Friday, November 15, 2013

Deep Risk, Discipline and a Punch in the Mouth

William Bernstein’s new e-book, Deep Risk: How History Informs Portfolio Design (Investing for Adults), is introduced with the story of Lucie White and Mark Villa, a couple who sold at the bottom of the market in 2009 and bought back in after missing the great run-up that followed. Sadly, not an uncommon story.

The passages that caught my eye in the first few pages of Deep Risk describe the couple’s plight:
“This story speaks volumes about risk. All investors experienced it during 2008–2009; if you did not lose sleep then, you’re not human. But the outcomes varied greatly from investor to investor, depending on their individual level of discipline
and. . .
“For the rest of this booklet, I’m going to assume that, like all investment adults, you’re disciplined and thus not vulnerable to the routine but serious buy high/sell low loss of capital.”
Let me repeat that. “You’re disciplined and thus not vulnerable.”

Notice how sweetly that rolls off the tongue.

Bernstein seems to say here that investment discipline is independent of context, but I know from his previous writings that he understands just how difficult that discipline is in bad times.  It's unbelievably difficult.

I have been young and old, dirt-poor and well off, through incredible booms like the 1990’s and horrendous crashes, like Black Monday and the Great Recession, and through the grinding stagflation of the 1970’s and, when it comes to decision-making, context matters.

Investment discipline is a function of risk tolerance and we know that our risk tolerance isn’t constant.

How difficult it is to maintain investment discipline depends on what’s going on around you, how much you have to lose and your prospects for earning it back and not just on some personal level of discipline you might have been born with or developed over the years.

Stock market discipline came easy throughout the nineties, but was a far different story come the end of 2007.

Bob is 25 and has $10,000 in his retirement portfolio. Discipline isn’t that hard to come by. His standard of living for the rest of his life isn’t at risk from a market crash and he has decades to recover from losses. Frankly, Bob doesn’t really expect that retirement day will ever come, so retirement savings aren’t quite real to him. In the words of that great finance sage and rolling stone, Bob Dylan, “When you got nothing, you got nothing to lose.”

Sam is 50 and his retirement savings account holds a lot to lose. On the other hand, he still has a decade and a half to recover from a loss and his salary is probably as high as its ever going to be. He can still save a lot. A big loss probably won’t change his lifetime standard of living. Discipline is more difficult for Sam than for Bob, but not as difficult as it will become.

At 64, Joe is about to retire. The prospects for earning back your losses are quite attractive when you’re young and have a lifetime of human capital on your balance sheet, less so when retirement is a year or two away. As I wrote in Even Your Portfolio Heals More Slowly as You Get Older, rebuilding your wealth is far easier when you’re earning a lot of money and saving for retirement than when you retire, have no earnings, and are spending 4% or so of your portfolio every year.

Donald is 70 and has been retired for three years. Returning to the workforce at anywhere near his old salary isn’t in the cards. His standard of living for perhaps the next 30 years depends on his retirement savings. Patiently waiting out a bear market and wondering if his standard of living is permanently declining before his very eyes requires more discipline from Donald than from all the others combined.

The salient point, I believe, is not that discipline comes cheap for 25 year-old Bob but dear for retired Donald, or easier for Sam in his fifties than for Joe at 64, but that you are, at various times in your life, Bob and John and Sam and Joe and Donald.

That discipline you found when you had twenty years until retirement and were packing away a large percentage of your peaking salary might not carry the day when you are 70 and watching your lifestyle flow into the black hole of a bear market, perhaps permanently.

Bernstein’s point about portfolio risk is that it will remain shallow risk — usually — if the investor doesn’t panic. The insurance against shallow risk becoming deep risk in this scenario, he says, is simple. Don’t panic. Adult investors don’t panic.

Getting out is usually the wrong decision. Of course, you never know. Maybe it's 1929 and getting out is the right move. If it were always the wrong decision, it wouldn't require much discipline.

My point is that avoiding panic is easier in some circumstances than others, and your capacity to avoid it before you retired may not suffice after you retire and have far less capacity to rebuild wealth. I suggest you rely on something safer than self-discipline.

