Archive for How To – Page 2

Understanding Your Real, Real Returns

Thornburg Funds has a new report out on understanding your real, real returns and it’s fantastic.  I discuss this topic in detail in my book, but they do a much better job covering this than I do.  So go have a read.

The chart below is super important.  Most people who get into investing think only of their nominal returns.  That’s the top line figure.  But what really matters to you is the bottom line.  And in the investment world that’s the real, real return you get.  That’s the after tax, after inflation, after fee return.  It’s the money that actually goes into your pocket relative to your purchasing power.


The interesting part of this discussion is that the mainstream media almost never focuses on this concept.  So we’re constantly fed this myth of generating 10-12% annualized returns in the stock market or generating high returns on housing.  The problem is, the stock market’s real, real return is only 5.97% over the last 30 years.  And single family real estate comes in at a pathetic 0.8%.  In other words, the return that actually goes into your pocket from these assets is substantially lower than most people think.  And that’s because most people don’t calculate their real, real returns.  They don’t properly consider adverse fee effects, adverse tax effects or the problem of purchasing power loss.

You can see the full details in the chart below.  Over the last 30 years every asset class has generated a far lower return than is generally touted.  Commodities are actually negative, as is cash while stocks and bonds are in the low to mid single digits:


We have to be realistic when we get involved in the process of portfolio construction and asset allocation.  Setting realistic goals is one of the most important things you can do because it will benchmark the way you manage your process over time.  Understanding your real, real returns is central to this.

Updated – added second chart.  



Is the Global Financial Asset Portfolio the Perfect Indexing Strategy? – Part 2

Last week I presented the Global Financial Asset Portfolio (GFAP).  In case you missed it here’s a brief summary:

    • The GFAP represents the current allocation of the world’s financial assets.
    • The GFAP is the only pure “passive” index as this is the index that gives you “what the market gives you”.
    • The GFAP is approximately a 55% bonds, 40% stocks, 5% REITs index at present.
    • The GFAP has performed extremely well in the last 30 years on both a risk adjusted and nominal basis.

While I think this portfolio could be fine for many people I also believe this analysis has exposed several flaws in the traditional view of “forecast free” and “passive” investing.  Instead, this analysis requires us all to take a much more nuanced perspective. It’s very likely that the people selling the idea of a purely “passive” or “forecast free” approach do not understand the underlying dynamics at work.  Let me explain.

First, as I explained previously, the true global asset portfolio (as depicted in this paper), is impossible to replicate perfectly.  So there is really no such thing as buying exactly what the “market gives you”.  You have to alter the index using various subjective assumptions.  In the case of my GFAP I removed commodities for instance because I wanted to remove non-financial assets based on the understanding that commodities don’t perform well in real terms over the long-term.  Clearly, that’s been somewhat wrong over the last 15 years as some commodities have performed extremely well.  But the point is that there’s a degree of subjectivity here that makes this a much more nuanced and active endeavor than we might think.

Second, the GFAP is an ex-post snapshot of what the financial asset world looks like today.   Historically, the GFAP should change over time as the underlying balance of assets will inevitably change over time.  So the GFAP has to be reactively dynamic to some degree.  Therefore, the portfolio requires its own degree of reallocation just to remain consistent with the actual underlying allocation of outstanding financial assets.

Third, because the GFAP is an ex-post snapshot of the underlying financial assets it is inherently reactive.  Therefore, it could be positioned in such a manner that it will not provide optimal future returns.  For instance, today’s balance of financial assets reflects the falling interest rate environment of the last 30 years.  So the GFAP reflects this balance.  As a result, the portfolio is bond heavy relative to equities because it has become significantly less expensive to issue debt relative to equity over the last 30 years.  As a result we’ve seen a huge decline in equity issuance relative to debt.  So the GFAP has shifted from what was a stock heavy portfolio 30 years ago to a bond heavy portfolio today.  But this is a reactive shift in the landscape.  Any smart asset allocator would look at this environment and argue that there are some unsustainable trends in place here.*

For instance, the Aggregate Bond Index has generated 8%+ annualized returns since 1980.  With overnight interest rates at 0% there is about a 0% chance that bonds will generate the same returns in the next 30 years as they have in the past 30 years.  So this bond heavy portfolio has an overweight to fixed income thanks to the ex-post nature of this index.  But there’s also a strong argument to be made that stocks are expensive in relative terms and likely to be more volatile going forward than they have been in the past.  This means that anyone actively choosing to deviate from the GFAP bond heavy allocation is potentially exposing themselves to a high degree of equity market risk which creates a whole other risk for investors in a low interest rate environment.

