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Week Ending: February 5, 2010

For all the controversy surrounding Modern Portfolio Theory, an indisputable contribution is the appreciation for the relationship between risk and return.  Naturally, the focus of the financial services industry and nearly all investors is on return.  But where most investors fail is their addressing risk.  This entry, then, is the first of several addressing risk, in the interest of helping people understand this imperative concept if their going to seek investments objectives, most notably for individuals financial independence.

I want to start by highlighting a major weakness of financial service providers (FSP): the longstanding client risk tolerance questionnaire.  (If you've never seen one, go online and Google the term, or walk into just about any FSP office.  They ask things like, "How would you feel about some losses in your account?")   This wholly inadequate, antiquated exercise owes its longevity to the fact that it allows FSPs a nice layer of liability protection.  If a client says they're a risk-taker, and a risky portfolio is constructed, and then goes on to destroy more wealth than the client can afford, whose fault is it?  It's the client's--it says right there on the Questionnaire.  However, if the provider takes a risky approach on their own, and it implodes similarly, the provider is the one held accountable.  In both cases, the wrong portfolio was constructed, which is the real travesty, not who was responsible for the poor portfolio construct.

The problem with these risk tolerance questionnaires are two fold:

  • They're a form of self-diagnosis--where the practitioner asks you, the non-practitioner, to identify some of the most important and complex variables to structuring your investment portfolio.  Additionally, terms used to describe personality traits are the same applied to investments, but have different meaning.  For example, a person may deem themselves to be "conservative"--and yet their portfolio might require just the opposite, as the term is used in investing. 

  • They're hugely impacted by the time period in which their filled out.  Recent market conditions, especially periods of abnormally good or bad results, dictate the responses.  Everyone's risk averse after a crash, and risk-hoarding during a rally.  Ironically, portfolios constructed after good periods tend to be too risky, and that's nearly always ill-timed, as bad times follow good.

IDENTIFYING OPTIMAL RISK-TAKING LEVELS IS A FUNCTION FIRST AND FOREMOST OF PORTFOLIO OBJECTIVE, which is typically the sustainable eventual cash flow demand vs. the present value of the portfolio.  The risk level is controlled by the asset allocation (weighting scheme of assets, by risk characteristics), and should only consider emotional tolerance or behavioral objective on the margin.  The more modest the portfolio objective, the less risk you have to take.   Conversely, aggressive goals require aggressive risk taking.  To take more than necessary is irrational (even if nearly always explained by greed).  To accept too little risk taking is often financially dangerous (even if nearly always explained by fear).

The real "risk" is both these contexts is the probability for portfolio success--and that's ultimately the only risk that matter to individuals.  And the only way to accurately asses true risk tolerance in a portfolio context is with robust Financial Planning software that uses a Monte Carlo Simulation tool. 

The Questionnaire needs to be done away with.  You don't know how to asses your own risk...but your Financial Planner does. 

CHART OF THE WEEK

 

 

You're looking at a chart of the performance of Financial stocks (XLF) versus the US stock market over the last twelve months.  Worth noting is the fact that Financials peaked last October, while the rest of the market peaked just a few weeks ago.  This kind of behavior--the non participation of one sector, coinciding with overall market weakness--suggests to me that Financials are particularly vulnerable in the short term, and may in fact continue to lead a downward retrenchment for the broad market.  The populist backlash against Financials also does not auger well for this group.  As is always the case, DO NOT TRY THIS AT HOME.  This information is provided as but one in many you should consider before taking action in any regard.

THE RICH LIFE:  Before I had children, I was one of those who presumed that "nurture" dominated "nature."  Not any more.  While the environment my wife and I have created explains the general sense of well being my kids feel, their personalities could not be more different, and are as uniformly consistent today as the day they were born.  Every conceivable trait is held by one of my boys.  And in thinking about it, it's one of the neatest aspects of being a parent...seeing how much you can positively affect, and yet seeing the limits of your contribution as well.  Love those guys...what a hoot to have them at at these ages (6,8,10,12) and at home.  I know those days are numbered, but my wife and I get the biggest kick out of this randomly assembled collection of personalities.  Enough of the gushy...

Week Ending: January 29, 2010

  1. Our Country's number one problem is DEBT--Governmental and Individual--owing to failures of fiscal and financial responsibility.  See chart below.
  2. Passage of 66/67 in Oregon will hasten the "Detroit-ification" of our State, is an affront to fiscal responsibility, and will serve as the new model of the Law of Unintended Consequences in many realms.
  3. The "Discretionary Budget freeze" announced in the State of the Union Address will trim just 0.2% - 0.4% of the Budget in year one, by my calculations--right idea, but a meaningless gesture and alternative to true fiscal responsibility.

