So let’s talk about the Shiller CAPE. It’s high, very high. It suggests forward looking stock returns are going to be low, very low. Robert Schiller, in a recent interview, made it clear the measure is not intended as a market timing mechanism.

For those watching the CAPE advance along with the total market cap to GDP, some, presuming the killer is in the bushes, will dart for full-on safety, only to find it’s the cat. Cautious observance coupled a comfortable and limited exit from stocks is better considered.

May I also recommend a warm brandy in your left hand as you fervently postulate your CAPE approach to others, if you are of drinking age, of course.

The opinions voiced in this material are for general information purposes only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial adviser prior to investing. Securities and advisory services offered through LPL Financial, a registered Investment Adviser. Member FINRA / SIPC

]]>Just as we might take on risk in the Amazon from uncertainties outside our control, we take on financial risk with uncertainties that jeopardize our money. If we *choose *to go down the river (versus being forced to go down it) we take on the added risk of making a wrong choice and incurring an opportunity cost.

Variance in tax rates, just like variance in our investments’ returns, invites uncertainty and both have a critical effect on how much money we wind up with. Tax risk is often understood, but not quantified. I’d like to suggest a way to measure tax risk so we, as investors, can make better decisions on the types of accounts we contribute to.

This is a back of the envelope measure and does not account for realized or unrealized gains.

**RISK AND STANDARD DEVIATION (A PRIMER)**

Let’s say you have a boss who has bipolar disorder. We’ll call him “Boss A.” When he’s walking on sunshine, it’s a great day! He showers his employees with hilarious jokes, and spontaneous free lunches! When he’s depressed, it’s pretty bad. Withdrawn and cynical, he spills out his personal woes, gets moody and demands you work late. On these bad days, you find yourself hiding in the shadows of large office furniture to avoid him. Now there’s also “Boss B.” Aside from a few mild exceptions, he’s not too spontaneous or funny, but he’s not a downer either. Every day is pretty much like the others, no big surprises.

What if you could measure the emotion in bosses A and B and pretty well predict what each would do according to how each felt that day? For example, you measure Boss A by assigning 1-9 to his behavior: a “5” when he’s normal, “1” on his worst days, and a “9” when he’s happiest.

Now you’ve learned from experience that on Boss A’s best days there’s a real good chance he’ll take everyone to lunch and give them the afternoon off. On his most depressed days there’s a real good chance everyone needs to work late. After seeing this pattern over and over, you can predict by late morning whether you’re getting a free lunch, will have to work late, or neither.

You apply a similar scale to Boss B. On Boss B’s best and worst days, you never expect anything as extreme as a free lunch or working late. His best and worst days are a smidgen north and south of an average day, so the spread of numbers you assign are not as wide. You give him a 3 for a worst day, a 5 for an average day, and a 7 for his best.

There’s an advantage boring Boss B has over A. Boss B’s behavior from one day to the next doesn’t vary much, so he’s pretty predictable. What that means is you can plan ahead with some confidence– you can afford to run five minutes late, because you don’t need to crouch in the shadows once you arrive. You’re also pretty sure you’ll make your son’s evening band recital because you never end up working late.

Financial investments work like Bosses A and B or somewhere between. Stocks are a little like Boss A. They can have really high swings (and greater unpredictability) than other investments, so on their best days, you feel the great benefit of those swings, like a free lunch. On their worst days, you really feel the cost, like having to work late. The difference of course, is that investments either make or lose you money. Bonds vary as well, but in general, they’re more like Boss B; most of the time we can expect modest swings and more predictability.

Remember that measuring system we used for our two bosses, statistics uses something like it called standard deviation. A bigger standard deviation indicates wider swings and that means greater unpredictability, signaling greater possible risk. Stocks, for example, generally have a higher standard deviation than bonds.

In our quest to measure the risk in changing tax rates, we want to keep in mind standard deviation, because we are going to apply a well-known measure to the risk that stocks, bonds, or funds take on, but apply it to tax changes. This measure is called the Sharpe Ratio and standard deviation is the denominator of that ratio.

