Who Benefits From Investment Performance Measurement?

Disproportionately, it is the lucky.  The reason is that most investors invest in particular securities and investment managers based on excellent past returns, and there is overwhelming evidence that this leads to disappointment.  Not only are past returns not very predictive of future returns, but returns unadjusted for the risk control needs of the particular investor are generally misleading.

Investment consultants benefit, because they generally provide measurements for use by institutional investors, and because they are  often able to sell consulting services to find replacement investment managers based on, among other things, these measurements.

Investors themselves benefit very little.  Investors in mutual funds do worse on average than the mutual funds, because they buy and sell at the wrong times, and even if they stay fully invested, the average mutual fund doesn’t do as well as an index of its universe – such as the S&P 500.  A study of large pension funds (Goyal and Wahal, Journal of Finance, 2008) found that the investment managers fired by pension funds actually did better in succeeding years, on average, than did their replacement hires.  Though one can certainly argue that somehow investors would have done even worse without  performance measurements, in fact investors as a whole tend to select new investments from those vehicles that have had much better than average measured performance in the past, and this appears not to do them any good.

Motivating Ourselves and Our Brokers, Advisers, and Money Managers

There is a cycle in hiring and firing either our agents or our own investment strategies.  We pick people and strategies, and we fire them, and start over.  Presumably we do this in large part based on their performance records.  It doesn’t work very well for two reasons.  First, it is hard to distinguish skill from luck in investing.  Second, we don’t try very hard to devise performance measures that would serve as interim motivators in an investment world that is so unpredictable.  In general, we want to motivate for better long-term compound return and that turns out to be highly dependent on risk and on our ability to sustain risk without dropping out.  (Again, taxes are important, too.)  What we are suggesting here is that we pay more attention to this middle step, the motivation that comes from a performance measure more aligned with out interests.

 

Of course, in a more realistic balance sheet, you may have other assets beyond investments as well as the present value of future savings or an inheritance that will also affect what you can afford to lose without damaging your ability to pay off your future obligations.  But the point is still the same.  Your leverage determines your ability to bear risk.

How does this kind of personal leverage affect your results at different levels of risk bearing?  The exhibit below illustrates for an investor with a fairly typical leverage ratio of 2.8.  It shows expected annualized returns over many periods for different risk-taking assumptions as they apply to both investments and discretionary wealth for this investor, given some realistic assumptions about the pre-tax returns and volatility of a mixture of index cash, bonds, and stocks today.

The general shape of expected long-term annualized returns as a function of risk-taking is curved.  Intermediate levels of risk do better than either very little risk or very great risk.  Look first at the flatter (blue) line.  It indicates that if there were no leverage — that is, if the investor could afford to keep playing the game even if nearly all his or her money were lost —  the optimum equity allocation is just slightly over 100%.  That is, in this example, one could invest on margin and do a little better.  The line is relatively flat, so that very little long-run result difference is expected among the various equity allocations between 80% and 120%.  Now look at the more sharply curved (red) line.  It shows the expected annualized return on the smaller base of discretionary wealth.  For low levels of risk, the leverage results in a high rate of return, but the curve peaks at around a 35% stock allocation and then drops sharply to negative rxpected annualized return by about a 120% leverage — that is, a 20% margin account, all in stocks.  Note that the chart generously assumes that the cost of borrowing on margin is no higher than the interest return on the fixed income portion of the portfolio.  In reality, margin borrowing is more expensive and would result in a faster drop off.

If the investor’s discretionary wealth were even lower than in this example, leverage would be still greater, and the discretionary wealth return would be higher at its maximum, since on a smaller base, but the optimium would be at a lower percentage allocation to equity.  This kind of exhibit makes clear the need for conservatism as the amount you can afford to lose, your discretionary wealth, shrinks relative to the investments you hold.

For those readers familiar with Markowitz mean-variance optimization, what we have done is to locate a customized tradeoff between risk and return based on the investor’s ability to bear risk, as shown in the exhibit below.  The advantage of this approach is that it is more objective and less likely to be far off the mark than asking yourself what your risk tolerance is, or inferring it from what you imagine you would feel under varying circumstances.

The curves in the preceding example were constructed based on assumptions of return mean and variance, as well as their correlation, for fixed income and equity portions of a portfolio.  But that is an approximation of a more generalized form of this optimization – maximizing expected log leveraged return, or ln(1+Lr), where r is the portfolio return and L is the leverage multiple obtained from the balance sheet shown earlier.  This formula has the property of providing the best expected annualized rate of return. It takes into account not only mean and variance of return, but also the shape of the probability distribution — whether it is skewed or has “fat tails,” meaning non-normally high probabilities of very extreme outcomes.  Note that there is a disproportionate penalty attached to big losses.  This is because a significant loss interferes disproportionately with the ability to compound returns so as to produce a satisfactory long-term annualized return.  If you don’t believe this, consider a process in which you with equal probability gain 100% or lose 50%.  The expected return in a single period is +25%.  The expected long-term return over many periods is ZERO.  For the statistically minded, this function appropriately penalizes both negative skewness and high kurtosis, or “fat tails” of return probability distirbutions.  that is, risk reduces annualizes compound return from the expected return for a single period. 

Now we can present our recommended measure of investment performance.  Average ln(1+Lr) gives us the growth rate of discretionary wealth.  Dividing this expression by leverage L scales the return down so that it is an appropriate risk-adjusted return for your investment portfolio.  You can think of it as approximately E – LV/2, where E is the expected single period return, V is the return variance, or the standard deviation squared, and L is the investor’s leverage relative to his or her discretionary wealth, or what can just barely be afforded as a loss.  The main difference is that the expected logarithmic leveraged return takes into account adjustments needed for the shape of the return distribution.

Now we have arisk-adjusted return measure appropriately customized to the needs of a particular investor with a leverage of 3 times.  That is, he could barely afford to lose a third of his investments without running into serious future problems.  The exhibit below shows the compounding effect of 4 hypothetical return histories.  They are constructed to begin and end at the same place, so as to illustrate the impact of taking the customized leverage of 3 times into the performance measure.  What we are trying to do is to measure performance in such a way that a sequence that would lead the investor to a greater chance of defaulting on their future obligations is penalized and a greater chance of enhancing their discretionary wealth so that they could increase their spending plans, is rewarded.

