Reaching Consensus

September 22, 2019

by Steve Stofka

In the early 1980s, scientists at NASA raised the alarm that much of the protective ozone layer over Antarctica was missing. Newspapers and TV carried images of the “ozone hole” (Note #1). In 1987, countries around the world enacted the Montreal Protocol and banned the use of aerosols and chlorofluorocarbons (CFCs). There were some arguments and a few AM radio talk show hosts called the ozone hole a scientific hoax. However, most of the world reached consensus. There will always be crackpots who ride backwards on their horse and claim that everyone is lying about what lies ahead.

Compare those days of yesteryear with today. We have a wide array of media and information outlets. People who can’t make change are self-proclaimed experts on climate change. The Decider-in-Chief can’t reach consensus with himself for more than a day. A slight breeze changes his opinion. Intentionally or not, he has become the Anarchist-in-Chief.

The younger generation is quite upset because they will have to live with the consequences of climate change. The fat cats who make their money proclaiming climate change is a hoax will be dead. Next week there’s a climate summit at U.N. headquarters in NYC. A lot of young people demonstrated in cities around the world this past Friday to let the world know that they are concerned. That’s consensus.

What happened to us in the past thirty years? It’s tougher for us to reach consensus about guns, immigration, climate change, women’s rights, and health care to name a few. Let’s turn to a group of people whose job it is to craft a consensus. In a recent Town Hall Supreme Court Justice Neil Gorsuch pointed out that the nine justices reach unanimous consensus on 40% of the 70 cases that they decide each year. Only the most contentious cases make it to the Supreme Court. 40% unanimity means they agree on many principles. 25-33% of their cases result in a 5-4 decision. Those are the ones that get all the attention. The nine justices who currently sit on the Court were appointed by five different Presidents over the past 25 years. Despite the changing composition of the Court over the past seventy years, those percentages of unanimous decisions and split decisions have remained the same.

Let’s turn to another issue concerning consensus – money. Specifically, digital money like Bitcoin. Some very smart people believe in the future of Bitcoin and the distributed ledger concept that underlies digital money. In this podcast, a fellow with the moniker of Plan B discusses some of the econometrics and mathematics behind Bitcoin (Note #3). However, I think that pricing Bitcoin like a commodity is a mistake.

I take my cue from Adam Smith, the father of economics, who lived during a time and in a country with commodity-based money like gold and silver. Unlike today, paper money was redeemable in precious metal. However, Smith did not regard gold or silver as money. To Smith, the distinguishing feature of money is that it could be used for nothing else but trade between people. Money’s value depends exclusively on consensus, either by voluntary agreement or by the force of government. Using this reasoning, Bitcoin and other digital currencies are money. They have no other use. We can’t make jewelry with Bitcoin, or fill teeth, or plate dishes as we can with gold and silver. The additional uses for gold and silver give it an anchoring value. Bitcoin has an anchoring value of zero.

When people lose confidence in money, they lose consensus over its value. Previous episodes of a loss of confidence in a country’s money include Zimbabwe in the last decade, Yugoslavia in the 1990s, and the sight of people pushing wheelbarrows of money in Germany during the late 1920s.

Like gold, Bitcoin must be mined, a process that takes a lot of electricity and supercomputers but does not give it any value. Ownership in a stock gives the owner a claim on the assets of a company and some legal recourse. Ownership of a digital currency bestows no such rights.

In an age when we cannot reach consensus on ideas like protecting our children at school or the rights a woman has to her own body, we seek consensus with others on more material things like Bitcoin. We seek out information outlets which can provide us with facts shaped to our perspective. When facts don’t fit our model of the way things should be, we bend the facts the way water bends light.

John Bogle, the founder of Vanguard, died recently. He was an advocate of investing in the consensus of value about stocks and bonds. Now we call it index investing. That’s all an index is – a consensus of millions of buyers and sellers about the value of a financial instrument. There are several million owners of Bitcoin – a small consensus. There are several thousand million owners of SP500 stocks. That is a very large consensus, and like a large ship, turns slowly in its course. A small ship, on the other hand, can zip and zig and zag. That’s all well if you need to zig and zag. Many casual investors don’t like too much of that, though. They prefer a steadier ship.

