News & Views

Notes on Morgan Housel’s The Psychology of Money

After reading a number of endorsements and receiving numerous recommendations to read Morgan Housel’s The Psychology of Money, I finally got around to checking it out. I found several concepts in the book important enough that I decided to take the time to write them down and share them.

Three big messages materialized, in my view:

1. Investing success frequently requires more time than many investors expect.
2. Many investors triumph despite being uncomfortable.
3. Practicing humility, checking your ego, and forgiving yourself tend to lead to better investment outcomes over the long term.

Drilling deeper on point #1: without sufficient time the wonders of compounding returns lack the duration necessary to overcome the inevitable interim periods of negative returns. To drive this point home Housel noted that of Warren Buffett’s $84.5 billion in wealth, $81.5 billion came after Buffett’s 65^th birthday! Of course achieving $3.0 billion of wealth in the first 65 years is nothing to scoff at, but seeing it multiplied over 28x in the next 25 years truly astounds.

Housel contends that success with money comes at a cost. Treating uncertainty, doubt and regret as fees to be paid rather than fines to be avoided represent to investors the costs of admission to success. Similarly, risk should be embraced as enduring it pays off over time. A key corollary of embracing risk, however: avoid ruinous risk as it prevents investors from being able to incur future risks that likely will pay off with time.

Humility, kindness, and compassion likely will garner investors the respect and admiration they seek much faster and more completely than will allowing ego to dictate investing decisions in search of newer and flashier material possessions. Housel defines savings as the difference between an investor’s ego and their wealth. Likely, investors will sleep better at night practicing self-forgiveness for their investing mistakes and avoiding the extremes of financial decisions that typically plague those looking for more stuff. Managing to avoid the excessive risks that frequently characterize ego-driven investing also likely better equips investors to avoid succumbing to the overly pessimistic storylines that force long-term investors out of winning positions.

While Housel employs the following example closer to the beginning of his book than to the end, it distills the importance of time, humility, and embracing risk. The families of Sue, Jim, and Tom invest $1 per month from 1900 to 2019. Sue’s family invests through thick and thin, feast and famine, dutifully plowing $1 per month into the U.S. stock market while staying fully invested regardless of the prevailing economic condition. Tom’s family is more milquetoast than Sue’s family, though, and only invests $1 per month when there’s no recession, sells six months after a recession sets in, and fails to re-invest and restart their $1 per month investing until six months after a recession ends. Meanwhile, Jim’s family is just flat-out risk averse and only invests $1 per month when times are good, sells everything and keeps their $1 per month in their pocket during recessions, and only goes all-in again and recommences their $1 per month investments once the economy moves beyond recession. While Sue’s family may test its intestinal fortitude remaining invested and continuing to save come hell or high-water, they end up with $435,551 by 2020 while Jim’s family had $257,386 and Tom’s family $234,476. Notably, all three families ended up relatively large winners as only 1,438 months exist between 1900 and 2019, but Sue outperforms Jim by 77.8% and Tom by 95.1%. All too much like the PTA raffle, investors pretty much must be present to win.

Emerging Market Debt and Junk Outperform Treasuries: What Gives?

Exchange traded funds (ETFs) holding emerging market debt denominated in local currencies (EMLC in the graph below) – Brazilian reals, Chilean pesos, etc. – generally outperformed US long-term Treasuries (TLT) since the beginning of the year. Despite raging inflationary pressures, Treasury Inflation-Protected Securities (TIP) relative performance stinks. Junk bond ETFs (SJNK) performances’ also generally outpaced US investment-grade corporate securities since the beginning of the year. “What’s the fixed income world coming to?” one might ask.

As usual, the devils reside in the details impacting these sectors of the fixed income markets. With respect to EMLC performance, the emerging market debt that trades in local currencies ETF, investment capital disproportionately flowed worldwide toward those economies that addressed inflationary pressures proactively: Brazil, Chile, and Mexico. Meanwhile, the US Fed’s inaction placed the domestic rate environment at a disadvantage vis-à-vis those more aggressive emerging markets governments.