Lastly, we should note that there are many factors that play into an asset allocation decision outside of trying to replicate a “pure” index like the GFAP (there is a degree of indexing overkill in some discussions these days).  Clearly, this allocation isn’t appropriate for all investors and you need to be very precise about understanding risk and how it relates to your personal decision before you can allocate your assets appropriately.  So generalizations about the GFAP should be taken with a grain of salt as they do not apply to everyone.

All of this presents an interesting conundrum for asset allocators.  Using an ex-post snapshot of the financial world is clearly not always an optimal approach for everyone.  Most importantly, there’s an obvious contradiction in the idea that we should just accept “what the market gives us” since this implies that the forecasts of the asset issuing entities comprising the current underlying asset allocation, is optimal, and we should therefore just accept the return that their asset issuance generates.

A reliance on a “pure” indexing approach like the GFAP is not necessarily a bad idea for some people, but it has obvious flaws as well.  Asset allocation requires a certain degree of active forecasting and “asset picking” based on how we think the future performance of specific asset classes will translate to our risk profile and financial goals.  There’s a certain degree of forecasting and guesswork involved in any of this.  A reliance on a pure ex-post approach is reactive and static relative to what must be a proactive and dynamic endeavor (asset allocation).  Finding the perfect balance will be difficult for all of us to achieve.  Hopefully this series helps you put things in the right perspective so you can come a little closer to optimizing your own approach.

*  To highlight this point consider the fact that a 40/60 bond/stock portfolio has substantially outperformed a 60/40 bond/stock portfolio over the last 30 years on a risk adjusted basis and only slightly underperformed in nominal terms.  In other words, buying the GFAP from 30 years ago when it told us to be stock heavy, was precisely backwards!


This Commonly Referenced USD Purchasing Power Chart is Useless

You’ve almost certainly seen the chart below over the years – it shows the purchasing power of the US Dollar over time.  It looks terrifying.  And it’s constantly cited by hyperinflationists and other people trying to convince you that the world is quickly coming to an end thanks to the “fiat monetary system” and all the “money printing” that’s going on due to nefarious governments.  Well, the chart is basically a misrepresentation of anything important.


(Figure 1 – Stupid Chart)

The problem is, this chart doesn’t show whether per capita wages are rising or falling.  For instance, if your dollars buy you half as many eggs today as they did in 1913, but your income is twice as high as it was in 1913 then you haven’t gone backwards.  Yes, the USD’s purchasing power has fallen, but your ability to buy the same quantity of eggs has remained exactly the same.  Your living standard hasn’t fallen even if the purchasing power of the dollar has declined.

So, it’s important to put this in the right perspective here.  And when we look at this discussion it’s best to use an inflation adjusted perspective of wages and salary accruals on a per capita basis.  And when we run that figure the chart looks a lot different (reliable data only goes back to 1947):


 (Figure 2 – Smart Chart)

It’s not exactly a thing of glory (especially the last 20 years or so), but it clearly tells a very different story than the chart above which really tells us nothing.  So, next time some hyperinflationist throws the USD purchasing power chart in your face refer him to this post and tell him he isn’t telling the full story.


Buy Cullen Roche’s New Book Pragmatic Capitalism – What Every Investor Needs to Know about Money and Finance

Is the Global Financial Asset Portfolio the Perfect Indexing Strategy?

*  This is part 1 of this post.  Please refer to this link for part 2.  

If there was such a thing as an indexing purist that person would simply buy all of the outstanding available financial assets in the world and call it quits.  In other words, they would “take what the market gives them” rather than trying to make active predictions about which parts of the financial asset world will perform better than other parts.  Of course, that’s not how most of us invest.  Even the so-called “passive” indexers are engaged in a form of active index picking which generally results in a portfolio that is overweight stocks. But what if you could be a purist?  What if you wanted to just accept what the “market gives you”?  And how would that portfolio perform in general?