**THE SHARPE RATIO**

In financial markets, funds that take on risk attempt to compensate for it by paying a higher return. The Sharpe ratio is one measure of whether the return you receive justifies the risk you take on. The ratio divides historical risk into historical return (Avg. return – risk free rate / standard deviation). The Sharpe is a relative ratio so you want to be sure you are measuring apples with apples, for example two funds composed of large, blue chip stocks like Coke and Pepsi between 2001 and 2010.

The Sharpe has its limitations, but the higher the ratio the better; because it suggests that the risk you’re taking is low compared to the return you’re expecting. For example, consider that over ten years fund A has annual average returns of 10% and a standard deviation of 8% and fund B has the same annual average returns of 10% but a lower standard deviation of 5%. Fund A .10/.08 = 1.25; Fund B .10/.05 = 2. Accordingly, fund B has a greater return to risk relationship, at least as the Sharpe ratio measures it. Just like boss B who is pretty average even on his high and low days, when standard deviation doesn’t swing too high or too low from its mean (or average) we have a smaller divisor, like .05 instead of .08 and this suggests lower risk.

The Sharpe ratio also subtracts a risk-free rate from a fund’s total return. The risk-free rate, the return often tied to 3 month t-bills, is what a fund’s return should beat if it is taking on risk. Since t-bills are “risk free,” our riskier fund should at least beat them. Don’t you agree? For simplicity and since this is a comparative exercise, I’ve left this risk free rate out of our example.

**APPLYING THE SHARPE RATIO TO TAXATION RISK**

Tax rate changes invite uncertainty because of unforeseen volatility just like the changes in returns of stocks and bonds invite uncertainty. Like choosing among different stocks with risk/return relationships, we have choices among how the accounts holding our investments are taxed. Generally these accounts either are taxable, tax deferred, and tax-free.

The variance within tax brackets, capital gains taxes and dividend rates over the life of an investor’s portfolio sheds light on account-related risks as affected by taxation. Just like the risk of a stock, bond, or fund is measured by the distance of high and low swings in its returns from its average return, the higher the swing away from the average tax rate, the more risk you take on. Like an investment’s returns, tax rate hikes vary and aren’t entirely predictable.

If we modified our risk and returns to show taxes on our portfolio, we could use the Sharpe ratio to see the tax-affects across our tax-free, tax-deferred, and taxable accounts, providing a new, quantifiable perspective on the risk of changes in taxation. We will apply the Sharpe ratio to hypothetical portfolios in which tax brackets change with each portfolio to represent variance in taxation over time. We will then compare the before-tax ratio to the after-tax ratio to quantify taxation’s risk in our accounts. First, we must find the numerator, or the return to our tax-adjusted Sharpe ratio.

To apply tax-adjusted risk and return to our accounts, we can begin by thinking of taxable, tax-deferred, and tax-free accounts as typical funds with varying returns and risks measurable by the Sharpe. For example, say a mutual fund has a return of 10%. We can treat our tax-free and tax-deferred accounts just like this mutual fund. If my tax-free account had a return of 10% like fund A, then I will use 10% – the risk free rate as the numerator in my Sharpe Ratio. I used Excel’s RAND function to generate a number of hypothetical portfolios. However, if we applied the Sharpe to a real portfolio we could determine the excess return from our portfolio, similar to any fund inside that portfolio (R – R0, where R is the average return of the portfolio and R0 is its risk-free return from money market and treasuries). For example, say our average annual return on our account’s portfolio from 1972 to 2011 was 12% and 3% of the return came “risk-free” from money market and treasuries in that portfolio; we would arrive at 12% – 3% = 9% excess return.

Adjusting the average retirement income for a college-educated retiree from 1972 to 2011 yields the tax brackets below. In 2011, such a retiree roughly has a retirement income of $45,000. The table discounts income each year by 3.1% to account for inflation to arrive at that year’s average retirement tax bracket. The mean (average) tax rate from 1972-2011 turns out to be 18% using this method.