Each of the 4 sequences achieves a 7.3% return on investments.  but risk adjusted, the returns for the base “normal” case were reduced by volatility to 3.9%, a substantial reduction.  Even this case with returns generated from a normal distribution is heavily penalized by the apparent exceptional risk.  the higher variance sequence seems visually to be only a little more volatile, but of course when already high standard deviation is squared, apparently small differences loom much bigger, and the negative impact of this is multiplied here by 3 times!  Consequently, the customized risk adjusted return is only 2.8%.  Finally, to show the impact of changes in the shape of the return distribution when leverage is involved, but without affecting its mean or variance, sequences 3 and 4 were adjusted to produce a negatively skewed return distribution without excess kurtosis, and a stronger kurtosis (fat tails) return distribution without skew.  Each did better than the high variance case, but slightly worse than the “normal case,” producing risk-adjusted returns of 3.6%.

Well, you might say, such big differences reflect unusually high leverage or very highly volatile returns.  Actually, the return volatility is not particularly extreme for an investor holding individual stocks rather broadly diversified indexed funds in a balanced portfolio.  Well, then , what about the leverage?  Isn’t it rather high?  No, based on my experience, it is similar to that of many high net worth investors, and most investors probabily have higher leverages.

But it is true that the substantial reduction from unadjusted, unleveraged returns might give pause to the investor in any of these strategies.  That is the whole point.  Keeping track of your investments in this way reinforces two messages.  The first is to keep your risk-taking consistent with your ability to bear risk.  The second is to further motivate accumualting an adequate reserve of discretionary wealth so that you can afford to bear more risk and aspire to future increases in planned spending and gift-giving.  That is, it reinforces both good investing and good financial planning.

Jarrod Wilcox

August 28, 2011

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Insights Into Taxable Investing

QWAFAFEW Boston

March 16, 2004

Jarrod Wilcox

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Realistic Study of

Taxable Stock Returns for Private Investors

• Key paper: Jeffrey & Arnott  “Is Your Alpha Big Enough to Pay its Taxes?” (JPM ’93)

• More recent studies by Arnott et al., Brunel, Garland, Jacob, Stein, Reichenstein but still…

• Some lack of clarity about sources and full extent of tax alpha available under realistic conditions.

• And still too little practical impact on active managers. 

• My presentation is based on joint study with Jeffrey Horvitz:  “Know When to Hold ‘Em and When to Fold ‘Em” Journal of Wealth Management, 2003.

• We quantify the current US benefit of:

                    Avoiding short-term capital gains treatment.

                   Waiting longer to realize long-term capital gains.

                   Selling the lowest tax liability tax lots first.

                   Holding stocks until death.

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Our Research

• Bootstrap study of 1000 simulated histories using monthly dividend yields and price returns of S&P500 1926-2001.

• Realistic payment of short-term, long-term capital gains, loss carryforwards, liquidation and estate taxes where relevant.

• Up to 600 tax lots over 50 years in each history.

• Tax alpha here is difference (from tax-insensitive portfolio with 100%/12 monthly turnover) in annualized after-tax return through liquidation and final tax payment – includes 0.25%
  one-way trading cost differences.

• Conservative – restricted to a single index-like stock.

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Benefits of Deferring Gain Realization – Median Results

You see the benefit of deferring short-term capital gains taxes right away.

But the benefit of further deferral of long-term gains is very slow to build

A non-linear process requiring very little turnover and not too much dividend reinvestment.

Some benefit to index funds or to corporate investors at 35% tax rate.

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Distribution of Bootstrapped Results

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Tax-Sensitive Sales

• At any given turnover rate, selling tax lots with lowest tax liability first

                    Greatly accelerates buildup of unrealized gains, leveraging current liquidation value

                    And accelerating the buildup of tax alpha with deferral of liquidation

                   Making long-term gains deferral much more valuable.

• With this policy, even fairly high annual turnover rates can result in build-up of tax alpha…

• Because age distribution of portfolio bifurcates, and a buy-and-hold sub-portfolio is created while…

• Another high turnover sub-portfolio creates tax benefits.

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Impact of Cost-Basis Stepup at Death

Heirs and charities benefit greatly from the avoidance of all gains taxes, even after estate taxes are taken into account.

If you care about avoiding taxes after death, don’t sell stocks with net gains.

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Implications for Active Management

• Alpha generated for non-taxable investors is often useless to taxable investors.

• You are unlikely to improve on available tax alpha unless you design your active process to complement it. The hurdle is significant, and bigger than shown here.

• Realizing no net short-term gains or selling a few deep losses at year-end will not be enough for informed large private investors.

• Hedge funds that throw off short-term gains for private investors face an uphill battle.

 In 1997 there was a raging debate as to whether the European Currency Union would get started and whether it would include Italy, which many in Germany thought was a bad idea.  They may yet be proved right.  I was asked for my view, not as to whether it was a good idea, but as to whether it would happen.  I said yes, because of the specifics of the negotiation.  Here was my analysis.

 WHAT THE EURO MEANS

TO A GLOBAL INVESTOR

DRAFT #2

6/26/97

by

Jarrod W. Wilcox

The promised advent in 1999 of the Euro, a common European currency, is a significant event for the global investor.  Its impact will be felt not only by commercial banks, brokers, investment bankers, mutual funds and investment advisors but also by corporate and government financial professionals dealing with pension funds or charged with raising money.

Abolishing multiple European currencies will cause far-reaching simplification beyond leaving fewer currencies in which to deal.  The lower transaction costs and reduced risks of cross-border investment will create a unified European capital market similar to the United States.   Frictional costs, and therefore opportunities for financial intermediary revenue, will shrink.  Many ways to add value through skillful cross-border arbitrage will also dwindle.  Even the scope for cleverly picking the right country in which to invest will diminish.

Some financial experts argue there are grave difficulties in the way of the Euro which have now been accentuated by the changed political climate in France.  This is natural because the financial industry has something to lose in the short run from a common currency.  However, a major reversal is unlikely.  While some politicians may be intimidated by voters and while there could be setbacks, the key leaders of Europe will likely push ahead with a common currency for a very simple reason.  It is part of a policy of dismantling barriers to economic progress that dates back 45 years to the founding of the European Coal and Steel Community in 1952.  To bet against the Euro is to bet against history. 

Further, it probably will be here on time, in January 1999.  Since not even Germany truly meets the convergence targets set by the Maastricht Treaty, the issue is not when standards are met.  It is simply how long it takes to complete the inevitable horsetrading.  And that can be done on schedule.

