Compass July 2015

In this issue:

Compass is the quarterly newsletter of Creekside Partners. All information is obtained from sources deemed to be reliable, but is not guaranteed as to accuracy. Nothing in this newsletter should be construed as financial or investment advice to any reader. All material herein is the copyright of Creekside Partners.

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The Wisdom of, “Why?”

Or…be curious and ask questions.

We are unrepentant skeptics. If you want to get our attention, make a claim about a factual matter without providing any proof or data to back up your claim. Even worse, provide bad or incomplete data. The practice of skepticism has a long and shining history, starting with the Greek philosophers and running through such modern luminaries as Albert Einstein and Neil deGrasse Tyson.

At its core, skepticism is the art of asking, “Why?” Someone makes a claim or observation. You ask, “Why?” They give a first answer, to which you again ask, “Why?” The process of drilling down into the issue – of peeling back the layers of the onion – can eventually lead to truth. Or, equally often, it will uncover the lack of truth.

We’d like to illustrate the concept with reference to a magazine article from a few years ago (We keep it handy to remind ourselves of these lessons). A national news weekly gave the advice that, in order to beat inflation, you should buy stocks. They used three periods of
time to illustrate their point: 1926 to 2004; 1987 to 1990; and 1979 to 1981. During those selected periods, stocks paid significantly more than the rate of inflation. The investment skeptic will ask, “Why,” and look more deeply at the question.

First, we should notice the odd selection of time periods. A 78-year period, a 3-year period and a 2-year period. Hmm. What about 5, 10, or 20 year periods? We don’t have 78 years to wait, and 2-3 year periods are too short a horizon for stocks. On a hunch, We looked through the data ourselves. It wasn’t hard to find a few periods where stocks did not keep up with inflation. In fact, they all but leap out of the database.

For the 5 years from January 1973 to January 1978, stocks paid a total annual return of minus 4.5%, while the annual inflation rate averaged 8.0%. Stocks trailed inflation by a compounded 46%, over only 5 years! The spending power of stock portfolios was cut almost in half.

What about periods in which stocks made good money, but inflation was high enough to wipe out returns? Since you asked, the 5 years following January 1945 saw annualized stock returns of 5.2%, with annual inflation of 7.4%. We could go on and on.

The point here is that, with a sloppy or careless (or manipulative) examination of the data, one can find select periods of time that support almost any conclusion. The question, “Why?” doesn’t lead to an answer about why stocks beat inflation, but rather to the question: Why did the magazine choose these time periods?

As we continue to ask, “Why,” we begin to find that stocks tend to do well not merely when inflation is high or low, but rather when inflation is moving from high to low. Paul McCulley, formerly of PIMCO, has written about the difference between the journey and the destination. It is the journey of inflation from one level to another higher or lower level that triggers stock movements. Stocks move higher more often when inflation has drifted lower than when inflation is stable.

Since 1900, whenever inflation in one 5-year period changes a small amount from the previous 5-year period – what we call stable inflation – stocks beat inflation two-thirds of the time. This is true whether inflation is high or low. In times when the rate of inflation declines significantly across those sequential 5-year periods, stocks beat inflation an astounding 98% of the time.

Finally, if the rate of inflation increases significantly, stocks fail to keep up with inflation 55% of the time. In 5-year periods during which inflation rose, stocks trailed inflation by an average of 1.5% per year. These figures provide some evidence that it is the change in the rate of inflation that matters most to stock investors, not so much the actual rate of inflation itself. The national magazine article looked only at the average rate of inflation, not the change in direction of inflation. This article also highlights the fact that even well-meaning, independent investment advice can lead us astray.

While the magazine implored investors to move into stocks as inflation moves higher, the evidence from the 20th century provides advice to the contrary. If you believe that inflation is moving higher, you need to make a tough decision about stocks. In the longer run, stocks will almost certainly outrun inflation. In the shorter run…that often does not happen. How long can you wait?

Investors must be skeptical, and continually ask, “Why?” If someone advises you to buy an investment, you must ask, “Why?” If the answer is, “Well, it has paid 11% annually for the last 25 years,” you need to ask, “Why did it pay 11%?” What were the facts and circumstances that led to that 11%? Are those circumstances likely to repeat themselves? What about other time periods?

This last example should be asked of “robo advisor” investment promoters, who are fond of merely citing the historic average return, while giving no thought whatsoever to whether those historic returns have any hope of being repeated. Investment returns don’t just happen. They happen for reasons. An argument over index investing versus active investing misses the point.

  • What are the reasons and conditions that led to past investment returns?
  • Are those conditions present today?
  • Should we rationally expect the past to repeat, or should we actually pick up our heads and look
    around at the real world?

The skeptic has a reputation for being a curmudgeonly naysayer that questions everything and everyone. While this behavior might not be the best way to approach all areas of your life, it is the best way to approach your investing.

A “Sharing Economy” Experiment

Living in Northern California, we hear a lot about the “sharing economy.” What is the sharing economy? According to a recent Fast Company article, the sharing economy is “consumers (or firms) granting each other temporary access to their under-utilized physical assets, possibly for money.”

The idea of being able to lower day-to-day expenses by sharing intrigued me. I’m always looking to cut costs and save money. My three kids roll their eyes whenever they hear Dad switching TV service, DSL providers, etc. to save a few dollars.

I decided to break down a sharing experience to see if the economics made sense. My car sits the vast majority of the day so I thought I would try using Uber and Zipcar to commute to work and breakdown the numbers. First, a bit of information on this experiment.

I drive a 10 year old BMW 525i that I purchased used. Insurance is $144 a month (I’ll do another column on car insurance at a future date). I commute 24 miles total each day or approximately 480 miles a month to and from the office. We’ll call that around two tanks of gas per month for commuting or about $100 a month at current prices. CA Registration fees of $20 per month; maintenance of roughly $40. Grand total
of ~$304 per month to own my car and use it at will (and this ignores ongoing depreciation as I put miles and years on the car). In daily use terms this would be about $15.20 per work day.

The Uber experiment…I downloaded the Uber app to my iPhone and used the slick interface to upload my credit card and I was set to go. I pressed the button on the application and selected UberX (small cars like Prius, etc.) to pick me up. They driver arrived 6 minutes later. Very efficient and a nice ride to work while I read emails. The bad news: A $21 charge one way..that was a non-starter. Now I’m at work without a car. Fortunately, I can walk to BART. A $2.60 ticket from Lafayette to Rockridge station and then an Uber ride home for $10.29 or total of $12.89 one way. We are getting closer, but still way too expensive to make a change.

On to Zipcar: Their monthly driving plan has a $25 signup fee and a $7 per month charge. Then $8.50 per hour (no by-the-minute calculation). Basically they required a two hour minimum to cover the work day. This covers gas and insurance. The cost was reasonable, but the car pickup locations were not within walking distance so I would need to bike or walk a long way or spend more money to get to the location quicker.

My experiment was educational for me, but my conclusion was that If I want to cut costs, I should
probably sell my car and then ride my bike to BART…but that probably won’t happen until the kids are
out of the house! These services are great, but they are not quite the economic game changer the headlines
make them out to be.

Year-to-Date Index Returns (ending 6/30/15)

Total Market U.S. Stocks

Foreign Stocks (Developed)

Emerging Market Stocks

Muni Bonds

Taxable Bonds

Inflation (year-over-year)

1.84%

5.38%

3.84%

0.04%

-0.22%

-0.04%

Wherever possible, we use the returns on
Vanguard Index Funds as the benchmark
figures for various asset classes.

Readers wishing to review the actual performance
record of a composite of our client portfolios
should call or email us at info@creeksidepartners.com.