**ESTIMATED RETIREMENT TAX BRACKETS (40 YEARS)**

**Year and Bracket**

2011 (0.15) 2010 (0.15) 2009 (0.15) 2008 (0.15) 2007 (0.15) 2006 (0.15) 2005 (0.15) 2004 (0.15)

2003 (0.15) 2002 (0.15) 2001 (0.15) 2000 (0.15) 1999 (0.15) 1998 (0.15) 1997 (0.15) 1996 (0.15)

1995 (0.15) 1994 (0.15) 1993 (0.15) 1992 (0.15 )1991 (0.15) 1990 (0.28) 1989 (0.15) 1988 (0.15)

1987 (0.15) 1986 (0.18) 1985 (0.18) 1984 (0.18) 1983 (0.19) 1982 (0.22) 1981 (0.24) 1980 (0.14)

1979 (0.24) 1978 (0.25) 1977 (0.25) 1976 (0.25) 1975 (0.25) 1974 (0.25) 1973 (0.25) 1972 (0.25)

Now that we have the average tax-bracket of 18%, we can begin to find the tax-adjusted Sharpe ratio. As mentioned, standard deviation is a distance from the average. If we own a tax-deferred account, like an IRA or 401k and our mean tax rate is 18%, then we’ll keep 1.00 – 0.18, or 82% of our portfolio’s returns after taxes. To find the tax-adjusted standard deviation in our account’s portfolio, we will adjust our returns to reflect the effects of taxation compared to the mean. We will adjust upward our return when the tax rate is below our mean of 18%, since a lower than average tax rate allows us to keep more of our money as though our returns were higher; add zero additional return when the rate is 18%, since it is the average, and adjust our return downward when the tax rate is greater than 18%, since a higher than average tax rate will take more money from our portfolio as though our returns were lower. Below are three examples to better explain this.

1. WE ARE TAXED AT 18%

• Annual return on my account’s portfolio = 9%.

• Tax rates have a mean of 18%, which is also the rate we are taxed at.

• We keep (after taxes) 1 – 0.18 or 82% of our portfolio’s returns.

• Our tax-adjusted return is 82% of 9%, or 7.3%

• The change from the mean of 82% in terms of extra return from taxes saved is 0%, since the mean is 82%

2. WE ARE TAXED AT 15%

• Annual return on our portfolio = 9%.

• Tax rates have a mean of 18%.

• We keep (after taxes) 1 – 0.15 or 85% of our portfolio’s returns.

• Our tax adjusted return is 85% of 9%, or 7.6%

• Our change from the mean of 82% in terms of extra return from taxes saved is 3.7% or (.85/0.82)-1.

3. WE ARE TAXED AT 22%

• Annual return on our portfolio = 9%.

• Tax rates have a mean of 18%.

• We keep (after taxes) 1 – 0.22 or 78% of our returns.

• Our tax-adjusted return is 78% of 9%, or 7.2%

• The change from the mean of 82% in terms of extra return from taxes saved is

– 4.9 % or (0.78/0.82)-1.

This can be expressed as:

*R _{p}−R_{pf} +(1-T_{p })/(1-T_{μ })-1*

σ

Using the RANDBETWEEN function in Excel and the tax table that I created above, you can generate your own hypothetical portfolios between 1972 and 2011 (or fewer years) to see the tax-adjusted effects on your returns for each year. You can then use the tax-adjusted returns to arrive at an average return for returns. Finally you can use Excel’s STDEV function to get the standard deviation for those tax-adjusted, annual returns and arrive at a tax-reflective Sharpe ratio. Compare this ratio to ratios derived from other accounts with different tax effects and you get an inkling of how much extra risk you take on due to taxes.

**CONCLUSION****
**When considering taxation for retirement we often consider two options; a tax-free or tax-deferred account. The Sharpe ratio on a tax-free account like a Roth IRA, is the same as a before tax Sharpe ratio, because the uncertainty, or standard deviation due to changing tax brackets is zero. I ran 300 simulations comparing the before tax Sharpe to the tax-adjusted Sharpe. The tax-adjusted Sharpe was on average 14 percentage points lower and as much as 34 percentage points lower than the before tax Sharpe, due to the risk of volatility in retirement tax rates.

