Archive for How To – Page 2

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

The Scale of Monetary Happiness

Does money really buy you happiness?   

The opening quote in my new book is:

“The person who mistakes “money” for “wealth” will live a life accumulating things all the while mistaking a life of owning for a life of living.”

Although my book is all about understanding money, investing and the economy I tried my best to highlight what I think is one of the most important elements of understanding our monetary system – while money is important and necessary in this system it should not be viewed as the ends when it is merely a means to an end.

I got to thinking about this in more detail this weekend as I was reading this piece in the FT which discusses how greater wealth is indeed linked to greater happiness.  I don’t think this is necessarily wrong, but I would argue that greater wealth has a diminishing rate of return with regard to how effectively it can contribute to our happiness.

In order to conceptualize this I took Maslow’s Hierarchy of Needs and applied it to a spectrum showing that the higher up the hierarchy you go the less effective money is in helping you attain certain things.


Money is obviously a necessity because we all need things at the bottom of the hierarchy.  But as you climb higher you find that money has a diminishing rate of return in helping you acquire those things.  Money cannot buy you morality, purpose, meaning or many of the things that are higher on the scale.

So, does money buy you happiness?  Money can buy you a certain level of happiness and there is little doubt that money makes life easier in many ways.  But money cannot buy what might be seen as the ultimate forms of happiness. That includes things like purpose, meaning, friends, family, etc.  So don’t confuse the means with the end.  Doing so will warp your perspectives on what matters and what doesn’t.

Thoughts on “Artificial Interest Rates”

There’s been a lot of talking in the econ blogosphere about “artificially low interest rates”.   This is a concept that’s often expressed by people who are promoting the “Fed as manipulator” view of monetary policy.  And they’re basically right even if they overstep in the way they communicate the point.

I think Noah Smith’s article on Bloomberg View did a nice job explaining the key points here, but I will reiterate some of these points since they are concepts I think are important:

  • The Fed is the monopoly supplier of reserves to the banking system.  Therefore, it can always set the Fed Funds Rate.  In fact, in order to supply reserves (which are issued primarily for payment settlement) the Fed must ALWAYS force the Fed Funds Rate HIGHER from 0% where it would naturally go if the Fed did not establish a floor of some sort.  I like to think of the entire Fed System as an intervention in what would otherwise be a private clearing system.  Therefore, if you want to think of the Fed as an “artificial” construct then fine.  But we should understand that “artificial” construct as it is and not how we want it to be.
  • While the Fed Funds Rate is important it is simply one rate out of many.  Remember, banks and other credit issuers use the Fed Funds Rate as a benchmark, but that does not mean it drives the interest rate across the entire economy and across all financial assets.  It is merely one component of the spread that determines how profitable various credit instruments may or may not be.
  • I think Noah gets the description slightly wrong in his conclusion when he implies that the government creates money.  The government primarily creates “outside money” or money that serves as a facilitating form of money to “inside money”.  That is, bank deposits and other forms of inside money (money created INSIDE the private sector) dominate the medium of exchange.  And outside money (cash, coins and reserves) are really just there for facilitate the use of bank deposits (for interbank payment settlement, using the ATM, etc).  Thinking of the government as the creator of “money” can be an extremely misleading way to understand the monetary system.
  • Lastly, Noah references a Paul Krugman article which implies that there is a “natural” rate of interest in the economy where markets clear.  I just don’t think this is a very useful concept as it implies that the interest rate is some variable by which the economy can be steered by the Fed towards full employment and price stability.  I just don’t think that’s right, but that discussion will have to wait for another day.

In the end it’s all about constructing a coherent and consistent framework for understanding the monetary system.

A Cheat Sheet for Understanding the Different Schools of Economics

The guys at Zero Hedge posted this useful summary of the various economic schools.  But I felt like it didn’t go far enough to both simplify and summarize the various schools of economics so I thought I’d try to recreate the cheat sheet as best I could breaking down what I think are the most essential components of each school.   I hope you find it helpful:

Austrian Economics

Overview – A “heterodox” school of economics grounded primarily in the work of Mises, Hayek, Menger and Rothbard that advocates the purposeful economic decisions of the individual.

Mission Statement – The free market can solve most of our problems and the more we reduce government or eliminate government the better off we will all be.

General view of the economy – The less the government is involved in the economy the better it will perform.

How to fix the economy – We can fix the economy by reducing government and central bank involvement in free market forces.

What they love – Austrian Business Cycle Theory, free markets, individual freedoms and unfettered capitalism.

What they hate – Paul Krugman, the Federal Reserve, “Keynesians” and anyone who advocates for government intervention in markets.

Notable Pundits – Peter Schiff, Robert Murphy& Tom Woods.

Famous Dead Economist Associated with School –  Ludwig von Mises, Friedrich Hayek, Carl Menger & Murray Rothbard.

Political Associations – Libertarians, conservatives, extreme conservatives and just about anyone who dislikes the government.

Preferred form of communication – Generally aggressive promotion of anti-government views through blog comments and conservative media.

Further Reading: 

1 – What is Austrian Economics? –

2-  Understanding “Austrian” Economics – Hazlitt

3 – Austrian Business Cycle Theory, A Brief Explanation – Mahoney

4 – Austrian School of Economics – Boettke

Behavioral Economics

Overview – One of the newest and fastest growing schools of economics.  Widely perceived as one of the most positive recent developments in economics.

Mission Statement – The best way to understand the workings of the economy is by understanding the way the human mind reacts and adapts to markets and the economy.

General view of the economy – The economy is complex, dynamic and uncertain and is being navigated by imperfect participants.  Because of this it could be appropriate for government intervention at times.

How to fix the economy – Behavioralists don’t make specific policy recommendations, but generally believe that we can better understand the economy if we better understand human psychology as it pertains to money, markets and the economy.

