2015 – 3rd Quarter Letter – Risk Part II: A Multi Chapter Soliloquy
October 21, 2015
This has turned out to be a pretty good time to launch a discussion on risk. Since the date of our last letter the market has offered us some pretty good volatility:
|July 16, 2015||DJIA 18,120.25|
|S&P 500 2,124.29|
|August 25, 2015||DJIA 15,666.44||-13.55%||from July 16, 2015|
|S&P 500 1,867.61||-12.09%||from July 16, 2015|
|October 19, 2015||DJIA 17,209.43||10.99%||from Aug 25, 2015|
|S&P 500 2,028.51||10.86%||from Aug 25, 2015|
Interestingly enough, volatility has a host of varieties and definitions. It can be historical, implied, current, Gaussian random walk, or Wiener process. Many think volatility is risk and we think it’s opportunity. These recent swings, while contained, are unsustainable when annualized….. 13% per month is 156% per year. 11% per month is 132% per year….in either case an unsustainable rate of change. Not concerned? You must be a P&A client.
Webster, Merriman, Funk & Wagnalls…..
Let’s define our subject. As a noun, the definition of risk is exposure to the chance of injury or loss. As a verb, the same word is defined as exposing oneself to the chance of injury or loss. So as a noun, risk is involuntary, while as a verb it is voluntary. Involuntary risks are difficult to control. They include lightning strikes, tsunamis, tornadoes, floods and other acts of God. Voluntary risks include card games, riding motorcycles, buying stocks, climbing a mountain…. that kind of stuff. In virtually all cases, the participant expects some kind of positive reward for taking a voluntary risk. By their nature, involuntary risks tend to occur in harsh environments, voluntary risks not so much.
Risk creates both negative and positive emotions. The positives are welcome and bring smiles to our faces. The negatives disrupt timetables, create much hand wringing and gnashing of teeth. Frowns if you will. Both positive and negative emotions distract from good decision making. Wall Street has traditionally equated financial risk to volatility and defined it as standard deviation. P&A uses the full range of a set of returns when calculating fishhook curves or an efficient frontier. Statisticians understand standard deviation, while clients understand realized events. Regardless of the approach, it has been our experience that mathematics is not a comforting language when trying to evaluate risk.
Could it be that risk is inherent? Involuntary risks certainly are. I guess we would like to think we have some control over voluntary risks. Interestingly enough, most believe that assuming some voluntary risk is necessary in order to offset the involuntary stuff…..probably so. Saving for retirement is in itself a rather benign act. I always tell people, “If you save something, you’ll have something. If you don’t, you won’t.” That being said, the saver still needs to decide which investment classes to use……the introduction of voluntary risk.
Wall Street would like you to believe that risk is both volatility and quantifiable. To that end they have engineered a host of products that are designed to generate non-correlated returns. The idea is that by mixing these products with conventional stocks and bonds, a degree of volatility can be eliminated from the portfolio. These products are not cheap. If delivered in a mutual fund format they carry a 1.00-1.50% management fee. More typically, they are marketed as hedge funds or limited partnerships that charge a 2% management fee and want 20% of the gains. Few of these products deal with investment grade securities, most are high yield, illiquid, fallen angel types. They may or may not generate non-correlated returns but they will add investment risk (voluntary). We consider most of the folks marketing these products to be false prophets.
Markets are subject to systematic risks, credit risk, foreign exchange risk, interest rate risk and the ever popular event risk. Individuals have similar issues. Like it or not we are subject to relationship risk, liability risk, financial risk, health risk, employment risk, and environmental risk. Some of these risks are involuntary and some are voluntary. We insure against these risks when it is financially attractive to do so. Those that we can’t insure against we try to understand, prevent, or accept.
We have interviewed investors who elect to try slaying all these dragons by themselves. We wish them luck, tell them how we would approach the issues and encourage them to call if they need more help. We believe the preferable method for an investor to deal with these risks is to collaborate with a trusted advisor. In order to generate an environment of trust, that advisor will have to have a fee only, transparent business plan that eliminates conflicts of interest. Since an advisor hunt usually starts with fees and performance, enough energy must be reserved to properly vet the business plan. In our business the advisor cannot escape inferior business plans without a critical mass of assets under management and a loyal clientele. A bad plan makes doing business a torture while the good ones deliver success left handed.
