2015 – 2nd Quarter Letter – Risk Part I: A Multi Chapter Soliloquy
July 16, 2015
This letter will be as close to a mini-series as anything we have ever written. Assessing risk tolerances, dealing with client emotions and dialing in appropriate asset allocations is something we spend a lot of time on at P&A. We have learned all of our lessons the hard way and are fully aware that there is no graduation day. Risk is a relative thing; the same unknown can make one man giddy and another fearful. Good investors find a way of measuring their risk tolerance and in turn their ability to hold investments long term, which in our minds is the only term.
We have seen a number of mathematical approaches to evaluating risk, and most work to a degree. Surveys and questionnaires have experienced a degree of popularity; they deliver some success as well. Financial planning will direct us toward an asset allocation but the concept doesn’t specifically address risk. Client profiles are very important and their reactions to market events are really telling. Unfortunately, people often have a habit of telling you what you want to hear or answering questions the way they think they’re supposed to. Over the years, we have noticed that something is missing in these approaches….the advisor. Who we are and how we behave makes a difference.
So I started writing this letter about risk and thought it would be a good idea to offer our clients an account of how and why we look at things the way we do. The story quickly became autobiographical, which I considered a mistake at the outset. It is my preference to speak in first person plural because I am so proud of the team we have assembled at P&A. Unfortunately the story just didn’t flow very well that way. So I went back to the autobiographical approach and decided to include Dan for seasoning along the way. His career and mine have been as parallel as railroad tracks so that approach has always been easy.
That still didn’t work. There was way too much to say and too many voices needed to be heard. I abbreviated the letter and changed it to a nuts and bolts approach to risk and sent it off to Jon for his review (Jon was a 4.0 student, is grammatically correct, and was a 5th grade spelling bee champion.) Unfortunately I sent him the autobiographical stuff as well. He liked both letters and encouraged me to write a white paper. I don’t know how this will end up but I do know that risk is a very big subject and is key to investor success. If we can accurately assess the rick tolerance of a client, recommend an appropriate asset allocation, and keep them invested long term…..they will be happy for life. Some will earn 7% while others earn 9%, but everyone will be happy. Being happy is a good thing.
This epistle will have multiple parts. The letter you are reading will be Part I and it may remind you of Tom Sawyer and Huck Finn. Part II has already been written and I will be surprised if there isn’t a Part III. I also expect Parts I and II to be edited when my partners see they have something to add. Don’t read this and then tell me I didn’t do a good job of growing up. I did the best I could and continue to represent a work in progress.
As a kid….
My father and his brothers were children of the Depression, all three were very bright. Dad was blessed with a great personality and made a career out of dealing with people. He hailed from the Sandhills region of Nebraska and knew financial hardship firsthand. His father had nine siblings and the family went bust a number of times through no fault of their own….just hard times during the Dust Bowl. Mom grew up quite a bit better off in Omaha. Dad and his brothers went to war, put themselves through the university, and were the first college graduates in their family. Mom went to Frances Shimer College in Mt. Carroll, Illinois. She returned to Omaha after school and went to work for the CIA….sounds like she was in a steno pool but I wish I knew more about that.
My siblings and I were solid middle class baby boomers. We were taught to work and save, and everyone in the family had a job. My folks said I could have anything I wanted….all I had to do was earn it. Naturally, the WWII generation was much more conservative than the rock and roll baby boomers they spawned. You can’t choose your parents but looking back I probably hit a home run in that category.
I didn’t know it as a youth, but my parents peer group would eventually be my primary client base. However, they wouldn’t all know my family and they weren’t going to look to me for serious advice until I earned their trust. That meant I would have to outwork and outhustle the competition in order to win a spot at the table.
High school and college….
I loved working, and from paper route on, always held down multiple part-time jobs. I was fired once and it left a bad taste in my mouth. The reasons were political and I got out maneuvered by another kid that was happy to stretch the truth. I promised myself that would never happen again. We were a family of savers and in 1965 I paid $225 for a 1954 Ford. It was my pride and joy but my budget was $200 and I couldn’t sleep for a week. The insurance, gas, and upkeep ate me alive….almost $400 a year. At $1.00 an hour, I learned the value of a buck very quickly.
