Sunday, November 12, 2017

The Efficient Frontier

From Investopia

What is the 'Efficient Frontier'
The efficient frontier is the set of optimal portfolios that offers the highest expected return for a defined level of risk or the lowest risk for a given level of expected return. Portfolios that lie below the efficient frontier are sub-optimal, because they do not provide enough return for the level of risk.
The critical point about selecting assets to include in a portfolio to exploit the efficient frontier is that one must choose asset classes that do not rise and fall with a high degree of sychronicity.

Consider a portfolio that contains several US based .com companies.  They will all rise and fall with the same tide and there is no efficient frontier.

Now consider a portfolio that contains US based companies and gold.  When times are good the companies will do well and gold will languish.  When times are bad the companies will run into head-winds and gold will shine.

Historically, "The Efficient Frontier" is used to explain why it is good to have non-US stocks in your portfolio.  Given the tight coupling of the global economy that might be a moot point.

One place where The Efficient Frontier still has huge amounts of validity is in agriculture.

Agricultural income is extremely "lumpy" because it is effected by world prices, weather, disease, input costs.  It is inherently "not smooth" because most crops are a single, yearly harvest.

Getting fancy
I think placing a small portion of the farm into solar panels should be considered because it makes sense from a "portfolio" sense.  For one thing, the panels can be placed parts of the field that are marginal for agriculture.  Eroded, south facing hillsides and poorly drained areas underlain with clay hardpan come to mind.  Another reason is that solar panels don't require any new equipment.

But the financing...
Utilities are under the gun to produce "renewable" power.  Solar power qualifies.

Many utilities are so distressed that they offer financing to people willing to put in solar.  This in not all altruism.  They can borrow money at 4% and loan it out to their Solar Financing subsidiary at 5%.  The utility funds the projects and the "owners" of the solar panels agree that instead of getting checks from the utility, those monies will go to paying down the installation.  Not only does the utility get "renewable" power but they can make a decent spread on the money they plowed into the venture.

Even fancier...
Suppose I went to a farmer and made this sales pitch and tried to make it look attractive using "The Efficient Frontier" argument.  I will not make much headway because he will not see any income for the first five or seven years.

Now suppose I was working with a utility that had some flexibility.  What if the utility kept, on average, 75% of the income stream to paydown the loan and allowed 25% to flow to the farmer.  Better, no?

Super fancy...
What if instead of a flat 25%,  the contract used a formula to calculate payouts based on gross proceeds (yield per acre X acres X spot prices on November 1) to counteract the lumpiness of farm income?  Heck, you could even get fancy and factor in the price of diesel as a proxy for input costs.

When the farmer has a great crop and solid prices all of the solar money flows into paying down the loan.  When the farmer has a dismal year then he might get 50% of the solar money as monthly checks to help tide him through the hungry times.

Using a variable formula suddenly makes solar farms a fantastic asset to put into the farmer's portfolio.  The utility is still getting paid back although it will be over a longer time span.  They are not hurting too bad because they borrowed at 4% and loaned it out at 5%.

Getting monthly checks takes a lot of the sting out of a crop failure.  And since it is in a different bucket it should not jinx crop insurance payouts.

Some of you are gritting your teeth.  "Damned goobermint needs to get out of people's business!"

Allow me to talk around the problem...
There are some farms near Weidman, Michigan that grow fabulous corn.  The soil is total crap.  It is blow-sand, that is, ancient sand dunes.

The corn is +200 bushel to the acre because it is irrigated and because the true, economic reason for the farm is that large, local dairy farms need a place to spread manure.  See, I told you the land was total crap.

The dairy farms have legal obligations to dispose of their manure in ways that do not contaminate surface water or ground water.  The best way to do that is to sequester the nutrients in corn and feed it back to the cows.
This is what the fields can do without irrigation and manure.

So who is bruised by the fact that farms around Weidman can now economically grow corn?  Not the people buying milk.  Not the people drinking water from local wells.  Not the fisherman in Isabella County. Not the dairy farmers. Not the owners of the fields that before irrigation and manure slurry produced 500 pounds of Poverty Grass and Russian Knapweed per acre.

I don't see how farmers who places a few acres into solar panels are significantly different than the farmers planting corn in Weidman.  They are both just trying to feed their families.

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