Monday, November 9, 2015

Homo Economicus

William Bernstein is my favorite financial writer. I have followed him since his early days at the Efficient Frontiers blog when hardly anyone without a neurological disorder had heard of him. I like him because he is brilliant; I love him because he writes wonderfully.

One of my favorite Bernstein lines came from Efficient Frontiers in reference to the 1999 book Dow 36,000. The argument put forth by the book's authors was probably based on a not-uncommon misreading of Jeremy Siegel's Stocks for the Long Run. Siegel had noted that over long periods of time, stocks nearly always outperform bonds and the authors of Dow 36,000 apparently understood that to mean that stocks are ultimately safer than bonds. If that were true, then stocks would have been tremendously underpriced in 1999. One day, investors would wake up to just how safe stocks are and the Dow would soar to 36,000 or higher.

Unfortunately for the authors of that ill-fated tome, and for all of us who invested in equities back then I suppose, sixteen years later the Dow is around half that value. Siegel's argument that stocks outperform bonds over the long run does not equate to stocks being safer than bonds. Stocks can and do take stomach-churning dives along the way and bonds don't. The short-term volatility of stocks is much greater than that of bonds and as Siegel and Zvi Bodie agreed in a famous interview (download PDF), stocks are risky no matter how long you hold them.

To quote Professor Siegel from that interview, “In other words, [stocks] are relatively safer in the long run than random walk theory would predict. Doesn’t mean they’re safe. . . Well, they’re not safer in the long run—that’s definitely not true.”

The Bernstein comment I have always remembered is “James Glassman and Kevin Hassett . . . in Dow 36,000 postulated a new species of homo economus [sic] impervious to short-term volatility.”

I suspect that the vast majority of us retirees are keenly aware of short term volatility, even if we firmly believe that the market will always recover, eventually. I haven't found research that specifically addresses this issue, so I recently conducted a simple survey to determine if at least some retirees care about short term volatility.

In that survey, I asked retirees and near-retirees if they would invest their portfolio totally in equities if their non-discretionary expenses were securely covered by a floor, noting that such a portfolio might have fallen 50% or more in value during the 2007-2009 bear market. The survey should not be confused with science – it's merely the thoughts of about a hundred and fifty or so readers of my blog – but the results do suggest that a lot of retirees care about short term volatility even when their living expenses are secure.

About 84% of respondents indicated that they would prefer to reduce portfolio volatility, presumably through a bond allocation, even with a secure floor. About 14% said they would go full bore with equities if their non-discretionary living expenses were safely covered, and 2% implied that they'd rather shave their head with a cheese grater than allocate any of their retirement savings to the stock market.

OK, not precisely in those words.

84% of respondents to an informal survey say they would want to manage portfolio risk even with a solid floor of income.
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My take from this informal, unscientific survey is that there are at least some retirees who would need an allocation to bonds in order to sleep at night even with a bedrock-solid floor. (No one wants to sleep on the floor, but some are willing to risk it.) Whether the numbers are as dramatic as my informal survey suggests, I cannot say. My goal was simply to find out if I'm the only retiree who cares if his portfolio occasionally crashes.

To assume that retirees with a secure floor would not care about short term volatility is to recreate the Dow 36,000-postulated homo economicus, a retiree impervious to short term volatility. My standard of living was not threatened by the 2007-2009 crash because I had a sizable allocation to cash and bonds, but it was not a fun ride even so. I suspect that most retirees see a portfolio crash as the evaporation of wealth that can no longer be replaced by human capital and that they find that worrisome.

Some will be quick to point out that the market as measured by the S&P 500 index recovered to it's 2007 high by January 2013, but as I explained in this post, retiree portfolios don't recover as quickly as the market. The market doesn't take annual withdrawals to cover its living expenses.

Your tolerance toward market volatility, even when your floor is secure, is something you want to understand up front. Getting it wrong has consequences. If you believe you can tolerate the high-equity allocation roller coaster and find out after your first big bear market after retiring that you can't, your response will probably be to reduce your equity allocation at the worst possible time – after your portfolio has crashed and before it recovers.

It's tough to keep investing largely in equities, especially for a retiree, while you are watching your wealth vaporize day by day. For a real-life example, read my next post, The Role of Xanax in the Asset Allocation.


  1. Dirk, I enjoyed this post. I too like reading Wm Bernstein. One of the hardest decisions I struggle with is my asset allocation in retirement. I read somewhere that if you are unsure of the proper allocation error on the side of being a little more conservative in your stock allocation. I think this is good advice.

    While my wife and I have the capacity to take more risk, but we choose not to. I think Larry Swedroe had this quote which I really like - 'Don't take more risk than you have the ability, willingness or need to take or that you don't receive a premium for taking.' I think Wm Bernstein said 'the name of the game is not to get rich; rather its not to die poor.' I guess this is where I fall on the risk spectrum. I have 25% in stocks which I know is a little low by most standards for a couple who are 54 and 61 with one working. But the expected difference in return between a 25% and 40% (the most we would allocate to stocks) stock allocation would not be worth the tradeoff in worry to us (at least right now). Thanks for another thought provoking post. Brad

    Couple links for Wm Bernstein quotes that were fun to read.

  2. “84% of respondents to an informal survey say they would want to manage portfolio risk even with a solid floor of income.” Clinically I find this to be true among my retired clients as well – even those with State or Federal pensions and/or Social Security service as their “solid floor.”

    So one method is to separate out two basic elements of retirement income coming from the markets – of which are varying degrees of volatility. The behavioral approach knows Homo Economicus has issues with volatility. Thus the volatility should be in a portfolio structured for the long run = a.k.a. the rest of one’s life. And yes, data does show that shorter periods should have less volatility (Journal of Financial Planning, March 2012, by Larry R Frank Sr, John B Mitchell, and David M. Blanchett. ). There should be some stock market exposure in order to improve the odds one's income may stay up or ahead of inflation. Social Security does that too - but not all pensions do. As time gets shorter (known as aging), one's exposure to the effects of inflation is muted too - thus less need to try to stay up or ahead of inflation.

    So what about those near term years? Shorter periods should have less exposure to volatility means that those income needs for the coming three to five years should not have stock market exposure at all or not mid to long term bonds (all classes where volatility tends to come from). This is the part of the plan that always funds the check book for this month's expenses over and above what income comes from Social Security/pension. This part is refilled during normal times and not refilled when markets misbehave ... there's a visual here ... .

    Properly diversified portfolios, which William Bernstein also writes about in many of his books and one of my favorite authors as well, when globally allocated, shouldn’t go to zero value unless everything globally has (the zombie or asteroid scenarios). Here’s a visual on this concept – an ocean analogy ( ).

    Yes Dirk – humans have issues – and there are behaviors that can address those issues to help humans improve their surroundings as humans have always done since the dawn of history. Great post!