What they love – Prospect theory, studying human biases and highlighting the fact that we’re totally ill-equipped to deal with money and markets.

What they hate – That their work is often rejected by mainstream economists as being something outside of the field of real economics.

Notable Pundits – Richard Thaler, Robert Shiller, Dan Ariely & Daniel Kahneman.

Famous Dead Economist Associated with School – George Katona & Amos Tversky.

Political Associations – No direct political associations.

Preferred form of communication – Well researched papers and books primarily.  Behavioralists, not surprisingly, tend to be open-minded and well behaved.

Further Reading: 

1- Prospect Theory: An Analysis of Decision under Risk – Kahneman & Tversky

2- Behavioral Economics – Thaler & Mullainathan

3 – Predictably Irrational - Ariely

Classical Economics

Overview – The “original” school of economics based on the understandings of the “classics” like Adam Smith, David Ricardo and John Stuart Mill that stressed economic growth and freedom emphasizing free markets.

Mission Statement – The “invisible hand” of the free markets is all we need to achieve equilibrium.

General view of the economy – Classical economists were the emerging capitalists from the age of feudalism.  They saw outside intervention in the markets (such as regulation and government) as a disruption to the natural order of markets.

How to fix the economy – Let the free markets do their thing.

What they love – Say’s Law, the concept of the “invisible hand”, laissez fairre ideas and free markets.

What they hate – Outside intervention in markets and mercantilism.

Notable Pundits – None living.

Famous Dead Economist Associated with School – Adam Smith, David Ricardo & John Stuart Mill.

Political Associations – Conservative.

Preferred form of communication – This school has evolved into the modern neoclassical schools.

Further Reading: 

1 - The Wealth of Nations – Smith

2 – On Liberty – Mill

Market Monetarism

Overview – Largely seen as a revival of traditional Monetarism utilizing the foundations of Milton Friedman’s work and growing extremely popular with the “freshwater” schools.

Mission Statement – The Central Bank can steer the economy on a glide path to prosperity through a laissez fairre approach if we implement NGDP targeting.

General view of the economy – The economy is unlikely to reach equilibrium without a permanent NGDP targeting rule in place.

How to fix the economy – Duh, NGDP targeting.

What they love – NGDP targeting.

What they hate – Anyone who rejects NGDP targeting.  And people who confuse their thinking with traditional Monetarist views centered around monetary aggregates, monetary velocity and interest rates.

Notable PunditsScott Sumner, David Beckworth & Nick Rowe.

Famous Dead Economist Associated with School – Milton Friedman.

Political Associations – Libertarian and conservative.

Preferred form of communication – Scott Sumner’s blog.

Further Reading: 

1 – Scott Sumner’s Market Monetarism FAQ

2 – Market Monetarism, The Second Monetarist Counter Revolution – Christensen

Marxian Economics

Overview – A largely defunct school of thought based on the economics of Karl Marx.

Mission Statement – Capitalism is not just flawed, but likely to screw most of us all if left to its own devices.

General view of the economy – A capitalist economy is not just flawed, but naturally self destructive and therefore requires outside intervention and regulation to be consistent with prosperity.  In essence, the capitalist class will obtain exceptional power over the labor class resulting in massive inequality and general hardship.

How to fix the economy – Intervene preemptively to make sure the capitalists don’t wreck it.

What they love – The labor class.

What they hate – The capitalist class.

Notable Pundits – Karl Marx, Karl Marx and some guy named Karl Marx.

Famous Dead Economist Associated with School – Some guy named Karl Marx.

Political Associations – Extremist liberals.

Preferred form of communication – The darkest corners of the internet and slowly becoming extinct in all other corners.

Further Reading: 

1 – Capital: A Critique of Political Economy – Marx

Modern Monetary Theory (MMT or Chartalism)

Overview – A heterodox school associated with a branch of the Post-Keynesian school of economics (see below) that has become very popular on the internet in the last 10 years.

Mission Statement – There is no economic problem that fiscal policy can’t solve.

General view of the economy – Capitalism is naturally flawed and can only operate at full capacity if the government is used to permanently fill any demand shortages that exist.

How to fix the economy – Fiscal policy in the form of tax cuts and spending increases in addition to the implementation of a government Job Guarantee to employ anyone who wants a job.

What they love – Job guarantees and telling you how little you know about economics.

What they hate – That the mainstream won’t take them seriously.

Notable Pundits – Warren Mosler, Randall Wray and William Mitchell.

Famous Dead Economist Associated with School – GF Knapp, Abba LernerAlfred Mitchell-Innes.

Political Associations – Liberals, extremist liberals and socialists.

Preferred form of communication – Aggressive and very active commenting on any blog comment section usually reminding the author that they “just don’t understand MMT” or the economy.

Further Reading: 

1 – Soft Currency Economics – Mosler

2 – 7 Deadly Innocent Frauds – Mosler

3 – Modern Money Theory – Wray

New Classical Economics

Overview – The New Classical school is the modern adaptation of the classical school (see above).   It is based on Walrasian assumptions, rational expectations and arose out of the failures of the Old Keynesian schools during the failure of the Phillips Curve and stagflation in the 1970’s.

Mission Statement – Macroeconomics requires new classical microfoundations to be properly utilized.

General view of the economy – Rational agents are always making optimal decisions and firms are always maximizing profits, but the economy is often shocked by “real” effects like unanticipated policy changes, changes in technology or changes in raw materials.

How to fix the economy – New Classical economists are generally associated with a laissez faire approach to policy.

What they love – The Lucas Critique, Ricardian Equivalence, rational expectations & microfoundations.

What they hate – The concept of “involuntary unemployment” and  policy stabilization.

Notable Pundits – Edward Prescott, Robert Lucas, Thomas Sargent and Robert Barro.

Famous Dead Economist Associated with School – John Muth.

