Warren Buffett: Bonds and portfolio risk

It is a terrible mistake for investors with long-term horizons – among them, pension funds, college endowments and savings-minded individuals – to measure their investment ‘risk’ by their portfolio’s ratio of bonds to stocks. Often, high-grade bonds in an investment portfolio increase its risk.

~ Warren Buffett, letter to the shareholders of Berkshire Hathaway – February 24, 2018

Please note

I have resigned as a director of Porter Capital Management Pty Ltd (“Porter Capital”) and Porter Private Clients Pty Ltd (“Porter Private”) as I find this interferes with my primary business (Incredible Charts). In future, I will no longer publish newsletters under the banner of Research & Investment nor issue investment updates for them.

I no longer work under the AFSL and would like to remind readers that any advice in these newsletters and on the website is provided for their general information and does not have regard to any particular person’s investment objectives, financial situation or needs. Accordingly, no reader should act on the basis of any information contained herein without first having consulted a suitably qualified financial advisor.

The Trouble With Chasing Hot Strategies | Josh Brown

This should be blindingly obvious, but amazing how often it is ignored. Great post from Josh Brown at Reformed Broker:

How do most investors (and many advisors) select funds or strategies to allocate to? They look at what’s been working, learn the story and get long…….
And then mean reversion shows up – outperforming managers subsequently underperform, hot themes become over-loved, winning strategies become too crowded to offer excess returns. “No problem,” says the advisor, I’ve got six new ideas to replace the six ideas that are no longer working!”

It’s sad to say, but this is exactly how it works. I’ve been watching this for almost 20 years…….

Research Affiliates has an interesting pair of charts demonstrating this phenomenon in a new note from Rob Arnott, Jason Hsu and Co. They illustrate that increasing fund flows are a decent predictor of subsequent underperformance and that performance-chasing is destructive to returns across all types of investment products:

Research Affiliates

Former Trader Tom Hayes Sentenced to 14 Years for Libor Rigging – WSJ

From David Enrich at the Wall St Journal:

LONDON—Former bank trader Tom Hayes was sentenced to 14 years in prison on Monday after a London jury convicted him of trying to fraudulently rig the London interbank offered rate, or Libor.

The unanimous jury verdict, followed about an hour later by the judge’s 14-year prison sentence, delivers one of the harshest penalties meted out against a banker since the financial crisis.

This sentence will hopefully establish precedent for other regulators to follow. If management condoned the actions, they are as guilty as the trader who perpetrated the crime. Let’s see what actions are taken against them.

Read more at Former Trader Tom Hayes Sentenced to 14 Years for Libor Rigging – WSJ.

Is Mathias Cormann acting in investors’ best interest — or the banks?

Chris Joye from the AFR comments on Finance Minister Mathias Cormann’s final Future of Financial Advice (FoFA) bill:

Cormann seeks to assure consumers that a commission “is banned if it is made solely because a product . . . has been sold”.

This is part of his new definition of a commission, which lawyers say bears no resemblance to the real legal meaning of commissions under precedent laws.

The word “solely” makes the definition a farce. Cormann’s explanatory statement says: “If an employee [had] to meet a reasonable target – [like] selling 1000 products – as well as a compliance target . . . the payment would not be made solely because of general advice [and] . . . would be permitted.” In every other universe, these payments are a “commission” and/or “conflicted remuneration”.

I do not have a problem with the Coalition’s changes to the laws on “general advice”. Companies should be free to motivate sales staff, as is the case across the rest of the economy.

My main concern is with Cormann’s modifications to the “personal advice” laws, which allow planners to earn up to 10 per cent of their total remuneration in sales bonuses partly determined by how many products they sell to customers relying on personal advice.

Cormann’s logic is because he has exempted these “performance bonuses” – which planners do not support – from the ban on conflicted remuneration, they are not conflicted remuneration: “With personal advice the requirements are very stringent, so all remuneration that would conflict the advice given is banned, and the overarching requirement for the adviser to act in the best interests of the client remains in place.”

Conflicts of interest are rife in the provision of financial advice. Removal of the overriding requirement that an adviser act ‘in the best interest’ of their client leaves the door open to an array of abuses. The argument that advisers are already obliged to act in the client’s best interest is not an argument against removal of the provision. If the obligation is already implied, making it an express obligation would simply reinforce this by removing any doubt.

In my view, advisers offering personal advice should not receive any (material) incentive for recommending specific products. That would limit the potential for any conflict of interest and improve public perception of adviser integrity. And where general advice is offered, the adviser should be required to (prominently) notify readers or listeners that they (the adviser) receive incentive payments based on the products they recommend. After all, the primary concern of the industry should be to protect the consumer. In doing so, advisers will benefit from an enhanced reputation and trust from the community.

