Risky Business

The Risky Business Report, a bipartisan project backed by three former U.S. Treasury Secretaries as well as other political and business leaders that seeks to quantify and publicize the economic risks from the impacts of a changing climate, calls for new policies to “reduce the odds of catastrophic outcomes” from extreme heat and rising sea levels linked to climate change. Such severe impacts will likely cost billions of dollars in annual property loss, threaten human health. lower labor productivity and endanger the nation’s electricity grids, according to the report The findings summarized by the report also show that the most severe risks can still be avoided through early investments in resilience and through immediate action to reduce the pollution that causes global warming.

“I know a lot about financial risks — in fact, I spent nearly my whole career managing risks and dealing with financial crisis,” former treasury secretary (under George W. Bush) Henry M. Paulson Jr. says in the report. “Today I see another type of crisis looming: a climate crisis. And while not financial in nature, it threatens our economy just the same.”

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What will trigger the next correction?

As I was thinking about my 2014 Investment Outlook (watch this space, it will be out shortly), I considered what obvious catalysts might stem the tide of higher equities and saw none. While it was already clear to me that market obstacles need not be foreseeable in advance (think Donald Rumsfeld’s famous “unknown unknowns”), that lack was still a significant factor in my preliminary thinking. Other than the unforeseeable — which seemed limited to me somehow — it looked like clear sailing ahead, despite high market valuations and the need for some correction to clean things out. That is, it looked like clear sailing until I remembered Black Monday: October 19, 1987. Coverage by The Wall Street Journal of that day began simply and powerfully. “The stock market crashed yesterday.” 

The Tragedy of Errors

Larry Walters had always wanted to fly.  When he was old enough, he joined the Air Force, but his poor eyesight wouldn’t allow him to become a pilot. After he was discharged from the military, he would often sit in his backyard watching jets fly overhead, dreaming about flying and scheming about how to get into the sky. On July 2, 1982, the San Pedro, California trucker finally set out to accomplish his dream. But things didn’t turn out exactly as he planned.

Larry conceived his project while sitting outside in his “extremely comfortable” Sears lawn chair. He purchased weather balloons from an Army-Navy surplus store, tied them to his tethered Sears chair and filled the four-foot diameter balloons with helium. Then, after packing sandwiches, Miller Lite, a CB radio, a camera and a pellet gun, he strapped himself into his lawn chair (see above). His plan, such as it was, called for his floating lazily above the rooftops at about 30 feet for a while and then using the pellet gun to explode the balloons one-by-one so he could float to the ground.

But when his friends cut the cords that tethered the lawn chair to his Jeep, Walters and his lawn chair didn’t rise lazily. Larry shot up to a height of over 15,000 feet, yanked by the lift of 45 helium balloons holding 33 cubic feet of helium each.  He did not dare shoot any balloons, fearing that he might unbalance the load and cause a fall.  So he slowly drifted along, cold and frightened, with his beer and sandwiches, for more than 14 hours. He eventually crossed the primary approach corridor of LAX.  A flustered TWA pilot spotted Larry and radioed the tower that he was passing a guy in a lawn chair at 16,000 feet.

Eventually Larry conjured up the nerve to shoot several balloons before accidentally dropping his pellet gun overboard. The shooting did the trick and Larry descended toward Long Beach, until the dangling tethers got caught in a power line, causing an electrical blackout in the neighborhood below. Fortunately, Walters was able to climb to the ground safely from there.

The Long Beach Police Department and federal authorities were waiting. Regional safety inspector Neal Savoy said, “We know he broke some part of the Federal Aviation Act, and as soon as we decide which part it is, some type of charge will be filed. If he had a pilot’s license, we’d suspend that. But he doesn’t.” As he was led away in handcuffs, a reporter asked Larry why he had undertaken his mission. The answer was simple and poignant. “A man can’t just sit around.”

The One Percent Doctrine

A number of years ago, during George W. Bush’s second term and by sheer happenstance, I ended up playing a round of golf with a Navy SEAL Commander (half the SEALs train here in San Diego).  Obviously, much of his job was classified and he was very circumspect in what he shared.  However, when I asked where or how I could become better informed about foreign policy, he recommended Ron Suskind’s book, The One Percent Doctrine.

The “one percent doctrine” (also called the “Cheney doctrine”) was established shortly after 9.11 in response to worries that Pakistani scientists were offering nuclear weapons expertise to Al Qaeda. Here’s the money quote from Vice President Dick Cheney: “If there’s a 1 percent chance that Pakistani scientists are helping al-Qaeda build or develop a nuclear weapon, we have to treat it as a certainty in terms of our response. It’s not about our analysis … It’s about our response.”

