Miscellaneous Provisions

Gambler's Fallacy and the Stock Market: Mean-Reversion or Dilution

2017-12-13T21:38:00.000-08:00

On an annual basis, the Dow Jones Industrial Average rose 66% of the time from 1896 to the present regardless of whether the market was up 20% the prior year, rose the prior year, or fell the prior year. (Marketwatch: Here are the odds that U.S. stocks will rise in 2016). From year to year, the stock market appears to follow a random walk. Over time, this random process dilutes the deviations from the long-run average. The Gambler's Fallacy basically says that if something happens more frequently than normal during a given period of time, it will happen less frequently in subsequent periods. Likewise, if something happens less frequently than normal during a given period of time, it will happen more frequently in subsequent periods. If stock market returns are completely random, then it would be false to believe that if the market was up one, two, three, etc. years in a row, the market would be due for a down year.

In contrast, the stock market's value may randomly wander around its intrinsic value. By reverting to the mean over time, the process is not entirely random. One could expect to take advantage of periods where valuations over or under shoot the mean. Models that attempt to take advantage of mean reversion such as Research Affiliates' Asset Class Expected Returns, GMO's 7-Year Asset Class Forecasts, and John Hussman's Market Cap/GVA typically use a time frame of 7-12 years.

Avoid the gambler's fallacy in the short-run, but keep in mind periods of overvaluation may lead to periods of under performance and vice versa. While there is no way to predict turning points based on valuation, it can used to manage risk, provide courage to buy when others are selling, and sell when others are waiting for one last rally.

Form 10-K Risk Factors: Tracking Changes in Company Financial Reports

2017-12-01T15:31:00.000-08:00

"Mr. Cohen and economists Christopher Malloy and Quoc Nguyen downloaded all the 10-K and 10-Q filings with the Securities and Exchange Commission from 1994 through 2014 and used textual-analysis software to create a similarity score showing how the language in corporate filings differed one period to the next.

They then looked at stock performance following filings. The finding: Shares of companies that had significant changes did much worse than those of companies that didn’t. This was particularly true when it came to changes in the risk factors section of 10-Ks."

WSJ: Hidden in Plain Sight: A Powerful Way to Beat the Market

How to Use Gold in Your Asset Allocation

2014-11-18T15:23:00.002-08:00

Gold: First Eagle’s Potential Hedge Against Extreme Outcomes

John Hathaway discusses valuation, inflation/deflation, bullion versus gold stocks, and a few stock picks. Said John: "Before we get into that, let me add that for a conservative investor who simply wants protection and is risk-averse, whatever allocation he has to gold should be more heavily weighted to the metal, because that's safer. The only risk with gold is the price you pay. But for the investor who is more of a risk-taker, and sees gold as a strategy to get positive returns in the current macro environment, then that exposure should be more weighted to the stocks."

Further Reading: Barron's: The Golden Mean

From Barron's Penta: "Long considered an asset that only a conspiracy theorist could love, gold has suddenly become a staple in the model of private bankers and other advisors to the rich. Many experts now recommend about 5% of your assets be put in gold, chiefly as insurance...."

A useful heuristic for maintaining a proper exposure to gold in relation to your equity holdings is a ratio of 10:1. Chuck de Lardemelle’s response to a quarterly conference caller's question about why the IVA Worldwide Fund holds 6% of its assets in gold:

"Just as a last comment, if you look at the price of gold versus equities, we view gold as money and we ask how much that money could buy us in financial assets. Over time, you needed, on average since the Dow was created, roughly 10 ounces of gold to buy the Dow. And so we like that 10 to 1 ratio as long as gold's not too expensive. Right now gold, under that metric, is about 20% expensive [Gold was about 1270 at the time of the conference call]. We think it's worth the premium for being able to sleep at night, and we think that it could double or triple in constant dollars, but we like that kind of ratio of 10 to 1 versus our equity exposure. We have about 65% in equities. We have a bit more than 6% in Gold. I think that's an appropriate hedge in the portfolio."

International Value Advisors Update Call September 21, 2010

How to Choose an Appropriate Retirement Savings Rate

2013-07-18T18:50:00.000-07:00

Retirement planners tend to promote two different approaches to asset accumulation for retirement. The first approach creates an asset accumulation target (“Nestegg”) that must be reached in order for the retiree to withdraw a safe amount during retirement. The typical withdrawal rate during retirement is 4% of the Nestegg per year. The second approach focuses on a “safe” savings rate that provides for the replacement of a pre-determined percentage of the retiree’s final salary based on historical experience and several assumptions enumerated below. The Nestegg approach is very popular, but I think the “safe” savings rate approach is more intuitive and easier to implement.

