A few interesting items from John Mauldin's Frontline thoughts
What is Wealth?
“How we define wealth,” says good friend Rob Arnott, “or investment success, drives our approach to investing. Benjamin Graham was fond of saying that the essence of investment management is the management of risks, not the management of returns. Well-managed portfolios start with this precept.”
Writing in this month’s Financial Analysts Journal, Rob gives us a different way to look at wealth. (Rob, besides successfully running billions of dollars at various funds, is the editor of the FAJ and has given me permission to use this material.) Quoting:
The Return of the Muddle Through Economy
• “Can we measure our wealth as the value of our portfolio? Hardly. Today, $1 million buys much less than it did 25 years ago.
• “Is wealth defined by the real value of our portfolio? Only if we plan to spend it all right away.
• “Is wealth the long-term spending that our portfolio can sustain—the annuity that our assets could procure? This definition is closer to the truth, but like the first, it ignores purchasing power.
• “Is wealth, then, the inflation-indexed real income that our assets could sustain over time? For most investors, this is probably the most useful definition of wealth.” But what assets should we invest in to get the best inflation-indexed returns? Stocks? Bonds? Commodities? And what about the risks of these various asset classes? In a very interesting study, Rob redefines risk not as volatility of the asset class in terms of price but in terms of real sustainable spending. And he defines returns as not just a simple return, but as the growth in the real spending stream that the portfolio can sustain.
It’s all about cash flow, or about the cash flow an asset or business can maintain. Real estate can produce a stream of income. Stocks can produce dividends or can be sold and invested in an annuity. Bonds pay an income. Entrepreneurs strive to build a business income model that does not solely depend on their continual involvement. (If you can’t walk away and the business still produce an income, or if you can’t sell the business to
someone for cash to invest, you have a job, not a sustainable business.)
As investors, what we are ultimately concerned with should be future streams of income or cash flow. We work to get our portfolios to grow faster than inflation, and to enough size to support our desired lifestyle. But Rob is suggesting that it is not the size of the portfolio, but the ability to produce a sustainable long-term lifestyle.
Normally we think of T-bills as being the most risk-free investment. When
viewed in terms of sustainable spending, however, T-bills become riskier than TIPS (inflation-adjusted bonds) and/or a regular bond portfolio. Look at the chart below. It represents the sustainable spending risk-adjusted returns of various asset classes. The red line is drawn between T-bills and stock market returns (as represented by the S&P 500). This is the classic capital market line between the “risk-free” asset and risky stocks.
Surprise. What you find out is that almost all asset classes produce a return or alpha higher than does the classic capital market when your define risk in terms of sustainable spending.
And the difference in returns between (1) TIPS, (2) a classic 60/40 stock and bond portfolio, (3) a simple portfolio comprised of all the asset classes, and (4) an all-stock portfolio in terms of sustainable spending is not all that much; but the volatility difference is huge.
I am currently doing a study that I will release later this year, but I'll give you a preview. Let's start with a portfolio diversified among two or more asset classes. At some point one of those asset classes will either underperform or undergo severe volatility. At such times the data suggests that a typical investor will switch to the better performing asset class. And this is precisely what almost guarantees that his total portfolio is going to underperform in the future.
Why? Because now he is over-allocated to an asset class that is likely to regress to lower than normal returns, especially if that asset class is mean reverting, like stock markets.
(This is not an argument that you should stay the course on a poorly performing asset class. Your asset allocation model should strongly depend on the current valuations of the various asset classes.)
But back to the conclusion of Rob’s article:
“What can we conclude…? First, [investors] singular focus on portfolio return and volatility and peer-group comparisons, to the exclusion of sustainable real spending and its volatility, is misguided. It leads us away from a balanced assessment of investment success.
“Second, the power of true diversification should not be underestimated as a means to sustain long-term real spending power at modest risk. The classic 60/40 balanced portfolio is not true diversification. Indeed, one of the best-kept secrets of the investing community is that stock market return so dominates the risk of a 60/40 portfolio that the portfolio exhibits a 98–99 percent correlation with stocks! True diversification involves seeking out uncorrelated or lightly correlated risky markets, not low-risk markets. Finally, just as wealth is not solely a function of asset growth, risk is not solely a function of asset volatility.”
Here is the original essay by Robert Arnott, What Is Wealth?
From Bill Gross at PIMCO:
“… As nominal GDP growth rates have declined from 11%+ to a recent 5-year average of less than 5%, future asset returns of a similar magnitude are foretold. While [the chart above] suggests that a 5% GDP growth rate can be levered up to perhaps 6% or 7%, that levering is certainly more difficult with a Fed Funds policy rate higher than the current growth rate of GDP and with disinflation near its end. In any case, we appear to be looking at maximum 6-7% average annual returns over the immediate future from stocks, bonds, and real estate in total (stamps too!).”
But investors want more. The desired future sustainable income value of their retirement portfolios demands more than 6-7% returns today. So, they seek out riskier investments. Thus we see risk premiums in all sorts of markets go to historic lows. Emerging market bonds pay shockingly little more than US bonds. The riskiest of high-yield bonds are sought after for their yield.
Canadian income trusts are bought worldwide for their steady, tax-free income. Oops. Seems like the Canadian government decided to change the rules. Those income trusts got spanked between 10-20% in one day this week, even though the underlying fundamentals of the companies involved changed not one whit.
(This is a horror show preview of what will happen to stocks if the Bush dividend tax cuts are not made permanent. Taxes do figure in the valuation of stocks!)
And note that the 1.4% average is mostly the last 25 years, which was a period of disinflation. We are at an end of that period. We should expect lower than 1.4% in the coming years.