Over 250 years ago, Benjamin Franklin penned a four page pamphlet titled “Advice to a Young Tradesman from an Old One”. In it, Franklin dispensed wisdom that seems concurrently basic and indispensable. For example, Uncle Ben advised that if I owe someone money, I should make sure they hear my hammer banging early in the morning and late into the night, rather than hear my voice booming in the tavern at midday.
Franklin’s most famous saying from the short work is “Time is Money”. He explained it as such:
“Remember that TIME is Money. He that can earn Ten Shillings a Day by his Labour, and goes abroad, or sits idle one half of that day, tho’ he spends but Sixpence during his Diversion or Idleness, ought not to reckon That the only Expence; he has really spent or rather thrown away Five Shillings besides.”
The concept our forefather was explaining is something every reasoning creature has encountered since the beginning of time. Economists have labeled it “Opportunity Cost” or plainly, the cost of a missed opportunity. It’s a dilemma that plagued Adam in the Garden (“Do I risk Eve being smarter than me or risk wearing fig-leaf underwear?”). Robert Frost faced it in the Woods (“Two roads diverge, do I risk the monotomy of taking the same one everyone else takes, or risk the unknown of the road less traveled?”) And even Charlie Brown gave it far too much consideration on the Football Field (“Do I risk Lucy taking the football away at the last second for the 100th time and falling flat on my back or risk not achieving my life’s dream to kick a field goal?”)
“Hey…should I refinance?”
It seems every week we’re hearing about mortgage rates dropping to new lows, and with every drop we get a number of calls from clients and friends about their prospects for refinancing. With a simple online calculator, one can surmise the payback period for the refinance. For example, staying in a house for 22 months at the new lower payment might “pay for” the closing costs associated with refinancing. The calculator seemingly indicates that all one has to do is determine if they’ll to be in the house long enough to recoup the costs and whip-bam-zoom: refinance!
You’ll see from the chart below (click to make bigger or see full size chart at the end) that, only part-jokingly, the decision to refinance isn’t as easy as it sounds. I have to think through how long we want to stay there, figure the payback period, consider the emotional toll a mortgage takes on us, and how close I am to retiring. Most importantly, I must take into account not just the absolute rate (and for round numbers’ sake, a 3.5% fixed rate is really more like 2.5% after the mortgage interest tax deduction), but also how that rate compares to my other investment opportunities.
Only So Much Room
We’ve written about it before, but investing is like managing a 100 room hotel. Investors have 100 1% slots (rooms) in a portfolio to “rent out” to different stocks, bonds, commodities, and cash. A rational investor makes his room assignments by measuring the potential gain of one investment over the missed Opportunity Cost of not being able to invest in another.
Typically, the Opportunity Cost we’re presented with in the market makes sense (if I were an economist, I’d say something like “Markets are mostly efficient”…but I’m not, so thankfully I don’t have to). Often, investing looks more like Robert Frost’s somewhat difficult two roads dilemma than Charlie Brown’s no-brainer to let Lucy hold the football. For example, investors can typically buy a Utility Company with very little growth prospects, but little fluctuation, for 10 times what the company earns in a year. Or investors can buy a Tech Company whose earnings could grow rapidly, but fluctuate, for 20 times earnings (twice as much). Either one could be an appropriate choice, but neither goes against years of market data, current fundamentals, or at least common sense.
Ben Bernanke’s Bait…and Switch?
But the Opportunity Cost between Cash, Bonds, and Stocks is another matter. In the last three years, the Fed has lowered interest rates (and kept them artifically low) in an effort to increase investors’ wealth and stimulate the economy. GMO’s Ben Inker puts it well:
“Today, the Fed has engineered a situation in which the really unattractive asset classes [read: the ones with low to negative real returns] are the ones we have always thought of as low risk: government bonds and cash. And unlike the internet and housing bubbles, this time it isn’t a quasi-inadvertent side effect of Fed policies, but a basic aim of them. The Fed has repeatedly said that a central part of the goal of low rates and quantitative easing is the creation of a wealth effect by pushing up the price of risky assets. By keeping rates very low and taking government bonds out of circulation, the Fed is trying to entice investors into buying risky assets. The question we are grappling with today is whether we should take the bait.”
Investors are being asked to analyze the Opportunity Cost of holding Risk Assets (Stocks) against the prospects of holding Cash (which is susceptable to inflation) and/or Bonds (which are negatively sensitive to rising interest rates.) As PIMCO’s Bill Gross puts it, we must make a choice about which “cleanest dirty shirt” to put on. Gross’ comment pertained specifically to US versus Foreign Bonds, but we think it goes for other asset classes as well. The European Debt crisis isn’t near resolved, the US will likely have a rerun of last summer’s debt ceiling debate after an unsure election. As we wrote last quarter, profit margins and interest rates are still far outside their normal ranges. It’s like someone forgot to do the laundry.
As a result, we continue to tilt our portfolios to more conservative allocations across the board. We’ve said it before, but we do this by holding more Cash than typical and staying on the High Quality side of equities with a strong leaning to dividend paying stocks. At times, this can be uncomfortable, because typically this will cause us to lag behind a benchmark when the market is on the upswin
g. But as Warren Buffet said, “Holding cash is uncomfortable, but not as uncomfortable as doing something stupid.”
To Peanuts viewers, kicking the football always seemed like a decision Charlie Brown shouldn’t even consider. But Lucy’s assurances, the fear of missing out, and Charlie’s own behavioral biases (if cartoons can have such) made him think it was an Opportunity he couldn’t miss. And as strange as it sounds, the history of financial markets is made up of Charlie Brown type decisions. Without perspective and a good handle on history, it’s hard not to believe “Lucy” even though sitting out would save plenty of headaches.