Political Associations – Generally conservative, but at times also appealing to no specific political party.

Preferred form of communication – Academic work primarily.

Further Reading: 

1 – New Classicals and Keynesians, or the Good Guys and the Bad Guys – Barro

2 – New Classical Macroeconomics – Hoover


New Keynesian Economics

Overview – The New Keynesians are the adaptation of the Old Keynesians who responded to the criticism of the New Classicals in the 1970s and 80’s by creating an updated model of the economy to help explain some of the Keynesian failures of the 70’s.  Most of the “economics” one learns today is closely related to or directly related to New Keynesian economics.  It has become, by a wide margin, the dominant model used by policymakers.  Although it adopted the term “Keynesian” in its name the school actually pitches a fairly broad tent using some neoclassical foundations as well as Monetarist perspectives.

Mission Statement – Although economic agents are rational we believe policymakers can improve economic stability and help attain full employment through various stabilization policies designed to combat a variety of market failures.

General view of the economy – Economic agents are rational, but markets are imperfect due to phenomena such as “sticky prices”.  This can result in broad market failures leading to recession.

How to fix the economy – New Keynesians will generally deviate towards the use of Monetary Policy, but will at times also recommend fiscal policy to help stablilize the economy.  They have become particularly vocal during the recent recession due to the “zero lower bound” and the ineffectiveness of monetary policy thereby arguing for a fiscal approach.

What they love – Sticky prices, rational expectations, the Zero Lower Bound, the natural rate of interest, DSGE modeling.

What they hate – Not much.  They pretty much dominate the popular economic journals, textbooks and have the ears of policymakers.  If anything, they hate not being taken even more seriously than people already take them and mostly fight among one another regarding their minor differences on policy and politics.

Notable Pundits – On the liberal side: Paul Krugman, Brad Delong & Joe Stiglitz. On the conservative side:   Greg Mankiw, David Romer & Olivier Blanchard.

Famous Dead Economist Associated with School – JM Keynes although it should be noted that New Keynesian economics has actually deviated substantially from the original work of Keynes and has incorporated a good deal of both Monetarist and neoclassical concepts which Keynes would have rejected.

Political Associations – This tent is broad with both conservative and liberal economists.

Preferred form of communication – Academic research and several popular blogs such as Paul Krugman’s NY Times blog and Greg Mankiw’s blog.  These economists also dominate the textbook arena.

Further Reading: 

1 – What is New Keynesian Economics?  –  Gordon

2 – New Keynesian Economics – Mankiw

Post-Keynesian Economics

Overview – A branch of Keynesian economics that portends to get back to what the “true Keynes” thought about the economy and how to improve it.

Mission Statement – JM Keynes had it all right all along.  Involuntary unemployment is the result of aggregate demand shortages resulting primarily from failures by firms to maximize investment.

General view of the economy – Capitalism exists on an inherently unstable foundation and will at times require some forms of government intervention to achieve prosperity.

How to fix the economy – Counter-cyclical policies with a focus on fiscal policy.

What they love – Rejecting large swaths of mainstream economics and calling out modern Keynesians for having misconstrued the works of Keynes.

What they hate – Thinking that the mainstream thinks they’re irrelevant cranks.

Notable PunditsPaul Davidson, Tom Palley and Marc Lavoie.

Famous Dead Economist Associated with School – Wynne Godley, Joan Robinson and Nicholas Kaldor.

Political Associations – Centrists and liberals.

Preferred form of communication – Virtually none.  The school is almost entirely unrepresented by a prominent mainstream voice and is largely shut out of the prominent academic journals.

Further Reading: 

1 – Monetary Economics – Lavoie & Godley

2 - The Keynes Solution – Davidson

My Top Ten Non-Investing Books for Investors

By Robert Seawright, Above the Market

Last week, other bloggers and I provided favorite reads for Tadas Viskanta and his terrific site, Abnormal Returns. There are a lot of good and helpful suggestions offered there. But I am seldom asked about books in a broader context — books that changed my overall thinking and thus necessarily changed how I view investing and the markets. The ten books shown in the gallery below did just that. They were (and are) particularly illuminating. I highly recommend them.

How Much Longer Will the Dollar Remain the Reserve Currency of the World?

The US Dollar’s status as a reserve currency seems to be a perennial concern for many people these days.  I think this concern is often dramatically overstated.  I was reminded of this point as I was reviewing the slides from Jeff Gundlach’s presentation yesterday which showed the following chart:


(Source: DoubleLine)

As you can see, no one maintains reserve currency status forever.  That shouldn’t be remotely surprising.  The global economy is dynamic and market shares shift.  And at the end of the day that’s what reserve status is really all about.  Think about it – nations accumulate reserves of US dollars today because the US economy is the dominant player in global trade.

Of course, the US Dollar isn’t the only currency that nations maintain reserves of.  The Euro is also a major reserve currency and the Yuan is fast becoming a major reserve currency.  But since the USA produces 22% of all world output it happens to play a particularly special role in the global economy.  By virtue of being the largest economy in the world the accumulation of US dollar denominated financial assets happens to dominate the global financial system.  It’s sort of like being the top market share producer of a particular product in a particular industry.  Other entities accumulate your products because you’re the top producer.   And that changes over time.  Market shares change and regimes shift with the evolving economy.

So, will the USA lose its reserve currency status at some point?  Yes.  In fact, it’s already starting to lose its reserve status to Europe and China.  Will it be the end of the world and will it cause everyone to suddenly ditch the dollar?  Probably not.  It just means the USA will produce a lower proportion of global output and therefore, as a matter of accounting, the rest of the world will hold a lower percentage of US dollar denominated financial assets as a percentage of global output.  It’s not the end of the world.  It’s just a sign that market shares change and when you’re #1, well, there’s only one direction to go.

Should You Use an Automated Investment Service?