During the early ‘60s I started mowing lawns…. lining up about five or six each summer. A buddy and I actually formed a business and had cards printed…..Pitt & Witt Enterprises – no job too large or small. Witt split after about three weeks in favor of driving an ice cream truck. That was a bummer but turned into a bonus pretty quickly. We bid all our jobs at a flat fee, so the faster I worked the more I earned per hour. After I got paid a few times I bought some extra grass bags for my Toro. I could mow, switch bags, mow, switch bags and spend less time running to the trash can. I didn’t know it, but this was my first use of technology to leverage my time. I’m sure Steve Jobs was jealous. This was a good business plan.
Through high school and college I worked for wages but tried to expose myself to incentive comp. I drove a truck and kept books for Whitehead Oil Company and Bus was my boss. He paid me minimum wage and said I didn’t need any more than that. I stole some of his cigars and watched football games on Saturday afternoons. At night I worked in the gas stations and negotiated an incentive on oil changes, grease jobs and tires. Since he was able to sell my services to his customers at a higher price, it was a good business plan for Bus… but not me.
Tips in bars and restaurants were about as close as I could get to incentive comp in those days. At one of the restaurants the waiters bought their drinks from the bar and food from the kitchen. Both were then “supposed” to be sold to our customers for the same price. This system incented the waiters to discount the kitchen and over charge at the table. The plan had lots of conflicts and wasn’t good for anyone…..customer, employer or employee. I wasn’t very good in that environment and for some reason the other waiters made more money than I did. It was a bad business plan and the joint is now a tuxedo shop.
The bank was my first career position and it introduced me to a salary instead of hourly wages. First year employees made “X”, second year “X+1”, third year “X+2”….you get it. Not much in the way of incentive comp. There wasn’t a whole lot of hustle. I did, however, find opportunities to expand my horizons and improve my utility as an employee. As discussed in Part I, the computer and the retail client exposure I gained paid huge dividends going forward.
The bank also introduced me to regulatory restrictions that actually stifled that phase of my career. As a lending institution their product list was limited by the Glass-Steagall Act to municipal bonds, federal agencies and US government bonds. I didn’t know it at the time but I was selling from an empty wagon. A good business plan should triumph over regulatory issues, this one did not. That being said, the main driver in causing me to leave the bank in late ’75 was boredom…..I just didn’t have enough to do. Bad business plan says me. I left and all the “X+3’s” stayed.
Dean Witter solved the boredom problem very quickly. However, they added some issues that set me back in a surprising manner. The bank paid me as little as they could while trying to keep me loyal and long term (don’t get me wrong, I did enjoy working at the bank). Dean Witter paid me more than I was worth in an effort to keep me focused on selling…. instead of serving my clients best interests. Neither business plan was completely nefarious, but both advanced the employers interests first. So, this was a new set of challenges. It was my ethical compass against the corporate force fields.
My client vision has already been pretty clear….if their interests didn’t come first, second and third, I was not going to be successful. Dean Witter was a good broker but not a great public or corporate finance house. We didn’t have an exclusive on anything. I had to serve the client better than the competition or lose my place at the table. My compensation was transactional; I got paid when my clients bought and sold securities. I got nothing when I counseled them to stand pat. In either case, I owned the decision. The research required to come to either decision was exactly the same. Equal pay for equal work is not one of the hallmarks of the transactional model. By its nature, this model encouraged brokers to sell first and ask questions later.
Nonetheless, I found great success by aligning my interests with the client. That being said, the potential for a conflict of interest was always present. However, there was really no other business plan available in the ‘70’s and ‘80’s and my career path was pretty well set. I liked what I was doing.
Dean Witter was a good 20 year fit. Dan joined me in 1985 and the synergies were great. We had a ball putting together portfolios, underwriting bond issues, trading the local credits and making a lot of money for our clients. All the profit centers at Dean Witter generated their own income statement. It was reported to the head of each division on a form called a strip. OTC stocks, muni bonds, preferred stock, corporate bonds….all these guys had strips. Compliance, accounting and margins didn’t have a strip. Money went through that company like berries through a goose. Dean Witter’s business plan was sales oriented and very bad.
