The Permanent Portfolio, Investing, Finance and Random Thoughts.
Posts tagged risk control
Institutional Diversification: A Great Idea to Limit Risk
01 week ago
by Craig Rowland
in Investing
The topic of safety of keeping all your funds at Vanguard came up recently on the Bogleheads forum and an interesting post from The Oblivious Investor:
Is it Safer to Use Multiple Fund Companies?
This is a great post with an interview from a Vanguard PR rep about their internal controls and laws in place to protect investors. So I am not being critical of the post, just pointing out some things that I disagree with.
First of all, keeping all your money at one company or one fund provider is a very bad idea. I’m sorry because I know that it’s more convienent, but it’s just how I feel. I strongly believe in Institutional Diversification. That is the idea that you split your money up between financial services company and the funds they provide.
Institutional diversification is more than about fund managers commiting fraud or other shenanigans with customer funds (although that has happened in the past as MF Global customers just found out). There are a lot of other unknown risks that can show up as well. Some examples:
1) Your account is compromised and access to your funds is frozen while it is sorted out. It can be identity theft from some rogue player overseas, or (more likely) someone you know. You will likely get access to the funds soon enough, but with more than one company it is unlikely the perpetrator will gain access to all your funds in one fell swoop. And if they do, you have two companies to work out the problem with and one of them likely will handle it faster than the other so you can regain some control.
2) Physical attacks against infrastructure are very real as shown on 9/11. Directed cyberattacks against infrastructure affecting large numbers of accounts at a financial services company are also all possibilities. Again, having more than one company diversifies this risk of being locked out of all your money at once.
3) A natural disaster could happen to affect the company where you have all your money. Earthquakes, hurricanes, etc. are all possible and would be very bad for certain parts of the country where many financial sector companies are based.
4) Lastly, but most importantly (and likely) there is not so much fraud as there is just sheer manager incompetence. SIPC coverage and other legal protections do not do anything if the fund managers do something dumb like Schwab’s YieldPlus fiasco, the Reserve Fund breaking the buck in 2008, or even Vanguard’s own Total Bond Market Fund in 2002 that undershot their benchmark due to manager error. Keeping all your money in one fund type at one provider opens you up to this kind of manager risk that has absolutely no protection of any kind.
Just last week JP Morgan reported a $2 Billion dollar loss due to nebulous “trading errors” that employee(s) committed. Would you be covered if this kind of trading error happened to your fund? Maybe, but maybe not. It all depends on what the error was and whether the company management wants to make good on it. In summary, manager risk is very real and very dangerous if you concentrate your bets in one company.
If there is a problem in a fund the first thing that happens is a lot of finger pointing. Then the lawyers come in. Then the judges to sort it all out. It could take years to resolve some of these things. I had one commenter on my blog discuss what happened to him in this case:
Everyone should follow craigr’s advice. I always took cash safety for granted until 2008 when I lost a substantial sum as part of The Reserve Fund fiasco. I can vouch first hand that the media really played down how serious and widespread the problem was. What I basically learned was that there is a lot more risk out there then people realize and when things go wrong you will get virtually no help from the agencies that are supposed to be looking out for you. For the rest of my life my cash will be in FDIC/NCUA accounts (never going over deposit limits per bank) and in US Treasuries.
(read the comment thread there for more details)
The Reserve fund has now made whole (mostly) the people invovled, but it was a harrowing experience I am certain for those involved.
Here is what someone else wrote on the forum about his losses at Lehman:
…in September 2008, 50% of my “cash equivalent” position was in Principal Protected Notes issued by… Lehman Brothers! I lost 80% of that position. All in all my main investment portfolio (the “money not afford to lose”) was down 40% which was the same as if I had been 100% in a stock index. This was a slap in the face considering the time I had spent following the market and managing the portfolio and carefully mitigating my risks with “cash” positions…
I am not posting these things to be critical of the decisions because they were completely unknown to the investors. Just pointing them out so we can all learn about these risks and take sensible precautions.