As an independent financial consultant I do a lot of investment advisory audits.  That is, I spend a substantial amount of time reviewing portfolio managers, financial advisors and trying to help people steer clear of industry myths and value drags.  Helping investors understand what their advisor/manager does (or doesn’t do) is crucial to being able to help my clients.

In the last few years a new “advisor” has entered the fray – the robo advisor, now being called “automated investment services”.  Automated investment services are platforms that automate your investment portfolio and try to help you reduce fees, increase efficiencies and streamline your process through a simple computerized interface.  With increasing frequency I am encountering the same question from my clients – “should I consider using an automated advisor?”  You have probably started to hear about some of these firms like WealthFront or Betterment so let’s explore this further.

First, let’s look at the positives here because there are many benefits that are going to come from an increasingly automated investment advisory landscape.

The four primary benefits are:

1)   More pressure to lower overall fees.    Automated investment advisory firms will drive down broad fees as they undercut the traditional advisory business model through their low cost platform.  This should substantially reduce the fees clients pay on average.  This is fantastic news as I’ve long believed that investment advisory services are overpriced.

2)   Automated advisory services will drive out many sub-par advisors.  The ability to automate your advisory services means you don’t necessarily need a person to help you put together a financial plan.  And this means that the rest of the advisory business will have increasing trouble proving their value.  This means that sub-par advisors are likely to be driven out of the business over time as high fee structures and the lack of a value proposition renders them void.

3)  Automation creates a systematic process.  Portfolio construction and maintenance is all about having a plan and a process.  These automated services are good ways to help you establish goals and maintain a strict adherence to a plan.

4)  Some of the automated services are providing other valuable products that more closely resemble real financial planning and useful portfolio management.  The recent news from Vanguard, for instance, that they’re combining these automated tools with real personal advisory services, is a sign that the robots can work with the machines.  It actually discredits the pure Robo Advisory structure to a large degree, which I think is the right blend.

Another interesting example is WealthFront’s Single Stock Diversification Program which helps investors in public companies better diversify their portfolios.  This can be a valuable service for someone who isn’t interested in paying high fees to have a major investment bank manage this service for you (although, this service doesn’t appear to be terribly sophisticated and if you talk to someone like, say, Mark Cuban, he’ll let you know that having a sophisticated banker like Goldman Sachs on your side here can be the difference between being a millionaire and a billionaire).

On the whole, these are incredibly positive developments for the advisory business and consumers.  In short, automated advisory is changing the advisory landscape and forcing the entire industry to adapt and evolve with the times.  But technology has always been problematic for financial advisory in several ways.

Let’s also look at some of the potential problems here:

1)  Automated advisors reduce your fees by reducing your existence down to a number.  You input your information, they output the data.  It’s all automated.  They often don’t know you, they don’t know your feelings, your family, your personal needs, goals, precise risk tolerance, etc.  This is a big problem from a financial planning and portfolio construction perspective.  It’s great to cut fees, but we shouldn’t be willing to reduce the quality of our financial plans just for a low fee advisory service.  The pure robo advisor is a step backwards in this sense.  It puts costs ahead of quality.

For instance, I ran through a “risk profile” on one of the major robo advisor sites using VERY conservative inputs (elderly, low income, no risk tolerance, etc) and the base output was a 42% risk asset allocation (stocks and commodities).  That’s madness in my view.  The most conservative portfolio ouput in this scenario would have lost 20-25% in a year like 2008.  That’s terrible profiling of a client.  But this is what happens when you take the human element completely out of the picture.  You get reduced to a number in a computer algorithm and there’s no telling if that algorithm actually gets your profile right.  In this case, it looks woefully lacking.

The better solution here is a combination of the two.  I hope improved technology can be combined with the human quality of the necessities of a good financial plan.  The best robo advisors won’t truly automate their services, but will utilize the strengths of technology WITH good advisors to enhance the quality of the output.  As Erik Brynjolfsson says – we need to work WITH the machines.  Not against them.  The automated services, in an attempt to cut out the middleman entirely, have actually risked creating a model that is so simple that it actually misleads the client into designing a portfolio that may not be ideal for them.

2)  Most of the portfolios I’ve seen coming out of these Automated Investment Services are constructed based on flawed foundations and actually increase portfolio degradation.  This isn’t terribly shocking.  Wall Street has been hiring mathematicians and building computer algorithms for decades.  What these robo advisors are doing is just a dumbed down version of what many big investment banks are doing or what other investment managers have been doing for decades.  Unfortunately, they’re advertising it as something totally unique, innovative and superior.

Most of the big Automated Advisory Services are using Modern Portfolio Theory and Efficient Market Hypothesis to construct portfolios.  So they’re using flawed concepts like the Efficient Frontier and its nebulous concept of “risk” as standard deviation to construct portfolios.  The results, as expected, are not promising when properly benchmarked.

To analyze this, I went into the two largest and most well known Automated Investment Services (Betterment and WealthFront) and ran through their basic risk profiles.  When I say “basic” I mean a few questions, which, to be honest, is, deficient when assessing someone’s risk profile.  Risk profiling is a process I generally spend DAYS assessing for clients since it’s one of the most important elements of portfolio construction.  Not only do most clients have no idea what financial “risk” actually is, but they don’t understand how to properly connect the dots to an asset allocation plan because they’ve had the concepts of MPT and EMH jammed down their throats for the last 25 years.

Risk profile questionnaire’s are a fine starting point for building an understanding of risk tolerance, but they’re never enough because they’re necessarily incomplete and 95% of clients don’t understand what risk is and don’t understand how it relates to the portfolio (see here for a great discussion at Wealth Management on the inadequacy of risk profile questionnaires).  A robot using standard deviation as “risk” and asking you 5 or 6 vague questions (assuming you even fully understand them) can’t break down these complexities on its own.  But this is the problem with an atuomated service – you’re just a number in their algorithm and your output is likely to represent something that may or may not resemble who you actually are.

