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...