The chart below shows that a future retiree faces a wide variety of outcomes based solely on the investment returns achieved during the sixty-year span of accumulation and withdrawal. For example, if a member of the 1918 cohort saved 16.62% of her income for thirty years and replaced 50% of her final salary for thirty years, she left nothing to her heirs. Contrast this with a member of the 1966 cohort who did the same, but left her heirs 8 times her final salary after 30 years. This underscores the fact that the saver faces a very uncertain future with a wide possibility of outcomes. The “safe” savings rate is based upon the worst possible historical outcome so you hope that your generation does not create a new outlier to the downside!

Image source: http://www3.grips.ac.jp/~wpfau/images/safesavings_wealth.jpg

The study, Safe Savings Rates: A New Approach to Retirement Planning Over the Life Cycle, estimates “safe” savings rates that historically provided a retiree enough money to replace either 50% or 70% of her final salary. The author makes several notable assumptions: (1) the individual earns a constant real income, (2) the portfolio consists of large-capitalization stocks (“equity”) and six-month commercial paper (“bonds”), (3) there are no portfolio management fees, and (4) income taxes are not considered. These assumptions make a strict adherence to the “safe” savings rates in Table 1 of the study impossible so understanding how these assumptions create potential understatements or overstatements to the “safe” savings rate is important.

First, most workers do not earn a constant real income. A constant real income consists of an initial salary that is adjusted for inflation each year. If this were true, the employee would never receive an increase in salary due to a raise or promotion, for example. A typical wage earner sees a sharp increase in salary from the mid-20’s to the early 40’s, then a flattening out from there. There is also the issue of maternity leave leaving a sizable gap for women who choose to stay at home with their children. Consequently, this study may understate the amount of savings needed in the early years to produce the required 50-70% of the final salary.

Second, a portfolio consisting of only large-capitalization stocks and six-month commercial paper may provide a lower annualized rate of return than a diversified portfolio that includes small capitalization and international stocks among other asset classes. See The Ultimate Buy-and-Hold Strategy for an example of the possibility of increasing portfolio returns by diversifying into more than two asset classes. By using only two asset classes, the study may overstate the “safe” savings rate if a more diversified portfolio outperforms the two-class portfolio used by the author.

Another thing to keep in mind regarding portfolio construction is one’s individual tolerance for risk, which in this case means volatility. The study uses two portfolios: a 60/40 and 80/20 equity and bond mix. See Fine Tuning Your Asset Allocation for a table of historical annualized return, standard deviation, worst month, worst 12-months, and worst 60-month results for a given portfolio weighting. It is important to be honest about your risk tolerance rather than focus on the smallest “safe” savings rate. Likewise, one’s risk tolerance may change during the accumulation period; the study does not take a change in risk tolerance into account. An 80/20 equity and bond mix through the accumulation and retirement phase is flat out unlikely so the 60/40 equity bond mix numbers appear more appropriate.

Third, the study does not consider portfolio management fees. Retirement investors typically run into the following portfolio management fees: commissions, mutual fund management fees, ETF management fees, and concession fees paid for the purchase of individual bonds. These fees may cause the savings rate to be understated. The author estimated that omitting portfolio management fees may cause an understatement of as much as six percentage points if a 1% annual portfolio management fee is deducted each year so keep your fees as low as possible. There are many fee based planners that charge hourly rates that may make more sense than an annual fixed fee.

Finally, income taxes may change the “safe” savings rate depending upon the type of retirement vehicle used by the saver. Using tax advantaged accounts provided by the government is important. Higher marginal tax rates during retirement than the accumulation period may also require a higher “safe” savings rate.

As with everything concerning uncertainty, this study is not perfect. However, it does provide a useful framework. The framework requires three steps to quantify an appropriate “safe” savings rate: (1) determine the percentage replacement rate of your final salary that you wish to target, (2) choose an appropriate asset allocation, and (3) estimate the number of years that you expect to work and retire.

The author also published a similar study that shows how much to save if you have already accumulated a substantial retirement fund. The study, Getting on Track for a Sustainable Retirement: A Reality Check on Savings and Work, provides tables for 55 year-olds. Additionally, Pfau's blog post entitled Getting on Track for Retirement provides tables for 35, 45, 50, and 60 year-olds.

Bob Farrell 10 Market Rules

2012-01-03T19:46:00.000-08:00

Bob Farrell was Merrill Lynch's Chief Market Strategist from 1967-1992.

1. Markets tend to return to long-run averages over time

2. Excesses in one direction are usually followed by excesses in the opposite direction

3. There are no new eras

4. Exponentially rising or falling markets usually go further than you think, but they do not correct by going sideways

5. The public buys the most at the top and the least at the bottom

6. Fear and greed are stronger than long-term resolve

7. Markets are strongest when they are broad based and weakest when they narrow to a handful of blue-chip names

8. Bear markets have three stages - share down, reflexive rebound, and a drawn-out fundamental downtrend

9. When all the experts agree, something else is going to happen

10. Bull markets are more fun than bear markets

Another great investing rule coined by Don Coxe of Cox Advisors, LLC:

"Never invest on the basis of a story on page one, that is the efficient market. Invest on the basis of a story on page sixteen that is on its way to page one."