3)  You shouldn’t pay a “management” fee for a buy and hold portfolio – especially one that picks funds inside of aggregates!

I went in and ran some quantitative analysis on some of these portfolio outputs.  You can actually see what portfolios they’ll build for you so I was able to backtest the actual portfolios using a full market cycle and the actual funds they recommend.  I ran the analysis using all the various risk profiles, but the outputs were all generally pretty close because the cookie cutter process they’re implementing is not very sophisticated and their reliance of MPT outputs something that pretty much always looks like a variation of the same buy and hold portfolio (ie, the actual weighting towards risk assets like stocks and commodities is usually in the 40%+ range and even higher when you consider how that variance contributes to what they’re defining as “risk” – in other words, because stocks and commodities are more volatile than bonds, generally by several magnitudes, the “risk asset” portion of the portfolio is actually much riskier than a 40% risk asset allocation would lead one to believe).

In WealthFront’s aggressive output, the high risk investor is invested in a portfolio that results in a 90/5/5 portfolio (stocks/bonds/commodities).If you run this portfolio against a simple 3 fund allocation using the Vanguard Total Stock Index, Vanguard Total Bond Index and the GSCI Commodity Index at a similar 90/5/5 weighting the numbers show that their “optimal” allocation is actually leading to portfolio degradation.  The robo advisor output increases your risk and reduces your return by generating a 20.32 standard deviation, annualized returns of 3.94% and a zero Sharpe ratio.  The simple 3 fund alternative, on the other hand, generates a 6.47% return, 18.15 standard deviation and 0.36 Sharpe ratio over the same period.   In other words, this portfolio takes more risk, generates a lower return AND charges you a premium for it.

In the case of Betterment, they don’t use commodities (which I think is smart since commodities are nothing more than a hedging vehicle that comprise part of the costs of the capital structure and should never be an essential piece of a portfolio – ie, commodities generate flat real returns over long periods of time), but the results are essentially the same when properly benchmarked.  When properly benchmarked and risk adjusted there’s no value add over a standard low fee aggregate index.


 (Figure 1 – WealFront’s Aggressive portfolio vs the S&P 500)

The most conservative output generates the same results.   On WealthFront, this “risk profile” outputs a 37/58/5 allocation (stocks/bonds/commodities).   This portfolio generates a 4.98% return, 9.0 standard deviation and 0.38 Sharpe Ratio over the most recent market cycle.  But again, if you compare this to a simple cookie cutter 3 fund index using the Vanguard Total Stock Index, Vanguard Total Bond and GSCI Commodity Index you again see portfolio degradation.  In this case, the simple 3 fund portfolio generates a 5.77% return, 8.08 standard deviation and a 0.7 Sharpe Ratio.  The robo advisor is trying to sell the concept of “diversification” by picking funds more specifically than a simple broad index.  And in doing so they’re actually creating a portfolio that hurts your results.

What’s going on here is that the Automated Services are actually “picking” funds inside of aggregates.  If they were true adherents to Burton Malkiel’s Random Walk theory they’d recommend the Vanguard Total Stock Index and the Vanguard Total Bond Aggregate, apply the proper risk tolerance and weightings and call it a day.  Of course, if they did this most of their clients would turn around and ask why they need the robo advisor middleman when Vanguard can handle the two funds for them without the added fee.  So what’s happening is they’re picking funds inside of an aggregate index (such as a municipal bond holding for the bond position, calling it “optimal allocation”) and then underperforming the aggregate – which is exactly what a pure indexer would expect.  They basically sell a tactical asset allocation approach as being better than a true indexing approach and then call it a true indexing approach as part of their marketing plan.  Then they benchmark it relative to a high fee active manager and call their portfolio “optimal” or claim it generates “additional returns”.  I don’t like that one bit.    

4)  Beware of the Robo Advisor “additional return” claims.  

I found it quite alarming how some of the robo advisors calculated their “additional returns” they advertise.  You can see these claims on the front of just about any of their websites.  They generally claim anywhere from 4-5% in “additional” gains.

First of all, these firms are using index funds to construct portfolios.  So the claim of 4-5% additional returns should be an instant red flag.  The S&P 500 has averaged a real return of about 6% since 1925.  No index fund implementation is coming close to DOUBLING that figure no matter how fancy their algorithms are.  So some basic common sense tells us that these “additional return” claims look dubious.

In establishing the claim of “additional returns” the Robo Advisors misrepresent their benchmarks by comparing their allocations to active mutual funds or by citing studies using active management.  THIS IS NOT PROPERLY BENCHMARKED.  Of course, if you compare an index fund to an active mutual fund charging 1-2% per year then you can claim “additional” returns, but I have never seen anyone benchmark their portfolios relative to an active manager.  The proper benchmark is a highly correlated passive index of equal weightings.  But the Robo Advisors don’t do that comparison because then you’d see the results I posted above, which actually show that their results are worse than Vanguard’s most basic allocations.

Let’s look at this in more detail though.  What you see on the Robo Advisor sites are claims that look something like the following:

Get Additional Returns with Robo Advisor XYZ:

Passive Investing +1.25%

Index Funds Over Mutual Funds +2.1%

Optimal/Better Diversification +0.5-1.4%

Automated Rebalancing +0.45%-

Tax Aware Allocation +0.6%

Tax Loss Harvesting +1%

Better Behavior +1.25%

Total Additional Returns: 4-5%

This is well constructed marketing and little more.  First, it should be obvious that passive investing and avoiding high fee mutual funds will likely increase the return for the average investor.  No one benchmarks portfolios relative to a high fee active manager so let’s just ignore claims about generating 1-2% increased returns from this.  Second, the optimal allocation claims are dubious as I showed above and it’s probable that this figure is not just overstated, but potentially NEGATIVE.  Third, any automated rebalancing is pretty standard and  not necessarily a value add.  Fourth, the “tax aware” allocation is something anyone can find on the internet via a simple Google search.  Fifth, as Michael Kitces previously showed, the value of the tax loss harvesting is probably overstated.  And the claim about “better behavior” assumes an active portfolio management style.  In other words, the 4-5% “additional return” claim is only true if you’re doing just about everything wrong with your portfolio, you don’t have an advisor of any type or you don’t have access to the vast online resources for do-it-yourselfers.