The implications of creative destruction

 At the heart of the Euro lies financial deregulation or, expressed another way, creative destruction.  The first consequences are likely to be felt in the markets themselves but soon after there will be a major impact on many market participant organizations.  It seems likely that a single European capital market will emerge for each of three broad classes of securities – bonds, stocks and futures.  For the global investor the implications are as follows:

• In the bond market, many of the fixed income arbitrage opportunities that have led to trading profits and active management value added in prior years will disappear.  However, the pattern of lower government deficits for most countries should encourage more savings to go into corporate and mortgage bonds, leading to the development of additional tradeable fixed income securities in the European private sector.  This should create new diversification and active management opportunities.

• In the stock market, the deregulatory nature of the Euro should assist in improving productivity, leading to higher expected stock returns as productivity growth accelerates.  The disappearance of individual currency fluctuations will lower the risk of investing in an individual country but for a global investor this will be offset by a loss of currency diversification.  Since expected return is a bit higher, and risk largely unaffected, allocations to Europe within global investors’ portfolios should be increased.

• In the currency market the implications at a portfolio level are less certain.  Since the Euro in some sense represents a portfolio of its component national policies and business situations, diversification will tend to make it more stable than its typical predecessor components.  However, if currencies such as sterling, the Italian lira and the Swedish krona fail to join the Euro, there will be substantial loss of diversification potential.

The benefits of integration

 Before analyzing these implications in more detail, it is worth pointing out that the policy of European economic integration has been linked with increasing European economic promise.  The latter appears clearly in the world’s stock markets.  Figure 1 estimates the fraction of the world’s stock market value represented by developed Europe.  It plots the European part against the whole of the Morgan Stanley Capital International (MSCI) World Index plus the International Finance Corporation Composite Index of Emerging Markets.  The MSCI portions have been scaled up to account for MSCI estimates of total market size.  Even in the face of competition from the US, Japan and the emerging markets, Europe is rapidly increasing in relative stature on this measure.  It has risen from about 17% in 1983 to about 26% of the world of market equity in 1996.  As the countries of Eastern Europe catch fire with free market expansion, this trend is likely to persist.

As for the next stage of integration, if Germany does not meet the Maastricht convergence targets, then the negotiations as to which countries will be invited to join the initial monetary union becomes one of bargaining rather than of treaty-bound convergence criteria.  There will be convergence, but it will be to European and not necessarily German standards.

It is worth noting that the bargaining will be done within the European Council of Ministers, and that Spain, Portugal and Italy have a voting bloc sufficient to veto changes.  They will likely all stick together rather than exclude Italy.  Only Greece will be left out, and its time may come sooner than most people think.

That leaves some Nordic countries and Britain as the countries who seem headed for self-inflicted exclusion.  However, the recent British election of a Labor government with more flexibility toward Europe bodes well for early British participation even though the new government still pronounces it unlikely.

A silver lining for US firms  

The big losers from the appearance of the Euro are likely to be banks, particularly European banks.  They will lose an important source of profit, as well as employment, in currency exchange bid-ask spreads for the middle market.  They will lose most of the profit in the swap market.  Their ability to profit in a more unified bond market will decline. As national governments grudgingly abandon their favorite banks to the vagaries of competition, fees for security custody will be driven down toward US levels.  There will be more bank mergers and reduction of employment in these activities, reinforcing the trend already underway.

As European banks lose the ability to cross-subsidize their investment management activities, it is likely that we will see an acceleration of the trend toward fee unbundling that took place years ago in the US.  The combined impact of these moves  will also strengthen the ability of specialist firms to cherry-pick bank customers in areas such as mutual funds.  Because of the unified market, which does not require subsidiaries in each country, and because of a more unbundled fee structure US-style, it will be much easier for outsiders.  The Euro is a cloud with a silver lining for US financial service firms competing in Europe.

 When markets consolidate, it is typically a process of the big fish eating the little fish.  This argues for the coming greater dominance of the London exchanges in Europe, resulting in parity with large US markets.  The Euro is a threat to the employment of many financial intermediaries, and is thus widely feared in London.  Ironically, its arrival could lead to eventual greater prosperity through the overall growth of the London markets but if Britain does choose to stay out of the currency union, the door will be left open for Paris.  Because its markets were initially less sophisticated and less successful, Paris has had more nearly a clean slate on which to construct computer-age trading, and it has gone about this with vigor.

One caveat is the growing trend toward electronic trading.  Physical exchange marketplaces are no longer strictly necessary.  As geography becomes less relevant the issue may well become, not London or Paris or Frankfurt, but London, Paris, Frankfurt or Cyberspace.

New opportunities in the bond market

The impending arrival of the Euro and the European Central Bank has diminished and will further diminish both short-term money market yield differences and long-term bond return differentials.  Not only will the staple currency plays be eliminated but there will be continuing and greater levels of business cycle convergence.  Existing skills in arbitrage will have to adapt or be abandoned.

The European bond markets have become more stable and their yields have moved closer together during the process of convergence to qualify for the currency union.  The generally lower inflation rates, and, except for the UK, the growing simultaneity in business cycles, have brought even longer term bond yields into a high degree of alignment.  After the currency union begins, however, it may be longer than the market expects before the inter-European system reaches the kind of cohesion seen in, for example, the provinces of Canada.

Governments have always used currency depreciation as a tool, sometimes the tool of last resort, for escaping from a variety of pressures.  Businesses want protection from competitors.  There is generally an excess of people wanting government help over taxpayers willing to support them.  This causes fiscal budget deficits that create burdensome debt that can be financed temporarily by devaluing that debt.  Wage rigidities in the face of productivity improvement differentials cause changes in real exchange rates that are eventually reflected in changes in currency exchange rates.  The Euro closes all these escape hatches.  Until the ground rules change, these continuing social pressures will have no outlet left but fiscal deficits and government borrowing.

The Stability Pact signed in 1996 provides for fines as a percentage of GDP if a participating government exceeds government deficit targets.  This strict Teutonic idea has been compromised by  a loose political mechanism for deciding when fines will be enforced.  In any case, while member countries are still sovereign it is hard to imagine them submitting voluntarily to significant fines for responding to local social pressures.  Consequently, the Stability Pact looks unworkable.  It is likely that weaker governments will experience periodic credit crises as they overspend and then are forced to be extra prudent to recover.  The result for some years will be continued volatility in intra-European yield spreads and continued substantial average spreads between the best and worst credits.  The Canadian model of spreads of only 35 basis points between sound and imprudent provincial governments appears too optimistic.

Yet on the whole lower government deficits should draw more savings into private sector bonds.  This very important consequence will lead to enhanced growth for financial service firms involved in debt issuance and packaging and in trading in the secondary markets involving sophisticated credit and derivatives analysis.  The increase in opportunity for these new skills may well offset the probable trauma to traditional currency and monetary analysis skills.  We may even see the eventual emergence of an important European junk bond market which would benefit some firms but possibly represent another blow to bank profits.