[WRITER'S NOTE:  FOR THREE DAYS, THIS ENTRY WAS A LONG RANT EXPOUNDING ON THE POINTS ABOVE. BUT I DECIDED TO WITHDRAW MY COMMENTS.  MY EXPRESSED FRUSTRATION, WHILE UNDOUBTEDLY SHARED BY MANY OF YOU (OR MAYBE NOT), SERVES LITTLE PURPOSE AND GIVES GREATER LIFE TO THE VERY THINGS THAT I CANNOT NOT CONTROL AND THEREFORE NEED NOT LET CONSUME MY SPIRIT.  GOING FORWARD, I WILL CONTINUE TO SHARE MY OPINION ON SUCH THREATS TO THE ECONOMY AND MARKETS, BUT WILL STRIVE TO LEAVE THE EMOTION AND ACRIMONY TO OTHERS.  FELLING CATHARTIC ALREADY. -BV]

CHART OF THE WEEK

Source: Research Affiliates, LLC

THE RICH LIFE:  Reminded myself that: "For peace of mind, resign as General Manager of the Universe."  - Unknown

Week Ending: January 22, 2010

We learned last week that the Federal Reserve earned $45 Billion last year. That’s largely interest income from held notes. Considering that the Fed gave the money to Treasury Department, and since much of that interest was earned on Treasury bills, notes, and bonds, the Government got an interest-free loan from the Fed. And of course the Fed created the money ex nihilo. So in effect, the Treasury financed the budget gap with made up money. They might just as well have printed the currency directly.

The Fed’s duel primary objectives, as frequently stated, are to: Insure price stability (fighting deflation while controlling inflation), and Encourage full employment. They aim to achieve these objectives via monetary policy, as implemented by the Federal Open Market Committee (FOMC).

The first, predictable and understandable response to the Crisis was for the Fed to “loosen”—namely cutting the overnight rate to effectively 0% in December of 2008. After that, they undertook another step called “quantitative easing” (QE) to enhance liquidity. With QE, the Fed purchases instruments from the market, using money it creates out of thin air ("ex nihilo").

So where are we now and how did we get here? As you can see below, I’m re-running the chart of Fed Assets. The Fed has created $1.4 Trillion. Most of that has gone towards purchasing Treasuries and Mortgage backed securities.

Back to my original point, the Fed is seemingly floating Treasury the scratch to finance their extraordinary, unjustifiable budgetary gap. The Treasury creates bonds, the Fed buys them, the Treasury pays the Fed interest, and the Fed gives the interest back. Larcenous.

So to the duel primary objective (price stability + employment), the Fed has taken on the role of benefactor the Treasury department. While we haven’t fully monetized the debt in full yet, we’re on our way.

And yet, there’s another agenda the Fed’s adopted: controlling mortgage rates. You’ll see from the chart (the red area), that the Fed’s bought nearly $800 billion in Mortgage Backed Securities—all in the last 12 months. Thus, to their growing list of objectives, you can add "fixing the housing crisis." 

And on top of this, the Administration wants to give the Fed the power to oversee consumer protection of financial products.  The scope of the Fed is way beyond its intent.  And in the process of trying to finance the deficit and hold down mortgage rates, we've created at $1.4 trillion problem that either causes crushing inflation or a second recession that's worse than the first.   

Settle in folks.  The next few years should be stunningly regressive.

CHART OF THE WEEK

THE RICH LIFE:  My back seized up last Sunday, as I was stooping over, trying to decide which Vikings jersey to don.  I fell to the floor and was unable to get up.  It took me 30 minutes to crawl 10 feet to my bed and then spent the next two days there.  Why am I mentioning this?  Because I benefit from being humbled like that.  Puts my petty concerns into scale pretty damn quickly.  And yes, I've tried everything.  My weak back is a part of who I am.  But if it's the worst thing in my life, I consider myself blessed.

 

Week Ending: January 15, 2009 (No Blog)

 

Week Ending: January 8, 2010

 

I urge my fellow Oregonians to vote "NO" on Measures 66 and 67.  My thoughts follow...

 

- In spite of what the Pro and Anti campaigns claim, it will neither be catastrophic to the State economy if it does pass, nor will it be catastrophic to key services (schools, safety, health & human services) if it doesn't. Both are threats that are designed to scare.  We should all be more intelligent than to be driven by a commercial.

 

- The truth lies on the margin. There is no question that this will have a relatively small, adverse effect on the economy over the coming years. The Tax Foundation ranked Oregon 14th in business climate--but if 66/67 fail, we jump to 8th.  And the budget shortfall?  It's just 5%! To watch the ads, you'd think the State was going to implode without the tax hikes (4 day school week, prisoners running amuck...nonsense).

 

- But along those lines, we're actually a "middle of the pack" State by personal income tax burden, and (per the above), a "friendlier than most" State by business tax / business climate. And yet we have among the highest unemployment in the country and are losing citizens to competing neighbors.  Thus, the point that, "we can take the hit, because we're not as bad off as others" misses a few points.