There’s a lot of positives that are coming out of the Robo Advisor disruption.  I hope that doesn’t get lost in this message.  We’re likely to see increased automation, lower fees and fewer suboptimal advisors.   That’s fantastic news.  But I think you have to also approach their services with some skepticism.  In general, a pure robo advisor will never replace a good financial planner because your financial plan can’t be whittled down to a set of numbers without some personal analysis.  There’s simply no avoiding the human element there.  It takes more than an algorithm to understand a human being’s mind and feelings.  In addition, the investment management benefits are overstated in my opinion.  I would not expect these services to generate “additional returns” relative to a well constructed passive index fund strategy.  In fact, they’re very likely to underperform after their extra fees.

I would follow a basic rule of thumb here.  If you have a small portfolio or rather basic financial needs then the Robo Advisor can be a fine way to automate a process and better organize your finances.  Smaller portfolios generally don’t pay any fees using these services so that’s a good fit.  If, however, you’re a wealthy investor with sophisticated finances then I’d be hesitant to skimp on the quality of service in favor of what appears to be a low fee marketing pitch.  And if you’re a sophisticated do-it-yourselfer then there’s probably not much a Robo Advisor can do that you can’t already do at Vanguard for a low fee on your own – paying a management fee for a suboptimal buy and hold portfolio just doesn’t make much sense.

Personally, I am always in favor of a DIY approach and that’s what I try to help people better achieve through my business and Portfolio Review process, but I understand that it’s not for everyone and depending on your personal needs a Robo Advisor could be appropriate for you.

And let’s keep things in perspective here – paying a Robo Advisor 15-25 bps for a simple, automated portfolio approach is 10X better than paying an actively managed closet index fund manager ON TOP of wirehouse style brokerage fees.  So let’s all applaud the improvement in the industry.  Unfortunately, I think there’s a lot of work to be done on improving the Robo Advisor model before it becomes useful to high net worth and more sophisticated clients.  Vanguard seems to be on to something with their direction and I think the pure Robo Advisor firms are going to have to realize that people are more important than robots in financial management.

As of right now, there are simply too many problems in the underlying business model and portfolio construction process to be useful for anyone with a moderately high level of sophistication and planning needs so I am extremely hesitant to recommend these services over a reasonably priced alternative.


The Stock Market isn’t Where you Get Rich

As a society we praise people who make it rich in the stock market.  Every day we hear stories about money managers who “beat the market”, the stock that rose 100% in a matter of days or some myth about Warren Buffett.  This get rich story is all a very enticing story and it’s even true on many occasions, but the problem is, we’re often grappling with the tail of an elephant thinking we’ve got him by the trunk.

When you buy shares of stock on a secondary market you are not “investing” in the true economic sense of the word.  That is, you’re not spending for future production.  In fact, the firm whose production you’ve bought into doesn’t even care if you own the stock or if your neighbor owns the stock because they’ve already raised the capital (capital that can be spent for future production) by issuing the shares in the first place.  What most of us do with these already issued shares is simply an allocation of unspent income.  In other words, we’re actually just savers looking for various asset classes in which we can hold that savings to achieve various financial goals.  The real “investors” are people who start businesses and actually allocate capital for the purpose of generating future production.  I hate to break it to you, but you’re most likely not an “investor” when you buy stocks or bonds.

This is important to understand because it’s rather backwards to view the purchase of stocks on a secondary market as the place where you “get rich” or where you “invest”.  On average, the stock market generates a real, real return (that’s the after taxes, fees and inflation return, ie, the “in your actual pocket” return) of about 6.75% over the long-term.  So, if you’re a young aspiring “investor” who allocates, say, $10,000 to the S&P 500 at the age of 25 you can expect to have a whopping $70,000 or so after 30 years (assuming no further contributions of course).  Not exactly the “get rich” plan you thought, eh?  But that’s the idea that is continually pounded into our heads through various media sources – this myth that the stock market is somewhere where you get rich.  The reality is exactly backwards.  Most of the time what you’re buying when you buy stocks on a secondary exchange is a claim on assets that made SOMEONE ELSE rich.

You see, when shares are issued on a secondary market they’re being issued by companies that have to meet extremely stringent listing requirements.  And by the time any corporation has grown to the point that they’ve met these listing requirements they’ve likely established a business and source of output that is extremely valuable.  “Going public” and listing their shares on an exchange like the NYSE gives the firm access to funding, but it also gives the owners an exit from what was their real investment (most owners actually fronted capital for future production and later sell their shares to you as they reallocate their savings).  These owners spent for future production (made real investments by building a productive asset) and are likely exiting from their investment on the secondary market.  In other words, you’re allocating your savings into what was really someone else’s investment.   And there’s virtually no doubt that by the time the firm has achieved the growth necessary to be listed on a major public secondary market that its owners are fabulously wealthy.  If you don’t believe me just have a look at the Forbes 400 wealthiest – the vast majority of those people didn’t get rich picking stocks.  They built companies, built real goods and services over a long period of time and the only reason you likely even know what the firm is or who runs it is because they’ve already built something incredibly valuable.