In government issues, the reduction in opportunities for active management will be at least partly offset by increased simplicity and liquidity for passive investing.  Though progress is likely to be gradual, a more unified European bond market may eventually rival the US bond market in appeal as a store of liquidity.

A boost for indexation in equities

Just as in the bond markets, there will be changes within Europe’s stock markets. The new demand will be for skill in assessing and arbitraging different industry sectors within a broad geographical region.  For example, analysts will define their beat as a European electric utility sector, a European banking sector, and so on, rather than in Italian or French or German specialties.

The creation of Europe-wide stock indices and the apparent reduction of many country arbitrage opportunities will lead to an increase in the relative attraction of index funds as opposed to active management.  It seems likely that passive funds will grow to 25% of the market or more, as in the US.  Structured investment processes, which the market for pension and mutual fund management sees as intermediate between active and passive investment styles, may therefore become of greater importance.  This is likely to further open the door to the marketing of financial services by quantitatively oriented US investment management firms, as well as to European firms that see the same opportunity.

Short-term local stock market movements in response to inter-European currency exchange rate movements will disappear, leading to reduced volatility.  However, if changes in real relative profitability can no longer be ameliorated through currency depreciation, there will be greater long-term stock market return disparities.  The sorting out of the resulting complicated effects should give ample employment to stock analysts during the next five years or so.  For example, what will happen to local auto production in Italy if the lira cannot depreciate?  What will happen to the business of a German car manufacturer if the threat of DM appreciation is removed?

A strong or weak Euro?

Diversification will tend to make the Euro more stable but what will be its portfolio effect on a US or Japanese investor?  On one hand, the generally conservative nature of the currency union convergence criteria makes more countries more fiscally prudent.  This in itself diminishes the dangers of sudden, large devaluations.  However, the increased cohesion of monetary policy will reduce the risk reduction possible through diversification.  The Euro might be as stable as the D-mark.  However, it may be less stable than a portfolio of European currencies with diversifiable risks.  This concern is obviously a function of how many countries join.  If only those already closely tied to the D-Mark, there will be little change.  If sterling and others are lost, there will be much less diversification potential.  To summarize, the Euro is likely to be stable, but at a portfolio level the net benefit is uncertain.

It is not possible at this time to judge the policy that will be employed when the new European Central Bank is in place.  The plan has been that such an institution should be relatively independent of its political masters and should be modeled closely on the Bundesbank.  However, already there is talk of expanding its goal list from monetary stability to promoting growth.  Political pressure from less prudent countries and more populist political parties will tend toward greater tolerance of inflation in good times and lower short-term interest rates in bad times.

The demand and supply for currency on a short-term basis today seems to be largely a matter of hot money chasing short-term interest rates.  However, financing trade and holding foreign monetary reserves against a rainy day should not be ignored.  Part of the reason the US dollar is still strong despite 15 years of huge government deficits is that it remains the premier reserve currency for foreign nations.  The same thing was once true of the UK.  The prestige and respect enjoyed by the dollar is eroding, as it did for the UK, but only very slowly.  What will be the impact of the Euro on that process?

There is a mathematical argument for reduced demand by European countries for the dollar as a reserve currency.  As the boundaries of the currency union expand, less and less commerce will be with foreign currencies.  Therefore there is less need for currency reserves to finance fluctuations in trade balances.  Since the dollar is used as a general purpose reserve, the demand for dollars will fall.  This is a sound argument but any effect is likely to be slow and may be offset by increasing trade among other countries outside Europe.  However, the dollar’s market share of reserve usage may well decline at an accelerating rate as Europe re-emerges in economic growth and political presence.

Remember the Reagan Revolution?

The European Currency Union is social engineering on a large scale.  We can foresee only the general outline of its aftermath as governments, businesses and wage-earners cope with change. Governments, in particular, are giving up control over their money  before they submit themselves to checks and balances on spending and taxation.  During a transition period on their way to greater coordination, it seems likely that one or more governments will run the risk of credit default while others may tire of financing profligate neighbors.

Something on a similar scale may have happened in the US not too long ago.  Remember the Reagan revolution that began in the presidential campaign of 1980?  The thought process was very simple.  It said that the government was too big and that high taxes were sapping economic growth.  The premise was that if we cut taxes, not only would supply-side economics ensure more industrial growth through entrepreneurial activity but also, somehow, the government would stop growing.

The outcome could not have been imagined by most.  There was a big tax cut, but not much initial change in spending.  This caused a huge government deficit.  Because US government credit was superb, foreigners rushed to finance it.  The resulting strong dollar allowed a flood of imports that created a rust belt of abandoned inefficient plants in the older industrial sections of the country.  Eventual increases in productivity, encouraged not only by the imagined entrepreneurial benefit of cutting the top marginal tax rate, but by very tangible layoffs and plant closings, led to renewed commercial vitality.  After prolonged resistance by politicians and beneficiaries of government spending and income transfers, the budget deficit is beginning to close.  The growth of government has slowed.  Twenty years later, the Reagan Revolution has turned out well.

Just as tax cuts and deregulation led to renewed economic growth in the US, so, too, will breaking down currency barriers lead to radical improvements in the financial services industry in Europe.  As before, the full consequences will include not only competitive pressures but profitable new opportunities.  The D-mark is dead.  Long live the Euro!

WHY CURRENCY MANAGEMENT

Jarrod Wilcox

January 29, 1999

WHY CURRENCY MANAGEMENT

International diversification of stocks is greatly advantaged by at least a rudimentary knowledge of currency.  Many asset managers feel relatively comfortable in translating their knowledge of how to invest in their own home country to investing in other countries.  But they feel uncomfortable with the currency portion of their investment.  This paper introduces basic currency ideas that can provide a solid foundation for understanding currency and the opportunities it presents for enhancing return and reducing risk in international diversification.

Currency return is the percentage change in the spot exchange rate. For example, if the price  of a dollar quoted in yen rate moves from 100 to 120 as the yen weakens, one calculates the dollar currency return as 20%.  (The yen currency return is -16.67%.)  There is also a forward rate for delivery of currency at a time a few months in the future.  If you own a foreign security, you could imagine hedging against changes in its currency by selling short an amount of currency equivalent to the security’s current value.  In practice, this is done by entering into a contract to sell the foreign currency at a fixed rate in terms of the home currency at some definite point in the future.  There is an active futures market for currency; however, most hedging transactions are done on a customized basis with bank counter-parties.