Constructing the Portfolio

As I’ve noted previously, the global asset portfolio as comprised by this paper, is a pretty good starting point.  It looks like this as of 2011: global_portfolio

I have a few issues with the portfolio:

  1. We should be focusing on FINANCIAL assets as opposed to holding every asset in the world.  Clearly, an index of all the world’s assets is impossible to come even close to replicating so let’s stick to financial assets entirely.  Because of this focus on financial assets we are eliminating any exposure to non-financial assets like real commodities.
  2. In addition, this can be justified based on the understanding that commodities are mainly cost inputs in the capital structure that generate no real return in our financial portfolio over long periods of time (see here for more).
  3. To reduce repetitive allocations we will eliminate the “hedge fund” component” and instead allocate this portion in accordance with the HFRI Equal Weight Index.
  4. Private equity is is just equity on the primary markets so for simplicity of replication and practical implementation let’s just roll that into equity.
  5. Cash and all cash equivalents are not being included in this analysis, but it should be acknowledged that cash is an ever present asset class in any realistic portfolio that will require management (see here for more).

When we rearrange the portfolio based on the above assumptions we get a portfolio that looks roughly like this:


That’s basically a 55% bonds, 40% stocks, 5% REITs portfolio, which is pretty interesting because the common thinking on indexing is usually stock focused.  Keep in mind there are lots of different types of instruments within each of these components (like MBS, municipal bonds, high yield, etc).  But this is a good approximation of what the Global Financial Asset Portfolio might look like.  And it’s easily replicated through available funds.

Portfolio performance 

Because of the unavailability of some asset classes we can only backtest this portfolio to 1985.  The numbers are pretty impressive though:

Compound Annual Growth Rate (CAGR):  8.7%

Standard Deviation: 6.89

Sharpe Ratio: 0.73

Sortino Ratio: 1.32

Correlation to International Markets: 0.54

For perspective, a 60/40 stock/bond portfolio over this period generates the following:

Compound Annual Growth Rate (CAGR):  9.5%

Standard Deviation: 9.51

Sharpe Ratio: 0.5

Sortino Ratio: 0.77

Correlation to International Markets: 0.95

In other words, the stock heavy 60/40 portfolio is just leveraging the equity component of the GFAP which generates a better nominal return, but a worse risk adjusted return.  An indexing purist wouldn’t be shocked by that if they were an advocate of the GFAP as their ultimate benchmark.  Of course, most indexers are actually “asset pickers” who engage in a degree of asset class forecasting or factor based asset allocation strategies.   But just as with anything involving dynamic markets there is a certain degree of forecasting, guesswork and imprecision involved.  Given the limitations of this research there are some important caveats and further details that will require another post in the coming days.

In part 2 I’ll tackle the most important question:

“Is the Global Financial Asset Portfolio the perfect indexing strategy?”


1.  Global Market Capitalizations, World Federation of Exchanges, July 2014.

2.  The Global Multi-Asset Market Portfolio, Ronald Q. Doeswijk, Trevin W. Lam & Laurens Swinkels, January 2014.


What Backs the Value of Money?

I was reading this very good piece by Matthew Klein at FT Alphaville when I came across this line:

“The only kinds of money that reliably hold their value are the ones explicitly backed by a strong government*.”

This is an interesting point and one I don’t completely agree with.  I go into this in excruciating detail in my book, but I’ll spare you the copy and paste job from that since it’s too long.  Instead, here are some basic points on this topic which I think are important and put the above comment in the right perspective:

  • Money is primarily a medium of exchange utilized to obtain goods and services.
  • If the output of a society declines or is viewed as less valuable to its users then the money which is used as a medium of exchange will also be viewed as less valuable.
  • Spending in excess of productive capacity will cause high inflation which can threaten the viability of money.

Okay, so, no government here at all.  In theory, a totally private economy could utilize a form of “money” purely for the purpose of exchanging goods and services.  There are plenty of historical examples of this throughout time, but the problem is that, as inherently social animals, the mythical “Robinson Crusoe” concept of money just doesn’t work out very cleanly.  In other words, the existence of money impacts all of us who need it or want it.

