Wednesday, July 14, 2004

Another look at retirement planning. Are equities the way to go?

As hoped and expected, the recent post on Ahmet Tezel's article in the Journal of Financial Planning on how much a retiree could safely take out of his/her retirement account has sparked further discussion.

SSRN-Irrational Optimism by Elroy Dimson, Paul Marsh, Mike Staunton: "Although the probable rewards from equity investment are attractive, stocks did not and cannot offer a guaranteed superior performance over the investment horizon of most investors. Furthermore, their prospective returns are lower than many investors project, whereas their risk is higher than many investors appreciate. Investors who assume that favorable equity returns can be relied on in the long term or that stocks are safe so long as they are held for 20 years are optimists. Their optimism is irrational. "

On one hand it is true that given the track record of equities, the more money invested in equities, the more that can generally be taken out. But equities are also risky so the more invested, the higher probability of the portfolio suffering economically significant declines. (that word generally will always get you in trouble ;) )

This is particularly important because we do not know the future and any model we use is "assumption dependent." These assumptions are not as easy to make as some may believe. For instance, consider without searching the web or a book, what is the historical return on equity investments? No doubt many of you (myself included) figured somewhere around 12% for large stocks (see virtually any investment text for these numbers) which corresponds to a risk premium of around 8%. (keeping math simple ;) )

However, Dimson, Marsh, and Staunton report that this is probably an overly optimistic number. Not because the expected equity risk premium is expected to fall in the future because the market is currently overvalued as those in the Campbell-Schiller camp believe (although it may be), but because we are not looking at the right historical returns! (BTW for more on the Campbell-Schiller view see the January FinanceProfessor newsletter Investments section)

So what is wrong? Virtually every finance text book dutifully reports US equity returns from 1926 to the present. However, this is a period where the US stock market was a very strong performer. Dimson, Marsh, and Staunton do two things to adjust for this: 1. they go back further--to 1926 and 2. they look at global returns and not just US returns. Their findings? Stocks have had lower returns and higher risks.

For instance, it has been widely reported that in the US the stock market has never lagged inflation over a 20 year period. Many have concluded therefore that stocks are safer than they really are. However, looking more globally this is not true. As the authors write: "We find only three non-US equity markets (with a fourth on the borderline) that never experienced a shortfall in real returns over a 20-year period. The worst 20-year real returns of 11 countries were negative. Historically, in 6 of the 16 countries, investors would need to have waited more than 50 years to be assured of a positive return."

Therefore, the authors conclude that investors who rely on the optimistic US-only data are irrational: "prospective returns are lower than many investors project, whereas their risk is higher than many investors appreciate. Investors who assume that favorable equity returns can be relied on in the long term or that stocks are safe so long as they are held for 20 years are optimists. Their optimism is irrational."

So what is one to do? My favorite idea comes from Zvi Bodie who applies modern hedging theories to retirement planning. As he wrote in in 2001 Retirement Planning: a New Approach paper the first part of the plan is to assure some minimum standard of living (this is the minimum amount that you will need) by investing in "inflation-protected bonds and annuities as the way to guarantee a minimum standard of living in retirement."

The second part is to determine when you will need the money. Obviously the longer you wait to start taking money out, the more you can take out and the more risks you would be willing to live with. Bit he is careful to warn that just because you have a longer holding period, it does not mean that equities are the right investment: their risk goes up as well. This is driven home in his interview with Financial Advisor Magazine: "If stocks are safer the longer you hold them, Bodie says, a put option should be cheaper with a longer time horizon. But the cost of put options generally rise proportionally to the number of years going out."

Finally, and maybe most importantly, Bodie suggests that rather than merely investing the remainder of your portfolio in equities, you "use call options to lever potential income gains." That is, you buy long term call options to allow you to participate in stock gains without putting as much of your money at risk. This solution is not costless as options are generally not available in maturities matching the investor needs so they will have to be periodically updated, but overall it is a great (and very low risk) strategy!

Still unclear? Bodie has written a great deal on this issue. Financial Advisor Magazine has a very good article on Bodie's strategy. I highly recommend it (both the article and the strategy!)

Bodie did an interesting interview with Business Week on his strategy and of course his book Worry Free Investing focuses on the issue. (FTR I have not read his book--Sorry!)

SSRN Cite:
Dimson, Elroy, Marsh, Paul and Staunton, Mike, "Irrational Optimism" (December 2003). LBS Institute of Finance and Accounting Working Paper No. IFA397.


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Wade said...

I first came across your blog from this post when I was doing background reading about sustainable withdrawal rates from retirement savings. You have a great blog! My paper is finished now, and I summarize it at my new blog

if you have a chance to take a look.

Thanks, Wade