Human capital

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What’s human capital?
To start, we need a definition. Here’s what Wikipedia has to say: “Human capital is the stock of habits, knowledge, social and personality attributes (including creativity) embodied in the ability to perform labour so as to produce economic value.” A little tricky, but basically human capital is the economic value of a person based on their skills and ability in the workplace.

So who gets paid for human capital?
In a free-market economy, everyone gets paid based on their own human capital. We each own our own skills and abilities and we collect income based on our ability and value when we work. Regardless of whether we work for a company or ourselves, we’re compensated for the value we’re able to provide.

So far so good. Now let’s tie this into investing. Without some understanding of the market, people tend to believe that they can beat the market by picking the right stocks. Consistent success (beating the market) in stock picking is actually impossible, but let’s pretend for a moment that’s not. If the market was beatable, there would naturally be people who were especially endowed with the skills and/or training to beat it. Those people would often become money managers and they would be highly sought after by the general public looking for great returns in their portfolios. But who would collect the premiums for additional returns achieved above-market returns? Stock picking would be a human capitalist skill! The brilliantly skilled money manager would collect some serious fees for his valuable ability, fees almost exactly in line with the amount of return he was able to achieve above the market. The additional return of the portfolio wouldn’t end up in the pockets of investors, it would go to the brilliant manager with the impressive human capital skills.

So here’s the point: the stock market is efficient and so it’s not consistently beatable, but even if it was, investors would not be the beneficiaries. The super-skilled money managers would rightly collect large fees, highly correlated to the additional value they were able to provide based on their human capital skills.

On REITs

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REITs (Real Estate Investment Trust) are a hot topic in 2019. Real estate is popular, it’s tangible, it’s easy to understand the profits and costs involved, and many of us already own some ourselves. REITs offer the allure of owning income-producing real estate without ever having to take a call from a grumpy tenant or running over to fix a leaky toilet in the middle of the night. It’s real estate investing without all the hassle! Well, that’s not exactly true, here a few reasons to look elsewhere for investing returns:

  1. A REIT is not like investing in real estate the way most of us think about real estate investing (owning rental properties). Traditional real estate investing is a great way to make money, but it’s not passive. Ask anyone who owns rental properties and they’ll tell you it’s a job, maybe a part-time job, maybe a worthwhile job, but a job none-the-less. It takes work and time and good business sense. A REIT is like a mutual fund that only owns income-producing real estate (at least 75% of the income within a REIT must come from rental income or something similar), which sounds similar to traditional investing, but a REIT is completely passive. The expected earnings on the two types of investments are very different because they’re very different types of investments.
  2. Investing in REITs is redundant. If you’re invested in the stock market you already own real estate. In fact, you already own the same exact companies and properties that are also in the REIT you’re thinking about purchasing. You could theoretically double down on real estate, own it both in your investment account and in a REIT, but why would you do that? There are three essential market factors that drive returns: stocks (which outperform bonds over time), small companies (which outperform large companies over time), and value companies (which outperform growth companies over time); real estate doesn’t make the cut. There’s no additional benefit to increasing your exposure to real estate, no additional returns, no additional diversification benefits, nothing. You could buy into a REIT if you have a hunch that real estate as a market sector is going to do well in the next few years but that would be market timing, a proven great way to lose money.

REITs sometimes sound exciting, especially when they’re doing well, but keep the big-picture perspective. No one knows when REITs will do well or for how long, we just know that over time they won’t beat a well-diversified portfolio, which already owns a lot of real estate anyways.

Thoughts on capitalism (part 4)

4: Capitalism isn’t perfect.

I wanted to finish up these thoughts on capitalism with an observation: capitalism is great, but it’s not perfect. Again, many of these thoughts are extracted from John Addison Teevan’s Integrated Justice and Equality which I can’t recommend highly enough, and a few are gleaned from Not Tragically Colored by Ishmael Hernandez.

Capitalism does not contain values, it’s amoral. It can’t distinguish anything on any basis besides price. For capitalism, there’s no difference between a missile and a bushel of apples besides its market value. This basically means that capitalism is as good (moral) as the people who are utilizing it.

Capitalism relies on the self-interest of humans, a pretty reliable foundation. However, apart from values, self-interest can quickly and easily devolve into greed. Greed is a problem, Teevan argues that it ‘flattens the soul.’ Greed changes the equation from self-interest to gross indulgence. It’s the opposite of moral, and it can wreak havoc on society.