The unpredictable happens all the time in investing. Having your money spread around is more likely to give you options to deal with the extraordinary that you won’t have if it is all at one company and that company is having the problem. In summary:
History does not support the idea that entrusting all your life savings to one financial institution as being a good idea.
Vanguard is a great company and I don’t expect any problems, but the prudent decision is still to not keep all your money at one financial institution or fund provider. Hate to be the bearer of bad news, but that’s just the reality of things.
I call the above “Extra Spreadsheet Risks.” These are risks that a spreadsheet of backtest data won’t ever show you (nor academic research).
Thing is these kinds of losses, if they happen, are much worse than whether you diversified enough into Asset X, Y or Z. Yet as remote as they may be, they do happen and you need to diversify against them. Fortunately, opening up more than one investment account is easy and a basically zero cost way of getting some protection from these Extra Spreadsheet Risks.
Of course, we cover this and other topics on how to protect yourself from these risks in our new book which I shameless plug yet again:
The Permanent Portfolio: Harry Browne’s Long Term Investment Strategy
Nassim Taleb Interview on Antifragility
1 month ago
by Craig Rowland
in Investing
I’m finally catching up on some listening and came across an interview on Econtalk with Nassim Taleb, author of books like The Black Swan. I’m a fan of Nassim Taleb because I agree with his ideas on the topic of uncertainty (especially in the markets):
In this interview, Nassim Taleb talks about his upcoming book discussing the concept of Antifragility. Basically the idea is to design systems that, when put under stress, become stronger as a result of the experience instead of weaker or outright destroyed.
For instance, the human body is antifragile. If you stress a muscle from exercise it gets stronger next time. Unfortunately a lot of modern banking and finance markets are the exact opposite of this. When put under even slight stress, large banks can quickly become insolvent and disappear. Or other events can cascade through the markets in unpredictable ways. The main reason for this, IMO, is the natural feedback loop of failure has been removed from free markets. This causes large incompetent organizations to thrive and grow even larger instead of fail when they make a bad decision. The system actually is making itself more fragile over time through this process.
What’s interesting about this interview is he discusses how a lot of people completely missed his point in The Black Swan that bad events cannot be predicted ahead of time. That’s part of what makes them Black Swans after all. Coming from the start-up world, I saw surprises happen so often that I just became use to the idea that they are normal so you kind of learn to roll with them. The biggest waste of time is to have elaborate plans to deal with worst case scenarios because:
A) They never happen as you envision.
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B) When they do happen they are almost always worse than you expected.
Don’t mean to be cynical, but this is just how it goes. So the best plan is to have a flexible set of tools and decision processes to deal with problems rather than some grand plan in your head. This will enable you to have a nimble and flexible response to the unexpected.
In many ways the Permanent Portfolio is a similar approach to my start-up experience which is why I like it so much. It holds basic assets that each respond very strongly to certain events if they come to pass. It is not predicting anything. But if something bad happens, it gives the investors the tools to deal with it flexibly. Risks of each assets are very unique and something very bad for one is likely very good for another. Plus, the assets are held in a balanced way so even if a true disaster does happen, the impact is contained to just that asset class alone.
The above is a much better idea than other strategies that predict that event A is going to happen so therefore only strategy Z can deal with it. Well what if A doesn’t happen? Or what if it does happen but you find out strategy Z was completely the wrong thing to do? That’s the problem with these fixed plan approaches, they make assumptions about the future that not only need to get the initial prediction correct, but also the response to the prediction correct. That my friends is really hard to do!
I can’t wait to read Nassim Taleb’s new book. Is the Permanent Portfolio antifragile? Hmm….I think it has shares a lot of attributes with the concept as he explains it in terms of investing in an uncertain world.
Vanguard Questionnaire Says 100% Stock is Great Idea and Unicorns are Real
1 month ago
by Craig Rowland
in Investing
I just read about a Vanguard retirement planning calculator recommending someone put 100% of their money into the stock market. Well, 100% in any asset class is gambling, not investing.
