The original content for this topic actually came from a continuing education that I wrote back in 2010 for lawyers and accountants. We are currently updating it, and modifying it for the whitepaper format. In the meantime, we’ve posted the course outlines, of which there are two. The first is the summary outline passed out to the participants. The second is a detailed outline that I prepared as a speaker’s reference…candidly because sometimes I forget exactly why I mention certain aspects of things and I find it helpful to give myself enough information to make a running start at the given section. BT
Challenges to Capital Management in the 21st Century
Continuing Education course by Brad Thomason, CPA
I. What We Thought We Knew About Managing Money (20 min)
~Past results are an indicator of future performance – We’ll keep getting what we always got
~We’re all in this together – You can’t beat the market, so we’ll all be market investors
~The risk is already priced in – If we were taking on risk our return would be higher
II. Post-modern Reality – The Tale of the Last 10 Years (20 min)
~Not 1984, 1987 – The beginning of the modern era
~That which goes up must keep going up. Or not – The Tech Bubble
~Something isn’t quite right – when gravity started pulling from a different direction
III. Challenges to Traditional Approaches (30 min)
~America is Built – Why the next 50 years probably won’t look like the last 50 years
~Technology isn’t what you think – ongoing lifestyle force, but a one-time economic force
~The Impact of Liquidity – Cash, cash everywhere!
~Sneaky Devils – Inflation, and other things we don’t seem to understand
~The Gypsies are in the Palace – The Age of the Trader
~Looking for Love (in all the places where everyone else is looking) – recent history and immediate future
IV. Other Places to Look (80 min)
~The Big 3 – The 3 domestic themes that should keep on working
~One if by Land, Two if by Sea – What about other countries?
V. What Good Financial Planning Looks Like (50 min)
~Where you will probably live – The range in which your rate of return will probably fall
~Worth the effort? – The impact of moving around inside the range
~Brother, can you spare me an edge? – How to hunt down seemingly small mathematical advantages that end up yielding big results
~Financial Planning Part A/Financial Planning Part B – Accumulation vs Distribution
~What the $#@& Do You Want? – The first step of any worthwhile planning exercise
~Accounting for Everything. Everything.
~~DETAILED OUTLINE~~
What We Thought We Knew
Past results…
For a period of many years the US stock market returned an average of about 12% per year. This was widely known, and served as the basis for many financial projections. Because it held true for many years, the strategies it spawned were reinforced. However, the market’s performance was an effect, and no one bothered to look for the cause. They assumed the effect would be perpetual, without checking to see if the cause was intact.
We’re all in this…
You cannot beat the market. This was “proven” definitively by smart people who used lots of math. They were so smart they won Nobel Prizes for it. It was a well-established, and self-evident truth that to attempt the impossible was a fool’s errand and that no one should even bother. The market gave people 12% a year, and that was good enough. Buy your stocks, forget you have them, hang on for the inevitable ride to higher ground. Or else you’re not very bright.
The risk…
Risk and return walk through life, hand in hand. Part of the reason you can’t beat the market is because the market already knows everything. Moreover, it has taken all of the information into consideration in setting the price of X. All of the risks have been fully accounted for and baked into the price. Those taking on higher risk may get a higher return, but it’s because of the market is allowing it to happen to compensate for the risk. In this way, it remains true, that on a risk-adjusted basis, everyone in the market earns the same thing.
Post-Modern Reality
Not 1984…
George Orwell identified 1984 as the year when the new world would be in place. He missed it by 3 years. The new world actually started in 1987 when the market crashed. People woke up to the fact that markets had become far more complex than anyone previously appreciated, and that the structural elements of the exchanges themselves were no longer adequate to protect participants from mind-numbing spurts of volatility which could seemingly wipe-out years of economic growth in a single afternoon. Apparently the market wasn’t pricing in all of the risk after all. And if not, what did that say about all of the other things people were sure about?
That which goes up…
The exchanges were overhauled, and all seemed to return to normal. The long-term average return kept plugging along (as long as you spread it back over enough years; a mathematical necessity to cover over the impacts of a few unfortunate outbursts of volatility – which were probably just caused by “over-reaction” on the part of a few unfortunately “emotional” investors, anyway). Then the world became enamored with all things technological. The future was going to be incredibly bright, because the market said so. How else to explain the soaring valuations of companies that were not even turning a profit? That had to be the case, or else it would once again call into question the supremacy of what we knew to be right (that the market was perfect at pricing risk and value). The economy really had to have grown into something it never was before. Then the prices fell. The market essentially lost half its value in a matter of months. Which is impossible. But someone forgot to tell the market.
Something isn’t quite right…
People became scared of stocks. They started putting their money into something safer instead: real estate. Except they forgot about those 401(k) accounts at work. That money kept going into the market. And the industry came out in force and explained away the impossible as a “fluke.” They said that they “believed in America,” and as such that was going to make asset values start climbing again. And they did, for a while. Then another bubble burst. And the long-term 12% annual average yield turned into a return of 0% for a period of 12 years (1998-2010); but it was an exciting 0%: the market lost 40% or more of its value, not once, but twice, in less than 10 years.
