Money Management Miscues
James Parry knew at a young age that he wanted to grow up to be a money manager. It was during his undergraduate years at the University of Washington in Seattle, that the economics major first subscribed to the Financial Analysts Journal (FAJ), the flagship publication of the professional society for Chartered Financial Analysts (CFAs). The articles in those days dug deeply into arcane methods of security analysis, or assessing the intrinsic value of a stock or bond. However, James didn’t carefully read the articles, which were somewhat over his head. James planned to take two advanced classes in investment theory under Professor Charles D’Ambrosio, who subsequently became the long-term editor of the FAJ. Unfortunately, to be eligible to take these classes (Finance 460 and 461), James would have had to run through a gauntlet of pre-requisites including three quarters in accounting and several courses in business administration. This proved too much for James. He chose the easier course of sticking with the economics major, along with a few Shakespeare courses.
Besides taking the investment classes from Professor D‘Ambrosio, it would have been smart for James to have applied to elite MBA programs like Columbia, or the Universities of Pennsylvania or Chicago. Instead, James followed the course of least resistance and applied to the PhD program in economics at the University of California at Berkeley. Tuition was much lower at Berkeley than at private schools, and he was able to obtain a fellowship that covered tuition, and provided opportunities for modest compensation as a teaching or research assistant. Unfortunately, professors in the economics department at Berkeley had zero interest in investment theory. However, there were young finance professors in the School of Business that were on the leading edge of investment research at that time (early 1970s). Several of these professors, notably Barr Rosenberg, Mark Rubenstein and Hayne Leland eventually became quite well known.
One strategy that James considered was to attempt to transfer from economics to finance. James did take a few classes under the hotshot finance professors, but was dismayed at the subject matter. A central theme of academic thinking at the time was the Efficient Market Hypothesis that asserted that available information was rapidly and efficiently captured in the prices of financial assets, like stocks, and that therefore there was little opportunity to find “bargains” through the application of securities analysis. Meanwhile, James was following the non-academic literature that included “The Intelligent Investor” by Benjamin Graham, “The Money Game” by Adam Smith, and “Common Stocks and Uncommon Profits” by Philip Fisher. The upshot from this reading was that careful analysis can reveal Investment bargains and lay the foundation for extraordinary investment returns. The conflict between the academic theory and the practical books was stark. James was inclined to go with the practical, but was swayed by his brilliant professors who were certain that security analysis was useless.
Naturally, there were examples of investors who did better than the overall market for long periods of time; investors like Ben Graham or Phil Fisher or, most notably, Warren Buffett. Even in the 1970s, Buffett had already created an extensive track record of outstanding performance and, in the form of stock in his company Berkshire Hathaway, offered the opportunity for the ordinary investor to ride along with Buffett at zero expense. The academic view of the track records of these investment superstars was simply that they were “lucky.” After all, if thousands of people flip a coin repeatedly, there will be a few that obtain long series of “heads.” Of course, in Buffett’s case, he continued to obtain heads long after he became notorious.
James’ take on this debate was that both sides were probably correct, to a degree. Achieving exceptional investment performance over an extended period was extremely rare simply because there was tremendous competition. Yet in every field there is exceptional skill, including investments. Warren Buffett has continued to demonstrate this level of skill in the subsequent forty years. Unfortunately, as he later realized, James was no Warren Buffett.
James didn’t have any money to invest, and if he had money he probably wouldn’t have had the foresight or confidence to invest in Berkshire. Finally, had he invested in Berkshire he no doubt would have sold way too early. But if so he could have been one of the many people that could proudly proclaim: “I sold Berkshire at $200 for a 100% gain.”
Today that same Berkshire share trades for $450,000.
One of the ubiquitous strategies recommended today is to periodically rebalance your portfolio, which generally means to sell assets or asset classes that have risen in value and buy assets or asset classes that have fallen in value. This is consistent with the notion that you should “buy low and sell high.” It represents contrarian thinking, as opposed to momentum thinking (“hold on to your winners and sell your losers”). It is also consistent with another ancient market aphorism – “you never go broke by taking a profit.” This approach has a major flaw. It automatically means that you will never have a mega-winner in your portfolio.