College was even more expensive. I was highly social and as a result needed to be very hardworking. Somehow I got a promotion at Whitehead Oil Co., my daytime job, and my wages jumped to $1.25 (they might have raised the minimum wage.) I worked nights in the company gas stations where I asked my boss, Charlie Perdew, for incentive pay. It wasn’t much, but it made me hustle. The cause and effect that I learned probably shaped my future…..I sold oil changes, tires, batteries, and accessories… anything I could to make a buck and keep gas in my tank.
High school wasn’t too tough but college was a good test. I was a B-/C+ student but math was one of my long suits. During my sophomore year I caught a statistics class, the study of collecting, analyzing, interpreting, and organizing data. That probably sounds boring, and it was, but I liked it. Somehow I got a “B” and expected to be done with the subject forever.
In Finance 101 we calculated lots of metrics and eventually learned to quantify risk over a period of years. The average return (or mean) was a pretty simple concept that was learned in high school. Standard deviation was more complicated and to this day I still don’t understand a statistician’s love for it. You start with a set of annual returns over a long period of time….we’ll use 50 years. Each of these returns is spread across a normal distribution which is also called a bell curve. The middle or peak of a normal distribution represents the most frequently repeated number in the array and is also the arithmetic average (mean). Each side of the curve slopes away from the mean toward the least frequently repeated numbers. On one side of the mean returns increase in value and the other side they decrease in value. The numbers that fall between +/- 34.1% of the mean represent one standard deviation.
The next +/- 13.6% either way from the mean represents a second standard deviation which seems to be of little utility. The third standard deviation is +/- 2.1% and as far as I can tell is completely meaningless. I have no idea who came up with these percentages but they have developed quite a following and all the heavy thinkers really get off on them. You’ve probably seen a bell curve before, it looks like this:
If we use the annual returns generated by the S&P 500 over the last 50 years as our universe, a normal distribution would reveal the mean return to be 9.41%. Likewise, one standard deviation of these returns would fall between +/- 17.14% of the mean. Although the industry writes “past performance does not guarantee future results” as a disclaimer on all performance reports printed, the impact of these numbers invariably produces the opposite conclusion. Our normal distribution tells us that over a 50-year period, the S&P 500 has produced returns that fall between -7.74% and +26.55, 64.2% of the time. The statistician’s conclusion is almost inescapable, if you choose to invest in a large cap diversified portfolio for the next 50 years, this is probably what you are going to get.
This was my first exposure to quantifying risk. In the eyes of a statistician, volatility was risk. I rejected that concept as being an oversimplification. No one asked my opinion and other than being knowledge required to pass a test, it had little impact on my negative net worth at the time. So I pass the test and stuffed standard deviation in an unemployed brain cell for future use. During the several years that I spent learning these concepts, I borrowed money to buy a newer car, paid higher insurance premiums, and watched the price of gas soar. I moved into an apartment and the world was my oyster. My exposure to risk continued.
A serindipitous event occurred during my junior year. College campuses were in revolt against the Vietnam War and politicians decided to flip all draft eligibles a bone by lowering the drinking age. That was the genesis of my table-waiting and bartending career. I caught on at a downtown bar where people tipped (I was bright enough not to work at a college bar)….more hustle equaled more cash. I could now finance my lifestyle seven days a week instead of just five…nirvana.
Then a banker….
The University spit me out in four years and I exercised my wanderlust. Six weeks in Hawaii, flat broke, and then back to driving the truck at Whitehead Oil Co. Dad wasn’t too keen on my act and wanted to see a better return on his tuition investment. So I hit the interview circuit. The First National Bank offered me a job in their investment division selling municipal bonds….I was almost giddy with excitement. No diesel fuel, A/C in the summer, heat in the winter, and you got to with women…there were girls everywhere. I really didn’t know what a municipal bond was but figured I would learn. My mom bought me three new suits and the counterculture lost a player.
