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Optionality has value in finance. Think about it this way. If you are dating someone, there might be, there likely are, a lot of plusses in the relationship. However, there is a slight loss in that your optionality to date someone else diminishes. Or at least there is more friction in the switching process.
Financial firms like to design products that remove optionality, because it makes it harder to move capital. As an example: private real estate investment trusts (REITs), private equity positions, annuities, whole life insurance, and CDs from banks. Even owning a rental house as an investment. All of these remove optionality. Capital gains taxes do so as well, in that they trap capital in areas of lower return and lower productivity when it should be moving to more dynamic, higher return parts of the economy. 1,
When optionality (and related liquidity) are removed from an investment, the expected return needs to be higher to compensate the investor.
As portfolios arrive here, we are seeing growing use of "alternatives," including private REITs and private equity. These products perpetuate the myth that there is a secret sauce beyond indexing to higher returns. The problem is compounded because the accounting often is manipulated.
The problem is that these private markets are not liquid or transparent, and so there is no force that says "this is what the investment is worth" in a timely manner, the way a publicly traded index fund does. Say a private equity manager had a bad year, which many did with their leveraged funds in 2022. If they report the true drop in the fund, not only will their own fees collapse, but the limited partner that invested the capital is going to be unhappy and turn down the invite to play golf at Pebble Beach. So the private equity manager has an incentive to use accounting gimmicks to "smooth out the loss" so that it doesn't hit in one year. Problem resolved, back to the links everyone!
Almost five years ago, Sebastien Canderle at the CFA Institute dove into this topic, if you are interested. This is a well-done piece, and shows the pitfalls of investing in private markets: read it here.
This is something to watch out for. It's not a good situation: as an investor, you don't know the value of your assets. It likely will take many years to find out. In the meantime, your optionality is shut down, as these funds can be difficult to exit.
When someone mentions a financial product that reduces your optionality, you should think hard about the compensation. You are giving something up, you deserve something extra in return.
Dan Cunningham
1. This is a real effect, and it exists at One Day In July. We probably hold north of $50 million of client investments that we would sell and exchange for better positions if it weren't for capital gains taxes. So weirdly, these taxes help entrenched, wealthy financial firms get even wealthier, to the detriment of more efficient firms, or entrepreneurs that could use the capital. I probably should do a full newsletter on this, as the topic is complex.
Today we're going to focus on the practical. No more of this pie-in-the-sky economics theory, let's talk about some retirement financial planning issues.
Lots of people pay for financial plans that come in big binders. Almost no one actually reads the plan, from what I can tell, and some level below "almost no one" actually does anything about it if they have it. One of the problems with a Monte Carlo-type financial plan, where a bunch of inputs are plugged in and then you see some curves that tell you where you might be in 10 or 15 years, is that if you change one input even a little bit the scenario 15 years from now swings wildly.
Keep in mind: the concept of full retirement is extremely new in human history. It's only a couple generations old. This is in part due to the fact that people are living longer.
Let me share some observations that you can use in your own thinking. These are generalizations from many client meetings, so not all of them will apply to you.
All this inflation does have a benefit: we don’t have to hear from certain academics about Modern Monetary Theory anymore. You’re probably thinking “I don’t really care about the PhD path of an economist, I care that my grocery bill is up 20%+ in two years.” Stay with me.
Modern Monetary Theory was/is a dream cooked up by certain economists that a nation that issues its own currency can do so without risk or remorse. Magically, debt does not even have to be issued! The market will absorb the currency increase, and the Federal Reserve can always issue more currency to pay the debt. There is the small caveat that they have to pull back at the correct time if resources such as labor get too tight to avoid inflation.
Except it’s not a small caveat. It probably should have like fifteen asterisks and pink highlighter all over it. Because, as anyone who walks down aisle 7 of a grocery store and looks at the pricing stickers knows, they have little ability to time the currency pullback. And that craters the main theory, which may, in certain contexts, have had some validity.
As the money supply soared and America began to buckle under inflation, the Federal Reserve acted too late in 2022, assigning blame to “supply chain issues.” Here is a graph the Wall Street Journal published last week, showing overall expectations on rate cuts versus reality:
Both of these examples show the Federal Reserve's ability to predict macroeconomic events, such as employment and inflation, is low at best. If you can’t predict it, you can’t react in time, and you end up with eggs doubling in price in a year. On the bright side, an aspiring economist somewhere got a PhD for his or her innovative theory.
There are lots of people on this list that run, manage, or work in businesses who would say “I would never issue that level of debt, that is too risky. What happens when it rolls over at a higher rate, and you have to deal with the interest payments?” First, keep in mind that in Modern Monetary Theory, they are issuing currency, not debt. Something a business can't do. Second, a lot of businesses did issue too much debt, in part because the in
However, I don't think the line is as clean between currency and debt as many economists believe. It all gets rather addictive - whether you are printing currency or issuing debt, the short-term boost is fantastic. Your shareholders or voters think you're a genius. The fallout is less thrilling. As the Federal Reserve works to get that excess money supply out of the economy, with higher rates, the government is now facing this (note the interest expense line).
Graph source: WSJ 2/16/24
Theoretically this should lead to lower economic growth, lower asset returns, and a lower standard of living over time as interest expense consumes the nation's resources at a significantly higher rate.
1. Modern Monetary Theory is fantastically complex. As such its implications are not well understood. Remember the One Day In July mantra: if it's not simple, it probably won't work. That which is simple is understandable.