Thus in Cheney’s view and per subsequent policy, the war on terror required and empowered the Bush administration to act without the same level of evidence or analysis as might otherwise be necessary. 

Mind the Gap

The question is a common one for many institutions – For the real estate allocation, should we use publicly traded REITs or private real estate?  The usual answer is to mix them.  Yet recent research highlighted by Institutional Investor magazine notes that public “REITs have beaten private funds by almost 5 percent a year over the past three decades.”  For the 30 years ended December 31, 2011, listed REITs returned 11.95 percent annually while private funds returned 6.97 percent. 

That’s a huge performance gap.

The Missing Lead

I’m a big fan of Jake Tapper.  I thought he was terrific at ABC News as the senior White House correspondent and I was disappointed when he wasn’t picked to host This Week both when George Stephanopoulos left in 2010 and when he came back in 2012.  As of 2013, Jake returned to CNN to become Chief Washington Correspondent and anchor of a new weekday television news show, The Lead with Jake Tapper.  The Lead, which debuted this week to generally good reviews, is the first CNN show to launch since Jeff Zucker took over as president of CNN Worldwide to revitalize the franchise.

I agree with the good reviews, but there’s a “big but” coming.

Establishing Your Top 10 Investment Default Settings

I pay a lot of attention to the investment process.  In that regard, every investor — personal or professional — ought to have a clear investment plan based upon appropriate personal considerations, goals and outlooks and every investor ought to stick to that plan unless and until something significant changes. But there is a crucial component of the investment process that gets surprisingly little attention:  our investment default settings.  We can use them when we aren’t sure what to do, when we’re deciding what to do, when our circumstances have changed but our plan hasn’t (yet), or when we’re just starting out. 

The idea here is that we all have default settings — known and unknown, acknowledged and unacknowledged — and that those defaults greatly influence how successful we are and become.  Having the right default setting in defined contribution plans make a big difference (more here). I would examine and apply my default settings across and throughout the entire investment process and even suggest that we need to look at our default settings as carefully as we look at anything else.

What follows are my suggested default settings.  Your mileage may vary.

My Top Ten New Year’s Resolutions

The New Year traditionally calls for reflection and resolution.  We should at least aspire to some thoughtful consideration and hope that we might do better going forward.  Accordingly, here are some resolutions for the New Year that we all should be able to agree upon.  May we actually fulfill them! 

