Tuesday, December 9, 2008

Big Trouble for the New Jersey Pension Fund

As of late November, New Jersey's State Workers Pension Fund has lost more than $23 billion this year. That places the balance at $57.8 billion, down more than 28% from $80.8 billion at the beginning of the year.

The New Jersey State Workers Pension Fund covers 700,000 working and retired individuals. The New Jersey Investment Council, led by hedge fund manager Orin Kramer, establishes broad policy and asset allocations for the fund. The Division of Investments, led by former insurance industry executive Bill Clark, settles on specific investments and managers.

Up until a few years ago, the fund was run entirely by state workers and invested heavily in stocks. Like many other pension funds, it has since taken up the Harvard and Yale endowment model of investing. This means diversifying outside of the stock and bond asset classes and into real estate, commodities, hedge funds and private equity.

Let's do some math. Current retirees account for $5.2 billion of withdrawals from the fund per year. Current workers contributed $993 million to the fund last year. The State is supposed to contribute an additional $1.1 billion, but Governor Jon Corzine has asked to have this amount reduced to $559 million. If we use the $559 figure, the fund has a current annual deficit of $3.648 billion.

How bad is that? As of late November, the fund has to return 6.31% a year on its investments just to cover this deficit. Even if the state decides to contribute it's $1.1 billion contribution, the return has to reach 5.38%. What happens if the contributions of current workers and the state stay the same and the fund has no gains for 5 years (a very real possibility if we are in a 1970's style investment climate)? The fund would be down to $39.56 billion in assets and would have to return 9.22% on its investments just to cover the deficit.

All of this does not even take into account the inevitable demographic changes that will take place over the next few years as the mass of baby boomer workers set to retire. Actuaries estimate that the fund needs $118 billion today cover its long term obligations. This is a shortfall of $60.2 billion and it only looks to get worse.

If anyone has a breakdown of the number of currently retired workers that make up the 700,000 of fund stakeholders and how this changes over time, please email me.

Monday, December 8, 2008

Volatility Is Not Your Friend

Which would you rather have for an investment....4 years of 10% yearly gains followed by a 20% loss year or 4 years of 5% yearly gains followed by a flat year?

Scenario 1: +10% + 10% + 10% + 10% - 20%

Scenario 2: +5% + 5% + 5% + 5% + 0%

If you answered scenario 2, 5% gains followed by a flat year you would be right. $1,000 invested in the first scenario would result in $1,171.28 (+17.13%) after five years while $1,000 invested in the second scenario would result in $1,215.51 (+21.55%). This despite both scenarios averaging a 4% gain per year.

Why does this happen? The difference can be described by defining the arithmetic average versus the geometric average of the investment. The arithmetic average of our investments is found by adding up the returns for each year and dividing by the number of years. This is what we typically mean whenever we use the term average, as we did above when we said a 4% yearly average for both scenarios. The geometric average is found by adding 1 to the annual returns, multiplying them, raising that to the power of (1/number of years) and then subtracting 1. It sounds like a lot but the gist of it is that returns for one year affect future returns when we calculate geometric average but this does not take place when calculating arithmetic average, and thus geometric average is a more relevant measurement for investors.

Let's see the results of calculating both averages for our two scenarios:

Arithmetic Averages
Scenario 1: ( .10 + .10 + .10 + .10 - .20 ) / 5 = .04 or 4%
Scenario 2: ( .05 + .05 + .05 + .05 + .00 ) / 5 = .04 or 4%

Geometric Averages
Scenario 1: [ ( 1.10 * 1.10 * 1.10 * 1.10 * .80 ) ^ ( 1 / 5 ) ] - 1 = .0321 or 3.21%

Scenario 2: [ ( 1.05 * 1.05 * 1.05 * 1.05 * 1 ) ^ ( 1 / 5 ) ] - 1 = .0398 or 3.98%

As you can see, the arithmetic averages are the same for both scenarios while the geometric averages for scenario 2 is greater than that of scenario 1. The geometric averages reflect our total average annual returns while the arithmetic averages do not.

Let's try some more scenarios. 4 years of 15% gains followed by a loss of 40%, 4 years of 20% gains followed by a loss of 60% and 4 years of 25% gains followed by a loss of 80% all have an arithmetic average return of 4%. The same can be said for 4 years of 5% losses followed by a 40% gain, 4 years of 10% losses followed by a 60% gain, 4 years of 15% losses followed by an 80% gain and 4 years of 20% losses followed by a 100% gain. How do their total returns stack up? Let's take a look at a table (click for larger image):

arithmetic versus geometric average, volatility and investment returns

Our best total returns are from those rows towards the middle. So what does this tell us as investors? It tells us that, all other things being equal, if two investments have the same average (arithmetic) returns but one has a greater volatility than the other, always choose the investment with lower volatility. Volatility is our enemy.

It also tells us to be wary of investments that have even several years of outperformance. I chose 5 years for a timeline here because that is the typical length of a business and stock market cycle. From the table above, you can see that 4 years of 25% yearly gains are completely wiped out and then some with a -80% year at the end.

If you would like to play around with the numbers and work out your own scenarios, click here to view my google docs spreadsheet which you can view, edit and save in google docs or download to excel. Good investing!

Sunday, December 7, 2008

Jim Rogers

I'm a big fan of Jim Rogers. He's the former hedge fund manager of the Quantum Fund and author of Hot Commodities, A Bull in China, Adventure Capitalist and Investment Biker. The first two of these books are good starting points for those looking to invest in commodities and China while the later two focus on his personal travel stories.

While I enjoy his writings, Jim Rogers is at his best in spoken form. Here is a sampling of his better moments in recent history.

Rogers talks about the pending demise of the US Dollar:

Why would anyone listen to Bernanke?

Mike Schneider interviews Jim Rogers (part 1 of 5):

Jim Rogers on CNBC's Power Lunch: