Archive for How To

Economics is a Social Science, not a Natural Science

Economics is categorized as a “social science” alongside anthropology, psychology and sociology.  Which makes complete sense considering that economics studies the relationships that dictate how we produce and consume goods and services within the society.   But you wouldn’t know that from the way many economists discuss economics.  Too often economists try to establish economics as an empirical science grounded in some sort of natural phenomena.

I was thinking about all of this as I was reading this piece by John Hilsenrath who was discussing Hayek’s views on this matter:

“His central grievance was the field’s long-running infatuation with scientific method and certitude. It was an impossible and misleading task for economists, he said. In their “vain search for quantitative and numerical constants,” Mr. Hayek argued, economists were constantly overlooking essential facts and misunderstanding the complexity of the social mechanisms under their microscopes.”

Hayek has this dead right even if we might have disagreed on how to apply it.  In the search for quantitative and numerical constants we often overlook just how much our economic system resembles the soft science and not the natural sciences.  And it can lead to extremely misguided thinking on certain matters.

Of course, the economy is not grounded in anything resembling the natural sciences.  There’s very little that’s “natural” about our economic system.  The economy is made up of the sum of the decisions of the people who operate within that system.  And the system exists, to a large degree, in our heads as records of accounting.   These records can be erased, created from thin air, manipulated, etc.  And the people creating those records are driven in large part by their own biases.  They react inefficiently and irrationally.  Mister Market, as Warren Buffett likes to say, is often manic.

This makes the study of economics extremely tricky because we’re dealing in uncertainties at most times.  Thankfully, we seem to be making good progress in fields like behavioral finance, but I do worry that the “science envy” of many economists continues to plague views and progress.

 

What is the Purpose Of Interest?

Good question here from the forum:

“Can you explain what actually is the reason/purpose of interest in our modern day monetary system?”

Money is endogenous in the modern monetary system.  That means it can be created by any user within the system and can be created from what is really nothing more than an agreement between parties.  The primary form of money in our system is bank deposits and they are created by banks when banks make loans.  Private banks essentially control the primary payment system that we all use and so they create the primary form of money and maintain the system in which it is used.  If you want to participate in the US economy to purchase goods and services then you need a bank account.

Banks make money by charging you a fee to use their system and to use the money they create within this system.  Because the system is privately controlled there is an element of risk management in everything that a bank does.  That is, if a bank doesn’t properly manage its risks it can end up like Washington Mutual or Northern Rock.  Because banks are private profit maximizing entities they have to balance how they generate a profit and how much risk they take in the process of doing this.

The privately controlled element of this system creates competition which makes banks operate more efficiently and makes them accountable for how they operate their businesses.  But since this payment system is so central to the health of the economy the payment system has a unique relationship within the economy.  And as we’ve all discovered over the last 5 years when the payment system doesn’t work properly the whole economy stops working properly.  And so you get this inherent and tricky mix between government intervention in the banking system and the way banks try to operate within their “free market” to compete.  It’s all a bit messy because the banks are profit maximizing and risk taking entities who can, at times, threaten the health of the entire economy through their ability (or inability) to manage their risks in the pursuit of profit.

When a bank lends you money they are essentially allowing you to use their payment system for a fee.  And they will assess this fee based on the duration in which you want to use that money and the risks you pose to using that system.  So, a borrower with bad credit could be rejected from being allowed to use the payment system that banks operate.  Or the banks could just choose to charge that person a very high fee (interest rate) to use the system.  So, in its simplest form interest is just the fee that banks charge users of the payment system.

Of course, there are lots of instruments which convey a similar temporal relationship like stocks or corporate debt.  These instruments convey a similar type of relationship where one party is again creating a financial instrument to obtain money and thereby paying someone a fee to use that money.  So, for instance, a corporate bond is an agreement by a corporation to obtain bank deposits for a certain period of time at a certain interest rate.  In the process of creating this instrument with lower moneyness than the bank deposit they will pay the lender a fee for the specific period.  They are, in essence, convincing the bank deposit user to forgo using their bank deposits in exchange for a fee.  So you can see how this process of financial asset creation can be thought of within the spectrum of moneyness with different entities creating different forms of money within that system….

I hope that helps answer the question.

Some Thoughts on Risk Parity

This is a very good piece by Cliff Asness on his new blog.  If you don’t follow it then add it.  Cliff is one of the smartest dudes around.  Anyhow, his firm AQR runs a strategy called “risk parity”.  I am not positive where this idea originated, but it was made relatively famous by Asness and Ray Dalio who has been running a form of risk parity for decades.  You can read Dalio’s description of the approach here.