Read more at Senate has last chance to fix financial advice.

Why Do Democrats Keep Trying to Ban Guns That Look Scary, Not the Guns That Kill the Most People? – ProPublica

From Lois Beckett:

Over the past two decades, the majority of Americans in a country deeply divided over gun control have coalesced behind a single proposition: The sale of assault weapons should be banned.

That idea was one of the pillars of the Obama administration’s plan to curb gun violence, and it remains popular with the public. In a poll last December, 59 percent of likely voters said they favor a ban.

…It turns out that big, scary military rifles don’t kill the vast majority of the 11,000 Americans murdered with guns each year. Little handguns do. In 2012, only 322 people were murdered with any kind of rifle, F.B.I. data shows.

These statistics are not a sound argument against a curb on assault weapons. Saving even a fraction of the 322 firearm deaths caused by rifles would be a positive step. But it does illustrate politicians’ propensity to follow the path of least resistance, rather than taking effective action. A partial restriction on handguns — whether on sales, ownership, storage or requiring trigger locks — would not grab as many headlines, but would be far more effective in saving lives.

Read more at Why Do Democrats Keep Trying to Ban Guns That Look Scary, Not the Guns That Kill the Most People? – ProPublica.

Growth or income?

Most investors face a decision as to how much of their portfolio to allocate to growth investments and how much to income investments. The mind-set of many income investors is that they cannot afford the volatility of growth investments. The following example illustrates how income investors can use growth investments to protect their portfolio against inflation and enhance overall returns.

Growth investments, historically, have outperformed income investments, but at the expense of greater volatility. They are typically favored pre-retirement by investors with long time horizons who seek to maximise their capital on retirement. Other than improved performance, growth investments also generally receive more favourable tax treatment than fixed income, further enhancing after-tax returns. Income investments historically exhibit lower volatility and are favored by retirees for their consistent income, also by risk-averse pre-retirees who wish to reduce the volatility of their overall portfolio.

Historic Returns

These historic returns to Australian investors from 1981 to 2009 illustrate the differences in returns and volatility. Data was originally provided by AXA:

Asset class: Australian stocks Australian fixed interest International stocks Australian REITS Australian cash
Annualized return (%) 11.38 10.41 10.81 10.49 9.18
Inflation (%) 4.41 4.41 4.41 4.41 4.41
Real return (%) 6.97 6.00 6.40 6.08 4.77
Standard deviation 23.32 7.60 21.41 18.75 4.95

Not all investment strategies are likely to match the broad asset classes, but they are a good starting point for developing a broad investment strategy.

What the future holds

One thing about the future is certain: it is not going to match the past. It also is not going to match our projections. Without a magic crystal ball, the best we can do is adjust past performance for expected changes and hope we are not too far off course.

My own expectations are that we are entering a low inflation environment. Central banks, after the global financial crisis, are likely to be far more vigilant about rapid credit expansion and asset bubbles. I have therefore adjusted my inflation expectation down to 2.0%. I also expect that low inflation will have greater impact on fixed interest and cash and have adjusted their returns accordingly.

Asset class: Australian stocks Australian fixed interest International stocks Australian REITS Australian cash
Annual return (%) 9.00 7.00 9.00 8.00 5.00
Inflation (%) 2.00 2.00 2.00 2.00 2.00
Real return (%) 7.00 5.00 7.00 6.00 3.00
Standard deviation 25 10 25 20 5

These projections are no more than an educated guess and are used for illustration purposes only. Make your own projections, but understand that unrealistic projections will yield unrealistic results.

Investing for Income

We can now determine how much to allocate to income investments and how much to growth investments.

Take a retired investor whose objective is to earn $60,000 per year (after tax) from investments while protecting capital from inflation.

If he/she earns an average return of 7.0% p.a. on income investments at an average tax rate of 15%, with 2.0% inflation, we arrive at a net return of 3.95% and a required investment of $1.519 million:

Average return: 7.00%
Less tax at: 15%
After tax: 5.95%
Deduct inflation: 2.00%
Net return: 3.95%
Required income after tax and inflation: $60,000
Required capital (60,000 x 100/3.95): $1.519 million

Adding growth investments

If we recognize hedging against inflation as a long-term goal and not an immediate cash flow need, we can consider funding the inflation element of the portfolio with higher-yielding growth investments.

Income Component

First we calculate the capital required to meet current income needs:

Average return on income investments: 7.00%
Less tax at: 15%
After tax: 5.95%
Required income after tax: $60,000
Required income investment: $1.009 million

Growth component

Growth investments typically enjoy higher after-tax returns because of improved performance as well as a lower tax component — through capital gains concessions and franking credits on dividends (for Australian investors).