The Vanguard questionnaire assumes many things about the future that history simply doesn’t support in terms of market risk. The past does not predict the future. Just because U.S. markets have had good runs in the past does not mean they will have those runs on your particular timetable.
The last part is important because the investment industry will often show a chart with 200 years of U.S. stock returns (or some similar very long time horizon). But these charts make a lot of assumptions:
1) That U.S. stock market history will repeat the exact same way (it won’t).
2) That any person or organization was able to capture those returns consistently (they didn’t).
No Campaign Plan Survives First Contact with the Enemy
“No campaign plan survives first contact with the enemy”
The above is a famous quote attributed to Helmuth von Moltke the Elder, a Field Marshal for the Prussian Army and military strategist. This quote has direct bearing on investing because people come up with all sorts of plans for what they think their favorite asset class will do. But when that plan enters the battle of the markets, things often go wrong.
Let’s pretend what 10% a year average stock growth over 200 years with starting investment of $1,000 would be:
$189,905,276,460.46
Looks pretty good, right? Well I don’t know of any individual that turned $1,000 into $189 Billion dollars, do you? Why not?
Ignoring the obvious that people don’t live 200 years, between Point A and Point Z on a timeline of 200 years of history you have a lot of things going on: Wars, depressions, inflations, high taxes, low taxes, government bloat, price controls, shortages, bankruptcies, trade wars, embargoes, market bubbles, market panics, etc. So while someone thinks they are going to take in their 10% a year in stock returns to easy riches, the reality is that the road is very bumpy and uncertain.
Stock Markets Don’t Care About Your Retirement Goals
In fact, I put the odds of an individual in 100% stocks capturing the historical average market returns over their lifetime at basically zero. That’s right, zero.
Why? Two reasons:
1) You’re human and your emotions are going to get in the way.
2) Stock markets don’t care about your retirement goals.
You may invest for something like 20-40 years in many cases and then retire. You may even need that money earlier for kids, emergencies, job loss, etc. So if that period is great for stocks and you make 10% compounded a year (before fortuitously cashing out before any market crash or prolonged decline of course) that’s great. But more realistically you’re not going to do that.
Chances are the stock volatility is going to rattle you so much eventually you’ll flee in terror. However even if you have nerves of steel, future market events are likely going to get in the way regardless. Crashes, prolonged declines, negative real returns after inflation, etc. These market events may get in the way right when you need your money. The market event that deals a serious blow to stocks is not going to wait around until it is a convenient time for you. No, it’s going to be a surprise as it always is.
Bad outcomes in the market can be absorbed with a diversified portfolio that is not 100% stocks. But if you’re 100% stocks? Well, you’re going to get a real shellacking eventually.
Bad outcomes in the market can be absorbed with a diversified portfolio that is not 100% stocks. But if you’re 100% stocks? Well, you’re going to get a real shellacking eventually.
Avoid Extremes in Investing
Be careful of anyone advocating 100% in any asset class, whether it is stock bugs saying 100% in stocks, gold bugs saying 100% gold, or bond bugs saying 100% in TIPS. These are all extremes and I always recommend you avoid extremes in investing. There is no asset class that is 100% safe, 100% risk free and 100% guaranteed to do what you expect it to do. It’s best to just acknowledge this weakness and develop a plan to deal with it. That plan should have you across multiple asset classes in a balanced way and those asset classes should not all be stocks.
I think putting 100% of your money in stocks is a terrible idea and will eventually lead to terrible outcomes. Vanguard should be ashamed for recommending this kind of allocation based on investor and market behavior. Me? I’m sticking with a widely diversified allocation like the Permanent Portfolio to take care of me no matter what is going on. Even if you’re not a Permanent Portfolio follower, please consider holding other assets besides just stocks.
Yeah, the new book we’re writing is going to talk about a lot of these issues. The industry constantly tries to sell people on owning way too much in stock exposure. Stocks are much riskier than people give them credit, even over the long run. Make sure whatever plan you develop for investing can survive first contact with the markets by being diversified.