If you live in the town next door and your town uses a different form of “money” than my town, but I want to buy the new long rifle that is only manufactured by a company in your town (who doesn’t accept my town’s money) then I have to obtain your town’s money.  You can imagine how this relationship plays out over history as money becomes an increasingly social construct in a world that is increasingly interconnected.  And since money is a social construct then money plays into other broader social needs.  While it is certainly an instrument of private exchange, it has become an instrument of public exchange due to the sheer complexity of the societies in which we live and their interconnectedness.

So, over time money becomes more than a private medium of exchange and becomes an instrument which can be used for public purpose like fighting wars and building roads.  And so governments begin to define what the unit of account is (things like the Dollar, Euro, Yen, etc), but continue to allow private entities like banks to issue money.  Unfortunately, we can’t trust everyone who uses money and because it is an instrument highly dependent on trust it can be helpful to have the government utilize its legal powers to enforce the use of money.

None of this government involvement in money comes first though.  You’ll notice that a viable form of money is ALWAYS preceded by a valuable private sector which produces valuable goods and services.  Almost everything the government does is after the fact in a supporting role.  As I like to say, capitalism makes socialism possible.  So yes, a government can certainly increase the viability of a form of money through things like the legal system, but we should never lose sight of the fact that money is only as good as the output it gives us access to.  And while much of that output is created by governments these days the majority of domestic innovation and production is a private undertaking.  Therefore, I would change Matthew’s comment to something more like this:

“The only kinds of money that reliably hold their value are the ones explicitly backed by strong private sector output*.”

More Thoughts on the CAPE and Valulations

I’ve made my opinion on valuations and the use of CAPE pretty clear - these sorts of metrics don’t tell us much about the macro environment because the whole idea of ” value” is dynamic and evolving.  If I am right then trying to calculate a market “value” through these types of metrics is likely to mislead you into thinking that the market is static and more predictable than it really is.

The point is, if valuations and market perceptions are as dynamic as I believe then the history of something like CAPE really doesn’t tell us much at all.  After all, “value” is really all in the eye of the beholder.  If investors are willing to pay more for stocks today than they were in 1950 then maybe a CAPE of 15 has no bearing on what a CAPE of 25 means.  That is, stocks could simply be perceived differently than they were in the 1950s.  Perceptions change.  And there’s no reason why stocks can’t be perceived to be inexpensive at a CAPE of 25 just because they once sold at a CAPE of 15.  In other words, what if a CAPE of 35 is the new “expensive”?   Now, I don’t know if that’s true, but in the process of managing one’s risk I think you have to consider that possibility.

I bring all of this back up because Brad Delong wrote a nice piece citing a similar view in response to Robert Shiller’s NY Times piece this weekend.  Delong basically notes that stocks were undervalued for no good reason in the past:

“Given the large number of investors and institutions in our economy with very long time horizons that thought to be in the stock market for the long-term–insurance companies, pension funds, rich individuals with grandchildren–for me the anomaly does not seem to be a CAPE of 25 (or, given historical real returns on other asset classes and very low current yields on investments naked to inflation risk, 33) but rather the CAPEs of 14-20 that we saw in the 1980s, 1960s, 1950s, 1900s, 1890s, and 1880s that Robert Shiller appears to think of as “normal” and to which today’s CAPE should someday return. “

I am going to be blunt – I have no idea if any of this is true.  I don’t know what the “value” of stocks are today.  And I don’t think anyone else really does.  And I think trying to put a value on them through these sorts of metrics is just a big waste of time that leads some people to believe they’ve been able to pinpoint the “value” of stocks at present when the reality is that they’ve simply tried to calculate, with  precision, something that is very imprecise (human perception).  Therefore, if “value” is just another dynamic and evolving concept based largely on human perception then calculating it at any given time is likely to mislead you more than it’s likely to help you.

Thoughts on Commodities as an Asset Class

I really liked this piece by Ben Carlson on commodities and how they might fit into your portfolio (I like Ben’s piece primarily because he agrees with my views so you’ve been warned in advance! ).   He goes over the historical performance of commodities and concludes that commodities are best used as trading vehicles and not something that you should invest in.  As I’ve discussed in the past on several occasions I completely agree (see here and here).  My thinking is a little different from Ben’s though.