If you have one safe “standard-of-living” portfolio that generates enough income to live on  and a separate risky “wealth” portfolio to possibly improve your standard of living or leave a bequest, you will be less likely to panic in a market crisis than if you depend on self-discipline. Your standard of living won’t be at risk.

Planning on self-discipline for protection is over-rated.

As that other great financial sage, Mike Tyson famously said, “Everyone has a plan 'till they get punched in the mouth.”


  1. Hello Dirk,

    I've been enjoying your recent posts, especially your series about sequence of returns risk. In one of your posts, you alluded to a strategy of defending against sequence of returns risk in your risky portfolio (for growth and inflation protection) by "buying and holding" your risk assets. (You keep a separate portfolio for income.) My question is, what do you mean specifically by "buy-and-hold" if you're retired? Surely you don't merely hold your risky assets forever -- you must either sell some principal, or harvest the dividends and put them to use elsewhere in your portfolio (perhaps on the income side). Can you elaborate a bit? Thanks, Matt

    1. Before I answer your question directly, I need to put this issue into perspective in two respects: how much wealth you have and the nature of sequence of returns risk.

      If we implement a retirement-funding strategy consistent with Life Cycle Finance Theory, we first build a portfolio that secures our spending needs after we retire (a “standard-of-living portfolio”, sometimes called a “floor") and then invest the remainder of our wealth in a “wealth portfolio”. We do this because we have two very different goals (maintaining our standard of living versus growth) and two levels of risk tolerance (money we can afford to lose and not impact our standard of living versus money we cannot). Those divergent goals demand different investment strategies — the best way to generate lots of spending capacity and portfolio survivability is not the best way to maximize the size of our portfolio at the end of our life.

      As many examples from 2007-2009 crash show, the result of combining both goals into a single stock portfolio can, and have, led to permanent losses of living standards for many people.

      The first perspective is that most Americans aren’t able to save nearly enough to maintain their standard of living after retiring. From the data I’ve seen, less than 5% of households can fully fund a standard-of-living portfolio so 95% can’t really fund a wealth portfolio.

      At the other extreme, I know people who have amassed wealth in the tens or hundreds of millions of dollars and more. Their wealth portfolio dwarfs their spending needs and much of their wealth will pass to heirs or charities and, therefore, contains assets that won’t be sold in their lifetimes. So, the scenarios do, in fact, range from not having enough wealth to create a wealth portfolio to having so much wealth that the individuals will, as you say, hold risky assets forever.

      Many of the "less than 5%" can afford to create a wealth portfolio, but will dip into it from time to time after retirement. If they follow the Life Cycle approach, their normal spending will come from their standard-of-living portfolio and withdrawals from their wealth portfolio will be special or unexpected expenditures. Alternatively, they might choose to transfer some of the wealth portfolio at some future date, if it grows a lot, to increase their standard-of-living. In other words, selling assets from the wealth portfolio will be sporadic, not periodic.

      Now, let’s look at the sequence-of-returns risk perspective. As I pointed out in an earlier blog post, a buy-and-hold strategy has no sequence of returns risk, but periodically spending from a stock portfolio does. I deduce from that observation that SOR risk comes from the uncertainty of stock prices when we will make withdrawals. Intuition tells me, though I have not tried to prove it mathematically, that the more stock we sell and the more often we sell it, the more SOR risk we introduce. As I also noted, this is risk for which we cannot be compensated—the kind I like to avoid.

      Putting these two perspectives together to answer your questions more directly, creating a wealth portfolio of stocks and bonds that only requires sporadic selling of assets would reduce (I believe) SOR risk, and certainly for the portion of the wealth portfolio that never needs to be tapped, there will be no SOR risk.

      Your safe standard-of-living portfolio should be in TIPs, fixed annuities and the like, and won’t be exposed to SOR risk.

      If you’re following the Life Cycle approach and need to periodically sell your risky assets to maintain your standard of living, they shouldn’t have been in the wealth portfolio to begin with. Assets in your wealth portfolio should, in fact, be those that you might be able to hold forever.

      Thanks for you compliment, for the excellent question, and for reading my posts!