As the early ‘90’s dawned I could see that technology was going to take its toll on traditional brokers. Commissions shrank, spreads tightened and transparency improved….pretty much a death knell. In those days the typical brokerage client generated annual fees of about 1.50%…..usually without knowing about it. Dan and I controlled a significant number of assets under management and always had management on our case about “under” producing. We blew them off. During that period we were covering a couple of Registered Investment Advisors and I liked their business plan. In January of 1993 I made a full investigation of it and really wanted to start my own version.
There was one major fly in the ointment. Dean Witter served as our custodian as well as broker dealer for our clients. Custodians aren’t very dynamic; they hold securities, collect dividends, account for splits and execute re-org events. They also generate an audited appraisal of holdings every month. You had to have one, just ask Bernie Madoff’s clients. In the 1993 RIA model, clients paid commissions of about 0.25%. The RIA’s management fee was around 1% and custodians charged a whopping 2% (Firstier Bank, NBC, Norwest, etc.) Way too much for their job description. That created an expense ratio of ~3.25%, which did not compete well with the traditional brokerage model.
My hopes were dashed and I returned my efforts to the brokerage business. During the fall of 1994 I was reading an industry periodical and noticed that Charles Schwab had decided to start courting RIAs. Their offer was compelling. In exchange for the opportunity to execute our brokerage transactions they would be willing to provide discounted commissions and free custodial services. Those services included an internet download of all daily transactions. The 3.25% RIA model dropped to ~ 1% overnight.
I was giddy with excitement. P&A was born on 6/30/95 and we have yet to look back. Our business was flight planned to attract $75 million in assets under management by 6/30/96. As I recall we crossed that date at $100 million and amassed $300 million by 6/30/98. On a national scale, RIAs were the fastest growing segment of the financial services industry and we were keeping up. Locally it was hard to find a comparison and we were distracted by that. When we opened the doors we thought an avalanche of competitors would follow…..the silence was deafening. None of our peers were tempted by this business plan. We are grateful for their foresight.
I liked this business plan because I thought it was fair. As mentioned earlier, the traditional brokerage model cost our customers about 1.50% and served three parties: Dean Witter, the client and Pitt. We reduced the client fee to 1%, shouldered the cost of the operating expenses, eliminated Dean Witter and kept the rest for ourselves. Pitt and the Client thought this was a pretty good deal…..two out of three ain’t bad.
So let’s recap our discussion a bit. Wall Street likes to quantify everything and describes portfolio risk as volatility. Their mainstream calculation is the standard deviation of a set of returns. Nobel Prize winners agree with this approach and believe that investors are rational. They will want to maximize their returns for a given level of risk or maximize their return for a minimum level of risk. It would seem like these factoids should make an advisors job pretty easy. Apparently all we have to do to assess risk tolerance is to ask prospective clients what threshold level of standard deviation they are willing to accept. Unfortunately my experience tells me that the conversation tends to drag at that point.
It is P&A’s contention that involuntary risk is a given. Geo-political stuff, tsunamis and hurricanes are good examples. It is an imperfect world and when these things happen they are going to deliver stress. Some voluntary risks tend to be inescapable as well. Those that we don’t willingly add, we accept, knowing they have the potential to be mischief makers from the outset. For our typical client there will be little relief generated by math, economics and technical analysis. Dan and I have spent hours, days and weeks trying to explain the mysteries of the market to clients using quantitative techniques. As observed by my grandfather, “you’re trying to teach a pig to sing……it’s a waste of time and you’re annoying the pig!”
During the first few years of P&A life we sat down and asked ourselves who are we and why we do we exist? What was different about us? How did we intend to deliver value to our clients? As the answers became clear, we included them in our contract and delivered it to our clients: P&A is a Registered Investment Advisor offering investment advice and financial planning. We hold ourselves out as a fiduciary, occupying a position of trust and always putting our Clients interests first.
These simple words and our fully transparent approach have created a highly collaborative/partnership relationship with our Clients. Since there are no sales encounters, hidden agendas or self-serving motives, both advisor and client have a mutual interest in communication that grows the Clients net worth. Trial and error has told us that this is a good business plan.