Does that mean you take on less risk when you invest in a Roth versus a traditional IRA? Yes, as far as the Sharpe sees it. But there are other factors to consider. For example, as your income increases, so may your tax bracket and with it the amount your next Roth contribution is taxed. Thus, even though the money you’ve already invested in a tax-free account suffers zero future volatility from taxes, the money you plan to invest still may. The great thing is you have foreseeable control over where you put your money when you receive that next promotion according to how it affects your tax bracket. Why, because you can own both types of accounts, tax-free and tax-deferred. You don’t have to settle for merely erratic Boss A or Boring boss B. You can have a little of each. Multiple retirement accounts can help to hedge against the risk of wrong choice, or opportunity cost, giving you greater control on how you manage the risk of taxation so you can grow your accounts more efficiently.

*This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.*

“You don’t know you’re beautiful; that’s what makes you beautiful”

– One Direction.

“One Direction says I’m beautiful because I don’t know I am! “I think I’d kiss Harry or Zayn if they were… Wait! I have to like, already be beautiful for me to not know I’m beautiful. So how can not knowing I’m beautiful make me? **OMG,** **One Direction do you love me or not?!**

(Presses furry stuffed pony into chest and flops on bed. The mattress gently bounces as sobbing ensues).

Alright, let’s cut to the Fed version: *We’ll keep you posted on our management of inflation by using a theory that denies inflation.*

**Can the Fed control it? First they have to isolate it…**

- The consumer price index uses “average income.” But the more unequal the distribution of income, the more the average gets shifted- a potentially faulty measure.
- The price of globally traded commodities used in domestic products will naturally affect prices of those domestic products. Very little can be done to control pricing on global commodities. Good luck Fed!
- Prices might be limited by short-term contracts. Again not much room to manipulate things, here.

You see, some argue that the Fed’s use of a neoclassical optic to view inflation, which, for example, states a proportional change in money equals a change in prices, doesn’t account for some real world factors. Along with 1-3 above, it assumes full employment and a constant velocity of money- -not too practical.

Key to the post is that not all Fed tools used to isolate inflation account for it. Like One Direction’s theory on beauty, You can’t theorize about something by using tools that deny that that “something” is there.

Portions borrowed from *Neoclassical Inflation. No Theory* *There*; John Weeks. Izmir Review of Social Sciences. Vol. 1, No 2, Jan. 2014. I recommend Weeks’ Book A Critique of Neoclassical Macroeconomics.

The opinions voiced in this material are for general information purposes only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial adviser prior to investing. Securities and advisory services offered through LPL Financial, a registered Investment Adviser. Member FINRA / SIPC

]]>Maybe it’s time for big banks to borrow a page from NIKE’s playbook and find heros to propagate their brands and improve the industry’s image.

The* *most recent** Edelman Investor Trust Study** (2013) finds that the financial industry is the least-trusted industry. It’s not that investors have lost faith in the investment markets, only the go-between financial services they’ve relied on.

Real Madrid and the Yankees are taken, but what about the FDNY? Toddler paraphernalia, including diapers and “onesies” should prove prime real estate for big bank logos, capturing the hearts of countless parents and grandparents who may feel beleaguered by the industry and who remain distrustful investors.

The opinions voiced in this material are for general information purposes only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial adviser prior to investing. Securities and advisory services offered through LPL Financial, a registered Investment Adviser. Member FINRA / SIPC

]]>Take today’s life expectancy, and a male with the same chance of longevity as Fillmore’s will live about six years longer. It’s clear these two guys share the same physical makeup: rounded chin, pointed,right brow with rolling bottom lip and tight, thin eyes above periorbital puffiness. Given the parallels, Alec should have a solid 25 years left.

Oh, and before I forget, the stock market is looking a lot like it did in 1929 and is going to crash within a month. Everyone’s talking about it so start sweating bullets.

