“Anywhere insight may be found “
Willem H. Buiter, in his appreciation article on James Tobin’s contributions to economics, asked the question, “Where do (or should) we economists find the behavioral hypotheses that change the models used to understand the world around us and to predict the future? I believe Tobin’s answer to be: anywhere insight may be found. While this answer is not an operational guide, it underlines Tobin’s life-long openness to old and new approaches and his non-dogmatic willingness to let 100 flowers bloom.”
Many of you recognize the names Ben Benanke, Paul Krugman and Nouriel Roubini as economists. A few of you may also recognize Joseph Stiglitz, Robert Shiller, Janet Yellen and Austin Goolsbee as economists. Because of my past letters you may even recognize Harry Markowitz or David Swensen and their influences on investment practices. But I would venture that very few of you would recognize the name James Tobin. All of the economists mentioned were at one time professional associates or students of Dr. Tobin during his 50 year affiliation with Yale University. So let’s take a moment and introduce James Tobin to you.
James Tobin died on March 11, 2002. He received the Nobel Memorial Prize in 1981 for his analysis of financial markets and their relations to expenditure decisions, employment, production and prices. His paper “Liquidity Preference as Behavior Towards Risk,” published in 1958, started modern portfolio theory. Mr. Tobin, together with Harry Markowitz, developed the mean-variance approach to portfolio choice under uncertainty. This theoretical work made possible the capital asset pricing model. His Q Ratio continues to be widely used as a measure of value of the stock market.
We are going to look at Tobin’s “Liquidity Preference” paper to seek out an old approach in hopes of seeing the benefits of using cash to reduce portfolio risk for the 99.9% of us that are not ultra wealthy. Before we do, we need to give you a little insight into where this 99.9% figure came from.
Show me the money
Capgemini, one of the world’s foremost providers of consulting, technology and outsourcing services together with Merrill Lynch Global Wealth Management produce yearly, a report titled the World Wealth Report. According to them, the report covers 71 countries in the market-sizing mode, accounting for more than 98% of the global gross national income and 99% of world stock market capitalization. The latest report published in 2010 covers the period ending December 31, 2009.
Some definitions and important findings as reported in the 2010 World Wealth Report:
- High Net Worth Individuals (HNWI) are defined as those having investable assets of US $1 million or more, excluding primary residence, collectibles, consumables, and consumer durables.
- Ultra-High Net Worth Individuals (UHNWI) are defined as those having investable assets of US $30 million or more, excluding primary residence, collectibles, consumables, and consumer durables.
- The world’s population of HNWI grew 17.1% over 2008 to 10 million.
- The world’s population of UHNWI grew 29.1% over 2008 to 93,100.
- Of the 10 million HNWI world-wide, 2.866 million reside in the United States.
- Of the 93,100 UHNWI world-wide, 36,300 reside in North America.
- There are 307,000,000 people living in the United States.
- Of the 307,000,000 U.S. citizens, 0.93% have investable assets exceeding $1 million.
- Of the 307,000,000 U.S. citizens, 0.0118% have investable assets exceeding $30 million.
- Of the 6,900,000,000 people living in the world, 0.0145% have investable assets exceeding US $1 million.
- Of the 6,900,000,000 people living in the world, 0.00135% have investable assets exceeding US $30 million.
- HNWI are demanding more “Specialized” or “Independent” investment advice.
- HNWI want increased “Transparency and Simplicity and “Improved Client Reporting”.
- HNWI want “Effective Risk Management” and consider it more important than previous years.
So now we know. The vast majority of us living in the U.S. do not have a portfolio exceeding $1 million. For those of you who do, congratulations. For those few that are UHNWIs with a portfolio exceeding $30 Million, please call me as soon as possible. My number is 803-324-5044. I can’t wait to talk with you!!
It is the last three data points above that is our concern. We, as a firm, have prided ourselves in meeting all three of these demands both before and after the crisis. For the majority of investors, those 99.9%, the greatest failure of the investment management business has been the “Effective Risk Management” of a portfolio. This failure is not the failure of professionals alone; part of the blame rests squarely on the shoulders of every investor. We all understand the relationship between risk and reward. Yet most of us, professionals and individuals alike, choose to view this relationship as a one way ticket to higher returns. We have forgotten that higher risk has just as high a probability of reducing returns.
$10 Trillion Lost
The great recession, and the decline in market value of virtually all investments, took its toll on every one of us. To put this into perspective I will rely on the work of another consulting firm; Tiburon Strategic Advisors which is lead by Chip Roame. Mr. Roame may be the most frequently demanded conference speaker by financial firms in the nation, and has led over 1,300 client engagements for over 300 corporate clients since 1998. At his latest CEO Summit at the Ritz Carlton in San Francisco, he emphasized the damage the last few years have taken on the net-worth of US Consumers stating that, “We own four things; our investment/savings accounts, retirement plans, our homes, and our business, and they are all down.” Specifically, Mr. Roame pointed out that US consumers have lost $12.8 trillion of net worth since 2008 but have regained just $2.9 Trillion in the 1 ¾ years since.