It is usually not possible to precisely offset currency returns by hedging.  Instead, one receives a hedging return that reflects the difference between the current forward rate, say 90 days out, and the future spot rate.  Arbitrage with short-term interest rates makes this the percentage change in the spot rate plus the interest-rate differential in favor of the home country.  Thus, an accurate measure of the performance of currency management must be based on hedging return rather than on currency return.  Assume you are a US investor in Japanese securities for a year and US interest rates were 4% higher than Japanese rates.  Then a move in the yen from 100 to 120 would create a hedging return of approximately 24%.

Suppose you hedge all foreign currency exposure.  The return that results is the total foreign return including currency, plus the hedging return.  The currency return cancels out, and you are left with the home country interest rate plus the excess of the foreign stock return over the foreign interest rate.

Currency volatility is often a significant part of foreign equity investment returns.  Exhibit 1 shows a history of the dollar priced in Japanese yen (lighter line) and German D-marks (darker line).  The price changes have been significant, both up and down.

Some in the investment community assume that growing globalization is making currency less important.  That is, as nations come closer together, the volatility based on currency movements should decline.  For example, consider the advent of the European Currency Union and its common currency, the Euro.  Exhibit 2 plots weekly standard deviation of currency hedging returns as seen by the US investor across two groups:  21 currencies in the EAFE index plus Canada (darker line), and the subset of those countries joining the European Currency Union, commonly known as Euroland (lighter line).  This perspective excludes entirely the volatility of the US dollar with respect to these baskets of currencies.  It measures only the within-basket return dispersion.  Note that while the volatility within the Euroland group has declined to essentially zero, the overall volatility of the larger currency basket has actually increased.  If currency volatility is going away, this is not yet apparent.

Having established that currency is important, let us go over what the investor needs to know to deal with it.  In the remainder of the chapter we will discuss the following topics:

1. The source of currency hedging returns

2.  Typical strategic mistakes

3.  Currency return statistical characteristics

4.  Optimally hedged asset allocation

5.  Ideas for active currency management.

The Source of Currency Hedging Returns

Currency returns are fundamentally different from either stock or bond returns.  Stock and bond returns each relate to a single economic unit.  Currency returns, on the other hand, relate to the differential performance of two entities, the differential value between the script of two governments.

Let us relate to something more familiar.  Suppose shares in Microsoft were your currency.  You could spend it on real things, or exchange it for shares in Intel.  The rate of exchange between Microsoft shares and Intel shares fluctuates every day.  Assume the exchange ratio begins at 1 Intel/Microsoft.  Over a period of time it may fall to 0.1 or rise to 10.0.  On the other hand, if both companies do equally well, there will be no movement in their exchange rate.  Suppose someone were to agree with you to exchange Intel shares for Microsoft shares at a fixed rate 90 days in the future.  Consider how the value of that contract would vary over the next three months.  Its expected return would be zero.  It’s standard deviation of returns would be different from that of the return of either Microsoft or Intel.  The risk of the differential would be lower than the average of their individual risks if the correlation of their returns were more than one-half.

Now let us come back to the currency impact of buying a foreign stock and not hedging.  You give up possession of your own currency, an obligation of your government, and take possession of a foreign currency, an obligation of a foreign government.  If you intend eventually to sell the stock and convert the proceeds back to your home currency, and do not hedge, it is as though you borrowed money from your own government and lent it to a foreign government.

Even if there should be no difference in interest rate, you will still take a credit risk on the loan.  Suppose the foreign government returns you a depreciated currency because it has created too much money during the period of the investment.  This is analogous to a partial default on a loan.  You should be concerned about the borrower’s ability and motivation to repay.

In practice, things are more complicated because each government that sponsors a currency stimulates conditions that create international interest rate differentials.  The forward exchange rate will approximate the current spot rate adjusted for these interest rate differentials.  Otherwise there would be profitable riskless arbitrage as follows.  Borrow money in the low interest rate country, exchange it at the spot rate, lend it in the other country, and buy a forward contract entitling you to convert it back to the original currency.

Factoring in interest rate differentials, you should think like a very good banker.  You must balance the excess interest rate paid by the foreign government against the excess credit risk of the foreign government over your own government.  Note that this can work in either direction, because the foreign currency may be either a better or a worse deal than your own home currency in terms of future ability to buy real goods.

Suppose, on the other hand, that you are considering hedging.  The decision to hedge will reflect the same ingredients, but with reversed signs.  That is, you should hedge if the excess credit risk of the foreign government’s script overbalances whatever excess exists in interest rates.

Hedging profits come when the market recognizes that the foreign country is falling in creditworthiness or your home country is rising in creditworthiness.  They also come when your home interest rate rises, resulting in a higher current value of your home currency so that it can be expected to depreciate, or when the foreign interest rate falls.

Although there are many individual sources of differential demand and supply for currency pairs, including trade balances, arbitrage with short-term interest rates means that the key uncertainty is market’s perception of creditworthiness.

Typical Strategic Mistakes

In our experience as currency managers, we have found that currency is little understood and that investors frequently make strategic mistakes in dealing with it.

Inadequate  international diversification:

The usual practice is to decide on how much foreign investment you want, and only later decide how much of it should be hedged against foreign currency risk.  Two different securities will always have equal or higher optimal allocation than one of them individually.  The choice of hedging a foreign holding creates a second security.  Consequently, the optimal degree of foreign diversification would generally be larger if the option to hedge were considered from the beginning.

The sub-optimality that thus results from sequential rather than simultaneous asset allocation has modest consequence for US investors.  However, it overlooks a major opportunity for investors whose home countries are a smaller part of the global market and who thereby derive greater benefit from international diversification.  The benefit of a proper Markowitz asset allocation study incorporating currency from the beginning can be quite large and economically significant for an investor from a smaller country.

Inappropriate passive hedging benchmarks:

The best way to derive long-term strategic hedging ratios is to conduct a Markowitz optimal asset allocation in which both hedged and unhedged assets are represented.  This should be done separately for stocks and bonds.  For the typical US investor in stocks with 20% of his or her portfolio placed outside the US, the resulting stock hedging ratio is likely to be between 20% and 50%.  (However, in practice one often sees 0% or 100% hedging ratios.)  The consequent risk reduction through a passive hedging policy may be translated to equivalent return enhancement units by taking into account the investor’s implied risk tolerance.

One might rationally set different hedging ratios for stocks in different countries.  However, the further potential value-added is sometimes small and the risk of a poor decision based on inadequate data is very large.