1. Demand Simple but Meaningful Honesty. MarketWatch recently ran a piece claiming that “beating the market is easy.”  Full Disclosure: I am a MarketWatch contributor.  The thrust of the claim focuses upon various sectors and approaches – such as small caps or value – that have beaten the S&P 500 index historically as well as suggesting that investors use leverage and lower fee products.  While strictly accurate, the claims are misleadingly so because the comparisons are all of an apples-to-oranges variety.  Suggesting that one can readily “beat the market” by taking on more risk via volatility and leverage is hardly a meaningful recommendation for most investors and especially for those – and the target of the article – who are engaged in retirement planning.  Moreover, defining “the market” as the S&P 500 and pointing out that various other indexes can and do outperform it historically isn’t very helpful either.  For performance measurement to have value, one must use an appropriate measuring stick.  Even if (when!) it doesn’t make us look great, let’s offer and demand meaningful honesty.
2. Address Issues Head-On.  As I have noted repeatedly in this space, our nation faces a serious retirement crisis.  Few of us have planned well enough and few of us are saving enough to expect to live a comfortable retirement.  These undeniable facts demand that we face some serious personal and policy challenges.  The defined contribution landscape – never intended as a stand-alone retirement solution – isn’t working nearly well enough.  Some more fundamental and far-reaching choices deserve careful consideration.  These include mandatory retirement saving, portable pensions, and comprehensive Social Security and Medicare reforms.  What we are doing at present isn’t working.  Accordingly, some difficult policy choices we might not otherwise prefer or endorse need to be considered.
3. Acknowledge Reality.  Our behavioral biases are alarming in their scope and impact.  They can be astonishingly difficult to perceive and overcome.  Yet because of what’s called the “bias blind spot,” even when we recognize these biases, we tend to think that they apply to others but not to ourselves.  For 2013 and beyond, let’s all resolve consciously to try to acknowledge and deal with our biases on a consistent and comprehensive basis. 
4. Embrace Personal Accountability.  Because of our behavioral biases, it’s also easy for us to take credit for our successes while blaming our failures and failings on bad luck.  Let’s instead resolve to be accountable for our choices and our actions, even (especially!) when they do not work out well.  In one way or another, we would all like to privatize our gains and socialize our losses, take credit for success and blame failure on somebody else.  Stop!  We all know a lot less than we think. 
5. Insist on Effectiveness.  Too many of our planning and investment choices are based upon ideological commitments of various sorts.  Whatever our market “schools,” economic and political preferences and party persuasions, we all tend to act first and ask questions later.  Let’s demand instead that the choices we make actually be predicated upon good data and evidence such that what we want to achieve has a reasonable likelihood of actually happening. As the saying goes, we are all entitled to our own opinions, but we are not entitled to our own facts.
6. Focus. We are all prone to being distracted by the new, new thing.  Being new isn’t necessarily bad, obviously, but it isn’t necessarily good either.  A well-researched and supported new idea or approach can be of value – even tremendous value.  But at least as often the new thing is a chimera that makes promises it can’t keep.  If that object of desire makes bold assurances like easy, huge, safe or revolutionary, be especially wary. 
7. Develop a Comprehensive Plan (and put it in writing).  In the same way having to teach a class on a given subject demands that we understand it really well (and, in my case, always engenders a lot of new research even on subjects I already know), developing a comprehensive plan is a great way to find and establish goals, ideas and priorities.  Going through this process goes a long way toward ensuring that the final result will be well thought-out.  Moreover, only a clear plan allows for an evaluation of how things are going and thus if any changes are called for.  Recent research from Advisor Impact Inc. goes one step further and shows that those who create their plan in written form and include a recitation of how they plan to react when trouble comes are a good bit more likely to deal better with the trouble that inevitably comes.  Too many of us let our investment and retirement planning strategies develop haphazardly, virtually guaranteeing that they are not thorough and making the likelihood of inconsistency in goals, purpose and execution astonishingly high.  An otherwise great investment plan can readily become a disaster is it doesn’t line up with our understanding, goals, objectives and risk tolerances.
8. Set Appropriate Defaults.  On a related note, our planning default settings need to be carefully considered and implemented.  These can relate to asset allocation, investment type and time horizon.  Some good examples follow.  When in doubt, lower fees win, passive beats active, manage risk first, simple beats complex, save more, spend less, and this time probably isn’t different.    
9. Evaluate and Re-evaluate.  Every plan, no matter how good, should be subject to regular scrutiny and evaluation.  Adjustment based upon new or better evidence is always in order.  This process also demands clear goals and targets, both interim and longer-term.  Most of us are aware of the Lewis Carroll saying:  If you don’t know where you are going, any road will take you there.  It’s a great warning.  We also need to know where we are at all times for planning to be truly effective.
10. Be Willing to Ask for Help.   My late father reminded me often of the Abraham Lincoln saying, Better to remain silent and thought a fool than to speak up and remove all doubt.  We would all be wise to think more, study more and reflect more while saying and doing less.  Similarly, most of us resist asking for help.  We all like to think we’re the smartest person in the room even though we would all benefit from asking for help often.  None of us knows nearly enough to do it all and to do it all alone.  Resolve not to try.

My thanks go out to all of you for reading and for a wonderful year here at Above the Market.  I am blessed by your interest and support.  May your 2013 be a joyful and prosperous one for each of you.

The NFL, Data and Player Safety

This season the National Football League introduced a full season’s worth (actually, 13 weeks, with games featuring every team) of highly valuable Thursday night games for the first time, all televised by the league-owned NFL Network.  Many players have gone on record complaining about the Thursday scheduling due to injury concerns.  Bill Simmons of Grantland, the world’s most famous sports blogger, has been the most prominent among many critics of the Thursday night match-ups, profusely criticizing NFL Commissioner Roger Goodell for putting players’ health at risk by scheduling games on such short rest. For example, Simmons cites the case of the Baltimore Ravens, who played four games in 17 days at the start of the season and subsequently suffered a rash of injuries, including the losses of star cornerback Lardarius Webb and future Hall of Fame linebacker Ray Lewis for the season (although Lewis may well return ahead of schedule). The Thursday night games have also been very sloppy, presumably due to a lack of both practice and recovery time, and last night’s match-up was no exception.

During his wide-ranging news conference earlier this week, Goodell claimed that ongoing efforts will continue to make the game safer.  Injuries have been a major focus of late, particularly as they relate to concussions and brain trauma.  But Goodell also asserted that there was no data to support the idea that the short weeks cause more or more serious injuries.  “We don’t have any information that indicates from our data that playing on Thursdays in any way decreases the safety of our players,” Goodell said.  “The injury rates do not indicate that at all over the years.  So I think we start with facts, and the facts are that that’s not a risk to the players.”  He may even be right.  Moreover, since the players’ union has approved the games, player complaints aren’t likely to make a difference any time soon (for at least as long as collective bargaining agreement remains in force).

There is pretty good reason to believe that the Commissioner is being more than a little hypocritical generally when it comes to player safety, but for the purposes of this exercise, let’s assume that his actions were and are entirely well-intentioned and that there really is no data supporting the idea of increased injury risk on Thursday nights.  As my masthead suggests and as I have written repeatedly (for example, here), I am committed to data-driven analysis — in investing and elsewhere.  But how should we deal with a lack of data?

As an initial matter, it is important to note that a lack of data is not the same as a lack of evidence.  There is a lot of testimonial evidence from the players — albeit anecdotal and incomplete evidence — that playing on Thursday is a serious risk.  The lack of data confirming that testimony may be because the player narrative is wrong.  But it may also be because there isn’t enough experience yet for the data to be meaningful or because the right measurements aren’t being taken (for example, the number of injuries may not go up on Thursday nights, but their severity might).  Remember, this is the first year that we have seen a full slate of Thursday night games.

The difficult question is how to select the appropriate default in the event that there isn’t any data or where the data remains inconclusive.  In most instances, it makes sense to maintain current practice if there is no data suggesting otherwise.  But when current practice is new or relatively new, it may be prudent to rely on anecdotal testimonial evidence alone if it sufficiently compelling.

That leads, obviously, to the issue of what kind of evidence is or should be “sufficiently compelling.”  In general, if the risks of proceeding are high, the threshold of evidence needed should be pretty low and vice versa.  Moreover, the types of risk are extremely important.  The NFL has a lot of money invested in Thursday Night Football, largely in the form of the NFL Network.  The financial stakes are enormous and they are known.  But the human injury risks are also huge, even though they remain — at least at present — somewhat speculative.

The appropriate conclusion, then, seems to depend upon how you measure and value the clear economic consequences of cancelling Thursday night games as compared to the serious but somewhat speculative injury risks alleged by many players.  There is no clear answer and the individual conclusions drawn will be predicated largely upon one’s values and priorities, not to mention any personal stake one might have in the outcome.  Roger Goodell works for the league and NFL owners, whose financial interests are at stake, which will obviously influence his conclusions (confirmation bias demands it).  The players face no financial risk, at least directly, but face a serious risk of injury (and thus career risk, with serious financial repercussions) every time they step on the field.  That reality will obviously influence their conclusions (confirmation bias demands it).

For me, the answer is clear (but remember that I’m biased too — one of my sons was a Division I college football player whose career was cut short by injury).  In my view, dynamic Baltimore Ravens safety Ed Reed said it best. “If they are really concerned about the violence and injuries . . . Why is there Thursday night football?” 

Why is there Thursday Night Football indeed?

What Will 2030 Look Like?

The National Intelligence Council is composed of the 17 U.S. government intelligence agencies.  The Council’s Global Trends Report has, since 1997, worked with a variety of experts both in and out of government service to examine factors such as globalization, demography and the environment to produce a forward-looking document to aid policymakers in their long-term planning on key issues of worldwide importance. 

“We are at a critical juncture in human history, which could lead to widely contrasting futures,” wrote Christopher Kojm, the Council’s Chair, in his introduction to the current Report, published just this week.

The Report is intended to stimulate thinking about the rapid and vast geopolitical changes characterizing the world today and possible global trajectories over the next 15 years. Significantly, it does not seek to predict the future – we have a dreadful track record in the regard – but instead it seeks to provide a framework for thinking about possible futures and their implications.

The Report argues that the breadth of global change we are facing today is comparable to that during and surrounding the French Revolution and the rise of the Industrial Age in the late 18th century, but it is being realized at a much faster rate. While it took Britain more than 150 years to double its per capita income, India and China are set to undergo the same level of growth in a tenth of the time, with 100 times more people.

I encourage all investors to read it carefully.  Despite the vital importance of the “long cycle,” it isn’t likely to change your current portfolio outlook, but it will provide a helpful backdrop to your overall thinking and to your longer-term outlook and analysis.

