 10+ years of experience in a similar role managing money. In other words, the person needed to be experienced, but perfectly average against their peers.
The posting didn’t ask for someone who has an above-average track record because this would dramatically restrict the pool of candidates, thus increasing the expected compensation well into the 7-figure range. The outperforming investment manager is an expensive unicorn – a unicorn that happens to revert back to the mean 9 times out of 10. So, instead of searching for a unicorn, the asset management firm hires for average.
Portfolio management departments of asset management firms are filled with such people – experienced, but perfectly average investment managers and research analysts. These folks are smart and knowledgeable, but they tend to lack any credible evidence that they can deliver on their mandate in any way better than their colleagues or an index. So you are left with a department filled with average managers and analysts eating up millions of dollars in salaries, research software and travel expenses.
Staffing an asset management shop is expensive, however asset management revenues (received via management fees) continue to shrink. Management fees are shrinking for a multitude of reasons, none of which paint a good picture of the exalted portfolio manager: 1) Forecasted market returns are lower, thus management fees must decline to somewhat compensate, 2) new cheaper investment products are available to all (i.e. index funds), and 3) a quarter century of research shows that it is almost impossible for anyone to outperform the market after costs on a consistent basis.
Today, the model is still profitable, but as pressure on fees intensifies something will eventually break.
The rift between revenues and expenses will widen, but only one of those things can be controlled by the company. Cost cutting will be critical to the survival of asset managers over the next decade and portfolio management and research is one of the fattest parts of the business, especially when evaluated in terms of contribution to investment performance.
When people get too expensive for the value they create salaries decline or machines move in. This is precisely why manufacturing is more capital intensive in Japan and America than in China or Mexico. Already, algorithms and artificial intelligence (AI) are taking the place of humans in the asset management business. Some firms are spinning this as a novelty, while other asset managers have used some form of AI at the core of their operations for years.
Still, the vast majority of investment management is performed by fallible, underperforming human beings. The avalanche has yet to start, but all it takes is a single snowflake to trigger motion that will change the landscape forever.
“In numerous years following the [civil] war, the Federal Government ran a heavy surplus. [But] it could not pay off its debt, retire its securities, because to do so meant there would be no bonds to back the national bank notes. To pay off the debt was to destroy the money supply.”
— John Kenneth Galbraith
In the investing world, you can take a 3 month view, a 3 year view or a 30 year view. One person looking at one asset class might have a different forecast depending on the time horizon he is considering. In this article, I will look at gold through a 30 year lens.
I believe that structural forces will support gold and other hard assets over the long term. While current forces may be bearish for gold in the immediate term as investors panic and liquidate everything, there are a number of underlying currents that demand a strategic allocation to the metal. While the sophisticated gold investor is already familiar with these concepts, I think it is important to re-introduce them to a broader audience who may have zero allocation to gold, other precious metals and hard assets.
The Origins of Money
Throughout history, money has always held an important position as a means to facilitate transactions, thus creating massive efficiencies within an economy. Sometimes money was issued by governments. Other times a common means of transacting arose organically within a population.
Many historians suggest that fractional reserve banking and private money creation started when gold owners stored bullion within the vaults of goldsmiths for safe keeping. As proof of deposit, goldsmiths issued paper receipts that could be redeemed in exchange for gold. Seeing an easier way to transact, when buying goods and services gold owners would simply hand over gold receipts as forms of payment instead of redeeming for gold and delivering the metal.
Eventually, enough people were doing this that some enterprising goldsmiths, who noticed that the gold in their vaults was rarely reclaimed, started lending (with interest) new paper receipts that weren’t tied to a specific gold deposit. After making these loans, more paper existed than gold in the vaults, resulting in an early example of expanding money supply and credit growth. Of course, any goldsmith that manufactured receipts far in excess of gold reserves risked a run on deposits and existing receipt holders may have experienced a loss of exchange value.