The Taxation of Master Limited Partnerships for Individual Investors

2012-01-03T19:31:00.000-08:00

A Master Limited Partnership (MLP) is a limited partnership publicly traded on a securities exchange. The partnership must meet the exception under Code Section 7704(c) that allows it to be taxed as a partnership instead of a corporation. Being a flow through entity, the investor is taxed on his share of the partnership's income, gains, deductions, losses, and other items. Certain investors with large positions may experience state tax issues. Tax information is reported to the investor via Schedule K-1, which may arrive after the April 15th filing deadline.

According to Standard and Poor's, during 2008 the size of the MLP market exceeded $100 billion, with most listings falling in the energy sector. There are at least 100 MLP's currently listed on stock exchanges. MLP's typically engage in the exploration, development, mining, production, processing, refining, transportation, and storage of oil, gas, coal, propane, minerals, timber, certain other natural resources, and certain real property (see StoneMor LP or Cedar Fair for real property examples). Investors are typically drawn to MLP's for high current income.

Some MLP Schedule K-1's suggest a Section 754 disclosure statement be made on the Form 1040 when the partnership investment is purchased because the interest may contain basis adjustments and a Section 751 disclosure statement when the interest is sold. In addition, some Schedule K-1 packages from MLP's include Form 8886 reportable transaction information that may need to be reported on the investor's Form 1040. These are typically small inconveniences and should not dissuade the investor from making an investment.

When the taxpayer sells his partnership units, he generally reports a capital gain or loss determined by the difference between the proceeds received and the taxpayer's adjusted basis in the partnership. However, the MLP is subject to Code Section 751, which may subject part of the realized gain to ordinary income treatment. The ordinary income treatment is related to the investor's share of unrealized receivables, inventory, unrecaptured depreciation for real and tangible personal property, and recapture of depletion taken for intangible drilling and development costs of oil and gas wells, mining development, and exploration expenditures. The allocation between capital and ordinary income is provided by the MLP.

The passive activity loss rules are applied to MLP's on an entity-by-entity basis. The loss from one MLP cannot offset the gain from another MLP. A loss from an MLP cannot be used to offset other sources of passive income. Losses that cannot be deducted will be suspended until there is income from the same MLP that created the loss or the investor sells the MLP. See Code Section 469(k) for more information. One last item to note is portfolio income from the Schedule K-1 will not be offset by any losses reported on the Schedule K-1.

Tax-exempt investors, which includes investors with MLP's held in IRA, SEP,and ROTH retirement accounts and nonprofits, may pay tax on unrelated business income (UBIT) if the gross income from unrelated business income exceeds $1,000 (See IRS Publication 598). If unrelated business income is an issue there are investments such as the JPMorgan Alerian MLP Index ETN, which would avoid UBIT, and provide exposure to the MLP asset class. However, the ETN does expose the investor to credit risk as the investment is essentially an unsecured note from JPMorgan. Additional products have been released which house the MLP investments in a corporation. This eliminates the Schedule K-1 issue for the investor, but creates additional tax issues which lowers over all returns. See "Tax Quirk Crimps Returns of MLP funds (Marketwatch)" for more information. Even so, certain individual investors may choose to gain exposure to MLP's via closed-end funds like those managed by SteelPath. The investor would then avoid the complications caused by Schedule K-1, Section 751 issues when the MLP is sold, state filing requirements, and other disclosure requirements. While MLP's may require cumbersome tax reporting, it should not deter investors from investing in them.

Further reading:
The CPA Journal: Master Limited Partnerships: Tax and Investment Issues
Cohen Fund Audit Services: A Practical Guide to the Tax Issues of Investing in Master Limited Partnerships
National Association of Publicly Traded Partnerships

The December 7th issue of Barron's discussed further tax issues related to Master Limited Partnerships in the article entitled "Even Better Than Bonds." [subscription required]

The article notes that 70% or more of many large master limited partnership's distributions may be tax-deferred because the distributions can be larger than the reported net income of the partnership due to noncash depreciation or amortization expense. The tax-deferred distributions reduce the partner's basis in the partnership. Think of it as a return of invested principal. Eventually, the partner pays tax on the distributions when the interest in the partnership is sold as the distributions reduce the partner's basis in the partnership, assuming the investment is sold at a gain. The portion that is not tax-deferred is typically ordinary income consisting of interest, royalties, and other types of ordinary income.

In addition to the current tax savings, some investors may be able to make the tax-deferred savings permanent by holding the master limited partnership until death. If there is a "step-up" in the basis of the master limited partnership to fair value at death, the prior reduction in basis as a result of the tax free distributions is eliminated.