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Risks, Not Risk

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I wrote the following on October 3rd, 2009:


While at our last denominational meeting, I made the offer to the pastors of my denomination that if they needed investment advice, they could contact me for advice.  Out of eighty or so pastors that that could have asked for advice, one e-mailed me.  (The pastors and elders did elect me to the pension board, to help manage the relationships with the defined contribution fund managers.  I’ll do my best for them.) The pastor is young-ish, with a wife and six kids.  He had 60% invested in a broad bond fund which had a high exposure to investment grade corporates and high yield (and AAA CMBS), and 40% in a stable value fund. This is a redacted version of what I wrote to him:

You’ve been playing it conservatively.  At this point conservative is good.  If I were not tardy in responding to you (my apologies), I might have suggested taking a little more risk at the time when you wrote.
This is the way that I view asset allocation:  look at the risk factors in the investment markets, and look at the funding needs of the person or institution that owns the assets.  (I.e., so what are we saving for?)

Most people don’t save enough.  The $4000 per year is good, but most people need to put more of a buffer aside than that, whether in IRAs (for retirement) or in a taxable account (for emergencies, future coollege aid to children, etc.)  You have six little liabilities that may need some help starting out as they reach adulthood.  Consider saving more.

Now for the risk factors:
  • Equities — somewhat overvalued at present.  (US and foreign)
  • Credit — Investment grade credit is slightly overvalued, and high yield is overvalued.
  • Real Estate — the future stream of mortgage payments that need to be made is high relative to the present value of properties.  There will be more defaults, both in commercial and residential.
  • Yield Curve — Steep.  It is reasonable to lend long, so long as inflation does not take off.
  • Inflation — Low, but future inflation is probably underestimated.
  • Foreign currency — One of my rules of thumb is that when there is not much compensation offered for risk in the US, it is time to look abroad, particularly at foreign fixed income.
  • Commodities — the global economy is not running that hot now.  There will be pressures on resources in the future, but that seems to be a way off.
  • Volatility is underpriced — most have assumed a simple V-shaped rebound but there are a lot of problems left to solve.
What this leads me to is this: I don’t know all of the bond and stock funds you can use at present, though I will after the next pension board meeting.  The bond fund you are using was a great play over the last 9 months, but is probably overvalued now.  If there is a more conservative bond fund, you might want to shift some funds there.  If not, use the fixed fund.  I don’t think we have an international bond fund, or an inflation protected fund available, but if we do I would add some there.

On a pullback in the stock markets, I would look to add some stock into the mix.  I would add some with the market 10% lower, and would add considerably with the market 30% lower.  If there are international stock funds, I would use them 30/70 with US funds.

Consider this a start of a discussion.  I’m not bullish on much right now.  This is a time to preserve capital, not make returns.  Let me know what you think, and sorry for being so slow to get back to you.

If I were talking to an institutional investor, I would have added illiquidity as a risk factor, which I think is fairly priced right now. I might have also added that I would be bullish on GSE-sponsored mortgage bonds and carefully selected CMBS.
Aside from that, I was pleasantly surprised in Barron’s to see Mark Taborsky of Pimco thinking about asset allocation the way I do.  There is no generic risk.  There are many risks.  Are you getting fair compensation for the risks that you are taking?  If not, invest in other risks, or if there are few risks worth taking, invest in cash, TIPS, or foreign fixed income.
Modern Portfolio Theory has done everyone a gross disservice.  It is not as if we can predict the future, but the use of historical values for average returns, standard deviations, and correlations lead us astray.  These figures are not stable in the intermediate term.  The past is not prologue, and unlike what Sallie Krawcheck said in Barron’s, asset allocation is not a free lunch.  With so many people following strategic asset allocation, assets have separated into two groups, safe and risky.
To this end, it is better to think in terms of risk factors rather than some generic formulation of risk.  Ask yourself, am I getting paid to bear this risk?  Look to the risks that offer the best compensation, and avoid those that offer little or negative compensation.
I still think this is the right way to view risks, though in hindsight, I was too bearish on a variety of risks.  You have to appreciate, though, how much the risk factors had run in the seven months since the bottom in March 2009.  It was a very violent move, and there was good reason to be skeptical of further improvement.  If nothing else, the move since then has been weak.  In equities, we have earned a mere 8%/year, on the heels of a 60% move in the prior seven months.
And so, I offer my current view of where we are here:
  • Equities — Overvalued at present.  (US and foreign, though Europe offers opportunities)
  • Credit — Investment grade credit is slightly overvalued, and high yield is overvalued.
  • Real Estate — Residential Real Estate has normalized on the low end but not the high end.  Commercial Real Estate is confusing, and must be approached on a deal-by-deal basis, because it it is fairly valued in aggregate, with a lot of noise.
  • Yield Curve — Steep.  It is reasonable to lend long, so long as inflation does not take off.
  • Inflation — Moderate, rising, and future inflation is probably underestimated.
  • Foreign currency — The dollar is the best of the bunch of bad currencies, though the Swiss Franc may offer some opportunity for profit if the peg to the Euro can’t be held.
  • Commodities — the global economy is slowing.  There will be pressures on resources in the future, but that seems to be a way off, aside from crude oil, which has remained in short supply.
  • Volatility is underpriced — too low in my opinion.

That’s all for now.

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David Merkel

David Merkel

2010-present, David is working on setting up his own equity asset management shop, tentatively called Aleph Investments. From 2008-2010, he was the Chief Economist and Director of Research of Finacorp Securities. He did many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, he was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. He also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, he was a leading commentator at the investment website His background as a life actuary has given him a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that he deals with in this blog. All of these goals rely on the help of Jesus Christ and his readers.
David Merkel

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