Even more sobering was Uncle Sam’s unscheduled insistence that I attend Transportation Officer Basic Training in Newport News, Virginia. I was operating under the assumption that this obligation had been dismissed and it hadn’t. Pitt and Elvis both had to do their time. In my case it turned out to be pretty brief, less than six months.
Meanwhile, back at the bank. In the 1970s, the Glass-Steagall Act prohibited banks from selling stocks, corporate bonds, revenue bonds, or anything remotely esoteric. At FNB we got pretty good at selling general obligation munis, Treasury bonds and federal agencies. The banks populating our correspondent network were our primary clients. I was the new kid on the block and my job was to develop new clients. I taped my phone to my wrist and ran up a long distance bill. No one else wanted my job because along with it came being the investment department contact with the computer division. I was also numero uno when it came to servicing the walk-in trade.
Individual investors came into our office wearing bib overalls, golf shirts, and cowboy boots….whatever suited their fancy. They weren’t the banker types that the other guys were used to talking with, but they had more money. I liked talking to them because they said things like “good morning,” “please,” and “thank you.” I didn’t know it at the time but in those days the individual investor was woefully underserved. Some of those people are still my clients.
The computer division was a math-based, geek-oriented, puzzle palace. My coworkers made fun of these guys and wanted nothing to do with them. Do I need to tell you how important a background in my industry this would become? I learned a little about programing and even more about people. I would bounce off these guys for years to come; they were an invaluable asset and some even became clients!
I loved my job at the bank. Learning how to build portfolios, fund liquidity needs, underwrite, trade, sell….it was a gas. Selling was an art form, while the other skillsets were pretty disciplined. Individual investors added bonds to their portfolios like a string of ponies, yield came first with liquidity a distant second. The institutions wanted laddered or dumbbell portfolios. The bonds we sold were short term and bullet proof, virtually all price changes were a function of maturity and interest rates….no credit issues. Since we couldn’t control the yield curve, risk became maturity.
The first five years (10,000 hours for Malcolm Gladwell fans) of my career were freed from equities, options, sales quotas, and the like. I was able to grow at my own pace and learn about people. Dan had it better. He spent 10 years at the National Bank of Commerce before we joined forces.
I threw myself headlong into a world of present value, duration, binary code, and customer satisfaction. My hourly wages became a salary, student loans got paid off, and in 1974, I invested in a new government program called the IRA. That same year I bought a townhouse, which seemed like a better deal that paying rent. My first mortgage rate was 9.75%. In 1975, Julie and I tied the knot. When we pooled our assets and liabilities I discovered a car loan. Much to my wife’s chagrin, the silver Mustang bit the dust…..she’s still mad about it. Enter a used Volkswagen and life was a bowl of cherries. Dean Witter came calling at the end of the year and I was soon selling stocks, bonds, options, futures….the whole enchilada.
Next a stockbroker….
This was a big change. Bye-bye salary, hello commission. Stockbrokers were not held in the same regard as bankers so mom and dad weren’t very keen on the change…no new suits this time. My in-laws didn’t understand it and my lovely wife didn’t like the idea of relocating to Omaha….or anywhere for that matter. Dean Witter decided to open a new office in Lincoln and all the brush fires burnt to embers. Volatility became risk again and equities were no longer academic…they would become a part of my life for the duration. I soon found out that stocks could do anything bonds could do, only better.
Slowly but surely a career path was emerging. Most of my clients were institutions and they stuck with me through the job change, which made me feel pretty good. Actually, my increased arsenal of products allowed my client list to grow significantly. Many of my institutional contacts actually became individual clients. The bank presidents and insurance execs were successful, but few really understood the securities industry. Fewer yet knew brokers they could trust. The institutional relationships I had developed transferred easily to their personal affairs. Most of them were happy to introduce me to friends and family members. A stockbroker without a rap sheet was a pretty rare event in those days. These people were long term investors and wanted help without being on someone’s fly rod.
By 1979 interest rates had blown through the double-digit barrier and I was doing bond swaps hand over fist. This was pretty esoteric stuff. The client would sell bonds that had dropped in value due to the rise in interest rates and buy replacements that were substantially identical. It required a lot of teamwork, broker and client had to be on the same page. The paperwork and math was monumental, and I was running Dean Witter out of yellow legal pads.
