Executive Summary
Enjoy the current installment of "weekend reading for financial planners" - highlights this week include a new pieces about tactical asset allocation by yours-truly in the Journal of Financial Planning, an interesting article about the correlation between use of financial planners and willingness to invest in risky assets, a number of great articles about the unfolding debt crisis in Europe and its economic and investment implications, and a nice discussion about the importance of establishing a work environment that's right for you. We also look at a great piece from Angie Herbers discussing how different today's new financial planners are compared to those of 10, 20, or 30 years ago - and the ways firms need to adjust to maximize on the opportunity. Enjoy the reading!
Weekend reading for December 3rd/4th:
Improving Risk-Adjusted Returns Using Market-Valuation-Based Tactical Asset Allocation Strategies - This article in the December issue of the Journal of Financial Planning by yours-truly (and Pinnacle Advisory Group co-authors Ken Solow and Sauro Locatelli) discusses how very basic tactical asset allocation strategies that adjust equity exposure +/- 20% based on market valuation can lead to both reduced risk, and higher returns, and a significantly improved risk-adjusted return, when analyzed on a long-term basis, due to the statistically significant differences in expected returns and volatility in high versus low valuation environments. The results are sustained even when analyzed on an after-tax basis, yet require very infrequent trades; the strategy modeled in the article averages only two trades per decade, yet provides approximately 50 basis points/year of increased long-term performance, comparable to the benefits shown from effective rebalancing strategies.
The Best and the Brightest - This article from Investment Advisor magazine columnist Angie Herbers discusses the situation for young students entering the profession today, and the significant differences in the training they have when they enter the workplace compared to the prior generation. As Herbers points out, the entering generation of financial planners is flat out better trained and better educated than the last generation that came into the profession, who tended to start out in traditional sales jobs and only integrated financial planning into their practices later. Of course, some experience and skills still need to be developed, but as Herbers points out, "Today’s young advisors will benefit from experience, but they are much farther up the learning curve than my peers and I were a decade ago [not to mention even earlier generations of planners] —a fact that today’s firm owners can’t ignore if they are going to successfully recruit and work with the students coming out of top-notch planning programs today."
Who Needs Financial Planners, Anyway? - This article by Wall Street Journal columnist Jason Zweig explores the results of a recent survey of consumer finances on the use of financial planners. The study found that 25% of households use a financial planner, up from 21% in the late 1990s. However, the study notes that use of planners is highly correlated with risk tolerance - 28% of families willing to take "average" levels of investing risk use planners, and 33% of families who are comfortable with "above average" risk; however, only 11% of families who said they were unwilling to take any risks with their investments use a financial planner. In other words, the implication is that for clients who aren't willing/interested to invest in stocks, there is remarkably little willingness to engage a financial planner at all; as I've blogged before, this has some troubling implications about whether financial planning itself has bet its future on the stock market and the willingness of clients to invest in it.
Why We Spend, Why They Save - This Op-Ed column in the New York Times by Sheldon Garon suggests some views about why it is that America spends and spends, while other countries have significantly better national savings rates and simply better savings habits amongst their citizens. While many of the differences appear to be cultural, Garon makes the point that culture can be crafted, shifted, and supported, with good public policy. For instance, while many banks today have a tendency to drive away smaller, unprofitable consumers, the French government attracts millions of lower-income and young savers with the Livret A, a form of small saver's account that is tax-free, with a small minimum balance, and a (subsidized) above-market interest rate... in the process, teaching good habits that last far beyond the few Euros of interest the government provides in direct support. The article then goes on to suggest some public policy initiatives, a few of which may be more controversial than others. But it still raises an interesting point: what might we do to encourage and support a better saving mentality more proactively than 'just' teaching financial literacy?
Do You Really Understand Rates of Return? - This article by Michael Edesess on Advisor Perspectives provides a great primer on the different ways that rates of return get calculated, and some of the caveats and concerns about how they're used. The article highlights not only differences between arithmetic and geometric rates of return, but also when it's appropriate to use one versus the other. There may not be any great revelations or breakthroughs here, but this is a nice article to keep as a handy reference point for the future.