Moving Toward the Real World
James did not take advantage of the most obvious investment idea of his generation – buying stock in Berkshire Hathaway for himself and for family members. Instead, he persevered in the economics PhD program at Berkeley, eventually achieving his doctorate by writing a dissertation in the field of theoretical econometrics. This took several years and moved him continually away from the goal of investment management. Again following the course of least resistance, James accepted a faculty position at the Claremont Graduate School (CGS), teaching econometrics and statistics in the economics PhD program for a gigantic annual salary of $16,000. By this time James was in his late 20’s and had not yet begun to put money away and begin the process of growing wealth through the power of compounding. James did manage to save 50% of his after-tax income from CGS, but eventually spent all of his accumulated savings to acquire a new pick-up truck when his old sports car died.
Thus, at age 30 James had zero financial assets and was very far removed from the real world.
At about that time James collaborated with a couple of colleagues in an economic forecasting venture called Claremont Economics. James was the guy running the econometric model that spat out scenarios for US real growth, inflation and interest rates. After a couple years turning out scenarios, James made two attempts to expand the product line of Claremont Economics. First, he proposed offering an “asset allocation” product in which recommendations about portfolio weights in major asset classes would be based on CE’s economic scenarios. Although two major corporate pension plans briefly signed up for the asset allocation service in the early 1980s, it was not a booming success.
Some years later, James heard about a similar approach created by hedge fund magnate Ray Dalio. Dalio termed his product the “All Weather” portfolio inasmuch as it was designed to perform well in any the four possible economic scenarios: inflation greater or less than consensus estimate, combined with real growth greater or less than consensus. Deviations from the All Weather base case were based on the degree of belief in any of the four scenarios.
James’s second attempted innovation was to introduce risk by contemplating the “worst case” economic scenario. That is, the scenario that is most troublesome for your portfolio. He suggested a decision rule to maximize the return in the Most Likely Scenario subject to a constraint on risk as measured by the loss in the Worst Case scenario. Again, CE clients did not find this to be a compelling criterion. Many years later a variant of the risk idea was invented by executives at J.P. Morgan bank and was dubbed “Value-at-Risk.”
Securities Portfolios
In 1984, James determined that he needed to push further in the direction of the real world, and accepted a job managing securities portfolios for one of CE’s savings bank clients. Finally, he was a money manager! Well, sort of. The bank’s securities portfolios were managed with a view towards maximizing interest income, not total return. In fact, the book value accounting model used by savings banks at that time recognized realized capital gains or losses in income and ignored unrealized gains or losses. This enabled the portfolio manager to generate reported income by “cherry picking” for sale securities that had gone up in value. Unfortunately, doing this tended to reduce the flow of interest income (because after selling a security at a premium, you would tend to reinvest at a lower yield), so it was not at all clear that reaping gains was a smart move. About that time James signed up to take the three annual exams to qualify as a Chartered Financial Analyst (CFA). This was accomplished by 1987.
Starting a Fund
Despite the tenuous accounting treatment used by the bank, at least James was buying and selling securities. So it seemed to him a propitious time to move forward on the next step of his journey and start his own investment fund. Unfortunately, as he contemplated moving forward with this idea, James came to an uncomfortable realization. Namely, there was no evidence that he possessed the extraordinary skill necessary to achieve super-normal investment returns. To be sure, James and his colleagues at CE did make a great economic forecast in 1981, namely that interest rates and inflation were beginning a long-term downtrend. This downtrend did occur, and in fact carried on for thirty years. The obvious investment implication of this forecast would have been to invest in 30-year Treasury zero-coupon bonds, continually rolling over into newly issued 30-year Treasuries so as to maintain the maximum duration and benefit from falling rates. In his securities portfolios for the bank, James did not deploy this strategy. Perhaps he was too concerned with the Worst Case scenario; namely, that the forecast was wrong.
Thus, instead of setting up a business to invest other peoples’ money, James decided it was safer to focus on his own portfolio. So he started his own “hedge fund” with the Parry family trust as the first and only client. James came up with an investment strategy that did not rely on expertise in predicting markets or in-depth security evaluation. He called the strategy the “All Weather Coffee Can.”
The “All Weather” name was stolen from Ray Dalio and referred to the asset allocation concept of diversifying across broad asset classes like stocks, bonds and real estate. In theory, there is some part of the portfolio which is doing well in any economic scenario (of course, there probably is some part of the portfolio that is doing poorly as well).