During the spring of that year I was contacted by a family friend. He was a nuclear physicist by trade and was in search of some fixed income pricing formulas. A common acquaintance told him I might have them….and I did. He was appreciative of the formulas and called a couple of days later to return the favor, a demo of his new Apple II computer. My FNB computer division training kicked in and I accepted the offer. I bought my first computer on my way home from work that night.
Julie thought I was nuts and knew the little beast had no place in her future. The Apple II solved problems I didn’t even know I had. Bond swaps, equity analysis, financial planning, portfolio management, contact resource management, and believe it or not….quantifying risk with normal distributions and standard deviations. Business was great. I ate my own cooking and bought muni bonds just like my customers. High rates persisted and I became confident that nothing short of an unbridled bond rally would stymie my bond swap machine. That happened in 1982.
The sound of children’s feet started at our house in 1978 and it became home, church, and work for me until the mid-1980s. All of us remember those early parenting years as a blissful blur. There were few opportunities to spend money so the savings machine was working well at our house. By 1985 I could tell I needed more education if I was going to fulfill customer expectations as well as my own. Lots of these guys had portfolios that rivaled my institutional customers. It was the same year Dan left NBC and joined me at Dean Witter, what a plus that was. He worked as hard as I did and we made a great team. I chose to pursue the Certified Financial Planner certification and out came the school books. I finished up in 1988 and haven’t regretted a minute of it.
Dean Witter dialed my education up another notch in 1989 when they invited me to attend the Dean Witter Wharton Account Executive Institute. This should not be confused with the rigors of an MBA program. It was a relaxed learning environment led by University of Pennsylvania professors who were outstanding in their areas of expertise. I thrived and graduated in 1991.
At the same time, University of Chicago professors Harry Max Markowitz and William F. Sharpe started raking in Nobel Prizes for economics. Markowitz developed the mean-variance portfolio model which is based on expected returns and standard deviation (like others, his surrogate for risk). Glad I went to school.
The Markowitz basic model employed seven assumptions. I’m sure I have reviewed them a hundred times over the years and have yet to have them mentioned by any of my peers. Pay attention, the guy won a Nobel Prize in economics:
- Risk is volatility.
- Investors are risk averse.
- Investors prefer to increase consumption (the final purchase of goods and services).
- Investor’s utility function (consumption ranking) is concave and increasing due to #2 & #3.
- Analysis is based on a single period model of investment.
- An investor will maximize his return for a given level of risk or maximize his return for a minimum level of risk.
- The investor is rational in nature.
Taking these apart is pretty entertaining. We’ll circle back to them in Part II as we make our conclusions.
My brokerage years were great fun. Dean Witter’s platform of products was very esoteric and I learned a lot about investing money. They were a highly ethical firm and I was always proud to represent them. Once again, Dan was a terrific partner and in our case one plus one made three. We didn’t know what was ahead for us but we used this period to expand our educations and soak up experiences. They say all good things must end and I guess our tenure at Dean Witter was no exception. We grew weary of the traditional brokerage model, its conflicts of interest, sales emphasis, and lack of transparency.
Now an Investment Advisor….
In June 1995, Pittenger & Anderson was born. As a fee-only advisor, we eliminated conflicts of interest and promised in writing to always put our client interests first. Our business model was completely transparent and we accepted the responsibility of being a fiduciary. During our last few months at Dean Witter, the plans for our new business were kept private. All the prep work for the firm was done afterhours and the help of a few close friends was enlisted. I kept thinking that once my peers saw the value added in our new business plan there would be a rush to mimic us. The silence was deafening.
By now my personal life was just as complex as my business career, both have been a hoot. My children survived their teenage years, graduated from college, married, and have produced seven grands…. pretty prolific for two kids. Dan and I have partnered through six bull markets and five bears. He tells me he can’t do another roundtrip but I know he’s got a couple left in him. The bond rally that started back in 1982 still has legs. People continue to tell us we are good at fixed income, but I must admit my true love has become equities.