Beware of Falling Masonry - This recent article from The Economist discusses the ongoing crisis in Europe, suggesting that the European situation is spiraling downwards into a recession, and that the recession in turn may accelerate on itself, potentially leading to a disintegration of the European Union and the Euro itself. In addition, the article points out that as more and more people believe some form of Euro breakup is becoming inevitable, those beliefs - as people act on them - may further increase the likelihood of the outcome as a self-fulfilling prophecy. Overall, the article provides a nice review of the situation across the European continent, and how the crisis could evolve (or devolve?) if it continues, and some of the potential trigger events that could advance it to the next stage. (Thanks to Jason Close for recommending this article!)
Changing the Rules in the Middle of the Game - John Mauldin's weekly article, posted on Advisor Perspectives, also discusses the ongoing crisis in Europe, noting how Merkel and Germany are now supporting changes to the European Union treaty, although it's not clear that enough can be changed before problems reach the point of no return. And Mauldin notes that unfortunately, that crossover point can occur - or not - at any time, as the research is surprisingly clear in showing that there is remarkably little to predict when a debt crisis emerges; instead, as Mauldin notes, "What one does see, again and again, in the history of financial crises is that when an accident is waiting to happen, it eventually does." In other words, it may not be clear when the crisis will reach the next stage, but there seems to be little question that the question at this point is "when", not "if", and the "when" can occur with a sudden and unexpected "Bang!" where confidence is fine, right up until it's not. The article also explores the implications for the US, noting that on a net basis the US banks have some exposure to Europe and its banks, but not enough to be systematically risky... unless a counterparty event occurs, at which point what matters is not the limited net exposure of US banks, but the much much bigger gross exposure, if banks suddenly discover that their hedges are worthless because the counterparty that backed them is no longer a going concern.
Are Corporate Balance Sheets Really the Strongest In History? - The weekly article from John Hussman of Hussman Funds is also quite strong this week, exploring whether corporate balance sheets are really as strong and cash-flush as the general media reports. The first part of the article actually discusses the situation in Greece, where 1-year bonds are now yielding 270% (yes, you read that right) and the Greek government is starting to privately discuss a write-down of their bonds to a mere 25% of their value. Such an outcome may cause numerous European banks to fail and be nationalized (as many are leveraged at 30:1 or greater!), although Hussman points out that when done in an orderly manner, that's not necessarily something to be feared. In terms of US corporations, Hussman emphasizes that while there is a great deal of cash in corporations, there is also still a great deal of debt (in fact, near all-time highs, albeit financed at relatively low interest rates); as a result, Hussman suggests that it's probably fairer to say corporations have a great deal of liquidity, than implying their balance sheets are actually quite so strong. And overall, Hussman still views equities as being priced for below-average returns.
A Few Simple Rules for Money Managers - This article by writer and investment manager Vitaly Katsenelson of Contrarian Edge provides some good perspective on what it really means to be in a business where the output from your brain is what provides value. Notwithstanding the title of the article, the real point is that you (and me, and Vitaly, and everyone else) needs to work in an environment that allows our minds and creativity to work. In many situations, that is NOT represented by the traditional 8AM to 5PM assembly line mentality, which can create pressure to produce something - anything, even if it's not valuable - rather than allowing the time for good thoughts and ideas to cultivate. Some people do their best thinking in the morning, others in the afternoon; some require coffee and caffeine, while others might eschew it. The point is whatever works for you. As Vitaly asks the reader: "If I was not bound by the obsolete routines of the dinosaur age of assembly-line manufacturing, how would I structure my work to be the best investor [or planner] I could be?" Then make whatever changes are necessary to make that happen.
I hope you enjoy the reading! Let me know what you think, and if there are any articles you think I should highlight in a future column!
Your article on tactical asset allocation was really compelling.
One point isn’t quite clear to me, though: were the thresholds used for the “high P/E environment” and “low P/E environment” constant throughout the entire data set? Or were they calculated on a shifting basis using only the data that would have been available to an investor making a tactical allocation decision at the time?
For example, at a quick glance, it appears that the threshold for “high P/E” in the entire data set is about 23.6. Yet an investor in the early 1990s, using only data available to him at the time, would have identified a “high P/E” threshold of about 19.4. That would have led this investor to tactically shift away from stocks in, approximately, mid-1993, rather than in mid-1995 — thereby missing a substantial share of the stock rise of the 1990s.
Given that P/E ratios have drifted up over time, it seems that this phenomenon would have happened repeatedly throughout the data set. Static thresholds based on modern data could thus create a hindsight bias, inadvertently exaggerating the effectiveness of tactical allocation. (My apologies if this point is addressed in the article’s text.)