I’m oversimplifying here, but the basic approach is to create a risk balanced approach.  So, if you have a 60/40 stock/bond portfolio most people don’t realize that over 80% of the portfolio’s performance is being driven by the 60% portion because stocks are so much more volatile than bonds.  So you’re not really in a 60/40 when you buy a 60/40.  You’re really in something more like a 80/20.  The idea of risk parity seeks to eliminate this imbalance by making the portfolio risk balanced.  This is generally done by overweighting the low volatility assets in the portfolio to make them equal contributors to the portfolio’s overall risk.  So, if you wanted to make a 60/40 more balanced you might buy a 40/60 stock/bond portfolio and leverage it up 1.5X. This gets you to the same standard deviation, but it beats the living daylights out of a 60/40 portfolio on a nominal and risk adjusted basis (over the last 20 years it generates a CAGR of ~11% vs the 8.4% CAGR of the 60/40 with better risk adjusted figures).

So, what’s good and bad about this approach?   First the good:

  • It’s a smart form of strategic diversification.  In other words, this isn’t just some cookie cutter index fund approach that anyone and everyone can implement.  It’s a very sophisticated and value adding methodology.

 

  • The focus on fixed income is a nice deviation from so much of Modern Portfolio Theory’s obsessive focus on equity returns and the nonsensical idea that “risk = returns”.  This changes the focus of the traditional debate by ensuring that shareholders are taking a more balanced approach rather than naively jumping into what they think is a “balanced index” like the Vanguard Balanced Index (which actually isn’t very “balanced” at all because the majority of the volatility is derived from the 60% equity portion of the portfolio).

 

  • Historically, risk parity portfolios add diversification to a portfolio in a way that reduces overall volatility and increases nominal and risk adjusted returns.

It’s not all good though (sorry Cliff).  There are some cons to the risk parity story (as there are in any portfolio):

  • The focus on “risk” as volatility leaves the door open for potential misalignment between the way client’s perceive risk and the way a portfolio’s risks are managed.  Shareholders don’t view risk merely as volatility.  This could result in periods of performance which don’t properly protect shareholders from the way they perceive risk.

 

  • There is some significant forecasting error risk involved in risk parity.  As with any allocation approach there is some degree of forecasting, but in a portfolio that is fixed income heavy the portfolio relies, to a large degree, on the positive risk adjusted returns of the fixed income portion.  This means that a risk parity portfolio, is, to some degree, a bullish forecast on the future of bonds (at least more so than a traditional balanced index).  The underlying model also involves some forecasting of changing risk dynamics.  This is difficult, if not impossible….

 

  • The portfolios are sophisticated.  The modeling is a little black boxy (is that a word?) because the idea of “risk” can be perceived differently at different points in the market cycle.  How risky are bonds in a world of ZIRP?  Who the eff knows?  Different models will come up with very different answers and so the degree of sophistication in the  black boxy model is a significant driver of future returns.  The investor doesn’t know how this is being done which creates some degree of added risk.

 

  • The fees on these portfolios are usually high.  We’re not talking about cookie cutter index funds here.  You’re paying for the modelling and strategic diversification that these portfolios add.  Personally, I am not always comfortable with a 1%+ fee structure, but given the degree of strategic diversification these funds add it could be appropriate for slices of a portfolio for certain people.

 

  • The leverage issue doesn’t scare me as much as it scares some other people, but it can be deadly in the wrong hands.  Leverage is like steroids – in the right hands it can be used in a controlled and intelligent manner.  In the wrong hands it can be very dangerous.  The use of leverage by someone like Asness or Dalio doesn’t scare me.  But you pay for that management expertise.

Now, the average indexer might say that risk parity portfolios are just another form of “active” management or a “better mousetrap”.  Well, I hate to inform you, but all of those Vanguard funds these indexers own are also active deviations from the global cap weighting being paraded as “passive” in order to create brand differentiation.  They’re just different forms of an actively picked index with lower fees.  They’re no less a “mousetrap” than any other index of assets that deviates from global cap weighting.  It’s just that people who buy Vanguard funds don’t often realize they’re in a mousetrap that’s just a lot less expensive than other mousetraps.

On the whole, I think risk parity is a smart approach, but like a lot of Wall Street’s recent innovations it’s probably too expensive to own in any substantial quantity.  That doesn’t mean it’s inappropriate for all asset allocators, but in a world where future returns are likely to be lower than most people expect the fee story becomes a glaring part of the equation.  If I could buy a risk parity portfolio for the same cost as a balanced Vanguard Index then it would be a no-brainer.  But we’re not there yet….

Read some more on Risk Parity approaches:

Saving is not the Key to Financial Success

You’ve probably heard it a million times from financial “experts” – the key to financial success is saving.  The idea is that if we save more now then we’ll have more to spend later.  And while that’s true at the individual level it’s actually disastrous advice in the aggregate.   Saving isn’t the key to financial success.  Investing is the key to financial success.  A lot of this is counterintuitive, but stick with me for a few minutes.

