A winter walk around the Central Park Reservoir
My friend “W” and I have gotten into a good habit of taking an hour-long walk around the Central Park Reservoir every few months. An hour’s walk is a perfect amount of time when two people speak the same language, are willing to not pretend or live in a fantasy world, are willing to engage in a two-way honest communication, and then want to return to their lives.
W is one of the sharpest minds on Wall Street. For more than twenty years, he has been applying macroeconomic data and central bank policy to asset markets to triangulate the best tactical medium-term investment opportunities.
Given everything we know, have lived, and learnt in the financial markets, our mutual quest is simple – how to become better investors of our own portfolios.
Everything is up for discussion. Active or Passive. Domestic or International. Index or Single Stocks. Stocks or Bonds. Short-dated bonds or long bonds. Options trading or no options.
Our most recent walk was in the middle of December, just a few weeks ago. Central Park can get crowded near the southern edge or near Bethesda Fountain. But in the north, especially around the bridle path surrounding the reservoir, tourists leave the locals alone on weekday mornings. The runners, walkers, and dogs are left to their own devices to enjoy the leafless Yoshino and Kwanzan cherry blossom trees which in due time will beautifully announce the arrival of spring.
Winter keeps us honest. With honesty in mind, we switch our talk to markets.
Taking stock of market returns for 2023 (and 2022): Tougher than it appears.
“You must be in a delightful mood with the recent rallies in stocks and bonds,” suggested W.
“I won’t lie,” I admit. “2023 is the kind of year where professionals have been burnt but those who had faith in asset markets, in diversification, and in keeping it simple, benefitted. I would not have predicted the stock market to bounce back as hard as it did, or the bond market to turn around the way it did. I didn’t make great calls. Passive investing worked in a way I hadn’t expected it to.”
I always try to outsmart markets, but with each year that goes by, I feel less smart. Having the discipline to be invested in assets through thick and thin has been the best self-help.
I add, “But it’s important to be honest. Any returns from 2023 must be seen in combination with 2022.”
I quote the numbers to the 3rd week of December. An investor with $1,000 in a 60/40 portfolio, where 60 is the US Total Stock Market and 40 is the US Total Bond Market is up 17% this year. Sounds great until one looks at the combined 2-year return. The investor would have a net of $972.50 assuming quarterly rebalancing. That is, the investor is still not back to par.
A 40 Stocks / 60 Bonds portfolio, which would traditionally be seen as lower market risk, fared worse. $1000 in the beginning of 2022 would be $952.70 now, or down a cumulative 4.7% for the two years.
A portfolio that included more diversification, featuring international developed markets and emerging markets had the worst of the three portfolio results. An endowment-type model portfolio invested in public passive ETFs is down more than 10% for the two years combined. $1000 would be $897.
“It’s humbling. In the euphoria of 2023, we seem to have forgotten that most academic book corner portfolios are DOWN over a 2-year period,” I submit. I understand that most people are not religious about the percentage and mixes, but these are common numbers to use as a starting point.
“And that is before including any effects of inflation on money erosion,” adds W. “The 10% increase in the general level of prices in the 2-year period makes portfolio values that much worse.”
“No one wants to adjust their wealth for inflation,” I protest. “It’s just not done. Do you want me to lose all sense of self-respect as an investor?”
To this humility, we add one more factor – the impact of withdrawals. Assuming a 4% withdrawal rate per year, the nominal values of the $1000 portfolio for a 2-year period would be $906, $888, and $837 respectively.
The last 90 days feel like a vindication for the diversified, passive investor. But the two-year combined reality adjusting for nominal returns, inflation, and withdrawals reminds me of a proverb my grandma often used: Five notes of twenties don’t make a hundred. That is, just because you earned a hundred dollars doesn’t mean that you’ve got a hundred dollars of money to play with: groceries, taxes, mortgages, utilities, and doe-eyed children who’ve really got to have a new outfit for the school dance all eat away at it.
Digression: 40 years of investment wisdom from “MO”
A quick digression: It’s easy to rain on the parade of poor investment returns. I asked my friend MO, who has been retired for 40 years if the last two years have changed his mind. The answer was NO.
MO texted back, “Was just telling my grandson this morning that sticking to the same basic guidelines makes average investors like me look good: start as young as possible, stick to a certain asset allocation, have broad diversification, tax efficiencies, and low commissions (all of which you get with the S&P Total Market). Then sit back and enjoy the effects of compounding in an extraordinary 40-year bull market for stocks, bonds, and residential real estate. The previous 40 years were not as good as the last 40, so there is an element of luck involved.”
MO continued, “Big problem – young people have perhaps less wind on their back and this passive style of investing is boring, boring, boring, especially to young people.”