Challenges to Traditional Approaches
America is built…
The amount of economic growth in this country for the 50 year period starting at the end of WW2 was unprecedented in history. America became the world’s first “modern economy.” Fueled by an abundance of natural resources, a well-educated populace, and a national obsession to be part of the middle class and “live the American Dream,” we saw results which had never before occurred. And not just economic growth in the outright sense, but the evolution of financial markets to better facilitate the flow of capital from source to opportunity; and the wide-spread distribution of technology that allowed us to compress the timescale at which nearly every facet of life occurs. Which is all great. But similar changes are not likely for next 50 years: financial markets are now more complex than the most people actually think is good; nor do we particularly need a lot more Hampton Inns or Applebees. America is built. The American economy will continue to be huge, just due to the servicing of all the people who live here; innovation will still lead to opportunities; and the cycle of new replacing old will not end. America is not dead by any means. But the rising tide that has carried us higher for decades will crest, because after a point there won’t be enough “water” in the world left to drive it any higher.
Technology…
Has made incredible things possible. And will make even more incredible things possible in the future. But as an anthropological event – the democratization of personal technology – it has already occurred. Just as the decision to stop chasing animals and plant crops, and the decision to venture out onto the sea to look for others to trade with were significant developments in human history that influenced everything that happened after the fact, so will technology’s fingerprints be on everything it means to be human from now on. But as a development, it happens once, at a single inflection point in history. And that has already occurred. Such events put a “step function” into the graph. They are game-changers that irrevocably set the bar higher, and they are inordinately beneficial over time. That’s their nature. But it is also their nature that they confer much of their transitional benefit at a single stroke.
The impact of liquidity…
One hundred years ago there was some x quantity of useable natural resources on the planet’s balance sheet. Today that quantity is less, and the value of those assets has been converted into cash. The basic proposition of finance is to provide a way for cash to find a home: to match capital with opportunities (in the form of business pursuits, and by proxy, the financial assets which represent investments in those pursuits) so that the cash can earn a return. In simple supply and demand terms, in a world where capital grew at a rate that outstripped the rate of growth in opportunities, then over time there would be less relative demand for the funds. When supply grows and demand falls, price falls also. So the price for the use of cash would decline. The price for the use of cash is denominated in terms of interest rates (the fee that another is willing to pay to use the capital). So in a world with surplus cash, we would expect chronically low interest rates (without a scarcity of capital, there is no need for venturers to pay a premium for its use; and owners of capital lose pricing power relative to those who would employ their capital). Since capital is ultimately a commodity, the low-cost provider wins when there is no shortage.
Sneaky devils…
Inflation is a matter that inspires significant confusion. Not only do experts disagree on what it actually is (some say it deals with the balance of goods/services with purchasing power for the same; others that it is a function of the units of currency relative to a nation’s resources or productive capacity). But on Main Street, it simply addresses the idea that a dollar won’t go as far in the future as it will today. And not just because the things we know about get more expensive, but also because innovation and technology create new things for us to buy that didn’t used to exist (try calculating the rate of inflation over the last 50 years for satellite TV or IPod downloads, if you don’t believe it…). Moreover, inflation doesn’t happen in an across-the-board manner as is implied with common measurements such as CPI. Inflation relative to healthcare runs higher than general inflation, and becomes an ever increasing part of the inflation problem as people age (and enter the phase of their life where dramatic shifts in their cost structures can be the hardest to deal with financially).
The Gypsies…
The strength and ultimately the downfall of the buy and hold idea was that if everyone played along, the chances of getting a solid market return year in and year out were much better. It was something of a self-fulfilling (or perhaps self-serving) mantra. But not everyone plays for the same thing. Not everyone wants a steady consistent return. Some people would rather exploit the individual moves that cycle through the markets every hour and every day. These folks have always been around for a very simple reason: if they do it right they make a lot more money than the other guys (the ones who believe you really can’t beat the market, and don’t even try). So if they’ve always been around, what changed? Technology. Trading is now dramatically easier to do successfully than it was 40 years ago. The result is that a measurable portion of the market is no longer made up of investors, it’s made up of traders. People who are playing the same game for a very different win. And because markets are a closed system, their maneuvers can’t help but have an impact on everyone else. So the desire to profit found new toys and got better at coming to fruition. So capital followed, which made them that much more capable of landing in the win column. The desire to profit, the desire to win, the tools to do so, and the capital to pump it through the system: none of it is going anywhere. It’s here to stay. Those who think they can invest in the modern markets in the same manner that they did 50 years ago are in for a surprise. Markets don’t work that way anymore (and the flat return over the last dozen years, coupled with ever-increasing volatility, is pretty irrefutable proof of that).