Money Creation Today
In the US today, many believe that the Federal Reserve is the primary source of money supply growth. Many also believe that the Fed creates money and simply pumps it into the economy somehow. This assumes the Fed has some sort of authority over how money is spent, but this is untrue. Monetary policy is the handmaiden of fiscal policy, but both are quite distinct.
Through open market operations, the Fed adds to the money supply by purchasing assets such as US Treasuries and mortgages. Effectively, each dollar injected this way is the mirror image of someone’s liability, giving rise to the concept that money is debt.
Think about it this way, the massive fiscal response to the 2008/2009 recession and sluggish recovery has added trillions to the Federal debt. Much of this debt was indirectly financed by the Federal reserve (although they’d never admit it) via open market operations. So instead of simply printing and spending its own money, the US government has granted an independent entity (the Federal Reserve) the right to print and lend to the government and its citizens. Some might see this as ‘checks and balances’ while others might argue that it grants unnecessary power and profit to the banking cabal that controls the Federal Reserve. In the end, the US government has added $trillions to its debt.
The truth is that while the Federal Reserve can add to the money supply the biggest driver of money growth is the private sector. And this is where it gets especially important for the gold investor.
The monetary system does not stand still – it operates on a treadmill of debt. The majority of money in the economy is created when private banks make loans. One might think that these loans are based on deposits, but the reality is that – much like the goldsmiths of days past – in a fractional reserve system far more loans are made than deposits on hand.
Modern Money Mechanics, a publication by the Federal Reserve Bank of Chicago in 1968, states the following:
” For example, if reserves of 20 percent were required, deposits could expand only until they were five times as large as reserves…Under current regulations, the reserve requirement against most transaction accounts is 10 percent…Of course, they [the banks] do not really pay out loans from the money they receive as deposits. If they did this, no additional money would be created…The deposit expansion factor for a given amount of new reserves is thus the reciprocal of the required reserve percentage (1/.10 = 10).”
They further illustrate this with the following diagram, showing the initial deposit and the cumulative expansion via additional loans.
Fig. 1: Cumulative expansion in deposits on the basis of 10,000 of new reserves and reserve requirements of 10 percent, from: FED, 1968. Modern Money Mechanics – A Workbook on Bank Reserves and Deposit Expansion. Federal Reserve Bank of Chicago, Revised Edition, February 1994, p. 11
In essence, the banking system has the legal power to create money out of thin air
The Debt-Money Conundrum
Here’s the kicker: whether the money is created by the Fed or by the private banks, the money must be paid back with interest. Because only the principal amount is loaned, only the principal amount exists in circulation. In aggregate, enough money doesn’t exist throughout the economy to pay both principal and interest on all debts.
Bernard Lietaer, who helped design the Euro and has written several books on monetary reform, explains the interest problem like this:
“When a bank provides you with a $100,000 mortgage, it creates only the principal, which you spend and which then circulates in the economy. The bank expects you to pay back $200,000 over the next 20 years, but it doesn’t create the second $100,000 – the interest. Instead, the bank sends you out into the tough world to battle against everybody else to bring back the second $100,000.”
The debt-money conundrum results in two conditions:
1. Systemic Competition. Like rats in a cage, society is provided too few resources. In this case, the money required to repay debts plus interest is short. This means that if one person or company is able to repay their debts another is not. This raises the level of competition within society. Arguably this has been a positive economic characteristic since the industrial revolution, however one must wonder what the world would be like if debt-fueled competition didn’t exist. Competition goes far beyond the healthy – many wars and crimes can be traced to the competition for the resources required to indirectly repay debts through economic growth. Right or wrong, money loaned into existence has created systemic competition. On an individual level, many refer to this as the ‘rat race’. On a macro level some refer to this as the New World Order.
“The problem is that all money except coins now comes from banker created loans, so the only way to get the interest owed on old loans is to take out new loans, continually inflating the money supply; either that, or some borrowers have to default. Lietaer concluded: [G]reed and competition are not a result of immutable human temperament . . . . [G]reed and fear of scarcity are in fact being continuously created and amplified as a direct result of the kind of money we are using. . . . [W]e can produce more than enough food to feed everybody, and there is definitely enough work for everybody in the world, but there is clearly not enough money to pay for it all. The scarcity is in our national currencies. In fact, the job of central banks is to create and maintain that currency scarcity.