Despite recent, 7% US inflation figures the TIP ETF declined 4.4% thus far in 2022. Differences in actual inflation and inflationary expectations largely explain this price decline. Investors commenced pricing expectations for higher domestic inflation into TIP late in 2021. From the end of 3Q21 to a peak price November 9, 2021, TIP appreciated 2.3% – a relatively large move for a fixed income ETF for such a short period of time. Notably, TIP’s recent 1.57% yield fell exactly in-line with iShares 1-3 Year Treasury Bond ETF’s yield, but the 1-3 Year ETF declined only 1% thus far in 2022. We conclude that TIP very rapidly priced in expectations for rising inflation late in 2021. Thus, barring a significant step-up for inflation expectations from 7% TIP appears relatively quite expensive.

The distinction between credit risk and rate risk defines the price performance discrepancy between SJNK and TLT. Investors estimate that the generally smaller and less well-capitalized companies that typically access the high-yield debt markets remain well-equipped to service their debt obligations. As such, these investors continue to purchase more SJNK, which offers a yield – 4.46% – almost three times higher than that of TLT (1.50%). It bears mentioning, though, that early 2022 total returns for SJNK and for TLT both were negative, however, due to their respective 2.8% and 7.7% price declines.

Since inception September 8, 2021, Solyco Wealth favored private credit providers Ares Capital (ARCC) and Hercules Capital (HTGC), over lower risk and lower yielding debt and credit investments. Both ARCC and HTGC maintain >70% of their loan portfolios in adjustable-rate debt. As a result, ARCC appreciated 2.1% and HTGC 7.3% thus far in 2022 while offering respective yields of 7.8% and 7.5%.

While Inflation Might Not Be Transitory, It May Be Rolling

We anticipate inflationary conditions above the Fed’s 2% target persisting across various sectors of the economy for at least the balance of 2022. However, we expect the extremes of durable goods, energy, and foodstuffs inflation realized early in 2022 soon will give way to services inflation. As the rate of Omicron infections declines and consumers revisit all things services – restaurants, gyms, theaters, travel and hospitality – the increased labor intensity of these sectors probably will result in the goods inflation rolling over to the services sector.

As shown in the chart below, the Baltic Dry Index, which reflects the cost to ship dry bulk goods such as iron ore, coal and grains, declined precipitously over the past four months from its extreme 3Q21 peak. In fact, this Index recently moved ~35% below its 2Q21 level. Notably, while the Baltic Dry Index declined over the past four months, backlogs of waiting ships continued to wait to be unloaded at offshore U.S. ports. As those goods make their way into inventories and onto store shelves, representative prices likely decline in response to increased goods availability and reduced goods scarcity.

The prospects of increased goods availability at prospectively lower prices in combination with boosted activity levels resulting from warmer weather and fewer COVID infections, likely translates to increased services demand. Notably, however, the services sector offers far more substitutes than do the Energy and Automotive sectors, the two largest drivers of excess inflation, per the following graph from Morningstar.

If our rolling inflation theory proves to be correct over the next 6 to 12 months, we anticipate fewer actions will be required of the Fed to reign in inflation. As compared to the recent discussions of as many as seven Fed rate hikes over the next year, in an environment of rolling inflation the Fed likely achieves its inflation goals by achieving neutrality with its open market operations and three rate hikes. Under this scenario we expect much reduced market volatility and more accommodating environments for risk assets as compared to that with which we started 2022.

Quantifying the Value of a Financial Advisor

Financial services and investment behemoth Russell Investments, purveyor of the eponymous Russell Indexes and advisor of $2.9 trillion of investments, recently released their 2021 Value of an Investor Study. Likely surprising to many, Russell estimates the most valuable component of investors’ relationships with their advisors probably centers on those advisors convincing their clients to do nothing.

As presented in the following table, Russell derives that the behavioral coaching many advisors provide – convincing their investor-clients to stay the course amid market volatility and downturns – amounts to 2.02%. This behavioral coaching ranks as almost three times as valuable as the combination of active rebalancing (0.17%) and investing (0.62%). The folks at Russell arrive at this 2.02% figure by subtracting the average equity investor’s return of 9.28% over the 1984-2020 period from the 11.30% return of the Russell 3000 Index over the same time period. In other words, investors’ propensity to “buy high and sell low” rather than “set it and forget it” cost them 2.02%.