I do hope we can move toward a consensus about the bigger issues, but I honestly don’t know how we get there. In 2008, former President Obama called out “Si, se puede!” but quickly lost his super-consensus in Congress. “No, you can’t!” called out the new majority of House Republicans in 2010. We’ve gotten more divisive since then. Journalist Bill Bishop’s 2008 book “The Big Sort” explained what we were doing to ourselves (Note #4). Maybe he has an answer.

In the next year we are going to spend billions of dollars gloving up, getting on our end of the electoral rope and pulling hard. Our first President, George Washington, was reluctant to serve a second term. Hadn’t he given enough already? In our times, each President looks to a second term as a validation of his leadership during his first term. There’s that word again – consensus.

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Notes:

  1. Images, video of the ozone hole in 1979 and 2018 from NASA.
  2. We the People podcast from the National Constitution Center
  3. Discussion of bitcoin on this podcast
  4. The Big Sort by Bill Bishop

High Optimism

June 18, 2017

Last week I looked at two simple rules: 1) don’t bet on which chicken will lay the most eggs, and 2) don’t put all your eggs in one basket. This week I will look at index averages and I promise I won’t mention chickens.  Lastly, I will look at a metric that disturbs me.

When I first started investing in Vanguard’s SP500 index mutual fund VFINX, I thought I was buying the average performance of the top 500 companies in America. Like many index funds, VFINX is weighted by market capitalization. With this methodology, a relatively small number of companies have more influence on the movement in the index than their numbers might warrant.

Let’s turn to Vanguard’s breakdown of the top ten stocks in their VFINX fund. These ten stocks are household names, including Apple, Microsoft, Google (Alphabet), Amazon, and Facebook. These five tech stocks are 1% of the 500 companies in the index but make up 13% of the fund. The ten companies make up 20% of the fund.

For investors who want to cast a wider net, there is an alternative: equal weighted funds. Guggenheim’s RSP is an equal weighted ETF first offered in 2003. Using Portfolio Visualizer, I started off in 2004 with $100,000 and invested $500 a month. Despite the higher expense ratio, RSP had a better return, besting a conventional market cap index by 1% annually.

VFINXVsRSP

Why does RSP outperform VFINX?  Funds that mimic the SP500 are heavily weighted to large cap stocks. Equal weight funds have a greater percentage of mid-cap companies which may outperform large caps in a particular decade but that outperformance may come at a price: volatility.

Standard deviation is a statistical measure of the zig and zag of a data series, like measuring how much a drunk veers as he stumbles along his chosen path. The standard deviation (Stdev column above) of RSP is slightly higher than VFINX, and the maximum drawdown of RSP is almost 5% higher during the 2008-2009 financial crisis.  The Sharpe ratio is a measure of risk adjusted return, and the higher the better. As we can see in the Sharpe column, the two strategies are within a few decimal points.  In the past 13 years, an equal weighted strategy produced higher returns with only a slightly higher risk.

If I want to mimic some of the diversity of an equal weight index, I can spread out my investment dollars among large-cap, mid-cap and small-cap funds. As SP500 index products, neither RSP or VFINX includes small cap stocks, but let’s add a small percentage into our mix.

Into my comparison of strategies, I’ve added a portfolio with a 40% allocation to VFINX, 40% to VIMSX, a mid-cap Vanguard index fund, and 20% to VISVX, a Vanguard-small cap value index fund. The performance is almost as good as the equal weight RSP and the Sharpe ratio, or risk adjusted return, is similar.

VFINXVsRSPVsMix

In 2011, Vanguard published an analysis (PDF) of various approaches to indexing that may be of interest to those who want to dive into the topic.

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Household Net Worth

Let’s turn from indexing strategies to stock market valuation. We base our expectations of the future on the recent past. Those expectations are the primary driver of valuation. If we expected an affordable self-driving car in the next few years, the current value of today’s cars would be lower.

I have written before about a store of value compared to a flow of value. Savings are a store of value. Income is a flow. The historical ratio of wealth (store) to income (flow) reveals a trend that should give us caution.  The Federal Reserve charts estimates of  both household wealth and disposable income. The current ratio of wealth to income is now higher than the peaks in 2006 and 2000 when the real estate and dot-com booms inflated wealth valuations.