The direct consequence is that we have to fight with each other in order to survive.”
2. The Ultimate Ponzi. If money was lent into existence on a single occasion only, the first condition would lead to a deflationary outcome and shrinking total credit. Lenders would take haircuts and, knowing this in advance, potentially would have never lent the money in the first place. Or lenders would have priced the defaults into interest rates and covenants, paradoxically making it even harder for all loans to be repaid with interest. The banking system simply would no longer exist in its current state.
In reality, new money supply begets new money supply. To reduce the number of defaults caused by the competition for money, the banking system must continually lend more money into existence. As new money is introduced it helps money flow to past borrowers enabling them to repay their debts. To adequately offset the number of bankruptcies in the system, money must continually be created. This is precisely why modern industrial economies have a implicit ‘normal’ inflation rate of 1-3%. In good times and bad, money supply simply must expand for the system to survive. Normally that money is created by banks; however, sometimes the lender of last resort (i.e. Federal Reserve) – as the only lender that can continually accept losses – steps in to offset private loan destruction in periods of extreme financial distress, such as the 2008/2009 crisis.
The Growth Imperative
When inflation must be maintained at 1-3% for the system to stay solvent, many other areas of society are significantly affected. Companies must continuously raise prices, salaries must continuously increase, economies must continuously grow, populations must continuously increase, food supply must continuously rise, and so on.
Over the long run, continuous monetary expansion leads to the destruction of the value of the dollar relative to stable assets. While continuous monetary expansion can provide a tailwind to many businesses with pricing power, I think most investors are already set up to benefit from this through the equity portion of their portfolios. Where I think many investors are deficient is in a strategic allocation to gold.
Gold is Money
Many investors have a 3 month or 3 year view on gold, but few have a 30 year view. While I agree that intermediate forces could send the gold price down, I believe that structural monetary expansion means that all long-term investors should have some strategic weight to the yellow metal, which can serve as stable money while fiat currencies around it are devalued.
While equities (and other assets) can benefit from these same structural forces, gold has different risk-return characteristics and can help to diversify a portfolio. I am not saying that investors should dump half their portfolio into gold bars. What I am saying is that, as a stable currency, gold can help mitigate the effects of never-ending monetary expansion, and most investors are significantly underweight.
Gold can provide factor exposure not obtained through traditional asset classes and may be a valuable tool in the preservation of long-term wealth in a world in which money is debt and gold is money.
(I originally wrote this in 2011 for another publication. I recently found a copy and posted it here.)
The world is experiencing the worst economic recovery since the Great Depression. So why is oil hovering around $100/bbl? And as a gold investor, why should you care about oil?
Some might point to developments in the Middle East as the reason for high oil prices. However, I believe the root cause of current Middle East angst is the steady depletion of easily accessible oil and, consequently, government revenues needed to quell the population. Everything that is happening across the Middle East — citizen revolts, government crack downs, production disruptions and oil price inflation — tells me the world may have crossed the point of peak oil.
I don’t think the world will run out of oil anytime soon. However, based on the advice of expert geologists, I do believe that a) the world is running out of inexpensive oil and b) global demand is pressuring oil prices.
Given these pre-conditions, it is my view that the world has entered a new boom-bust cycle driven by oil prices. Oscillating oil prices — as opposed to credit cycles — will repeatedly stimulate and crash the highly levered global economy. Governments have not recognized this new cycle, and as part of a fruitless effort to retain control over deteriorating real growth and rising unemployment central banks will print more and more money, risking a hyperinflationary depression (stagflation at best). The only respite for many investors is gold.
The 2008 Financial Crisis was the First of Many
During the last thirty years debt has spread like a cancer throughout the developed world. Today’s consumption was financed by tomorrow’s higher revenues, creating a vicious cycle between growth and the need for debt. This system worked as long as growth needed to repay expanding credit could be subsidized by inexpensive energy.