Saving is our unspent income.  It is the residual of your income. And my spending is someone else’s income.  So if I decide to save more then someone else has less income.  All else equal, the economy has less spending power when I save more of my income.  If we all saved more then we’d all have less income.  So saving more can’t actually be the key to financial success because, in the aggregate, saving leads to lower incomes.  That’s simple enough, right?

Investment (not the financial type you’re probably aware of with regard to buying stocks and bonds) is spending, not consumed, for future production.  When you invest in your future you build an intangible (or tangible) asset that (likely) makes you more valuable.  In other words, when you invest in yourself you make your future production more valuable which makes your future income more valuable which allows you to save more of your future income in the future.   Importantly, investing adds to aggregate saving because one does not dissave in order to spend on investment.  That is, when you invest you have an asset that is as valuable or more valuable than your prior savings PLUS someone else has your spending as their income.

So, next time some financial expert tells you that the key to financial success is saving more tell them they have their economics precisely backwards.  The key to financial success isn’t saving, but investing in your own future production.

 

The Savings Portfolio Perspective

I really liked this piece by Ben Carlson.  Particularly the conclusion:

“There will always be a handful of standout market performers that earn seemingly easy profits, but that’s really a pipe dream for 99% of investors. For the rest of us, getting rich at a painstakingly slow pace is still the best option.”

It’s funny how “investors” abuse the term “investing”.  What we’re really doing when we buy shares on a secondary exchange is not really “investing” at all.  It’s just an allocation of savings.  Investing, in a very technical sense, is spending for future production.  So, if you build a factory and spend money to do so then you’re investing.  But when companies issue shares to raise money they’re simply issuing those shares so they can invest.  And once those shares trade on the secondary exchange the company really doesn’t care who buys/sells them because their funds have been raised and they’ve likely already invested in future production.  You just allocate your savings by exchanging shares with other people when you buy and sell financial assets.

Now, this might all sound like a bunch of semantics, but it’s really important in my opinion.  After all, when you understand the precise definitions of saving and investing you realize that our portfolios actually look more like saving accounts than investment accounts.  That is, they’re not really these sexy get rich quick vehicles.  Yes, the allure of becoming the next Warren Buffett by trading stocks is powerful.  But the reality is that you’re much more likely to get rich by making real investments, ie, spending to improve your future production.  Flipping stocks isn’t going to do that for you.

This leads you to realize your portfolio is a place where you are simply trying to grow your savings at a reasonable rate without exposing it to excessive permanent loss risk or excessive purchasing power loss.  It’s not a place for gambling or getting rich quick.  In fact, it’s much the opposite.   It’s a nuanced view, but one I feel is tremendously important to financial success.

Who Determines Interest Rates?

I get this question a ton – who determines interest rates in the economy, the markets or the Fed?  The answer is actually neither.  The state of the economy determines how interest rates will be set.

It shouldn’t be controversial that the Federal Reserve could, in theory, control the nominal rate of interest on US government issued debt.  As the monopoly supplier of reserves to the banking system they can effectively set a ceiling on interest rates by making a market in bonds.  Bond traders don’t fight the Fed because they know the Fed is the monopoly reserve supplier.  You can’t beat the Fed’s printing press.  Therefore, “bond vigilantes” in the USA are an overstated risk in general.

Now, this gives the appearance that the Fed determines interest rates.  But there are many more interest rates in the economy than the overnight rate or the rates on US government bonds.  Yes, these are important benchmark rates, but they are just benchmark rates.

Most importantly, it’s crucial to understand the context in which interest rates are set at a certain level.  For instance, in an environment of high inflation the Fed is likely to respond to the state of the economy by raising interest rates.  The Fed can’t control the economy and generally reacts to the state of the economy. In addition, the market rates on other interest rate products are likely to rise in a high inflationary environment even if the Fed were to keep overnight rates low.  If a bank can charge you a higher real rate on bank loans because the economy is stronger then the difference between the benchmark rate and the lending rate just makes it more profitable for the banks to issue loans.  This could also become inflationary and so the Fed is very likely to respond to a high rate of inflation by raising interest rates.  Therefore, the Fed responds to the state of the economy.

Anyhow, the point here is that neither the Fed nor the markets determine interest rates.  The state of the economy will lead the markets and the Fed to respond in certain ways which may or may not lead to interest rate changes.  But make no mistake, while bond vigilantes aren’t going to push the rate of interest on US government bonds higher if the Fed doesn’t want them higher, the Fed also can’t control the rate of interest on all credit instruments.  In other words, the Fed can control the nominal rate of interest on US government bonds, but it can’t control the entire economy.  So, as is generally the case, the answer to this question isn’t quite as black and white as many assume.