HouseholdNetWorthPctIncome

The current ratio is far above the 70 year average but a moving ten year average of the ratio may better reflect trends in investment allocation over the past few decades. Using this metric, today’s ratio is still very high. Rarely does the wealth-income ratio vary by more than 10% from its 10 year average.

When the wealth-income ratio dips as low as 90% of its ten year average, extreme pessimism reigns, as in the early 1970s.  A ratio that is 10% more than the ten year average indicates extreme optimism as in the late 1990s, mid-2000s and now. Today’s ratio is 13% above its ten year average.

In early 2000, the ratio was 16% above its ten year average when the enthusiasm of dot-com expectations began to deflate and the price of the SP500 fell from its lofty heights. The ratio reached 14% above its ten year average in 2005 and remained above 10% till mid-2007 when the first cracks in the housing crisis began to surface and the SP500 said goodbye to its peak.

A picture is worth a 1000 words so here’s a chart of the Household Wealth to Income ratio divided by its ten year average. I have highlighted the periods of extreme pessimism and optimism.

HouseholdWealthRatio10Year

If history is any guide, the ratio of wealth to income can stay elevated for a few years. The “haves” keep trading with each other in a game of muscial chairs until people begin to leave the game and move their dollars into other assets, other markets, or bonds and cash. Unfortunately, many slow moving casual investors are left in the game with deteriorated portfolio values.

Economist Robert Shiller, author of Irrational Exuberance and developer of the long term CAPE ratio, recommended a strategy of shifting allocation in response to periods of exuberance and pessimism.  When valuations were historically low or average, an investor might allocate 60% or more of their portfolio to stocks.  As valuations became overextended, an investor might shift their stock allocation to 40%.  The investor is not trying to predict the future. The portfolio remains balanced but the stock and bond weights within the portfolio changes.

Using this wealth-income ratio as a guide, the casual investor might gradually implement an allocation shift toward safety in the coming year.

Investment Fees

Let’s put aside our rosy glasses, put on our fine print glasses and look at some percentages regarding investment fees.

I will compare two bond funds holding the same type of bonds. Fund A, an index fund, charges .5% while Fund B, an actively managed fund, charges 1.5% in management and other expenses. The manager or salesperson for Fund B may tell a prospective client that the returns for their fund are superior and will make up for the 1% difference in fees. Many brokers are of the Lake Wobegon mentality, believing that the products they sell are above average.

1% sounds like a small amount so this might seem reasonable to you if you are wearing your rosy glasses. But let’s look at some hard data. Let’s say that the index Fund A averages a 5% return before expenses. The more actively managed fund B would have to earn 6% before fees just to break even with the return on Fund A. Again, that 1% sounds small but what it means is that Fund B has to make a return that is 20% greater than the index. Very few funds are able to do that.

Let’s look at those fees again as a percentage of the return, not the total dollars invested. On a 5% return, index Fund A’s fee of .5% is 10% of the return. Even if Fund B can generate a 6% return, it’s 1.5% fee is a fat 25% of the return, more than what many hedge funds charge.

Let’s say that Fund B has generated these higher returns in the past. How does it do that? Often, by taking more risk than the index fund A. You can check an assessment of a fund’s return vs. risk at any number of stock research sites. Yahoo’s finance site has some good assessment tools. Enter the fund’s symbol and in the resulting summary page, click on “Risk” in the left column. You will be taken to a page which shows 3 year, 5 year and 10 year risk and return ratios.

Alpha measures the amount of return for the degree of risk involved. The average is 0. Less than 0 means that the fund does not get a return commensurate with the risks it takes. More than 0 means that the fund gets a better than average return for the risks it takes. You will be able to compare the fund with other funds in its category.

There are so many index funds and low cost index ETFs in the market for an investor to choose from. If you are willing to take more risk in bonds, for example, you can probably find an index product that invests in a riskier class of bonds. Over the long run, expense fees do matter. The lower the return, the more they matter. Over 10 years, that additional 1% in fees will cost you $1400 on a $10,000 investment in a fund averaging a 5% return.

In short, play the percentages.