Warren Buffett might also weigh in here, as he did in his 2020 Shareholder Letter to Berkshire-Hathaway investors: “Despite some severe interruptions, our country’s economic progress has been breathtaking. Our unwavering conclusion: Never bet against America.” Nothing I write can beat their guidance for long-term, faithful, investors. If we can digest the boredom and enjoy the years ahead, the work is done. No better fund or finding the next trade is needed.
For those who prefer more heartburn, continue reading ahead.
Bond investing: Hopes for sanity?
“Tell me, W, what are good reasons to continue being a diversified long-only investor,” I ask provocatively. “By October of this year, both stocks and bonds were looking ugly. Had the year ended in October, would we be calling the death of diversified portfolios.”
W takes me through the case for sanity. The last two years were different. COVID-related money printing or supply-side shocks created behaviors in employment and inflation which surprised the Federal Reserve (the Fed), which was behind the curve for a large part of the last two years. It had to catch up by getting ahead of the markets. And in doing so, it had to show hawkish credentials. This hurt bonds badly. When stocks tanked, bonds could not provide their traditional help and a 60/40 portfolio looked bad.
W continued, “But now, this Fed vol (a phrase to describe the volatility created by the actions of the Federal Reserve itself) should be in the past tense. Going forward, bonds can once again start reacting to economic growth and recession risks, as opposed to Fed mistakes. In such a case, if earnings decline and stocks go down, bonds can be helpful to the portfolio. Asset allocation and portfolio diversification benefits, which had temporarily been halted, have a greater chance of working.”
We stop to admire a London Planetree stripped to its bare bones and are glad to be spectators to the beauty of this giant at this time of the year. The tree is faultless in its structure. I still have many questions about US bonds, which don’t look as faultless to me.
I rebutted, “All year long we heard warnings from demonstrably smart guys. Howard Marks wrote Sea Change (December 2022) and Further Thoughts on Sea Change (October 2023), which holds that the good times in fixed income are done. Ray Dalio noted that the USA is getting to an “inflection point” (November 2023) where we become derailed because we are borrowing just to pay for our borrowed money; that is, fund interest payments on a quickly rising national debt. Robert Rubin argued in a Goldman Sachs exchange (October 2023) that the greatest risk is the lack of political will in Washington DC; that is, there aren’t enough adults left to do the hard, grown-up things we need. Jim Grant of the Grant’s Interest Rate Observer, in a Fortune interview (December 2023, with a paywall) that higher inflation is permanent and fumbling attempts to control it are compounded by lags and variable and uncertain impacts. Should we forget about all these warnings now and line up to buy bonds again?”
W is a balanced mind and less incendiary than me.
“If you have Biden, and he doesn’t do anything stupid, the propensity of the markets to digest US debt will be higher. But if you get a Trump comeback, there could be a problem. Also, there is an argument that the bond market from time to time gets too excited about the Fed cutting interest rates and the end of 2023 seems to be one of those moments with bonds being overly optimistic once again.”
W asks me if I have still been holding my 30-year TIPS. I share that I had to eat some humble pie.
“Most of 2022, I was in T-bills. That helped when US Treasuries went down last year. In the spring of 2023, I bought some NY Municipal bonds, which are no home run.”
Municipal bonds don’t make bond investors money. They provide tax-free income to those who care for such things. Residents in high state-tax jurisdictions might benefit from munis but one needs to pick them carefully with the help of a good bond broker.
“In December 2022, I purchased some long-dated TIPS when they were aggressively being sold. I was early and had some quick wins. But as the year progressed, the selloff in TIPS was greater than I was willing to digest. I rebalanced out of TIPS into three assets – short-term T-Bills, short duration high yield credit funds, and US Equities.
I didn’t expect the bond market to be as volatile and lost for anchors. When “portfolio hedges” trade this poorly, I realize I stretched myself too far. I am okay with nominal losses on stocks but don’t have the same sympathy for bonds. It’s something I need to think about more and fine-tune my expectations for the future.”
I pointed out that while we don’t know if Berkshire Hathaway bought bonds in the fourth quarter of 2023, we do know that he had $160 Billion of Treasury Bills at the end of September. Maybe if it’s good enough for Mr. Buffett, it’s good enough for me to be in short maturity fixed income instruments.
W’s two tools for asset allocators: Patience and Anchors
At this point, W reminds me of the two important tools that a long-only asset allocator must recognize and sometimes use to their advantage.
“First, as you have learnt,” points out W, “Long only investing means living through volatility because you never know when or where the positive returns are going to come. We only know the portfolio works over long periods. The smartest people fight over the short-term movements and their track records year to year are highly questionable.”
“Second, it’s important to have anchors. That is, we need to know when an asset class is irrationally cheap and when it is irrationally expensive. One percent yields on 30-year US government bonds in 2020-2021 was wrong. You were not supposed to hold bonds then. The journey from 1% to 5% might not be trivial, which was the challenge this time around. You need to use those anchors to shape allocations.