Now, this doesn’t mean it’s impossible to become wealthy picking stocks on a secondary market.  There will always be people who “beat the market” and ride stocks to riches.  But that’s not the point of this story.  The point is, in the aggregate, the market returns the market return and the market return isn’t likely to make investors rich quickly in the aggregate.  In fact, you’re almost certainly buying an asset that has already made someone else rich well before you ever had the opportunity to own a claim on that asset’s cash flows.  This doesn’t mean that buying stocks and bonds is bad.  It doesn’t even mean you can’t “beat the market”, but we should be careful about the concept of “investing” and how it actually leads to us becoming wealthy.  You’re much more likely to become wealthy investing in your own ability to generate future production than you are by buying an asset that was actually someone else’s investment.


Is Active Investment Management Dying?

This piece at FactSet asked an important question: “is active investment management dead?”   As more evidence of the difficulties of active investment management points investors in the direction of “passive” funds, we have to wonder if active investment management is beginning to die off.  I don’t think so.  Here’s why.

First, this probably says a lot about the current state of the market cycle.  It’s inevitable that we will ask this question at the point in the cycle where it looks like a long only monkey dart throwing strategy beats most “active” managers. Of course, the whole discussion will shift as soon as we’re in a bear market.  So let’s keep that in mind as we ponder the above question.

Second, I hate the distinction between “active” and “passive” investment management.  As I’ve explained before, we are all active to some degree.  The idea that anyone is totally passive is a pure myth.  It was a line drawn in the sand to create a distinction that does not truly exist.  So we should just all agree that we’re all active to some degree and that, in general, reducing your degree of activity will reduce frictions in your portfolio which will increase your average real, real return.

Thirdly, the “investment” industry needs to dump the term “investing” and replace it with “saving” or just asset allocation.  The allocation of assets on a secondary market is not investment.  It is allocation of saving.  This might not seem like an important distinction, but I think it is.  The idea of investment implies that you can or should try to generate sustained outsized returns in your portfolio through the use of allocating assets on a secondary market.  I find this concept to be completely misleading.  True investment is done on primary markets for the most part and savings are allocated on secondary markets.  And when we think of allocating our savings we are likely to take a different approach than what often turns out to be a gamblers mentality through the idea of “investing” in a secondary market.

Fourth, more active managers prove their value during bear markets.  The thing is, bear markets are pretty rare relative to bull markets.  If we look at the business cycle, the economy tends to be in expansion for about 80% of the business cycle and only dips into recession for 20% of the cycle.  That means there’s a 4 in 5 chance that your bearish overall outlook will be wrong if it’s sustained over the course of the entire cycle.  Exhibit A is all the permabears who have been crushed for the last 5 years.

But this doesn’t mean more active managers are useless.  In fact, they earn their keep when the you-know-what hits the fan.  And the reason why is because market losses are devastating.  A 50% loss requires a 100% return to recover just to your break-even point.  Any manager who can help reduce that sort of negative variance in a portfolio is doing his/her clients a great service.  And that ultimately gets at the problem of a long only “passive” approach – it often doesn’t protect us sufficiently from negative variance.  As I’ve stated before, these approaches not only are not “passive”, but they are specific macro long only bullish bets.  In fact, most passive approaches based on Modern Portfolio Theory are extremely stock heavy which means that the variance in the portfolio is higher than most investors even think (much higher than your allocation says).  And that means exposure to negative variance in our savings portfolio can be extremely disruptive to our portfolios even if we’re in a so-called “passive” allocation.

And that’s the thing – as long as there are bear markets there will be active managers implementing strategies designed to reduce tail risk in portfolios.    And they will be providing their clients with an extremely valuable service.  In general, I think it’s probably safe to say that there’s an excess of more active managers at present and that many of these active managers are charging fees that they can’t justify.  But that doesn’t mean they’ll become extinct.  Not unless we can extinguish the business cycle.  And that ain’t happening because irrational animals (humans) dealing with a tool (money) they don’t understand very well will continue to make mistakes predicting the future with it – and ironically, that active manager (who probably can’t predict the future better than your dog can) will often be there to protect you precisely from the errors in thinking that lead to the variance in the business cycle that ultimately make him/her valuable.

Revisiting Price Compression

5 weeks ago I posted some thoughts on the concept of “price compression” (see here).  I said:

“Price compression is when market participants price in many years worth of future performance into the current price.  They are, in effect, buying today with the expectation that future earnings will justify current prices.   When you combine this concept with an understanding of behavioral finance and the understanding that market expectations can become irrational, you can build some understanding behind the concept of market bubbles.  As I’ve described before, A bubble is an environment in which the market price of an asset has deviated from the underlying asset’s fundamentals to an extent that renders the current market price unstable relative to the underlying asset’s ability to deliver the expected result.”

Along with that explanation I posted a chart of the iShares Biotech Index saying “Who buys stuff like this?”  Since then, the index is off 15%.  I wasn’t making a market call.  In fact, the purpose of this concept is not to make market calls.  But to be able to understand certain market dynamics and when the market appears to be getting ahead of itself.

The concept of price compression isn’t intended to help you time bubbles or short the market.  It’s a concept that helps us merely identify markets that may be a bit irrationally exuberant or irrationally bearish.  In better conceptualizing the markets through an understanding of pricing dynamics we can be better prepared to manage certain risks that will inevitably arise.

On Portfolio Differentiation

The latest from Howard Marks of Oaktree is as good as always.  But I wanted to highlight something that I found particularly important – differentiation.  Marks says:

“Here’s a line from Dare to Be Great: “This just in: you can’t take the same actions as everyone else and expect to outperform.” Simple, but still appropriate.

For years I’ve posed the following riddle: Suppose I hire you as a portfolio manager and we agree you will get no compensation next year if your return is in the bottom nine deciles of the investor universe but $10 million if you’re in the top decile. What’s the first thing you have to do – the absolute prerequisite – in order to have a chance at the big money? No one has ever answered it right.

