Saturday, April 6, 2013

It's Hard To Believe.

Well, at least I'm not the only one to notice grandmother's portfolio.

The last posting (“In the Eye of the Beholder”) mentioned a widows’ and orphans’ portfolio.  When first I introduced the portfolio in “Investing PART 9: One versionof the ‘Unfinished symphony,” I described how my grandmother, who was a widow with children to support, first introduced me to some of the stocks.  So, when I saw an article on Yahoo finance entitled “Why Your Grandmother’s Portfolio Is Beating the Pros’,” naturally, I was curious.  Alas, it was not about my grandmother, but it certainly was about her investment style.
Sure enough, it made the same point as the last posting.  Some very conservative, high-quality stocks have been leading the market.  Or, to quote from the Yahoo article, “A scan of the stocks leading the rally to new index highs in 2013 reveals a pantry full of household-name, blue-chips of the sort that might have entered a conservative investment account 30 or more years ago.”

The interesting question at this point is what that leadership implies for future gains.  The WALL STREET JOURNAL article that mistakenly attributed leadership to low-quality stocks argued that it was time to rotate into the high-quality stocks.  However, as discussed in the last posting, much of the performance of the high-quality portfolio results from its lower volatility, especially in down markets. 
At some point the market will correct, which is market speak for go down.  At that point, it will be interesting to watch whether it is the market leaders (i.e., high-quality stocks) that decline the most.  That would be extremely atypical, but then the market likes to do things that are atypical.  More than likely, and therefore a good forecast, is that some of the stocks in the widows’ and orphans’ portfolio will go down more than the market and some of them will defy the market decline.  Overall, the portfolio will probably outperform the market during the next correction. 

An excellent illustration of the point of the posting right before the last.

The posting, “A KISS for Financial Education,”concluded with the statement:
“Financial management can be boiled down to a few simple principles. Interest rate compounding, inflation, and risk and diversification are important, but one suspects that often the failure of financial management education results from the fact that stating simple truths is sometimes painful. No one likes to accept the fact that there are limits. As a consequence, financial management education often focuses on how to try to avoid the limits rather than on what those limits are. The limits are unavoidable.”

As if on cue, the day following the posting, the WALL STREET JOURNAL ran an article entitled “12 Debt Myths That Trip Up Consumers.” The subtitle was “Borrowers too often fall prey to the conventional wisdom. And it can cost them.” The article was a perfect illustration of the concluding paragraph of the posting.
It started with the simple statement: “Avoid debt if you can. If you can't, borrow carefully and conservatively.” The article could have been very educational, if at that point it had explained why and pointed out the unavoidable limitations associated with consumer borrowing. Instead, the article provides an excellent example of using information to obfuscate. It goes on to state: “So the conventional wisdom goes. But if you follow it blindly, you may miss out on key nuances of dealing with debt.”
The information the article presents is interesting and accurate, but the deficiency is that the only potential use of the information is to try to avoid the limitations inherent in consumer debt. One can go through each of the 12 points and use it to illustrate the theme of the previous days posting. But in the interest of brevity, only the introductory examples are discussed in this posting.
The article starts with the statement: “For instance, consider store-brand credit cards. They often offer no-interest financing and rewards on store-bought products. Sounds great. But did you know those attractive financing terms can come back to bite if you carry a balance after a promotional period?” One has to wonder why the author thinks it “Sounds great.” It's equally reasonable to assume that having a bunch of merchandise in your possession that you don't own does NOT sound great.
This statement only makes sense if one assumes that it is legitimate to apply the logic of present value calculations to consumer goods. But, as has been argued on this blog in a previous posting entitled “Truth In Lending:”
“…present value relationships are appropriate for investing. They do not apply to consumption. A dollar today can be invested with the result that it’s worth more than a dollar paid a year from now. However, there is no guarantee that a dollar spent today will result in more satisfaction, happiness, benefit, or whatever you chose to call it, than the dollar spent a year from now. If a year from now it’s a medical treatment for a potentially life-threatening condition that is in question, the treatment has a pretty big benefit to most people. It would be rare to have whatever was bought be worth more than the treatment.”

Even the inducement of the rewards may not justify accumulating a bunch of junk that isn't yours. The statement is deficient in that it treats the absence of an interest charge during some specific period of time as the absence of a cost. Using any consumer credit involves giving up a very valuable asset: your control of your future income and the optionality implied by controlling your future income.
That critique should not be misinterpreted. In the body of the article, it does present the way in which using those interest free loans implies risk. It stresses the risk associated with not servicing the debt in a timely manner, but it overlooks the relationship between the surrender of optionality and that risk. Consequently, it misses an important concept. It completely ignores the fact that all leverage, even interest-free leverage, creates risk.

The second introductory example in the article is as follows: “Then there's mortgage debt. A big down payment may be a great way to steer clear of a huge home loan. But if you get the money for the down payment from relatives, lenders may scrutinize your financials closely.” It would seem to me as a casual observer that whether the debt is to a financial institution or a relative is quite irrelevant. If I isn’t a gift, it is still debt.
Perhaps if the article had gone into issues related to interest rate costs, or something else relevant, it would have made sense. But the whole focus of bringing up the point seems to be on preserving the ability to borrow more money by not affecting your credit rating and the mortgage review process.

Why should anyone in a position of taking on a major debt worry if an independent party wants to look closely at their financials? A more rational approach would be to welcome an independent party evaluating whether the loan makes sense. Further, the lending organization should have an incentive to want to be sure that the borrower is not taking on more debt than they should. One of the critiques of the behavior of financial institutions before the current financial crisis is that they weren't doing just that. So, the article seems to be trying to present ways one can develop the same sort of over-leveraged position that many people got into during the buildup to the financial crisis.
The posting included the comment: “We seem more intent upon making it possible for people to borrow rather than to educate them about the risks associated with borrowing.” That same focus seems to apply the WALL STREET JOURNAL article. As stated in the posting, “That is unfortunate because nothing is more destructive of prosperity, both for the individual and for society, than the US public's attitude toward borrowing. It is a system-wide problem.”
 

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