The basic idea of the “Coffee Can” is to buy individual stocks and then forget about them. The name comes from a well-known investment manager named Robert Kirby who founded and led Capital Guardian Trust in Los Angeles for many years. As Kirby told the story, he had as a client a wealthy woman. He would meet regularly at the client’s home to review portfolio changes – stocks that he had bought or sold. The woman’s elderly husband was also wealthy, but he did not purchase Kirby’s services. Eventually, the husband passed away and Kirby was hired to be the trustee on his estate. Kirby was annoyed to find that the husband had “stolen” Kirby purchase recommendations. Each time that Kirby purchased a stock for the wife’s portfolio, the husband would buy the same stock for his portfolio. However, the husband ignored Kirby’s sell recommendations. Kirby was disconcerted to find that the husband’s portfolio far outperformed the wife’s portfolio. This was because a few of the stocks went up ten times and one stock went up 100 times (Xerox). The lesson Kirby took away is that it is easier to make smart buy decisions than smart sell decisions. Kirby designated the strategy of purchasing a portfolio of stocks, and then leaving the portfolio alone, as the Coffee Can portfolio. Instead of “buy and hold” or “buy and hope” this strategy is “buy and forget.”
Eventually James’ Coffee Can portfolio did wind up with some great companies, like Apple, Microsoft, Berkshire Hathaway, Amazon, etc. However, for the most part, with the exception of Apple, these stocks were purchased far too late to fully participate in their giant up moves.
Performance
As he looked back, James realized he had made a series of decisions that undermined his objective to achieve long-term market-beating investment performance. Worse than this, he realized that he did not possess the inherent skills necessary to perform well in this endeavor. It was little solace that the same could be said for most people. The securities markets are highly competitive and the ability to out-perform is rare. So, given the lack extraordinary skill, how did James’ portfolio perform?
James’ family trust portfolio was established in 1987 and as of 2017, had generated an average annual rate of return of about 10%. This is just about identical with the return on the S&P 500 over that time frame. Thus, you could have achieved the same returns as James simply by buying an S&P500 index fund (as was offered back in 1987 by Vanguard, among others), and re-investing the dividend income. On the plus side, James’ portfolio was generally about 50% invested in equities; thus he had considerably lower portfolio risk than the S&P 500.
Although he never made the effort to evaluate the performance of the equity portion of his portfolio against the overall market, he suspects there was very little or no value added from his stock selection strategy, which was to screen companies for low relative valuation and a long-term track record of high return on capital. Evidently, there is more to successful stock selection than such simple screens.
However, James’ wife Ellen did buy Apple stock for her IRA at a very low price in the early 2000s. If there was any outperformance of the combined family accounts it almost surely would have been due primarily to this purchase.
By contrast, one example of poor decision-making was James’ decision to concentrate the equity portfolio in stocks of financial services companies during the run up to the financial crisis of 2007-2008. His rationale was that, since he was in this industry, he naturally would have greater insight. Wrong! James’ financial sector portfolio cratered in 2008. Earlier, James made another mistake when he allowed himself to place an over-weight on the stock of his own company, the savings bank. This turned out poorly during the thrift crisis of the late 1980s and early 1990s.
Family Wealth
Ultimately, the purpose of managing a portfolio of securities is increase future spending power. This means that you ultimately have to start spending a portion of the portfolio. About the time James retired from his savings bank position, he started to think about the problem of what fraction of the portfolio could he safely spend each year. The conventional thinking at the time was that a person could retire at the age of 65, spend 4% of his wealth in the subsequent year, and then adjust annual spending up each year by the rate of inflation. A fellow named Bengen had come up with this rule, which was cleverly named the “4% rule.”
The principle rationale for this rule was that it worked for the data set analyzed by Bengen, which covered the period from 1950 to 1994. Key features of that period included high stock and bond returns and the mortality expectation of expiring before the age of 90. James was concerned that future rates of return might be lower than historical returns (and surely would be in the Worst Case scenario) and he was vaguely aware that people were living longer. Finally, he had the idea that it would be desirable for the portfolio to grow over time. After much experimentation using his rusty econometric skills, James came up with what he thought was a better rule – the “1% Ratchet Rule.” According to this rule, you can spend each year 1% of the high water mark of the “family” portfolio. The “family” portfolio is that portion of your wealth that you wish to pass on to heirs. For most people, it will not be all their wealth. The “high water mark” is the maximum value that the family portfolio has achieved. The ratchet feature means that spending will be constant or increasing (so long as the family portfolio does not run down to zero). The beauty of the 1% rule is that a portfolio with this modest annual outflow is extremely likely to grow over time.
Conclusion
After half a lifetime of thinking about these issues, James reached two conclusions. First, he was not able to develop the ability to outperform the financial markets over an extended period. On the other hand, James discovered that it is relatively easy to achieve market returns. Thus, James second conclusion was that you don’t have to be a genius to create family wealth. He hesitated to make this claim in public for fear that it would be deemed a “micro-aggression.”
