Editor’s Letter

This Winter 2020 issue is really special. For the first time since our first issue in 1998, we are publishing a supplement to our regular issue. We are delighted to be able to present a monograph by Ambassador Board member, Meir Statman. The piece, entitled “Well-Being Advisers,” focuses on well-being in a broader context than the traditional financial well-being. The author argues, “Well-being, however, is broader than financial well-being, and enhancing well-being, even in the context of finance, entails more than enhancing financial well-being. The domains of well-being also include those of family, friends, and communities; work and other activities; and health, both physical and mental. Financial advisers do well as they transform themselves into well-being advisers, enhancing clients’ well-being in all its domains.”

In this letter, I would like to discuss the dangers of the current focus on “narratives” rather than “facts.” We have broached the theme a few times in the past, but I feel that the current environment is replete with hidden dangers. Late stages of a bull market—as would be the case for late stages of a bear market—are notoriously treacherous: The tendency is ever present to extend the recent past into the indefinite future, be it focused on themes, valuation levels, or other factors.

The massive amount of information available to all of us and the increasing prevalence of “sound bites” or their social media incarnations has forced conversations about markets to a level of superficiality that I can only remember focusing on Japan in the late 80s or the US in the very late 90s.

Let me make sure that I offer the necessary nuance: Many of the rationales I hear are not fundamentally wrong. In fact, many of them contain highly relevant considerations. Yet, the problem arises because of two reflex behaviors that are both potentially quite misleading. The first involves what I call “excessive unidimensionality.” The second relates to a misevaluation of risk.

Using an example might help illustrate the concept of “excessive unidimensionality.” Consider the risk of inflation in the US at present. Many observers argue against the risk of inflation, based on the fact that excessive liquidity creation has been prevalent since 2009 and yet failed to trigger the forecast rise in prices. They tend to credit technological improvement as the source of increases in productivity, with the attendant decreases in the growth of unit labor cost. That is a fair point… At the same time, at least two other factors seemed to have some bearing on the issue.

• (1) The first relates to the perception that the aggressiveness of current monetary and fiscal policies may well be associated with a willingness to see some weakness in the US dollar. This would be a reversal of the trend of the last several years and would be bound to affect the price of commodities globally traded in US dollars. Could that not lead to some higher input cost?

• (2) The second relates to labor costs. We have already cited the quote: “China inflates whatever it purchases and deflates whatever it sells.” China’s labor markets started tightening in 2016, in part because of prior demographic policies. Also, tense geopolitical conditions and the perceptions of the limits of globalization might well lead to a lower reliance on Chinese exports. Could that not lead to a reversal in the shift of the share of capital in national income toward a greater share for labor? Would that not lead to inflation?

Ostensibly, our point here is not to offer investment advice or even economic forecasts. Rather, it is to show that the discussion of inflation risks should go beyond the simple affirmation that technology will win the day…

A recent article in Institutional Investor reported on a study that addressed the issue of the ability of CFOs to forecast markets. In short, the conclusion of the piece was that CFOs were generally correct, but mis-appreciated risks. CFOs were asked to project returns of the S&P 500 Index. Each respondent provided a range of outcomes such that there was an 80% likelihood that returns would fall within the range they indicated. Only 36% of realized stock market returns fell within the ranges they provided…

These findings are not surprising and would likely have been predicted by behavior finance specialists. We do not need here to return to the multiple bias that Kahneman and Tversky first identified. They all revolve around the same general principles: We tend to be overconfident, to use inadequate framing, and to remember successes more than failures, among others. Thus, though we can learn from experience—and the aforementioned article did point to the fact that a bad miss in one year lead CFOs to widen their ranges the following year—the fact remains that we will often project the recent past—or something that follows a preferred narrative and is supported by recent events—into the indefinite future.

To this observer, the fact that we are human is a given. We can work around our known weaknesses, but they will never totally go away. Thus, we can only encourage our readers to avoid making dramatic decisions in times such as the ones we live today. Future history could well demonstrate that decisions made today may well look like the perfect illustration of changing horses at the worst possible time.