Alright.. maybe it will, maybe it won’t. If it does, *it **won’t** have anything to do with this over-circulated chart.* Basing predictions on similarities that have little or no predictive power is a fool’s game.

**WHAT DO YOU THINK? Leave a comment.**

]]>

How do you explain it? Most of the best forecasters didn’t see it or call it. The impetuous market again favors us, but for how long?

For me, the market personified, is provocative, but certainly not the lady (or guy) you would choose to elope with. I wouldn’t expect it to be a responsible partner, stuffing laundry into the machine after hurrying the kids off to school. It wouldn’t be loving and sympathetic, making me tea and cookies on my sick days.

I’ve seen its temperamental behavior enough to know a meaningful relationship is out, so I meet it on more professional grounds. I diversify my holdings into low-cost quality, then let it do its job until it’s time for me to rebalance. Please understand, I’m tempted like the son of a high-toned Quaker noticing Hustler on the convenience store shelf, I want to crack its cover and peer inside.

I try my best to use my practical, more rational, ehem…more adult side to say “leave it alone.” There’s the cost of the magazine, but that’s not the total cost. Like the hot stock everyone has to own, we ultimately pay more by getting too close, at least that’s what research has traditionally shown.

Once I know I am in quality; once I am properly diversified, I’ll stay the course and revisit my investments when rebalancing comes around–a practice less exciting, but more fruitful. After all, the best minds in finance have tried to predict what this most fickle of ladies wants, and utterly failed.

Your purchases might be a fair measure of your “affection” for your artist, but your strong feelings without a wallet are meaningless. Think of capitalism as the high school prom and you’ve romantically chosen 3M Corporation as your date. A starry gaze doesn’t cut it. The best way to show affection is to buy some 3M “Post It” notepads. When you do, you add to your lifetime value.

Companies measure customer lifetime value (CLTV) by estimating how much you spend, how frequently you spend, and how long you’ll continue doing it. The “eureka” here, is that you can amazingly apply the simple CLTV formula to your investments, because:

- Customers provide companies revenue and your investments provide you revenue.
- Customers have a “lifetime value”. Your investments have this too. You are the “company.”
- Companies incur costs to acquire customers. Your costs are the commissions and fees you pay your investment professionals.
- Companies have profit “margins,” the difference between the money they make and their costs to make that money. Your margins are the difference between what your returns earn you less your costs to make them, like advisory and investment fees.

Below is the ugly face of ILTV (Investment Lifetime Value) but what it tells us is beautiful. It helps us understand the cost of choosing and keeping our investments.

ITLV = ∑ (M_{a}) r ^{(a-1) }/(1+ i)^{a }– AC

* M = margin

* r = retention rate

* i = interest rate

* AC = Acquisition costs

TAKE AWAYS

All things equal, we are looking for the highest ILTV. ILTV gets lower when:

- the denominator (bottom) increases
- the numerator (top) decreases
- “AC,” aka our upfront costs increase

**Some things the formula tells us**

1. Hold your investment longer, your retention (numerator) and ILTV can go up.

2. Paying smaller fees for investments grows your margin (and ITLV).

3. Be in the best investment you can find, because:

- It lowers “i” since you’ll be apt to hold a “superior” investment longer.
- Your costs to buy it (AQ) are less a drag, the longer you hold the investment.

**Looking at “i”**** **Your statement shows what you’ve gained, but you have no idea what you’ve given up for that gain, which “i” attempts to measure. Considering an alternative investment that did better is and idea often lost by investors. Be sure you select investments by using measures with predictive persistence.

**Looking at “M” **Say you don’t have upfront commission costs, but have an ongoing advisory fee. This would be an annual cost that reduces “M,” your margin. The more you pay, the more M and ILTV drop.

**CAN’T GET ENOUGH ILTV?**

The formula is a rough guide. It works favorably with low volatility funds and, since research shows we hold our funds for only three years, we generally see low swings in our range of annual returns.

