Thursday, May 22, 2008

One Trillion Dollars


Total return is the combination of yield and capital appreciation. Income derived from interest (fixed income assets)or dividends (equities also known as stocks) and added together will give you the yield of a portfolio. The total income of a portfolio divided by the cost basis (the total cost of the assets) will give you the yield of the portfolio at cost. Take the same total income figure and now divide it by the market value (the present value of the stocks and bonds in the portfolio) and you get the yield at market. Yield at market tracks how well the portfolio is doing. Add total income of the portfolio to the total capital appreciation (the difference between the value of the portfolio at cost and at market) and then divide this number by the market value of the total portfolio. Your answer will give you the total return expressed as a percent. Sometimes referred to as the total rate of return because it is expressed as a percent. So why are these numbers so important? They tell us how well a portfolio is being managed. The higher the total return number the better the portfolio is performing. And, performance is what it is all about.

What is an actuary? An actuary makes actuarial assumptions. (How is that for a definition?) Actuaries work for insurance companies and anyone else who might need to figure beyond simply a gut feeling. When I worked for the State of Ohio, the bureau I worked for hired both in house and out sourced actuaries to tell them what kind of return they needed on the investments for the State Insurance Fund to have enough money in the future to meet its obligations to injured workers. After a very laborious process of crunching a lot of numbers, the actuaries come up with a percent. This percent is the return on investments that they calculate is what is needed for the State Insurance Fund to be able to meet its obligations in the coming years. Public and private pension funds do the same thing to determine how much total return they will need.

Calculated into the return is an assumption about inflation. Not all risk taking in the management of a portfolio is because of greed. When you work for a set salary and there is no bonus, risk taking is strictly limited to meeting the percent return calculated by the actuaries and implemented by an investment strategy.

Investment strategies can get quite complex, but the bottom line remains the same no matter how complex the investment strategy becomes - buy low and sell high. Pretty simple stuff, but the human mind can take that simple piece of philosophy and build a very complex investment portfolio. Today, nearly every billion dollar portfolio that is invested in stocks both domestic and foreign, bonds and notes of every stripe and an assortment of alternative investments.

One of the purposes of alternative investments is to disengage part of the portfolio’s investment performance (total return) from the stock and bond markets. There was a time when buying bonds was thought to be a hedge against a declining stock market. The late 1970’s and early 1980’s saw both the stock market falter and the bond market do even worse. Holding fixed income as a hedge against a faltering stock market turned out to be no hedge at all.

Alternative investments offer the portfolio an opportunity to hedge the portfolio with investments in private equity funds, commodities, real estate and other pieces of real property like perhaps art. Even gold coins, the collectible kind, can be used as an alternative investment if done right. Nothing under the sun, given the necessary study, should be excluded when seeking to hedge an investment portfolio. Marketability may become a question, as some markets can open and close rapidly, but no stone should be left unturned.

Recently a painting by the English artist Lucien Freud sold at auction for more than $33 million, and that is a record for a living artist. Many people think that the art market will be the next bubble to burst. Indeed it might, but hopefully that bubble’s burst will confine itself to the immediate players.

Inflation, in my opinion, makes the need for risk management so extraordinary. Without inflation to calculate into the assumption, investing for so many large state pension funds would be a lot simpler. I know I am setting myself up for a lot of criticism for saying that, but my purpose, my agenda, is to draw attention to the problems caused by a monetary policy that is built around things like cost of living allowances (COLA) and Treasury inflation protected securities (TIPS). What kind of game do we play here? How does the little guy, who works from one pay check to the next, the retiree on a fixed income from Social Security or a pension make it?

If I can be a little silly to make a point, can you imagine the size of the baseball changing with each inning? Or, the distance between bases changing with each inning? What kind of game would that look like? Our monetary policy needs to be examined. It is my uneducated opinion, I hold no PhD in finance or anything else, that our monetary policies need to be implemented with a view towards the least able among us to be able to withstand and survive the effects of inflation. Congress’ behavior has a place in these discussions of a new monetary policy.

Yesterday I heard on the news that the United States will spend one trillion dollars on oil this year. Some of that increase can be laid at the door step of our government's fiscal policies and the monetary policies of the Federal Reserve Bank. It is time for a Level Playing Field. Stay tuned.

3 comments:

Unknown said...

Not that anything I paint is ever going to sell for that kind of money - or sell at all, for that matter. Be that as it may, Fred, I wish to high heaven there was a way to assure that your voice was heard by those in a position to make a difference. Not that I think anyone should adopt your policies or position to the exclusion of all others, but that they become part of the mix of information that is available for consideration. That the voice of reason, given with clarity, is heard by those who would otherwise hear a confused cacophony of undecipherable crap concerning monetary policy. As far as all that crap is concerned, you are the bidet.

Vikki North said...

Hi Fred,
Working in television, my clients would stand with their mouth ajar as I carefully attempted to explain (in language they could understand)the technical process we went through to actuate their job requirement. This morning I stand with my mouth ajar reading your blog knowing that you write with the same considerations. I have printed this out and will re-read until my simple mind absorbs it.
I love the equation you always make to baseball and how it- financial investments,policies,inflation, etc,- can/does effect 'smoes' like me.

The painting you show at the top is one of my favorites. I think it should be the pictogram for Moneythoughts.
Vikki

winslow said...

I would love to have a member of Congress on this blog.

Do they ever "converse" with non-lobbyists other than with pre-written agendas