Among the Report’s conclusions is that there are certain “megatrends” that are relative certainties and that we should prepare to deal with them.  These include the following (and note that all have investment implications, some of them potentially enormous).

• For the first time in history, a majority of the world’s population will no longer live in poverty by 2030, leading to a healthier global population and a major expansion of the middle classes in most countries.
• Life expectancies will continue to expand rapidly.  “Aging” countries (such as those in the West – particularly Europe – and Japan) face the possibility of a significant decline in economic growth.
• Asia is set to surpass North America and Europe in global economic power, but there will not be any hegemonic power.
• Demand for resources will increase owing to global population growth from 7.1 billion people today to about 8 billion by 2030.
• Demand for food is likely to rise by 35 percent and energy by 50 percent over the next 15-20 years.
• Nearly half of the world’s population will live in areas with severe water stress by 2030.  Fragile states are most at risk, but China and India are vulnerable to volatility of key resources.

These megatrends will inevitably lead to a variety of vexing and potentially “game-changing” questions.  Each has profound political, economic, market and human implications.

1. Will divergences and increased economic volatility result in more global breakdown or will the development of multiple growth centers lead to increased resiliency?  For much of the West, the challenges involve sustaining growth in the face of rapidly aging populations. For China and India, the main challenge will be to avoid “middle income traps.” In general, the global economy will be increasingly crisis-prone and won’t return to pre-2008 growth levels for “at least” the next decade.
2. Will current governments and international institutions be able to adapt fast enough to harness and channel change instead of being overwhelmed by it?  While this sounds generally like the investment challenge we face daily, there are a variety of major global issues in this regard.  Potentially (more) serious government deficits driven by rapid political and social changes are likely to exist. Countries moving from autocracy to democracy are often unstable and about 50 emerging market countries fall into this major risk group.  All of them could – at least potentially – grow out of their governance incongruities by 2030 if economic advances continue.
3. Will rapid changes and shifts in power lead to conflicts?  The general answer is surely duh, with uncertainty only as to the number, extent and nature of the conflicts.  Limited natural resources—such as water and arable land—in many of the same countries that will have disproportionate levels of young men—particularly in Sub-Saharan Africa, South Asia, and parts of the Middle East—increase the risk of intrastate conflict.  It is particularly troubling to note that any future wars in (at least) Asia and the Middle East may well include a nuclear element. Many of these conflicts, once begun, would not be easily containable and would (obviously) have global impacts.
4. Will regional instability, especially in the Middle East and South Asia, spill over and create global insecurity?  See the commentary re #3 above.  Wash; rinse; repeat.
5. Will technological breakthroughs occur in time to solve the problems caused by rapid urbanization, strains on natural resources, and climate change?  The report identifies 16 key “disruptive” technologies with potential global significance out to 2030. They are generally grouped around potential energy breakthroughs, food- and water-related innovations, big data and the forecasting of human behavior, and the enhancement of human mental and physical capabilities, including anti-aging.
6. Will the United States, as the leading actor on the world stage today, be able to reinvent the international system, carving out potential new roles in an expanded world order?  The Report anticipates that the U.S. will likely remain primus inter pares (first among equals) among the other great powers in 2030 because of the multifaceted nature of its power and legacies of its leadership.  But it also expects that the “unipolar moment” is over. Overall, power will likely shift to networks and coalitions in a multipolar world. The United States’ (and the West’s) relative decline is seen as inevitable but its future role in the international system is much harder to project. China is deemed unlikely to replace the U.S. as international leader by 2030.  Non-state actors and even individuals, empowered by new media and technology, will be an increasing threat.  A reinvigorated U.S. economy – spurred perhaps by U.S. energy independence – could increase the prospects that the growing global and regional challenges would be addressed. However, if the U.S. fails to rebound, a dangerous global power vacuum would be created.

From these building blocks and issues, the Report posits potential  futures including a best-case scenario of increased cooperation between the U.S., China and Europe as economic and security interests increasingly align, a worst case scenario of conflict and fragmentation in a stalled global economy where political, social and economic inequalities work against integration and stability, and a scenario involving a “nonstate world,” where the nation-state does not disappear, but countries increasingly organize and orchestrate “hybrid” coalitions of state and nonstate actors which shift depending on the issue.

There is no earth-shaking news here.  But it is helpful to take a step back and look at the bigger picture once in a while.  Because change is so often incremental, it is easy to underestimate how quickly it can happen and how much impact it can have in the aggregate.  In the markets as in life, caveat emptor.