What Causes Recessions?

I am still working my way through the Q&A from the other week and I really wanted to highlight this question because it’s a good one:

“Noah Smith is always saying that no one knows what causes the business cycle, and in particular recessions. How would you respond to this?”

Economists don’t tend to see the economy the same way I do.  That is, at its macro level, the economy is really just made up of a bunch of balance sheets and income statements.  As I like to say, the language of economics is accounting.  If you don’t understand accounting then you are probably going to have a hard time understanding macroeconomics.

Based on this understanding the economy is just a bunch of balance sheets and income statements so recessions must occur due to shocks in these income statements and balance sheets.  If we could construct an economy where balance sheets and income statements grew at perfectly stable and steady rates then we wouldn’t have recessions.  After all, recessions are just 2 quarters of negative GDP.  So recessions are due to balance sheet and income statement disruptions.  But what causes these disruptions?

The short answer is that lots of things cause recessions.  You can have demand side shocks like a credit crunch, higher interest rates, falling real wages, etc.  You can have supply side shocks like spiking oil prices or other production shocks.  It really depends on the specific environment and the various macro drivers that lead to balance sheet and income statement shocks.  Interpreting each business cycle requires some degree of unique understanding of how the economy is evolving within each cycle.

In its simplest form the cause of recession is always derived from balance sheet and income statement shocks.  Those shocks can occur in many different ways and so an understanding of potential risks during the cycle should involve an understanding of the economy at its macro levels.

 

The “Allocation Matters Most Hypothesis”

My latest post on “passive” indexing made some people upset.  I have argued, in essence, that there is no such thing as “passive” investing and that most people who use the term don’t really understand that what they’re doing is actually quite active and forecast based.  These are not “strawman” comments or misunderstandings as some people (see here and here) have claimed.  They are incontrovertible facts grounded in macro realities.  Let me explain.

Fact #1 – At the macro level there is only one portfolio of all outstanding financial assets.  If you were a truly “passive” investor you would simply buy the total market of financial assets as opposed to trying to pick your own superior portfolio based on assets inside of the aggregate.  Of course, that portfolio can’t be purchased because that portfolio product doesn’t exist.

Fact #2 – We all allocate assets differently from the aggregate financial portfolio thereby rendering us all “asset pickers”.  This asset picking requires some level of forecasting or underlying prediction based on how your risk tolerance relates to how you expect a set of financial assets to help you meet your financial goals.  You can claim that your approach doesn’t rely on forecasting, but that’s like claiming that your ability to successfully sail from San Francisco to Hawaii does not rely on a weather forecast – it’s just not true.

Fact #3 – This portfolio and your risk tolerance to certain assets will evolve over time which will require you to maintain and alter the above portfolio in some manner.   Therefore, it will require some level of upkeep and maintenance even if this is rather minimal over time.

The above facts should not be controversial.  Anyone who constructs a portfolio has to accept the reality that they are an asset picker of some sort.  They should also acknowledge that their perception of risk and the underlying risks of assets changes over time.   Therefore, we are all asset pickers who are required to maintain an evolving portfolio over time.  Again, these facts should not be remotely controversial.

When someone tells you to invest in a “passive” portfolio they are basically telling you to pick broad indexes of assets and maintain a tax and fee efficient structure.  I don’t disagree with this concept AT ALL.  But what seems to have happened over time is that many people who advocate “passive” indexing seem to have forgotten the most important part of portfolio construction – the actual process and necessary forecasting of the assets you pick to allocate.

We know that John Bogle was right when he constructed his “Cost Matters Hypothesis”.  It should be another incontrovertible fact that the less active investor who buys the aggregate market will outperform the more active investor who buys the aggregate market.  Costs matter.   But we should also remember that the most important driver of portfolio performance is not the result of cost and tax structure, but allocation.  Therefore, I think one must adopt the most important hypothesis of all when constructing a portfolio:

THE ALLOCATION MATTERS MOST HYPOTHESIS

And make no mistake – when you allocate assets inside of the global aggregate financial asset portfolio, you are indeed making an implicit forecast and “picking assets”.  The investor who doesn’t embrace this reality is simply not understanding what they are doing.  So yes, costs and frictions matter.  John Bogle was right.  But the passive investing ideology seems to have gone a bit overboard in emphasizing these points.  And in this pursuit to differentiate themselves from “stock pickers” and “active” investors they have lost sight of the reality that what they are involved in is a process of asset picking that will leave some asset pickers inevitably outperforming others who engage in that process utilizing a superior understanding of what it is that they are doing.