Unfortunately, rising oil prices have stealthily and persistently chipped away at the foundation of our heavily indebted financial system. Ultimately, in 2008, oil prices and total debt passed the threshold beyond which the economy could not operate, and the financial system came crashing down. With collapsing demand, oil prices fell.
Many mistakenly point to sub-prime mortgages and CDSs as the cause of the 2008 crisis — I believe they were merely the transmission mechanisms. In reality, rising oil prices eroded the weakest links in the increasingly levered global economic system.
Enter the Central Banks
As we’ve witnessed repeatedly since Richard Nixon suspended dollar convertibility into gold, the Federal Reserve solves all economic problems with the monetary cure-all. Either by using the proverbial helicopter or the Treasury as an intermediary, central banks have repeatedly pumped liquidity into the economy and bought bad debts from the private sector. This effectively transfers the bad debt to the taxpayer by way of liability and currency debasement. In addition, fiscal policy (which is often the hand maiden of monetary policy) adds additional public sector debt in the name of stimulus. In whole, debt burdens and money supply rise. Of course, all this is done under the assumption that the economy will somehow be able to repay these new debts through future growth.
In the new boom-bust cycle driven by oil prices, the central banks are unknowingly impotent. As the economy crashes, they print money to stimulate economic activity, but it is short-lived and inflationary. More stimulative is the lower oil prices caused by the crash. However, any renewed growth and inflation sends oil prices back up towards another threshold, once again breaking the weakest links of the economy…and the default-bailout-growth cycle repeats.
Right now, oil price inflation is most noticeable when we fill up our gas tanks. But as high oil prices become pervasive throughout the economy the destruction of aggregate wealth will intensify. This will increase the number of weak links throughout the economy. It will also increase the sensitivity of those weak links to higher oil prices — another vicious cycle.
Consequently, as the default-bailout-growth cycle repeats and rising oil prices become more omnipresent, periods of economic growth become weaker, and periods of economic bust more frequent and persistent. Eventually, as the cycle repeats, the sharp economic contrasts of boom and bust blend together becoming a permanent shade of economic grey.
In a world of economic grey, defaults become more frequent, bailouts to support financial infrastructure and the growing mass of unemployed cause monetary growth to spiral out of control and economic ‘successes’ are characterized as periodic episodes of stabilization.
Assuming current policies persist, and until we find an alternative economic subsidy to inexpensive oil, over the long-run this cycle would turn into a hyperinflationary depression, as central banks print, the economy shrinks and the masses suffer.
The reversal of the cheap energy dividend would spell the end to middle class society, as the limited number of ‘haves’ hoard their wealth, food and weapons. What little wealth and property the middle class controls would be sequestered by the elite as the middle class citizens lose their jobs and default on their debts. Eventually the middle class become serfs living a life of subsistence, providing the labor to toil on the land they once owned – a less punitive alternative to debtors’ prison.
Those that are able to escape the drudgery of indentured servitude will be the middle class citizens who default while the system still works in their favor or who have nothing to default on. Unfortunately, the defaulting unemployed also cannot pay rent so to avoid the unfortunate trade-off between serfdom and homelessness one must own land that isn’t mortgaged or own enough assets to buy a home or pay rent indefinitely. In other words, to survive or thrive in this grey economic future one must either reduce their dependence on income or have a large enough asset base to generate cash flow.
Saved by Gold
As they did in 2008, central banks will print money to bail out collapsing financial infrastructure and support a growing mass of unemployed. While each cycle may begin as a deflationary shock, causing gold prices to decline, the eventual monetary response will destroy currencies and send gold prices soaring. This has already started to happen.
Unless high ROI replacement energy sources are found, over the long-run this cycle could turn into a hyperinflationary depression, as central banks naïvely fight a losing battle. Savings could be wiped out as the value of paper currency plummets, and in the new boom-bust cycle one of the few ways to protect wealth over the long run may be to own gold.