Value Foundations

This week, I successfully passed the CFA Institute Investment Foundations program exam. There were 20 chapters, ranging from Microeconomics and Macroeconomics to Performance Evaluation, among other topics. Despite a 15-year career and several degrees and certifications in business, I found myself learning more detail about the specific functions of finance from overlooked-or-underappreciated simple concepts up into the complex worlds of international trade and of business production. While I will not delve into the complex topics here, I also found certain recurring themes throughout the investment world that seemed to represent the core definition of "value."

When bond investors are willing to pay above par value for an existing bond, they are said to be buying the bond at a premium. A premium is effectively a surcharge on the additional benefits on investments (or other items) that make them more desirable, e.g. "premium seating." All other things equal, investments will be more expensive if they offer one of these three drivers: higher returns, lower risk, or flexibility.

Usually they balance each other out, such as investments that offer either high (potential) returns or low risk. Differences in motivation lead investors to decide between investing in stocks or putting money into a savings account. Consistently, one of those three identified factors could determine which investment was more expensive, and therefore, more desirable. If the risk-to-return ratio were equal between two options, then flexibility often determined which option would be more valuable to investors.

While the concept of time is not readily apparent among these factors, it is embedded within risk factors. The shorter of a time frame in which to invest (known as a "time horizon"), then the lower the risk tolerance. As defined by the CFA Institute, risk tolerance is comprised of an investor's ability and willingness to take risk. Of course, there are subtle differences between the two elements. An ability to take risk can be limited by time horizon or quantity of assets. If the assets will need to be used sooner than later, then investors should not take risks with those assets. Likewise, if an investor only has a few assets, then they should not take significant risks with those assets, even if it limits an investors ability to pursue a higher return.

Conversely, investors who have a long time horizon have the ability to pursue higher risks. However, an individual investor may not be so willing to take such risks. If this risk-adverse investor has limited investing experience or knowledge, then the ability to take risk may be stunted by the willingness to take risks. I can identify with this scenario. I was very risk adverse, regardless of the juxtaposition between returns and risks. I did not fully understand stocks. Admittedly, I related better to the horror stories than the enrichment tales, even if the latter were more likely than the former.

Index investing is the act of attempting to match the returns of a specific market index. Conversely, active investing is the act of attempting to outperform that market. Of the two, there is higher risk in active investing, which psychologically explains why people assess a premium to active investing (even when numbers favor index investing by large, and also despite the fact that investors generally dislike losses more than gains of the same value).

Furthermore, I remember working as a financial adviser for Simmers Capital Management in mid-2000, and being told that a successful argument for clients is that there is more pride in selecting your own stocks or investments than benefiting from the equal gains through a third party, such as a portfolio manager (or an investment adviser, but obviously, we would not feed them that information). This phenomenon supports the third and final factor of flexibility. Investors place premium on flexibility in part for this reason. Additionally, flexibility reflects an investors ability to select terms of an agreement or customize an investment to match their needs. By paying a premium for flexibility, investors immediately reduced their ultimate return; however, they (typically) have also lowered their risk involved.

I started studying for this exam in February and I took it this week, so there was a breadth of knowledge imparted to me. Unfortunately, I did not capture the full scope of the information (in fact, I would wager that I have studied some of the new information in the past for prior exams, such as the Series 6 registration exam or others) but I have the textbook downloaded to my computer to reference again in the future. The concepts of micro-/macroeconomics will be areas where I pursue additional understanding, as well as international trade, especially as our current affairs as a nation center around those concepts.

The Full Motley -- 3Q, 2018

I worked at Vanguard for 8 1/2 years. I have described their managerial style as "driving you insane, and then calling you crazy." Despite being away for over 7 years and counting, they still find ways to continue that methodology.

Last month, Vanguard made a decision for its 401(k) plan participants that baffled me greatly. It eliminated numerous funds from its line-up, including my Vanguard Explorer Fund and Vanguard High-Yield Bond Fund. Inexplicably, it moved the balance of those closed funds into their target retirement funds. I like target retirement funds. For my friends who do not care about investing or markets or rebalancing or any of this jazz, the target retirement funds are great! These funds handle that part for those people. They work great, *IF* that is the only fund in the account!

Mixing target retirement funds into an existing allocation would be incredibly complicated for tracking, and more importantly, generally unnecessary. Instead of investing in the target retirement fund, add the funds that make up the target retirement fund into your existing allocation. Which was how I handled this predicament here. The fact that Vanguard found it prudent to talk out of both sides of its proverbial mouth concerns me though, and I suspect that it may be only a matter of time before this behavior extends beyond its staff and begins to drive its customers crazy.

The target retirement fund consists of the Total Stock Market Index Fund (got it), Total International Stock Index Fund (got it), Total Bond Market Index Fund (got it), and Total International Bond Index Fund (need it). Therefore, I will introduce the Total International Bond Index Fund into my account and set its allocation based on the fact that it is both a bond fund and an international fund. For numerous years, I quietly held the Vanguard GNMA Fund, although its performance has not warranted special treatment. Now that I have been forced to rejigger my entire allocation, I will throw that fund out of the mix. It has been considered for years, alongside rising my international exposure.

Missing from this line-up is my precious PRIMECAP Fund, which I feel grateful that fund was retained in a small roster of so-called "supplemental investments." Their description of these alternative funds would be how most active investors would achieve their target allocation. In particular, my exposure to the Explorer Fund skewed my risk profile higher, and I was comfortable with that increased risk because I had a higher exposure to the bond markets simultaneously.

Therefore, I felt my prior allocation was more robust than the target retirement fund. Simple workaround though, I could take the existing target retirement fund's allocation and apply it to my account since there is enough carry over. However, I do not like its 60/40 split between domestic and international stocks. I would sooner have a 80/20 split, but I will split the difference and make mine a 70/30 split in both stocks and bonds (Vanguard has a 60/40 split in stocks but a 70/30 split in bonds).

My new allocation will have 30% allocated to both the Total Stock Market Index Fund and PRIMECAP Fund, 25% allocated to the Total International Stock Index Fund, 11% allocated to the Total Bond Market Index Fund, and the remaining 4% allocated to the new Total International Bond Index Fund (although I might later adjust the bond split to 10.5% and 4.5%, respectively to reflect a 70/30 split).

For the sake of interest, the other supplemental investments were Vanguard FTSE Social Index Fund, Vanguard International Growth Fund (any domestic growth/value counterparts are conspicuously absent), Vanguard Long-Term Investment-Grade Fund, Vanguard Retirement Savings Trust (in addition to Vanguard Prime Money Market Fund), Vanguard Short-Term Investment-Grade Fund, and three other balanced funds: Vanguard Wellesley Income Fund, Vanguard Wellington Fund, and Vanguard Windsor Fund. No mid- or small-cap funds, which concerns me slightly and perplexes me greatly.

I am not sure what Vanguard was thinking in this decision, especially considering its most loved fund (Vanguard Index 500 Fund) was completely excluded. Based on the number of lawsuits on 401(k) providers for having poor selection choices, making this move now could be inviting a lawsuit. I am certainly disappointed with Vanguard, but having worked there before, it is a familiar feeling.