Our resolution of risk might be a disappointment to some. Generally speaking, people like to see complicated answers to big problems. Our remedy is pretty simple. Risk is like water in your basement. You either let it in and deal with it or keep it out. Ground water and the pressure it develops is truly a force of nature….virtually impossible to keep out of a basement when it wants in. Best let it come in then deal with it. In our opinion risk has a lot of the same characteristics. Financially engineered products and leveraged portfolios will work to offset volatility from time to time, but over the long term (the only term) they are no match for common stocks and investment grade bonds.
Both risk and volatility generate stress. Investors will not decrease stress until they understand where risk and volatility come from. We are of the opinion that one of the greatest risks the individual investor can accept is working without a business plan. The second greatest risk may be working with what you know to be a bad business plan. Even if you prefer to manage your own portfolio, you need a plan.
We think your best defense against risk and the stress it produces is an RIA with an easy to understand business plan. Our Form ADV is now 26 pages long. It used to be 14 pages until the SEC streamlined it (thank you note in the mail.) Since P&A is completely transparent, we can explain ourselves pretty quickly. If you are shopping for an advisor or just curious, count the number of pages in a competitor’s Form ADV. If they number 50, 75 or 100….ask yourself why?.
When you hire an advisor, you hire his or her business plan….it is extremely important for people to know and understand that. My motivation for writing this letter was to make that point. A good plan will reduce risk amd stress. A bad plan will multiply it. Look for the following qualities in an RIA business plan.
- Compensation should be fee ONLY. Simple, straightforward and easy to understand.
- An RIA should be held to a fiduciary standard.
- The business plan should be fully transparent.
- Clients’ interests must be served first.
In addition, a good business plan will employ a contract, describe portfolio strategies, custodial arrangements, report frequencies, allow for termination and describe communication procedures. We throw in an investment policy statement for our clients to use in the event they don’t already have one. This document describes the type, grade and liquidity profile of securities employed by the RIA. All these items will have the net effect of reducing the risks and stress felt by the client during corrections, bear markets and short term disruptions. They will also help clients defend against bad decisions generated by greed. All of our clients have told us that they do not experience greed. It might be good for them to know that in the unlikely event any of them develop that emotion, the downside has already been addressed. All of this work focuses on helping the client hold investments long term, the only term.
The World According to Dan and Pitt
As all of you should know, several of our co-workers are now our fellow stock holders. In addition to Dan and I, Diane, Jon, Trey and Blake now own shares of P&A. Shane is about to join that club. We consider this good news for us and better news for you….the P&A business plan will continue to prevail with a well-developed succession plan.
Although our form is corporate, our style has always been partnership. It is now attempting to become democracy, an art form to say the least. I pioneered our LIKE, REALLY LIKE, LOVE system and don’t recall any internal grief about it. When the level of intensity needed changing I changed it. During a recent review meeting I informed my new partners that I thought we should go from LIKE to REALLY LIKE. Suddenly I felt like I’d just offered Susan B. Anthony a drink.
After some spirited debate, Trey suggested that this chore had been mine from the outset and perhaps it would be better if I just continued to own it. The rest quit arguing. So what you are getting is what you have always gotten….my market call. Don’t confuse it with a committee decision…..it is not now and never has been. Guess I’m the only one willing to put his neck in the noose for the privilege of pulling on the rope. The market action described at the outset of this letter has had the cleansing effect of moving stocks from weak hands to strong hands. As you know, I consider that a good thing. We have also had enough of a bounce to convince me that a bottom is in. Stocks will go higher.
Year end is approaching. Please work on your philanthropic projects and family gifts while keeping us in the loop. We have been harvesting losses to offset present and future gains. If you have taken real estate gains, sold a business, or generated any kind of income that we don’t know about….please keep us in the loop. What we don’t know can hurt you. If your income happens to be lower this year it may be a good idea to actually realize gains or release more money from your retirement accounts. We are not accountants but we are very familiar with these subjects and will be happy to work with your other advisors.
Last but not least, we were 20 years old on June 30th. We have also been remodeling for the last 6 months. We will be complete soon and want to celebrate and show off. You have been sent an invite to our open house which is on Thursday November 5, 2015. Please let us know if you can attend.
James S. Pittenger, Jr, Dan Anderson