Personally, I wondered how this could be when our own clients have recovered 90% to more than 100% of their savings/investment and retirement accounts since the dark days of 2008 – 2009. We of course have no control over real estate prices, but the valuations of local property have stabilized and represented far less of our clients net worth than many other people around the U.S. Which brings us back to James Tobin and his “Liquidity Preference as Behavior Towards Risk” paper of 1958.
Most of you recognize that I have not been very nice to the concept of Modern Portfolio Theory and Mean Variance Optimization, including those academics and professionals who believe in their merits and their use in portfolio management. So why then am I referring to Dr. Tobin and the paper that set off the entire process? The answer is that this paper introduced “The Separation Theorem” which Dr. Tobin summarized a number of years later with the comment, “Don’t put all your eggs in one basket.”
The paper begins by asking the simple question, “Why should anyone hold the non-interest bearing obligations of the government instead of its interest bearing obligations?” Dr. Tobin answers the question saying two kinds of reasons for holding cash are usually distinguished: transactions reasons and investment reasons. This is easy enough for all of us to understand. Some of our money is needed to pay our bills, and if we are lucky enough to have a little extra we can choose to invest it. It is the money available for investment that Dr. Tobin is concerned with and not your transaction money. This is the same money that all portfolio managers are concerned with. In fact Dr. Tobin viewed his separation theorem to describe the behavior of a portfolio manager.
Dr. Tobin described investors as Risk-averters, diversifiers and plungers which by all accounts is similar to our description today, only with a bit more color. With these investors he provides some wonderful results that change based on the degree of risk aversion each investor is willing to take. Of course the real beauty of his work is its simplicity. If I were to describe the Separation Theorem to you, it would be this: all you need to build a portfolio is two baskets, one that holds your risky assets and one that holds your risk free assets. How much of your money you put in each basket determines how much risk you are willing to take.
A lot has happened since 1958. My profession has not accepted the simplicity of this and has worked diligently towards expanding the number of baskets from two to as many as can be dreamed up by modern man. Controlling risk with the use of a risk free asset just doesn’t make much sense to most investment professionals. Today the preferred method is substituting diversification in lieu of a risk free investment.
Many of today’s professional investment advisors have ignored the risk control of cash and substituted fixed income assets, with both default risk and subject to market risk due to changes in interest rates, as a risk free asset. I am not necessarily opposed to this approach for UHNWI or Institutional funds, as their available funds for investment are quite substantial and, at least in theory, will continue far beyond a single lifetime. However, applying this approach to individual investors may be one of the reasons their total net worth declined $12.9 Trillion and has only recovered $2.9 Trillion.
I have been encouraged by countless marketing departments to sell the benefits of professional institutional style portfolio management for individual investors. Of course the implication is that it will make you more money with less risk. As a portfolio manager to both institutions and individuals I believe applying risk control procedures that work for large amounts of money need to be modified before being used at the individual investment level, especially for the 99% of us that have less than $1 million. The easiest modification is to reinstate the “risk free” asset into your portfolio. A risk free asset should give full protection against default. It should have a fixed maturity with a fixed interest rate earned through maturity, and it should have a short enough maturity so that “variability of market yield” is negligible. In today’s world that would mean FDIC insured money market funds, time deposits, CD’s, U.S. Treasury Bills and U.S. savings bonds. A short term bond fund or an ETF will just not work.
Let’s do a little math to help you understand the impact a risk free asset has on your returns. Our first example shows the result on your returns with a 50% allocation to a risk free investment that earns 1%, what you can expect with today’s interest rates. The second example shows the result with a 25% allocation. Changes in interest rates, the ups and downs of risky assets and how much is set aside in a risk free asset will change the results.
Say you have $200,000.00 available for investment. You place 50% of that in a risk free investment earning 1%, and 50% of that in a risky asset that may either earn 20% or lose 20% in any given year. Your earnings would have this outcome:
$100,000 earning 1% would be worth $101,000 in a year.
$100,000 earning 20% would be worth $120,000 in a year.
$100,000 losing 20% would be worth $80,000 in a year.
At the end of the year your total portfolio would be worth $181,000 (a loss of 9.5%) or $221,000 (a gain of 10.5%).
If we change the amount allocated to the risk free investment to 25% the results would be:
$50,000 earning 1% would be worth $50,500 in a year.
$150,000 earning 20% would be worth $180,000 in a year.
$150,000 losing 20% would be worth $120,000 in a year.
At the end of the year your total portfolio would be worth $170,500 (a loss of 14.75%) or $230,500 (a gain of 15.25%).
For 99% of all investors in the United States, risk control can be simplified by separating your funds into buckets of “risk-free” and “risky” assets. Just remember that “risk-free” cannot be substituted with investments that are almost risk free. With FDIC Insurance coverage of $250,000.00 per person, and unlimited amounts available from the U.S. Treasury, the ability for most investors to incorporate risk free investments into their portfolios is easily accomplished.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.