We know that capitalism is the single greatest sociological economic force in creating wealth and alleviating poverty. But we also know it’s not perfect, it can be manipulated for greedy ends, harming people and environments. So what’s the solution? A popular conclusion is to hand over responsibility to the government to regulate and stipulate and care for the underprivileged, that personal generosity and compassion should be delegated. That’s a bad idea, for a few reasons:
(1) Government compulsion stifles generosity and compassion within society. Generosity means giving, void of any obligation or compulsion. When the government requires and stipulates giving, generosity dies. Not only do people resent the government for taking from them, they learn to resent the people to whom their proceeds are redirected. They learn to hold what they have closely. Why do you think CPA’s do so well? It’s not because they help people pay taxes, they help people pay the least amount of tax possible. People lose compassion when it’s delegated to the government.
(2) Redistribution deprives people of their dignity. Recipients of government ‘compassion’ efforts don’t receive a gift, whatever they receive becomes a right, an entitlement. Instead of gratitude, they learn to expect. Instead of self-reliance, they learn dependence. Part of a person’s self-worth is lost in all this.

Instead, in order for capitalism to work in society, shared moral values, specifically personal compassion, are required. The delegation of personal generosity and compassion from the people to the government is destructive for everyone. Capitalism is as strong as the values of the people who embrace it. “P.J. O’Rourke is alleged to have quipped that civilization is a bootstrap operation: we have to work at being civil. We cannot assume that the bounty of wealth or the freedom to enjoy it can be continually provided without continual care” (Teevan, p121).

Are you market timing?

Market timing is the practice of moving money in and out of the market, or in and out of specific sectors of the market, based on a belief that the market, or specific sectors of the market, will do well (in which case you’d be in) or poorly (in which case you’d pull out) in the future. If you’ve read about stock picking, market timing might sound familiar. Market timing is similar because it’s also built on a false premise that the market is inefficient, but it’s also a little bit different. Market timing is more subtle than stock picking. Instead of a belief that you can buy underpriced stocks and sell overpriced stocks, market timing is a larger bet on the future of entire market sectors. It gives the allusion that you can simultaneously be well-diversified and engage in market timing since you might always own a few different asset classes. It’s sort of like stock picking in disguise (it’s often called ‘tactical asset allocation’ which sounds super smart) because it’s essentially picking market sectors (asset classes) instead of stocks. Market timing can seem more legitimate than stock picking, but it’s still essentially gambling.

Market timing is unfortunately just as pervasive in the investing world as stock picking. It is often incited by panic, people move their money around or out when the market seems especially scary and move it back again (or not) when the market feels more safe. The timing tends to be exactly opposite of what should be done, people end up selling low and buying high and sacrificing millions of dollars in returns. But damage is done apart from panic too. Dalbar (an investor research company) reports that the average equity (stock) fund investor stays invested in their funds for only 4 years before jumping to a different set of funds, perhaps unintentionally market timing. Money managers routinely shift strategies within popular mutual funds (referred to style drift), shifting focus between market sectors. Pundits constantly discuss market trends which include market timing suggestions. Similar to stock picking, we’re so immune to market timing that it just sounds like normal investing at this point. That’s bad, here are a few reasons why:

1) People are bad at market timing. A study by William Sharpe conducted in 1975 (Likely Gains from Market Timing) concluded that in order for a market timer to beat a passive fund they would have to guess right about 74% of the time. An update to the study by SEI Corporation in 1992 concluded that the market timer would have to guess right at least 69% of the time, and sometimes as high as 91% of the time in order to beat a similarly invested passive fund. So the important question is: does anyone guess right with that frequency? Maybe you’ve made your own guess by this point, the answer is a resounding no. CXO Advisory did a fascinating study on the success ratios of market timers between 2005 and 2012. They looked at 68 ‘experts’ who made a total of 6,582 predictions during that period. The average accuracy of all predictions? 46.9%, well short of the minimum 69% threshold. These predictions sell news subscriptions and online adds, but they’re detrimental to investor returns.

2) Market timers miss out on returns. Trends are a big topic in the world of investing. Market timers analyze previous trends, they track current trends, and they look for the next trend, it’s incessant. Nejat Seyhun in a 1994 study entitled “Stock Market Extremes and Portfolio Performance” analyzed the period between 1963 and 1993 (a total of 7,802 trading days) and found that only 90 of the days were responsible for 95% of the positive returns. That’s about 3 days per year on average where 95% of returns came from. In all the misguided ‘trends’ talk and the popular practice of moving money in and out and all around, market timers routinely miss the most rewarding days in the market. Instead of focusing on market trends, investors would do much better to focus on the whole market and ride the general stint of the market upwards.

3) Market timers misunderstand the market. The most culpable cause of market timing is panic. People do crazy things when they’re scared and their money is on the line. Don’t get me wrong, the stock market can seem pretty scary, and it definitely involves money, but just because it seems scary doesn’t mean you should be scared. The average market crash of 10% or more lasts just under 8 months, 4 months until it hits the bottom, and just under 4 months to return to the pre-crash high. That’s not so scary. Over the last 93 years (going back as far as we have super-reliable data) 68 years were positive by an average of 21%, 25 years were negative by an average of 13%. Also not so scary. There are 45 countries in the world with free markets and the ability to buy and sell stocks and over 17,000 companies to invest in. What would it take for a well diversified portfolio to lose everything? Only some type of global apocalyptical event, at which point you probably wouldn’t be concerned with the amount of money in your portfolio. That is scary but not because of the market, it’s actually pretty reassuring as far as your portfolio is concerned. Instead of panicking, investors would do much better to rebalance during turbulent markets and capture returns on the way back up.