Equally important is the first derivative of these tendencies: making several times the same bet. I remember a professor once telling me that it was true that a randomly selected portfolio of 21 stocks was likely sufficiently diversified. Yet, he immediately added that a portfolio of 21 bank stocks would not be a diversified equity portfolio, but a diversified portfolio of bank stocks.

In an environment based on simple narratives and some measure of momentum thinking, it is tempting to select the “diversification axes” of one’s portfolio to reflect the general thrust of one’s long-term strategy. If one believes that technology will be the source of non-inflationary growth for the foreseeable future—defined in decades—then it is tempting to select both industry and geographical portfolio axes to reflect that view. While this should pay off handsomely if the theory proves correct and if it was not already reflected in current prices, it could be deadly if one or both conditions are not met.

In short, I do not want to sound like the old-fashioned commentator who proves unable to identify or accept current changes. For better or worse, I have been privileged to see numerous similar situations around the world over the last 45 years. Things do change… However, they often do not change as fast as people expect or as dramatically. Cycles do exist and general economic principles have not been repelled. Humility and caution remain the order of the day, as is the need to focus on long-term strategic goals. At the same time, one needs to make sure one understands that portfolios are not reviewed in the long term, but in a series of short-term intervals. The focus should thus always remain on long-term goals and the strategy that is sustainable in the short to medium term, even if capital markets do not cooperate, to achieve them.

The Winter issue of The Journal of Wealth Management covers a wide range of topics, in addition to the topic covered in our special supplement.

Our first article stands on its own. It is by Fredda Herz Brown and Dennis Jaffe and discusses the values, goals, and life choices of 40 ultra-wealthy (net worth greater than $25 million), middle-aged (between 40 and 65 years old) women, focusing on their evolving relationship to their wealth and the role it plays in their decisions about work, family, children, and the community.

Our next three articles relate to the broad issue of the formulation of an overall wealth strategy. The first, by Lee Dunham and Kenneth Washer, examines two methods for determining retirement accumulations, contrasting the assumption that the client will live to a very old age with a method based on the use of life expectancy tables to weight retirement cash flows by survival probabilities, concluding that about 55% of clients will outlive their savings, and suggesting that risk-sharing, perhaps through a deferred life annuity, would be advisable. The second, by William Jennings and Brian Payne, argues a correction needs to induce a rebalancing trade and develops an algebraic solution for the width of the rebalancing range to ensure it does so. The third, by Javier Estrada, focuses on target-date funds and argues they are suboptimal in terms of capital accumulation; it suggests that their popularity reflects investors becoming more risk averse as they age, even though the asset allocation of target funds seems to be higher than probable.

Our next two articles are dedicated to two important questions for investors. The first, by Bradford Cornell, looks into the implications of using criteria based on environmental, social, and governance (ESG) considerations has been exaggerated, because of lack of clarity as to what constitutes an ESG investment in the context of a complex, integrated economy, because impact on investment performance has not been sufficiently recognized outside academic circles and because many leading practitioners have stated that the importance of ESG considerations implies the corporate objective of maximizing shareholder value, which lies at the core of much of finance theory, is outdated and needs to be replaced by a more comprehensive stakeholder model. The second, by J.P. Harrison and S. Samaddar, investigates who is better at making investment decisions, man or machine, concluding that human advisers are better, principally because advisers do not seem to alter their portfolio allocations by age or amount invested.

Our last two articles focus on very specific topics, which might be quite relevant at present. The first, by Jonathan Handy, Jessica Hennessey, and Tom Smythe looks into whether the presence of an institutional or a retirement-fund-class benefits retail investors in multiple share class mutual funds, concluding that mutual funds with several classes tend to have lower expense ratios. The second, by Mukesh Chaudhry and Vivek Bhargava, examines the relationship between volatility or VIX Index (volatility of the S&P 500 Index) and the prices of precious metals, concluding that a spillover of volatility occurs indeed for all precious metals, though there are differences between calm and volatile periods and even in the length of time it takes for the spillover effect to be corrected.

Finally, I would like to welcome Chad Armstrong to our Advisory Board. His help will be much appreciated, particularly when one deals with articles that require his detailed understanding of the insurance world.

Jean L.P. Brunel

Editor

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