We flight-planned this business for managing assets of $75 million and reached $300 million in our third year. The tech bubble bursting at the turn of the century taught us some real lessons about risk, volatility, and how to manage money. We underperformed and quickly changed our style. In 2007 the mortgage bubble burst and this time we tracked the market…..that was an improvement. We thought we would have earned a better reward but also knew that the volatility was probably a blessing in disguise. Knowing it was our job to take advantage of market inefficiencies as they occur, we never let go of the handlebars. We leaned into the wind managing our asset allocations, doing tax swaps, buying the munis that Meredith Whitney convinced Wall Street to sell, and made a concerted effort to connect with our clients on a regular schedule. It worked.
From now until retirement….
As you have probably figured out, Part I of this essay deals with personal history and a plethora of risks:
interest rate risks, inflation risk, political risk, media risk, communication risk, family risk, unpredictable risk, employer risk, tax risk, bureaucratic risk, health risk, self-employment risk, and of course the ever popular, volatility risk. Statisticians and academics would have us believe that all risks are reflected in price. They might be for institutions, but they aren’t for individuals. An efficient market that reflects all inputs is one of the core tenants of modern portfolio theory. We get it, we just can’t quite buy into it for all clients. It has been our experience that individual clients suffer from more than simple volatility risk and we will explore that in Part II.
Hard to say what the future holds but I love my job, our clients, and the people I get to work with. It is my intention to participate as an active member of P&A as long as they will have me. My life and yours probably have some parallels. If you think of any risks we haven’t mentioned, give us a call. The more we know about you, the more we can help. The more we know about each other, the easier it will be to collaborate. Part II of this dialogue will appear in one of our monthly email blasts, or perhaps in next quarter’s letter….don’t quite know yet. We probably won’t draw any conclusions until next quarter or perhaps the one after that. In the end we hope to develop a tool which will help our clients deal with the subject of risk. Stay tuned, we have wanted to do this for a long time.
Warren Buffett has said, “I buy on the assumption that they could close the market the next day and not reopen it for five years.” Warren briefly had his wish on July 8th when the New York Stock Exchange halted all trading for four hours due to a technical glitch. Granted, trading still occurred on other exchanges and the overall impact was felt much more by traders than investors, but it sure made for a lot of news coverage and conspiracy theories. After all, in today’s world of major hack attacks and cyberwarfare, anything’s possible. Jokes went around on social media asking if the NYSE had tried shutting off their computers and turning them back on (the dreaded reboot we’ve all been told by IT support). Speaking of social media, the P&A Twitter account now has nearly 300 followers. If you tweet, or follow those who do, give @pittand a follow.
We continue to “like” stocks, fully aware this represents our least enthusiastic position when it comes to equities. Relative to bonds, stocks continue to be preferable. Frankly, we’d rather own a dividend-paying stock yielding 2.5% than a 10-year U.S. Treasury yielding roughly the same. Markets have now endured the beginnings of a third bailout for Greece, the seemingly eternal threat of higher interest rates, China’s stock market wobbles, a strong dollar…in other words, a lot of cross currents. Stocks have been climbing a wall of worry since March 2009 and have survived the punditry’s constant calls for a bear market all along the way. We think Warren Buffett was on to something: it pays to ignore the noise. Stocks will fluctuate, but the long term trend has been decidedly higher. At some point there will be another bear market. Anyone who has paid attention to history knows that bulls are followed by bears, which are followed by bulls again.
On June 30th, Pittenger & Anderson celebrated our 20th anniversary. We observed the milestone the same way as when our assets under management crossed the $1 billion mark in late 2014…by continuing to work. If you haven’t heard, we’re expanding our office footprint by another 800 square feet. Those clients who’ve stopped by the office or called in have most likely noticed the dust, black tarps, and loud noises emanating from P&A. We mention this because it’s our plan to have an open house sometime this fall to belatedly celebrate our firm’s birthday and the shared success we’ve enjoyed with you, our clients. Expect more on that once the construction activities come to a halt.
James S. Pittenger, Jr, Dan Anderson