A 1.20% return to tax management also bears mentioning as it exceeds what many investors pay their advisors. Russell derives this figure by subtracting the tax drag of domestic equity funds from that of domestic tax-managed funds over the 2015 to 2020 time period. We surmise that the long-term annualized magnitude of effective tax management probably vastly exceeds 1.20% due to nothing more than the power of compounded returns over time. For example, an incremental 100 basis points of increased return, or a 1% increase in investable capital from retained tax savings, over a 10-year period, from 9% to 10%, on a hypothetical $100,000 investment represents an increase of $18,605, or +8.6%.

Where Might Cryptocurrencies Fit into an Asset Allocation Plan?

One of our interns proved kind enough a couple days ago to engage me in a conversation about cryptocurrencies. I appreciated the opportunity to do so as I anticipate client inquiries concerning crypto increasing going forward. As I spent quite a bit of mindshare over the past few months noodling on where cryptocurrencies might fit into an effective asset allocation plan, I valued the exchange. Little doubt exists for me that leading cryptocurrencies qualify as alternative investments in that they offer a potential store of value uncorrelated with the performances of equities and fixed income securities.

I choose not to spend any time on the costs and benefits of trading, mining, or doing anything else with cryptocurrencies, like making cashless purchases. Rather, I address investing in crypto as one would evaluate the merits of buying any other investable asset for which addressable markets exist. For folks investigating spending capital on a cryptocurrency, I highly recommend verifying that such an addressable market exists for it: confirm that active buyers and seller exist to create sufficient liquidity to move into and, more importantly, out of the investment. Without sufficient liquidity an argument could be made that the asset in question more resembles a collectible than it does an investment. I advocate always separating collectibles from investments, not unlike keeping a primary residence separate from an investment portfolio.

Providing that sufficient liquidity exists to qualify the desired cryptocurrency as an investment and not as a collectible, I recommend investors define what characteristics they anticipate their crypto investment fulfilling for their portfolio. Like gold, do they expect crypto offering hedges against downturns in other asset prices? Or, as in the case of bitcoin, does the investor estimate that the fixed number of bitcoin available to the investment community will act to counter the deleterious impacts of inflation on the values of other assets?

An important self-check in this process requires investors to satisfy their curiosity as to why they anticipate their targeted cryptocurrency outperforming alternatives within their forecasted investment environment. A failure to do so qualifies the crypto purchase as speculating and not investing. Comparing the return profiles of cryptocurrencies to those of gold, commodities, currencies, private equity and venture capital funds, and managed futures, could prove highly useful to investors evaluating the applicability of crypto to their asset allocation and investment plans.

Model Portfolios Finish 2021 Strongly for Solyco Wealth

The four model portfolios managed by Solyco Wealth maintained their benchmark-beating performance to conclude 2021. Spanning risk tolerances from Conservative to Moderate through Moderately Aggressive and Aggressive, each of the four portfolios exceeded its respective benchmark’s performance since their 9/8/21 inception date after assessing an annualized 1.0% management fee, as shown in the following table.

Solyco Wealth Returns and Benchmark Comparisons by Strategy, Since Inception (9/8/21)

Past Performance Is Not Indicative of Future Results

Solyco Wealth used Morningstar Direct to calculate the above returns for the 4Q21 and since inception periods from September 8, 2021, through December 31, 2021.
Fees assumed in above calculations amount to 0.083% per month, or 1/12 of annual 1% management fee.
Actual client investment performance likely will differ from respective model portfolio performance due to several factors including: 1) Timing of securities purchases and sales, 2) Dividend reinvestment choices, 3) Securities held outside the model portfolio, 4) Weighting differentials for certain securities relating to whole versus partial share accounting, 5) Timing and pricing of rebalancing actions, and other minor factors.
Conservative benchmark = total returns for 10.0% Russell 3000 Index, 65.0% Bloomberg US Aggregate Bond Index, and 10.0% MSCI World ex-US Index and 15.0% cash allocations.
Moderate benchmark = total returns for 22.5% Russell 3000 Index, 45.0% Bloomberg US Aggregate Bond Index, and 22.5% MSCI World ex-US Index, and 10.0% cash allocations.
Moderately Aggressive benchmark = total returns for 32.5% Russell 3000 Index, 25.0% Bloomberg US Aggregate Bond Index, and 32.5% MSCI World ex-US Index, and 10.0% cash allocations.
Aggregate benchmark = total returns for 45% Russell 3000 Index, 5.0% Bloomberg US Aggregate Bond Index, 45% MSCI World ex-US Index, and 5.0% cash allocations.