“r” or retention, does not play into ILTV. However when evaluating your portfolio of investments, (“PLTV”), it does, because there is a “defection rate” (1-r), or the rate in which you change investments in your portfolio. You can track your investment turnover to find this annual defection rate. For example say you replace 10% of your investments the first year, 50% on the second and 90% on the third. Keep going until you’ve accounted for 100% turnover.

The “i” or discount rate you apply is your “cost of capital,” some other investment of similar risk you have forgone by choosing your particular investment. A starting point is to use the annualized 3 year return of a superior investment from the same asset class with a similar beta and standard deviation. Relax– you can find the beta or standard deviation by entering “Google Finance” into your browser and entering your investment’s name or symbol from your statments into Google Finance. Look for beta and standard deviation on the page.

If the stated returns have taken out the expense ratio, your cost is zero and there is no change in your “margin.” Otherwise subtract expense ratio from your returns and then apply it to the “M”. Adjust down your margin for the annual advisory fee as well. If you use an advisor and he or she is commissioned, then commission multiplied by the amount invested is your “AQ.”

**The Rules**

1. Try to choose the door that hides the car.

2. Two doors hold a “goat.” Monty will reveal one of them after you’ve chosen a door.

3. Monty will give you the chance to switch to the closed door you didn’t choose.

4. The simulator will tabulate your results. Click on a door to begin.

As you play, you’ll notice that once a “goat” door is shown, you have only two possible doors that can hide the car: the door you picked or the door you can switch to. That’s a 50/50 chance–why switch? Surprisingly, the wiring inside us can work against our making the better choice.

This puzzle, coined the “Monty Hall problem,” appeared in Parade magazine. As you might have noticed, there is a preferred (but unintuitive) solution that doubles the chance of winning. The solution, when put forward by one columnist, was contested by nearly a thousand PhDs. The well-known mathematician Paul Erdos insisted it was wrong until he was shown a computer simulation, perhaps like the one above.

I’ve looked at dry calculations showing why what appears to be a 50/50 choice is in fact not. It occurred to me there is a simpler way to understand it.

1. There are two goats and one car, so we have a two-in-three chance of picking a goat.

2. If we pick a goat and opt to switch our choice, we’ll always win the car.

3. Therefore, there is a two-in-three chance of winning the car, provided we switch.

Put another way, we are shown one of two goats. If we’ve initially chosen a goat, and there’s a two out of three chance we have, we will always win by switching. If we don’t switch, there’s is a one-in-three chance of winning. Monty affects the odds by showing the goat. This seems like a helpful gesture, but in fact allows our faulty reasoning to work against us.

There are at least three ways in which *Let’s Make a Deal* stacks the odds in its favor. Probability and psychology play big roles. The first is by making our choice appear to be what it is not: a 50/50 shot. The second is by banking on our counterfactual, or faulty gut tendency to *not* switch doors. Third is the show’s advantage in running a series of games to virtually assure its odds. Choose “1000 runs” after clicking on the above link to the game. First, pick “keep the choice” and note how you never deviate much from ⅓ wins and ⅔ losses. Next, pick “change the choice” and notice that you uncannily win about ⅔ the time, just as expected. This predictability is an advantage the game show enjoys but not individual contestants who play only once.

**Financially Speaking…
**We experience faulty (counterfactual) thinking when we refuse to sell a poor investment or purchase a stock at a price higher than what we once paid. We might find the industry’s use of odds in league with our counterfactual thinking when media baits us to adopt a herd mentality, giving us a gut-prompt to chase a stock’s returns or to seize the latest “hot” investment by tempting us with historical returns and other poorly predictive data.

In fact, by the time such hot tips hit pulp and print, most of their value is likely wrung dry. What seems like helpful tips, similar to Monty’s showing the goat, may in fact only serve to eke out greater sales for reduced value investments all at the cost of forgoing better investments.

A question is whether investors and advisers who act on poorly predictive media tips, display a counterfactual behavior that is in fact predictive and therefore, exploitable by financial media and the industry.

]]>