An earlier blog entry described the background of some recent e-mail correspondence between Michael Kitces and I on safe withdrawal rates (SWRs). Set forth below is the text of an e-mail that Michael sent to me on August 28.
Rob,
I will certainly be writing something about this discussion thread on my blog as well – I just haven’t had an opportunity amidst a lot of travel for speaking engagements over the past week. Hopefully I’ll get something out by early next week.
The bottom line challenge for EMT is that while most find it discredited, at least to some extent, few have put forth any kind of equally robust alternative theory upon which models can be built. Until we find a better framework to model the system, I think EMT will persist at some level, because right now it’s the “best” assumption framework we have, flaws and all.
As a sidenote, the reason why valuation is still challenged is because while it makes sense intellectually, sadly many investors still reject it when the time comes. Try taking your clients to cash in 1998 when valuations were the most ridiculous even seen in history up to that point. You could have stayed in cash for the subsequent ten years (through today) and would have BEATE the total return of the S&P 500! Unfortunately, if you were an investment manager, you would have lost so many clients that your business would have been destroyed by 2000. The old adage “the markets can stay irrational longer than you can stay solvent” is a huge concern for the professional investing community (although it’s something closer to “the markets can stay irrational longer than you can stay in business”). Between the “business risk” of trying to be more active, and the underlying challenge that still remains for many types of active management – sure, you can beat the markets, but can you beat them BY ENOUGH to recover fees, transaction costs, etc. – we find that passive investing remains dominant. In other words, you don’t have to BELIEVE in passive investing, per se, to adopt it as an investor (or financial planner). You just have to believe that any other method isn’t reliable and effective enough to be predictably superior in a
time horizon that you and your clients will tolerate. A lot of investors do a lot of damage to themselves with that approach, but unfortunately I think a lot of it is hard-wired human neuropsychology we’re fight to change those behaviors.
— Michael
John Walter Russell says
Michael Kitces brings up an important question: what options are available to the financial planner? I believe there are several.
In terms of straight Valuation Informed Indexing, I believe that Benjamin Graham’s 25%-75% stock-bond allocation satisfies the need to avoid regret (and the need to avoid getting the financial planner fired).
Within each stock and bond allocation is the selection of which securities to purchase. Our models are quite limited. There are many alternatives to the S&P500 and TIPS. We cannot address them with the same level of statistical confidence, but they can make a lot of sense. For example, today’s REITS have been around only a couple of decades. (There was another version earlier with a bad reputation). They provide a high income stream.
There are also alternatives. For retirees, as opposed to those still in accumulation, a focus on the income stream in spite of the risk of a declining portfolio balance often makes sense. Remember, a traditional annuity leaves you with a balance of zero. Alternatives leave something for your heirs.
Have fun.
John Walter Russell
Rob says
what options are available to the financial planner?
My belief is that most planners would like to give accurate and realistic and effective guidance. The fear that each one has is that, if he does so, the guy down the street will be selling the Get-Rich-Quick Passive Investing stuff and he will lose business. It’s a case where bad money drives out good.
What if a large number of big-name experts got together and made a joint statement that was covered by the big newspapers in which they all agreed that the Passive Investing model has been discredited by the research done in recent decades and that we need to begin work on developing a new and more realistic model? If clients were aware that the Passive model had been widely recognized as nonsense, no one would feel any pressure to argue in favor of Passive Investing. The competitive pressure would be removed.
I see this as a case of that old story where all the mice agree that it would be great if the cat had a bell around his neck so that they would know when he was coming but no one wants to volunteer to be the one to put the bell on him. What if we had 10 or 20 of the biggest names in the field all step forward to put the bell on the cat on the same day? From that day forward, no one would dare to argue that Passive Investing makes sense and the problem would be solved.
It wouldn’t even be necessary to put forward a new model. All that we really need is for those who argue that Passive Investing is “science” to drop the nonsense. If the experts even said the words “we are not sure” that would be enough to open all of the most important investing questions to debate, and once there is open debate, Passive Investing is going down. We have seen hundreds of people in the Retire Early and Indexing communities who have explored other models and who can do the work needed for us to build a new model together.
The key is getting the idea that Passive Investing is “science” taken off the table. Once that is done, the rest is downhill sledding.
Rob