Average return on growth investments: 9.00%
Less tax at: 10%
After tax: 8.10%
Deduct inflation: 2.00%
Net return: 6.10%
Required income from growth investments ($1.009m x 2.0%): $20,180
Required growth investment ($20,180 x 100/6.1): $0.331 million
Total required capital: $1.340 million

Using growth investments to fund the inflation component reduces required capital to $1.340 million, a reduction of $179,000. Alternatively, if we invest the previously determined capital amount of $1.519 million, we should average close to $11,000 of additional income (after tax and inflation) each year. With higher inflation rates, the difference is even greater.

Remember that this example does not take into consideration your personal needs and circumstances. Also, taxation and investing for retirement are complex subjects and we recommend that you consult a professional adviser before making any decisions.

“Highly unlikely to ever see a Storm again”

Andrew Starke welcomes the latest proposed changes to Future of Financial Advice (FoFA) legislation in FINSIA News:

Changes… outlined by the government on Friday have generally been well received, with many in the industry now hoping for final clarity on a process that has been running since the Labor Government revealed the proposed reform package in April 2011…..First and foremost, the changes outlined by the government on Friday ensure a clear ban on commissions after it had previously left the door open via the so-called ‘Wolf of Wall Street’ clause within general advice. Any possibility of a return to commissions on investments or superannuation products has now been ended.“This response removes all doubt that commissions will be introduced in the provision of general advice. The government will define and ban commissions in black letter law” said John Brogden, CEO of the Financial Services Council FSC. “The changes outlined by the government also maintain a detailed and comprehensive best interest duty requiring a financial adviser to act in the best interests of their client.”

Best interest clarified
While the perceived watering down of the best interest duty has attracted a great deal of attention in the mainstream press, Brogden said this should be put in perspective. Prior to FoFA, financial advisers simply had to offer ‘appropriate advice’ while they now need to comply with a raft of regulation. “There are six separate duties in the Corporations Act that require a financial adviser to act in the best interests of their client. In addition, there are six specific steps that must be met by an adviser when providing advice that codifies the best interest duty,” Brogden said. “The government has made one minor change to the best interest duty by removing an unnecessary ‘catch all’ provision. This change will actually clarify the best interest duty and remove any ambiguity for a financial adviser to always act in a client’s best interests.” The FSC has legal advice from leading commercial counsels Ian Jackman SC and Gregory Drew which it said confirms that the removal of ambiguous ‘catch-all’ phrase will not dilute the obligation of an adviser to act in the best interest of their client……The Australian Bankers’ Association ABA also welcomed the announcement and said the amendments would preserve the original intent of the law while correcting the current overreach and broader uncertainties.

What puzzles me is:

  • How an overriding provision — that advisers act in the best interests of their clients — can be “ambiguous”?
  • How removal of the overriding provision helps to clarify the situation? and
  • Why, if legal advice confirms that removal of the ‘catch-all’ phrase “will not dilute the obligation of an adviser to act in the best interest of their client”, should it be removed?

Major banks have spent billions of dollars buying up financial planning firms in order to secure distribution of their investment products. Christopher Joye at AFR puts it in a nutshell:

The big vertically integrated institutions (mainly the four majors and AMP), which now control 70 per cent of planners, want these tied distributors to have the freedom to recommend in-house platforms, super funds and investments without being hampered by a catch-all best interests duty.

An overriding provision would certainly not be in the banks’ best interests.

Read more at "Highly unlikely to ever see a Storm again".

Does evil exist and, if so, are some people just plain evil?

Interesting discussion by Prof Luke Russell (University of Sydney) on the nature of evil:

If someone is an honest person, honesty is part of his or her character. He or she can be relied upon to be honest when it counts. Someone who tells the truth on some occasions might nonetheless be a characteristically dishonest person.

Similarly, not everyone who performs an evil action counts as an evil person. In judging that Hitler was not only an evildoer but an evil person, we assume that evil was part of his character. That’s is not to say we assume he was innately evil, nor that he had no choice but to do evil. Rather, it is to say he came to be strongly disposed to choose to perform evil actions.

Were Hitler, Stalin or Pol Pot innately evil or did they merely commit evil acts? And how do we define an evil act, when violence is an integral part of human/animal nature? What forms of violence are acceptable or unacceptable? Is violence only acceptable in self-defense, in defense of others, or to negate a perceived future threat? Careful study of the factors that motivated Hitler, Stalin and Pol Pot will help us to better understand and protect against future despots. Demonizing despots prevents us from understanding them, leaving us prone to repeat the mistakes of the past.

Read more at Does evil exist and, if so, are some people just plain evil?.