Beyond passive benefits, a partially hedged benchmark adds significantly to opportunities for active management results, as will be described shortly.

Over-attention to short-term downside protection:

Given a concern with currency risk, isn’t downside protection what we should be interested in?  If by that one means protection over periods such as a few months, the answer is “probably not.”  Since the pursuit of short-term downside protection has been a large part of currency overlay management practice in the last few years, we now take an extended look at the phenomenon of disappearing downside protection with longer time horizons.

A popular approach to currency risk protection involves the purchase of puts against currency futures, or the replication of option results through dynamic hedging or equivalents.  Such methods attempt to alter the statistical distribution of returns so as to prevent large losses in a single period.  While this can be a valuable short-term exercise, it is not generally understood that the resulting skewness does not carry over to the distribution of returns over multiple periods.

The most famous theorem of statistics is the Central Limit Theorem.  It states that the sum of independent random variables tends with increasing numbers of variables to be distributed as a normal distribution.  This is true no matter what the probability distributions of the variables being added, so long as they have finite variances.  The normal distribution is bell-shaped and symmetrical.

To construct an example, since we are concerned with compound returns, we put returns into log form.  (If we wanted to analyze percentage returns, there would automatically be downside protection for losses greater than 100%, but this would provide no comfort to the investor.)   Each period’s log return has a probability distribution which with downside protection will be skewed so that large losses are prevented.

The returns in successive periods are close to being independent.  What is the average log return over multiple periods?  It is the sum of these log returns, divided by the number of periods.  As the number of periods increases, the mean log return becomes distributed more similarly to a normal distribution, with less and less downside protection.

Exhibit 3 shows a beginning distribution of monthly returns representing a simulated program of monthly downside risk protection applied to currency returns.  (It is the result of 12000 drawings from a non-central chi-square distribution.)   The exhibit is a histogram showing what fraction of the outcomes falls within equally-spaced bins.  The mean of the sample distribution is adjusted to be zero, and the standard deviation adjusted to within a plausible range of currency volatility.  With downside protection, losses are limited to less than 2%, the median is a small loss of 0.2%, and there are some large gains of up to about 8%.

Exhibit 3 might appeal to many institutional investors.  However, this short-term picture is quite deceptive as to what will be received over longer periods.  Exhibit 4 shows the distribution of the cumulative log for this example over non-overlapping 12 month periods.  Because it contains only 1000 observations, the sample distribution is not as smooth as in Exhibit 3.  However, it is obviously much more symmetric.  It shows almost as much “protection” against upside results as downside results.  And whereas there was only a 1% chance of a one-month result worse than -.016, there is a 10% chance of a twelve-month result worse than -.046.  Short-term downside protection does not defend against the accumulation of small losses into substantial ones over longer periods.

At normal risk levels, there is little long-term impact from short-term downside risk protection.  This is not to say that short-term benefits should be entirely disregarded, especially if they come for free as part of return enhancement efforts.  But they do not provide downside currency risk protection over normal institutional investment horizons.

Separating Active Risk Reduction from Return Enhancement:

Some currency overlay managers have argued that forecasting currency returns is essentially impossible.  However, they advocate active hedging through a program that involves forecasting risk.  At times of higher risk, simply hedge more.

Although forecasting currency hedging returns is highly uncertain, in our experience it is no more so than is forecasting stock returns.  As for the distinction between active bets based on return forecasts and on risk forecasts, there is less here than meets the eye.  Once you actively depart from a benchmark there will be parallel consequences for both risk and return.  Active managers of any stripe should always be judged on both active return enhancement and active risk impact.  The question of how much value can be added by one or another active investment approach is strictly empirical.  Forecasting both risk and return seems to have more potential than either alone.

Linking Currency Decisions Too Closely To Asset Exposures:

Institutional investors come to currency from the viewpoint of hedging the risk of currency fluctuations as they affect investments in international stocks and bonds.  The currency position is seen as an adjunct to the underlying foreign security rather than as a portfolio in its own right.  Unfortunately, the tighter this linkage, the narrower the perspective within which the currency portfolio can be managed.  As compared to the Markowitz optimal portfolio, the problem is overconstrained.

In the evolution toward more sophisticated active currency management, most institutional investors retain single currency position constraints based on whatever they happened to have invested in particular country’s stocks and bonds.  They do not take a portfolio viewpoint.  Keep in mind that active currency returns reflect two main components that may be differentially constrained.  The first is position in the home currency versus a basket of foreign currencies.  The second is the position of each foreign currency exposure relative to that basket.  Three realistic examples follow.

1.  The benchmark is 100% hedged.  (This sometimes comes about because an institutional investor is attempting to reduce management fees by putting only a fraction of their international assets into a hedging program, rather than truly choosing 100% hedged as their passive strategy allocation.)  Within this mandate, the currency overlay manager may only choose not to hedge, creating a currency position in each country of between 0% and 100%.  Any manager skill in forecasting degrees of above-average home-currency strength will be lost, and since there is no cross-hedging, much of the ability to forecast relative strength among different foreign currencies will also be lost.  (Cross hedging is selling one foreign currency and buying another.)

2.  The benchmark is 50% hedged, but cross-hedging is still not allowed. This is better than 100% hedged because the manager can exploit skill in forecasting the home currency in either direction.  There is also less stress likely to result from incurring tracking error.  On the other hand, since there is no cross-hedging, exploitation of skillful forecasts of the relative strength of foreign currencies will still be inhibited.

3.  The benchmark is 0% hedged, but unlike the first case, cross-hedging is allowed.  However, the total of active positions must be such that the portfolio is never short in the home currency.  This alternative permits a reasonable degree of exploitation of skill in forecasting relative strength among a larger number of currencies.  However, it is like the 100% benchmark in that skill in forecasting the home currency will be used over only half its range because of the restriction against a net short position in the home currency.

Note that for all three cases, the ability to exploit information regarding weak foreign currencies is especially restricted in the case of small countries.  Suppose Singapore is 1% of the equity portfolio.  Then conventionally one can only short Singapore dollars by 1%.  However, a larger amount might be optimal in the sense of efficiency in achieving the least portfolio risk for a given level of expected portfolio return.

One must respect the organizational realities that bring about such mandated constraints, this is the usual case confronting the currency manager.  Paradoxically, however, constraints on individual currencies tied to underlying assets, imposed to reduce currency risk, may actually hamper currency risk diversification at a given level of expected return.  The fewer such constraints, while maintaining overall risk control, the better the job that can be done through currency management.