It’s not clear that most passive, long-only investors have these anchors. If you know you are not good with anchors, then you must live through the volatility. There is no other answer.”
In some ways, we have solved our way back to MO’s 40 years of investing wisdom. Live with the volatility.
International equity weights and performance deficits
W himself has experienced a different kind of investment challenge. While he avoided bonds all through the turmoil and was thoughtfully invested in stocks and T-bills, increasing his stock allocations in early October, he has been over-invested in international and emerging markets. Not having enough US equity exposure cost him a performance return in 2023.
I’ve now spent enough time with Charles B’s MFO Premium fund engine and talked to suave international fund managers like Andrew Foster, Lewis Kaufman, Amit Wadhwaney, and Rakesh Bordia to know that the Original Sin lies in believing what works in the US (with passive equity ETFs) works abroad. It does not.
“International and EM investing is done much better through active managers,” I propose, with great conviction. “Trillions of dollars are mistakenly invested in passive indices abroad.”
The passive indices internationally were built for liquidity, not performance. One big reason why international passive does not work is because there are fewer ways to hold corporate management accountable the way active investors do in the US.
The morass that most of Europe seems to be unable to get out of weighs down heavily on developed international. China has weighed down on EM. Skilled managers can traverse these lanes better than passive funds can.
There is a big behavioral finance dilemma here. After decades of trying to pick stock and find market-beating active managers in the US, investors realized it could not be done. The S&P 500 (or the US Total Stock Market) was beating almost all the managers. Investors learnt their lesson, withdrew money from active, and plowed into passive. They did this in the US and international markets. However, the data never supported that passive investing worked outside the US. Solid active fund managers are beating the passive benchmarks outside the US, and doing this year after year, leaving passive investors abroad with a performance deficit.
As we cross the tennis courts and approach Central Park West, we have about half a mile remaining. The last half mile is about the US equity markets. This is supposed to be the happy part of the walk, where we share how thankful we are for being US equity investors. We are both beneficiaries of having investible savings, knowing how to invest, investing those proceeds in US equities, and watching the tree grow. The idea that the bond market might turn the page and be more benign going forward adds to the scent of pinecones on the ground.
Nervous concerns about the state of the markets
But I have concerns and I must share them with a sympathetic friend.
I worry that we have reached an era where the financial investor swings too violently from narrative to narrative, that common sense as a weapon alone is too blunt for today’s markets, and while the VIX is at the ground floor level, the level of volatility of asset portfolios has increased tremendously from year to year.
“Think about crypto. We know it lives on faith alone. And I am bewildered to find so many smart people running crypto schemes. Why? Think about the greenwashing, where ESG became so important that everyone needed to be a friend of ESG. And then when ESG went out of fashion, they couldn’t wait to un-friend ESG. How is humanity moving so quickly, and so greatly in magnitude from one narrative to the opposite of that narrative? Why do I need to adjust myself to that narrative each time? And if I don’t, am I dumb? Or am I dumb if I follow every side of every narrative?”
I realize I am venting. But I need to be honest that this is not easy. I cannot always stretch my imagination to fit whatever narrative is being flung at me.
“The easiest answer,” suggests W, “is what we already know. Stick to the passive index ETFs and live with the boring. You don’t need to have more than 8-10% portfolio returns a year unless you want to fly to Mars or buy a social media company.”
My solution: Increase Berkshire Hathaway holdings
I offer my humble solution to the puzzle.
Indexing is fine, but with every day that goes by, I find myself increasing my portfolio weights in Berkshire Hathaway. Knowing my tendencies, I am probably too early. In any case, Berkshire offers a world-class portfolio of public and private businesses, common sense investing, low leverage, confidence to ignore the bullshit market trends of the season, a ton of cash that might be helpful in a stock-market crash, no fees, no dividends, no distributions, largest shareholder’s equity of any American company, and a bench of managers and Board Directors that are invested in keeping Berkshire working for its shareholders. At close to 1.35x the estimated Price to the Book Value of the company, this does not seem like a very expensive price to pay for common sense.
In a world that on some days feels like it has gone nuts, I like the warmth of the Berkshire Hathaway blanket. I don’t need to become wealthy fast. I need to know my money is in good hands.
As the year has officially ended, W and I have had a chance to look at and compare our portfolio returns for the year. We have simultaneously realized that long-term, passive investing, is not a natural forte of Wall Streeters with professional training in tactical investments. We are better at protecting our investments in down markets, avoiding the tail risk. We are not as good at the blind faith demanded by asset allocation. My mother used to tell me, “The day starts when the eyes open.”
We have come a long way on this path to becoming better personal investors and maybe one day our eyes will be fully open to seeing the magic and beauty in “boring, boring, boring”.