The answer may not be obvious, but it’s imperative: you have to assemble a portfolio that’s different from those held by most other investors. If your portfolio looks like everyone else’s, you may do well, or you may do poorly, but you can’t do different.”

This is important to understand when analyzing portfolios and constructing your own for several reasons:

  • First, be wary of people who refer to sweeping studies about portfolio manager “underperformance” when they compare all funds or managers with some broader index.  The vast majority of the studies I see are engaged in apples to oranges comparisons which take something like the S&P 500 and compare it to something like an actively managed multi-strategy hedge fund.  These are two totally different animals and if they’re not benchmarked appropriately (as most funds aren’t) then the comparison doesn’t really tell you much about anything.
  • Second, be wary of those who aren’t differentiated, but sell you their services as though it is.  There are a huge number of portfolio managers and strategies out there that merely mimic a closely correlated index without actually doing anything that differentiates the fund or strategy from the index.  They usually go by fancy sounding names like the “So and So Global Value Fund” or something, but the reality is that many of these funds are simply their benchmark masquerading as something different with a huge fee attached.
  • If you’re going to run a strategy that adds value relative to a benchmark then it needs to be differentiated.  This can be done in lots of different ways, but it’s not easy to construct a strategy like this that would outperform a closely correlated aggregate.

Differentiation is important.  But in addition to finding differentiation you have to ensure that you’re properly benchmarking it, properly evaluating it on a risk adjusted basis and ensuring that there’s more to this differentiation than a fancy sounding name and a high fee structure.

Vanguard’s Principles for Investing Success

I really liked this white paper from Vanguard.  It’s fairly basic, but it applies whether you’re a highly sophisticated trader or a more “passive” investor.  The core of the philosophy:

  1. Goals
  2. Balance
  3. Cost
  4. Discipline

These factors always matter.  Having a structured set of goals helps define your process.  Balance helps to diversify your ignorance.  Costs will always eat into returns.  And discipline is the ability to follow through with your process.

Read the full paper here.

Bank Lending is Primarily a Demand Side Issue

The real problem with concepts like the money multiplier and bank lending is that it boils bank lending down to a supply side issue.  In essence, it implies that banks can only make loans if they have some supply of loans.  It’s the mythical loanable funds or reserve constraint idea.  As if banks have to go bid on some loanable funds market or find reserves that they can go out and multiply BEFORE they make loans.

Of course, as the Bank of England nicely explained (and I’ve been explaining for years) this is wrong.  Yes, a bank has to be willing to supply loans (in other words, borrowers must be deemed “creditworthy”), but that doesn’t mean the bank is necessarily supply constrained.  After all, banks are in the business of creating debt contracts from thin air.  Unless the world runs out of air their supply of loans should be in safe supply.

I was reminded of this point as I was reading this excellent post from Frances Coppola.  She’s responding to a UK economist who is responding to the recent piece from the Bank of England on endogenous money (you can read his response here).  And as I was reading his response it occurred to me that one of the major hurdles to understanding endogenous money appears to be this concept of supply side monetary thinking.  As if banks are constrained by their ability to create loans from thin air because of reserve requirements or “savings” or something else.  But this is the wrong way to think about endogenous money.

It’s better to start from the demand side.  Remember, banks are in the business of making loans.  If creditworthy customers are walking in their doors they don’t turn them down.  And if the bank has adequate capital levels and deems the customer to be creditworthy then they write up a loan contract, expand their balance sheet endogenously (which creates a loan asset for the bank, a deposit liability for the bank, a deposit asset for the borrower and a loan liability for the customer) and, if they must, the bank will find reserves to meet reserve requirements AFTER the fact (in the interbank market or via the Central Bank).

So, when we think of banking it’s really better to think of it as being a demand side issue. If you start from the supply side you’ll likely get confused.  Yes, banks have real constraints (like capital and their own lending standards), but in a healthy functioning economic environment a well capitalized bank will service as many creditworthy customers as it can.  After all, that’s their line of business.

Some related work:


The Bank of England Debunks the Money Multiplier

Regular readers will be more than familiar with the debunking of the money multiplier and the concept that banks don’t lend out reserves or deposits (see here & here), but it’s nice to see it catching on in places more important than this lowly blog.  A new research report out of the Bank of England debunks the money multplier in one of the best overall presentations of the concept that I’ve seen.   And much of it sounds like stuff I could have written (in fact, I’ve stated almost all of these points at times during the last 5 years).  I won’t go into too much detail, but here are a few highlights:

• the majority of money in the modern economy is created by commercial banks making loans.
• Money creation in practice differs from some popular misconceptions — banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’ central bank money to create new loans and deposits.
• The amount of money created in the economy ultimately depends on the monetary policy of the central bank. In normal times, this is carried out by setting interest rates. The central bank can also affect the amount of money directly through purchasing assets or ‘quantitative easing’.

They also do a good bit of explaining on QE and its operations.  I personally think they overstate the case with regards to how the central bank “ultimately” determines the amount of money created, but I think they’re trying to emphasize the fact that the Central Bank is the regulator and price setter of reserves.  But don’t mistake this for the BOE implying that the Central Bank controls loan creation directly.  I might have said it a bit differently, but their point is totally consistent with Monetary Realism’s views.

You can read the full report here.  I highly recommend it.

Some related work:

New Primer on SSRN – Understanding Quantitative Easing

New white paper of mine at SSRN on QE.  It’s a brief primer that offers a succinct undertanding of QE and debunks some misunderstandings:

“Many misunderstandings are still circulating about the actual operational aspects and impacts of Quantitative Easing, also known as Permanent Open Market Operations or Large Scale Asset Purchases. This brief primer will provide a series of basic understandings that give the reader better insights as to the actual impacts of the program and how it works with the hope of clarifying some of the misconceptions.”
Read the whole paper here.