 

1) We don't need to hike taxes. Literally! Sen. Chris Telfer has identified $733 million in budget cuts (that's the deficit amount 66/67 are trying to close) that wouldn't affect General funds services. Most notably they include:

- Asking State employees to pay for their health care at the same rate teachers currently do: saves $131 million (that's fair, isn't it?)

 

- Rolling back the pay raises granted to State employees: $160 million (duh! But the unions will howl!)

 

- Suspending part of the Business Energy Tax Credit: $85 million (most State politicians [both parties] agree the BETC has been a disaster...it was intended to cost $5MM, but has ballooned to over $300MM. Oops!)

 

- Use part of the $3 billion in "Other Fund" Ending Balances: $133 million (you should see where this comes from...amazing!)

 

- Use part of the Education Stability Fund / Rainy Day Fund: $203 million (isn't that what it's for?  Of course it is.)

If you haven't looked at these line items, and are serious about understanding what really happens in Ways and Means in OR, check this out: http://www.leg.state.or.us/telfer/newsletter/062409_newsletter.pdf

 

2) We have a spending problem in Oregon. Over the last 16 years, the Total fund budget for the State has grown much more than: Population change + Inflation (see the CHART OF THE WEEK below). You can't do that without repeatedly raising taxes. In this biennium alone, the General fund grew 9%, while revenues and assets are falling everywhere.  The unions won't budge an inch on things like salary and benefits for their workers--they'd rather see less school days.  We need to send the State and the unions a message.

 

3) The most interesting aspect, in my mind, is "Why do people choose to live where they live?" The answer is that states compete for citizens and businesses, just like companies compete for customers. Some states naturally rank high in Desirability (weather climate, existing infrastructure, access to the outdoors, university system, public services, culture, thriving businesses). Against that, states exact a Burden (tax, regulatory framework [business regulation and social laws], and cost of living). The higher a state ranks by Desirability, the more Burden it can get away with.  It's kind of like when a good is in high demand, it's expensive to buy.

 

Consider the states that rank high in Desirability: Hawaii (climate, outdoors), California (topography, Silicon Valley, Hollywood, universities), New York (infrastructure, capital, culture), Ohio (industry). Then there are less desirable places: North Dakota, Michigan, Alaska, Wyoming. The high-desirability states have the highest burdens, and vice versa. Otherwise, everyone would live in the high-desirability states, and no one would live in the low-desirability states. There exists a natural balance between Desirability and Burden.

 

When, on the margin, a state's Burden-to-Desirability increases, it increases out-migration and economic losses. And vice versa. On a migration basis, we're losing to our "competitors"...states like WA, NV, ID, and AZ. AND, we have high unemployment. Passing 66/67 will exacerbate the problem. We will see a brain-drain, and a move of the "investor class" out of state. I see it on the front lines every day (many of my clients are moving, or plotting to, as we speak).

 

So, as I said, if 66/67 fail (i.e. no tax hike), the Legislature will have to look hard at the budget next month. They don't have to cut General fund spending--but I fear they'll make unnecessary cuts because they're in a corner and if they don't punish us for not passing 66/67, they lose what little credibility they have.  Many State Democrats are beholden to the unions and if they say, "Hey, Telfer actually solved the problem, let's follow her lead!" they'll have a hell of time getting re-elected. Passing 66/67 in order to "just get by this one time" is like giving a little more junk to the junkie...but it's only this time, right?

 

And if all of the above wasn't proof enough that these Measures are detrimental, consider that even the sympathetically left-leaning Oregonian is encouraging its readers to vote them down.

 

CHART OF THE WEEK

 

All agree that State government services (and therefore budgeted spending) need to adjust for changes in the population and price levels (inflation) over time.  So naturally, that trend is typically upwardly rising.  Yet in Oregon, spending has grossly outpaced the growth of population-plus-inflation.  This is a chart comparing how the Oregon State budget has grown from the 1991-93 biennium to-date (dark blue), with how the budget should  have grown if just tied to population-plus-inflation.  Public resources are cannibalizing private ones to the detriment of Oregon, which is in the top 10% of states by unemployment, and is loosing citizens to neighboring states in droves.

 

 

THE RICH LIFE:  Under the "Put your money where your mouth is!" column, I'm going to make a modification to my long-standing radio show in the interest of "rich living."  For six years, I've taken one weekend day away from my family to do my live, three-hour radio show.  Starting January 31, I'm returning Sunday to my family, and myself.  Going forward, I will record the show during the week, for Sunday broadcast.  Additionally, I am shortening it to two hours. I will miss the caller interaction, but will continue to invite questions by email, and answer them on the show.  I think the show will benefit from this tightening-up and reinvigoration.  I know I am already just thinking about it. 

 

 

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