Currency Return Statistical Characteristics

The first statistical property we illustrate is that of dispersion of currency returns, examining them for non-normality.  We will examine, not spot returns, but hedging returns.  Exhibit 5 compares to a normal distribution the distribution of weekly log hedging returns into the US dollar for each of the 21 currencies represented in the EAFE Index plus Canada over the period 1981-1997. Over 20,000 observations are summarized.

The exhibit shows two major departures from a normal statistical distribution.  The first is an excessive fraction of returns near zero.  It is as though exchange rates were sticky with respect to small changes.  This is not the result of artificial restriction in prices, such as we find in stocks that are quoted in eighths – exchange rates are quoted with far greater precision.  The second departure is the existence of a fair number of returns that are from five to eight standard deviations from the mean.  These would be almost impossible to observe if the distribution were truly normal.

Exhibit 6 explores these events in the tails of the distribution in more detail.  Each small circle represents the weekly hedging return for a particular currency in a particular week.  Since over 20,000 observations are represented on the chart, only the widely separated extreme cases show up as separate events on the exhibit.  For each circle, the vertical scale shows the actual hedging return, while the horizontal scale shows the return that would have occurred if the return fractile (quantile) were drawn from a normal distribution with the same mean and standard deviation as the actual distribution.  The straight line represents that set of values mapped to the vertical axis.

The peak near zero seen in Exhibit 5 shows up as a small flat area in the center of the curve of the distribution in Exhibit 6.  What is better revealed are the points in the tails –those with more than a 4% weekly currency movement that would come as a surprise to any investor projecting normality on future currency returns.

Both the stickiness of small movements and the occasional appearance of surprisingly large movements would be characteristic of a system in which governments resist and then capitulate to economic change.  The dam breaks and the accumulated economic problems flood out to be incorporated in a new price.

The second major property of currency hedging returns is the existence of more trends than could be accounted for if successive returns were precisely independent.  To demonstrate this property, we first do a sequence of 25 regressions, each based on the more than 20,000 weekly currency hedging return observations previously collected.  The first regression forecasts next week’s returns against last week’s returns.  The second forecasts next week’s returns based on the average weekly return over the past two weeks.  The twenty-fifth regression forecasts next week’s return based on the average weekly return over the past twenty-five weeks.

Exhibit 7 charts the successive regression coefficients of the 25 best fits over weekly lags from 1 to 25.  An additional point is placed at the origin to make clear the cumulative nature of the coefficient as we take more and more information into account.

A smooth line is drawn through the points to show the overall tendency.  The function appears to rise rather steadily, although at a declining rate, through the first 10 weeks or so, and then to level  off.  Those with a good imagination may see somewhat more structure, possibly an overshoot near the 15^th week, but that is not our point.  The key fact is that returns up to about 10 weeks old seem to positively affect the subsequent return.  The market, at least in an overall sense, seems to only gradually adjust to new information.

Showing in a rigorous way that this effect is statistically significant is more subtle than it looks, not only because of correlated residuals within the same time period, but because we extend the effect through successive regressions.  If we look at any single regression in the range between 3 and 16 weeks and also take the extraordinarily conservative assumption that we have only one degree of freedom at each time-period because of cross-sectionally correlated returns, the effect is significant at between the 2% and 10% levels.  For eight of the first ten lags, the coefficient on the average prior return increases as each lag’s effect is added.  This gives us evidence not on a single regression, but on the overall pattern.  The binomial probability of 8 out of 10 increases if there were no overall lag structure would be .05.

While it is possible that the tendencies toward currency trending arise from speculative dynamics, the relatively long delay and the lack of a greater overshoot suggest adaptive sluggishness caused by governments resisting economic change already signaled to the market.  Taken together, Exhibits 5,6, and 7 reinforce that picture.

The existence of fat-tails tells us that risk control should be conservative relative to the evidence of recent periods.  The existence of trends tells us that technical models are likely to be helpful.

Optimally Hedged Asset Allocation

One should determine an optimal passive hedge policy as part of an overall asset allocation study.  In doing so, it is important to consider the total portfolio including both domestic bonds and stocks.  This is because currency-hedged assets may have return correlations with these other assets that differ asset by asset from those of the unhedged foreign securities.

Let us go through a simple example, in which all foreign stocks will be aggregated as the MSCI EAFE Index.  For the purpose of estimating risk, we will approximate the risk of hedged EAFE as though it were EAFE in local currency terms.  This is a good estimate since short-term interest rate volatility is quite small compared to stock volatility.

The risk and correlation statistics shown in Exhibit 8 are for quarterly returns for the 55 calendar quarters beginning in 1982 and running through 1995.  The risk standard deviations have been doubled to annualize them on a familiar scale.  Cash and  US bonds have been added to the asset menu.

We will use our own a priori estimates for expected return based loosely on long-term history.  The difference between expected hedged returns and unhedged returns reflects an estimated annual cost of 40 basis points for hedging in terms of frictional costs and fees.  These priors, though plausible, are given simply for illustration.

Exhibit 9 shows the resulting efficient frontier if no hedging is allowed.  The rows labeled CASH, SP500 and so on, show the percentage of total assets allocated to that asset at points of increasing risk and return on the frontier as one moves rightward.  Since we have used a historical correlation of only 0.53 between US and foreign stocks, diversification benefits cause large fractions of non-US stocks to be allocated at every risk level, upwards of 37%.  This effective risk diversification also allows large amounts of stock to be used for quite conservative portfolios.

When in Exhibit 10 we add the opportunity to hedge the currency exposure, we see very little change in the overall efficient frontier for a US investor.  (The standard deviation in the middle of the frontier is reduced only from 11.2% to 11.1%.  Again, however, the improvement can be much larger in smaller countries.)  However, the optimal composition in terms of assets is noticeably altered.  This form of analysis allows us to see immediately the best hedging ratios as well as the additional foreign exposure that is optimum.

In this case, the optimal foreign exposure is increased from 37% to 43% across most of the frontier.  The optimal hedging ratio varies depending on risk tolerance, but is in the range of 30% for all but the highest risk portfolios.

The apparent improvement in the efficient frontier possible through currency hedging may increase materially as one divides assets into more and more categories.  However, the problem is that the quality of the statistical estimation involved will decline in an offsetting way.

It is apparent that for the US investor the benefits of passive hedging are real but very modest.  Yes, optimally, you should hedge.  But the average benefit if you have no skill in forecasting will be small.

Ideas for Active Currency Management

Currency management efforts can usefully be split into better return enhancement and better risk control.  An effective process will do both.