Commodities are substantial cost inputs in the capital structure.  So they don’t tend to produce real long-term returns due to their high correlation with the rate of inflation.  And the trading of commodities has traditionally been done not for the purpose of generating a profit, but hedging a business activity.  For instance, a classic example of commodities trading is an airline that hedges fuel prices in order to make their business forecast more stable.  They aren’t really trying to generate a profit.  They are trying to lock in a price so their business can be run more efficiently.  The commodity is being used more like insurance than a profit making vehicle.

The evolution of commodities as a vehicle for pure profit is a much more recent thing that seems to have arisen with Wall Street’s increasing promotion of these vehicles as an extra asset class that you can “diversify” through.  I don’t like that one bit.  I think it stinks of Wall Street trying to repackage an asset class as something it’s not just so it can push it on unwitting investors.  Hence the rise of countless commodity ETFs and trading strategies designed around “diversifying” into “alternative asset classes”.

In my opinion, a portfolio should be constructed primarily around instruments that are tied to the underlying production of the economy.  It’s fine to use commodities as a hedging vehicle in some cases, but I think it’s crucial to understand where commodities sit in the capital structure, why their long-term returns have been very poor and why commodities aren’t a sound long-term bet as a core portfolio holding.

Anyhow, I’ll get off my soapbox.  Go have a read of Ben’s piece and if you want to read some more you can explore the following:


Reserves Don’t Really “Go Into” Loans

Very good piece here by Robert Murphy of the Austrian school regarding stock prices and how it’s erroneous for people to state that money “goes into” other financial assets.  He’s dead right of course.  The fact that the Fed has increased the quantity of reserves/deposits doesn’t mean more money is “going into” stocks.  It just means that the composition of the private sector’s balance sheet has changed which may or may not lead to higher prices.  Let me elaborate.

When you buy a share of stock someone else is selling you their cash.  You are getting their stock and they are selling you their cash.  The price you agree on is the new price of the security.  But you aren’t putting money into that security.  You are engaging in a simple exchange.  That’s why they call the NYSE the New York Stock EXCHANGE.

A good way to think about this relative to QE is to think about how a stock buyback works.  When a company buys back shares they are changing the composition of the outstanding financial assets.  All else equal, this will lead to higher EPS which will lead to higher stock prices.  But all else isn’t always equal.  Indeed, if the company’s operations are failing massively it doesn’t matter if they’re reducing the share count – the stock will still price lower.

The same basic idea can be applied to QE.  If the real economy doesn’t improve then the Fed can alter the composition of financial assets all it wants and it could make no difference for share prices.  All of this highlights the importance of “value” being separate from merely looking at quantities of assets and understanding the idea that more money doesn’t mean more money is “going into” stocks.  It could mean more money is competing to own the same quantity of stocks, but money doesn’t “go into” stocks in any meaningful way that automatically implies higher prices.  I think you get the point.

Anyhow, a similar point can be made regarding bank loans and QE.  I bring this up because I am going to pick on Robert Murphy a little bit.  He correctly points out that QE and more deposits doesn’t mean that more money is “going into” stocks.  But he should also acknowledge that this doesn’t necessarily mean more money needs to “go into” bank loans.  He stated back in 2011 that the excess reserves in the banking system posed some huge inflation threat as they were beginning to “leak out” of the banking system.  But this concept of reserves “leaking out” is as meaningless in the context of bank lending as it is in the context of stock prices.  The reason is simple – banks reserves don’t “go into” making loans.  When a bank makes a loan it expands its balance sheet endogenously.  It makes loans and finds reserves later if necessary.  As I’ve stated ad nauseam, the textbook concept of the money multiplier is wrong.

I’ve beaten this drum pretty loudly for 5+ years now and it’s nice to see that some economists are at least understanding the point about stock prices.  But it would be nice if they also started acknowledging the point as it pertains to bank lending and QE as well.  It would make for a much more informed and accurate discussion.


The Bank of England Debunks the Money Multiplier

Bank Lending is Primarily a Demand Side Issue

The Money Multiplier Doesn’t Exist Outside the Zero Lower Bound Either