Looking…
There’s an old saying in baseball about how to be successful at the plate: Hit ‘em where they ain’t. Just as you don’t want your baseballs going to the part of the field where the other team’s players are standing, neither do you really want to be looking for opportunities where everyone else is looking. If everyone is looking at the same investments, those investments start behaving just like all the others. The term for this type of behavior is “correlation.” When lots and lots of individual stocks move up and down in more or less the same way that the general market moves, correlation is high. Again, it means everyone is looking at the same things, and the likelihood of individual investments moving differently (and in so doing, creating the prospects for non-market returns), diminishes. We live in a period of history where correlation within the stock market often runs 80% or more (i.e. 8 out of every ten stocks is moving in lock-step with the market). Why would we want correlation so high? We probably don’t. But the emergence of stock mutual funds, index funds and EFTs (exchange traded funds) almost guarantees high-levels of correlation, especially to the extent that the offerings of different fund companies merely seek to deliver conformity to some market or sector. Our love for financial products over individual securities has had a huge impact on our ability to find unique opportunities in the market; and trend-wise this tendency has only increased in the past few years.
Other Places to Look
The Big 3:
Operating Businesses (because if operating assets didn’t have the ability to out-earn financial assets, there would be no need for financial assets in the first place. No one would intentionally start a business and pay investors 5%-10% on stock or bonds if they could only get a 3% return on the capital.)
Temporary Imbalances in Exchange Traded markets (because markets actually don’t get the pricing right all the time, and because a lot of the time that’s caused by the traders dragging things around to suit their own purposes. If you aren’t able to adapt to these realities, the results could be dire – like a decade or more with no net return… And if you are going to adapt to these factors, you might as well deploy adaptations that are going to make you money in the process)
Distressed Assets (because even in the best of times there are those who cannot arrange credit or sell assets at market rates, due to some factor that they probably would just as soon not have to deal with. Rather than shut them out altogether, transacting at terms that account for the difficulty is better for everyone. For investors, though this may lead to more work, it also leads to the prospect of better returns, from higher interest rates on debt and/or discounted prices on asset purchases. Again, that’s in the best of times. Which these aren’t. Volume increases accordingly.
One if by Land…
America may be built, but there’s a whole world out there trying to catch up. Where the desire to grow and develop is strong, the willingness to pay a premium for capital will drive rates higher. Where financial markets are evolving there will be volatility to be harvested by those not faint of heart.
What Good Financial Planning Looks Like
Where…
Historically most individual investors end up earning 4% to 10% over time, portfolio wide. Within that range changes of even a single percentage point of yield make a big difference over the 20 to 30 year span of most financial plans.
Worth the effort…
Since small changes make a big difference within that range, they are important, provided they do not come at the expense of unacceptable risks.
Brother…
So if they are worth it, where do you look? The easiest places are the places that may not be immediately obvious: tax efficiency and good organization can actually make a noticeable difference (though they may not be very exciting). Others: effectiveness of capital deployment, awareness of places where equivalent risks don’t provide equivalent yields (Hint: you want the ones that pay more), and a handful of mathematical tricks that answer the question, “What do professional portfolio designers know that I don’t?”
Financial Planning…
There are 2 distinct stages: accumulation and distribution. The first stage gets all of the attention, and is the one that’s fun to talk about (since presumably this is the period in which your wealth swells). But technically speaking, the second phase is far more complicated. Saving money and watching it grow is cake compared to figuring out how to convert it back into income that’s going to allow a person to live the life they want to live. The first phase gets all the attention, and is the part that people are most likely to seek help in executing well. Paradoxically, the second phase is the one where professional help is probably much more valuable. And double-paradoxically (if that actually is a thing) it is the part that relative few who hold themselves out as financial advisors are actually qualified to help with (because, again, it’s complex).
What…
All planning starts with knowing what you want to accomplish. At least that’s certainly the place that it ought to always start. You must be able to articulate what you want to do if you want to have the best chance of actually pulling it off.
Accounting…
Some people knowingly leave out factors that they know are going to have a financial impact, on the grounds that they just want to “keep it simple.” Whether they do this because they are lazy or incapable of handling complexity is often unclear, though ultimately it’s a distinction which is moot: the end result is the same. If you do not at least attempt to account for everything that you know is going to be impactful (and leave a few place holders for the items that will inevitably be forgotten the first few times through), then you do not have much of a basis for trying to plan for what’s coming down the road. Nor do you have a way to record actual results, as projections give way to reality, so that you can adjust the plan accordingly. That is to say, you don’t have much of anything, period. A financial plan that is knowingly incomplete is going to be misleading at best, and perhaps quite dangerous. Given that a person’s finances will impact their ability to live the life they want to live more so than any factor other than their health, it would certainly seem that a bit of diligence is in order, even if it does mean having to work a little.