Each of Solyco’s Model Portfolios includes fixed income and cash allocations, ranging from a cumulative 10% for the Aggressive portfolio to a cumulative 80% for the Conservative portfolio. Equity, fixed income, and international allocations for the three more risk-averse portfolios all outperformed since-inception returns for their respective benchmarks – Russell 3000, MSCI All-World ex-US, and Bloomberg US Aggregate Bond Index – as well as their equity component exceeding same-period S&P 500 returns. The post-Thanksgiving downdraft negatively impacting domestic riskier assets, however, resulted in the domestic equity and fixed income allocations within the Aggressive Model Portfolio modestly underperforming their respective benchmarks; returns to the Portfolio’s international equities, though, outpaced those of the MSCI All-World ex-US benchmark.

Why Tech Stocks Could Stumble Amidst Rising Rates

Prospects for higher interest rates sooner rather than later really appear to be disproportionately whacking Tech stocks. Given that many of these companies retain substantial sums of cash net of debt on their balance sheets, this trading behavior may be confusing to many investors. Institutional investors’ concerns likely focus on the discounted value of Tech companies’ future cash flows rather than on its prospective balance sheet condition.

Theoretically, for a company generating $1 billion in free cash flow with a 7% average cost of capital – its discount rate – incurring a two-percent increase in that discount rate, while relatively benign optically, translates to an estimated reduction in value of $17M+ in a year. If our company has 100M shares outstanding and trades at 20x free cash flow, that $17M drop in value results in a share price decline of only $3.43, or about 1.7%. That price change falls well within the range of typical market gyrations and probably, never garners another thought.

However, that theoretical increase in the company’s discount rate also likely results in a down-tick in the cash flow multiple that investors will pay for shares of the company, say from 20x to 18x. Now, that $17M decline in value amounts to a $23.09, or 11.5%, downward revision in value. Even for the most resilient, longest-term investor an 11.5% price drop likely results in at least a raised eyebrow.

Of course investors may argue that rising rates impact companies across sectors and question why Tech trades differently. Two factors, in our view, serve to explain Tech’s potentially increased sensitivity to rates vis-à-vis companies in other sectors: 1) significantly higher expected future free cash flows and 2) elevated trading multiples for those expected future free cash flows.

If you want to chat about any of this, we’re here to help: (713) 444-3560 or ctrimble@solycowealth.com.

Volatility, Cash and Options

No sooner than I put the Thanksgiving leftovers in the fridge than COVID rear its ugly, spiked head again and blew up Black Friday. Bah humbug, indeed. From an investor’s perspective, though, the timing, magnitude, and driver of last Friday’s volatility spike offer valuable lessons. Chief among these lessons are the benefits of:

• Maintaining a solid, actionable investment plan commensurate with your risk tolerance,
• Allocating a portion of your assets to cash, and
• Utilizing options to mitigate a portion of this volatility.

An investment plan should be crafted to your risk tolerance with appropriate allocations to fixed income, equities, and cash, and with well-researched equity, ETF, or mutual fund weightings across economic sectors. If a few percentage points of volatility in the equity markets one way or the other rattles confidence in your plan, chances are it and your risk tolerance are misaligned.

Having a cash component in your asset allocation plan offers a buffer with which to get your plan aligned with your risk profile – if it’s not already. Also, cash provides dry powder with which to add to disproportionately beaten down positions if you deem them worthy of additional investment – an active
rebalancing effort, if you will.