So market timing is a losing game. It can’t provide any consistent value to a portfolio, it actually causes a drag on returns, and it’s often driven by an inaccurate understanding of the market. Unfortunately it’s prevalent, and many portfolios engage in market timing while investors remain unaware. So take a look, have an advisor do an analysis for you. It pays to understand how you’re invested and to avoid market timing in your portfolio.

Sources:

https://www.ifa.com/12steps/step4/#footnote_3

https://money.usnews.com/investing/buy-and-hold-strategy/articles/2018-06-19/no-right-time-for-market-timing

3 Questions to Ask your Financial Advisor

Your investment advisor is a very important person. You rely on this person to help you navigate your lifelong financial journey, and hopefully guide you to a successful outcome. There are obvious characteristics we want in an advisor: integrity, honesty, diligence, etc., all good things. But there are other, almost equally important things most of take for granted in an advisor: What’s their investment strategy? What’s their view on the market? How do they expect to help you capture returns? These are questions we don’t tend to ask, after all, they’re the professionals, but the answers to these questions will have a profound impact on your future.

  1. Do you think the market is efficient or not?

This is a simple question with massive implications. Basically, you’re asking whether or not your advisor thinks he/she can consistently get you better returns than the market by actively buying and selling stocks (stock picking), moving in and out of different market sectors (market timing), and using funds with the best recent return history (track-record investing). If the market is not efficient then these are valid exercises. An inefficient market means that stock prices could be underpriced or overpriced and assumes that smart advisors should be able to figure out which stocks are which and pick the ones that will outperform all of the others. Unfortunately, advisors don’t consistently beat the market, they can’t consistently pick the winners. The results of choosing stocks and timing the market have been overwhelmingly negative and research has resoundingly supported the assertion that the market is actually efficient (Efficient Market Hypothesis). An efficient market means a stock is never overpriced or underpriced, its current price is always the best indication of its current value. If the market is efficient, that means it’s impossible for anyone to consistently predict or beat it, in fact, attempts to do so are more like gambling than investing. Instead of trying to outperform the market, the goal should be to own the whole of it as efficiently as possible. This brings us to the next question.

2. What Asset Classes Do I Own?

In order to efficiently own the market, you need broad diversification. That means you want to own many companies, but more importantly, you want to own many companies in many different asset classes (large companies, small companies, value companies, international companies, etc.). When you ask, most advisors are going to tell you that the large majority of your money is in Large US Growth companies (S&P 500), which is unfortunate because the Large US Growth company asset class is one of the lowest returning asset classes in history. That’s not to say the asset class is a bad investment, it’s great for diversification, but it’s certainly not where you want most of your money. Small and Value asset classes return better over time, so you want to ensure you’re broadly and significantly invested in those asset classes.

3. How will you help me capture returns?

There are three important components to successfully capturing returns: 1) diversify, 2) rebalance, 3) remain disciplined. Diversification (1) means you’ll have ownership in companies of all different shapes and sizes all over the world. Good diversification does two things for an investor: it reduces risk/volatility and increases return. Since we don’t know which sectors or stocks will do best this year, we own all of them, and then we rebalance, which brings us to point 2. The goal in rebalancing (2) is to keep an ideal percentage of each of the different asset classes in your portfolio. Since stocks and asset classes don’t all move the same way every year when one asset class is up and another is down your portfolio percentages get out of whack. That’s where rebalancing comes in. In order to rebalance your portfolio, your advisor will sell some of the asset class that went up and buy some of the asset class that went down, bringing the percentages back into alignment. This must happen systematically, for example, it could be every quarter, in order for it to be effective. The end result is that you’re automatically selling high and buying low. There’s no gut instinct, no guessing, no market timing, it’s committed disciplined rebalancing, which brings us to point 3. Discipline (3) isn’t something that comes naturally to most of us, but it’s extremely important in capturing returns and planning for your future. There’s a behavior element that all of this hinges on, if an investor doesn’t have the discipline to ride out the ups and downs in the market they can’t be a successful investor. The average investor switches advisors and funds and strategies every 3.5 years, that’s a losing game. So how will your investor help you stay disciplined and on track to capture those returns and achieve your goals?

Since I’m writing this and I’m an advisor, you probably assume I’ve got answers to these questions, your assumption is correct. But this isn’t just a sales pitch, good answers to these questions are critical for successful investing, and far too many people simply have no idea what their advisor is doing for them, whether good or bad. So ask a few questions!