Risk Control:

Currency risk is best controlled at the portfolio level – otherwise too many diversification benefits are left untapped.  The key challenge here is to prevent small errors in estimation from becoming big errors in allocation.  It is important to limit the size of apparently offsetting long and short positions.  It is also important to take into account inherent risk that may be apparent in the history of one currency pair that may not yet have appeared in the volatility of another, but is still latent.  The ability to forecast bursts of volatility can be useful if one does not become so enmeshed in statistical technique that the essential unreliability of the past to forecast the future is forgotten.  In the short-term, currency risks can also be converted into new forms through the passive use of options.  However, active option management is essentially an attempt at return enhancement through another means.

Return Enhancement:

In contrast to the literature on stocks, much less has been written about currency market efficiency and inefficiency.  It is our experience that the structured investor interested in currency management is in the enviable position of working in a field where the prevailing views are largely pre-scientific.  It appears that one can add value best through combining a large degree of fundamental analysis with a smaller portion of technical analysis.

As we have already seen, on average and over a long period of time, cumulative hedging returns have followed trends.  The problem for the currency manager is that these trends are highly clustered both by currency pair and by time period.  For example, in recent years the British pound and the US dollar have moved more or less together relative to continental Europe and to the Japanese yen.  To the extent that the British government makes an effort to maintain a stable dollar/pound relationship, one will observe more counter-trending, or reversion to the mean, than trending.  The challenge is to discriminate when trends are most likely.  This circumstance will reflect both any government intervention that may cause under-reaction to news, and the extent to which speculators have already built into the current price an expectation of trend continuance.

If the essence of hedging is a decision not to lend, then relative interest rates and relative creditworthiness are the factors of most interest.  (Trade-related indicators such as purchasing power parity, the ability to buy the same goods at the same real cost in different countries, are also important.  But these can be viewed as additional ingredients in the ability to repay.)

Relative interest rates are critical but tend to be impounded in prices very quickly indeed, especially for major currencies.  The better opportunity for most active investors is to become specialists in discerning changes in perceived creditworthiness, and, better, to forecast these changes.  In our experience, the key ingredients are of two kinds – economic expansion and recession on the one hand, and accumulated government mistakes or deliberate inflationary tactics on the other.  The classic currency deterioration comes when economic recession exposes an accumulation of economic problems.  The government comes under pressure to lower interest rates or otherwise devalue the currency in order to satisfy domestic political needs.

Conventional measures of accumulating problems include a poor current account balance, but better active returns are likely to come from unconventional measures.  For example, one might note the extent to which government or international agencies have subsidized the economy.  Another important source of information is the stock market, which can reveal information about coming recessions far ahead of actual events.

Summary

We have covered the basic mechanics and return characteristics of currency.  They are different from those involved in the more familiar world of stocks and bonds.  We discussed the strategic mistakes most investors make in consequence.  The antidote to poor strategy is to begin at the beginning, recognizing currency differences but including hedged assets as separate securities but including them in a general asset allocation.  When this is done, we conclude that although passive currency hedging of a portion of foreign assets is beneficial, the benefits are modest compared with the active return enhancement and risk reduction potential.  Finally, some ideas have been offered as to the appropriate investment approach for active currency management, focusing especially on forecasting changes in country creditworthiness, and having a broad view of the kinds of indicators that can be brought to bear on this fundamental issue.

Our distant ancestors might have invested by draining a field or building a shelter or raising children who would care for them in their old age. They sacrificed time and energy now for later benefits.  Later on, if they were able and fortunate, they might have invested in tools and customers for a trade.  Today, specialization makes it practical to translate much or all of our foregone consumption into money capital that we entrust to other people. They in turn use it to train employees, purchase equipment, design products and find customers. When we invest in anything but our own business, we merely select whose projects to back.

The basics are still there – our savings, and someone using the resources thus transferred from current consumption to create real wealth. We no longer have the same personal involvement. But as an offsetting advantage, there is much more opportunity for risk reduction through diversification in today’s world.

Why should we save? We may save to create a buffer against unemployment or ill-health. We may save for a car or a down-payment on a house.  If we have children, it is desirable to save ahead for college tuition. We may save for the capital to start a business.  Most importantly, because we can expect to live longer than our parents and their parents, we need to save for retirement.  Money should not outweigh the other ingredients of a life well lived.  But it is a significant component in an interdependent world where many desirable goods and services are obtained chiefly with interchangeable IOU’s.  We save to make sure that we have enough when we need it.

What if you are already wealthy? Then there are a new set of challenges.  But one similarity is the desire to preserve capital — and, in the face of inflation and taxes, you will be taxed on “income” and “gains” that are mere illusions when put in terms of real goods and services that can be purchased.  Today’s inflation rate, as in the 1930′s, is low, but not insignificant when compounded.  Over your lifetime, there are very likely to be periods of higher inflation rates. [This may be even truer now than it was when written, as deveeloped economy governments run huge deficits and the only way out may be to deflate the currency so as to reduce indebtedness.]

For most people, the biggest need for saving is for retirement.  The first thing most financial planners will tell the average investor is that they are not saving enough for retirement.  It is painful to recognize and deal with.  Unfortunately, the best solution is to start saving from a young age when we do not spend much time thinking about retirement. It gets harder by the time we reach middle age.  However, even if you start saving at a relatively young age, if you are in an income level where Social Security is only a modest increment to your retirement income, you need to save something on the order of 20% of  your income.

This high rate of saving is exactly what many people in emerging market in Asia are doing today, but it is at least three times the rate of personal saving in the US and likely considerably more than you are saving now.

If we do not inherit considerable financial resources, if we don’t start a
successful business, we’ll have to save from normal income, and probably more
than we are saving now. We’ll benefit from starting to save earlier, rather than waiting until our children, if any, are out of college. We’re going to need a higher rate of return than that available in risk-free bonds or bank savings accounts. Paradoxically, despite the need for better returns, we also have to avoid serious erosions of capital through risk and taxes along the way to our goal.  Easier said than done, but reality.

If we have already accumulated capital that we depend on for spending,
the analogy to saving is properly balancing spending with real income.

Investing depends on saving. Saving is deferred gratification.  But it can be satisfying in its own way.  Think of your financial resources as a reservoir.  To fill it, we have to coordinate what flows in (saving and investment returns) and what flows out (consumption spending).  There is also a feedback mechanism involved, because the rate of investment return inflow is proportional to what is already in the reservoir.  Staying with water-based analogies, saving is the primer that allows the well-pump to draw much larger quantities.