Finally, providing that you possess a solid understanding of how options function, covered calls and cash-secured puts present the potential to mitigate the possible impacts of short periods of volatility. Income generation represents another prospective benefit of complementing your core investment plan with an options strategy.

If you want to chat about any of this, we’re here to help: (713) 444-3560 or ctrimble@solycowealth.com.

Model Portfolios Turn in Solid 2nd Month

Each of Solyco Wealth’s four model investment portfolios outperformed its benchmark, net of fees, over the two-month period ending 11/8/21. As shown in the following table both the Aggressive and Moderately Aggressive portfolios, which hold heavier weightings to equities, also their first two months in existence exceeded returns for both the S&P 500 and the Russell 3000 after fees. Past performances are not indicative of future results, however.

Solyco Wealth Returns and Benchmark Comparisons by Strategy, 9/8/21 – 11/8/21

Past performance should not be construed as illustrative of potential future performance.

Solyco Wealth used Morningstar Direct to calculate the above returns for the 1-month and since inception periods from September 8, 2021, through November 8, 2021.
Fees assumed in above calculations amount to 0.083% per month, or 1/12 of annual 1% management fee.
Actual client investment performance likely will differ from respective model portfolio performance due to several factors including: 1) Timing of securities purchases and sales, 2) Dividend reinvestment choices, 3) Securities held outside the model portfolio, 4) Weighting differentials for certain securities relating to whole versus partial share accounting, 5) Timing and pricing of rebalancing actions, and other minor factors.
Conservative benchmark = total returns for 10.0% Russell 3000 Index, 65.0% Bloomberg US Aggregate Bond Index, and 10.0% MSCI World ex-US Index and 15.0% cash allocations.
Moderate benchmark = total returns for 22.5% Russell 3000 Index, 45.0% Bloomberg US Aggregate Bond Index, and 22.5% MSCI World ex-US Index, and 10.0% cash allocations.
Moderately Aggressive benchmark = total returns for 32.5% Russell 3000 Index, 25.0% Bloomberg US Aggregate Bond Index, and 32.5% MSCI World ex-US Index, and 10.0% cash allocations.
Aggregate benchmark = total returns for 45% Russell 3000 Index, 5.0% Bloomberg US Aggregate Bond Index, 45% MSCI World ex-US Index, and 5.0% cash allocations.

Significant upside moves from Earthstone (ESTE; +48.7%), Advanced Micro Devices (AMD; +37.6%), and Sociedad Quimica y Minera (SQM; +25.6%), generally aided performance while Zendesk (ZEN; -18.4%), Universal Health (UHS; -16.9%), and ViacomCBS’s (VIAC; -13.4%) hampered performance. Holdings in private debt capital providers Ares Capital (ARCC; +6.9%) and Hercules Capital (HTGC; +7.1%) paced fixed income-linked holdings over the past two months. Notably, not all of the portfolios held all of these positions.

Solyco Wealth utilizes its model portfolios as baselines for creating investment programs customized to its clients’ individual investing goals and risk tolerances. For more information call (713) 444-3460.

Looking to 2022: End of Year Checklist

As the 2021 holiday season quickly advances on us, now offers a sensible time to execute a quick run-through of a financial planning checklist. Just like with holiday shopping – which we also recommend you commence soon as supply chain issues likely will present challenges even greater than unraveling changes to the 2022 tax code – starting early probably leads to better outcomes. Here are a few quick pointers to get the ball rolling:

• Review and update beneficiary designations for brokerage and other accounts
• Complete charitable giving plans
• Evaluate insurance coverage: home, auto, life, other
• Spend balances in flexible spending accounts
• Analyze investment portfolios to rebalance asset allocations
• Identify any tax-loss harvesting possibilities
• Assess potential tax liabilities: stock/asset sales, income withholding, child tax credit paybacks
• Check emergency savings account balance
• Complete – for retirees – any required minimum distributions
• Give some thought to possible life changes arising in 2022: job, home, car, surgery…
• Read over financial and/or estate plan with those possible 2022 changes in mind

If you want to chat about any of this, we’re here to help: 713-444-3560 or ctrimble@solycowealth.com.