An earlier blog entry described the background of my recent correspondence with Michael Kitces on safe withdrawal rates (SWRs). Set forth below is the text of an e-mail that I sent to Michael on October 19.
Michael:
Again, thanks for the frank and helpful response.
We are ALL walking like lemmings to a cliff! That’s my take.
We have been doing so ever since the mid-1990s, when prices went to insane levels. We returned to reasonable price levels in the past month. But we have not yet had a chance to absorb what has happened in the recent price crash. So I don’t think it can yet be said whether this is going to be the blow that causes us to abandon confidence in the Passive Investing model or not.
When I say something like that, it is not my intent to ridicule the investors who stuck with high stock allocations at a time when it was not rational to do so. Nor is it my intent to ridicule the financial planners who either encouraged such behavior or failed to speak out in strong opposition to it. My intent is just to hold a mirror up to reality — this is what we did. We need to accept that and come to understand how it is that we came to do such a crazy thing if we are to learn how to become more effective investors in the future.
You noted in an earlier e-mail that investors are “hard-wired” to give insufficient attention to prices when investing in stocks. To a point, I agree. I call this the Get Rich Quick impulse. It is real. But it is not all-powerful. I have spoken with tens of thousands of investors over the first six years of The Great Safe Withdrawal Rate Debate and I have learned some highly encouraging things. Most middle-class investors want to rise above theGet Rich Quick impulse. Most middle-class investors want to overcome the hard-wiring that has caused such human misery on earlier trips to la-la land price levels.
They need help. They cannot overcome their hard-wiring on their own. ACCURATE safe-withdrawal-rate analysis can provide a huge amount of help. Accurate SWR research pulls people back to reality when they don’t particularly want to go there.
A message that I hear frequently from investors is that all that I say about how stock investing works makes sense, but that they are reluctant to abandon Passive Investing so long as the “experts” continue to express confidence in it. The “experts” have become the problem!
The problem is that the experts are presumed to know more than the average investor. This is of course so in one sense — the experts have read more books and have more experience. It is not so in another sense, however. The experts are every bit as much vulnerable to the negative investing emotions as are the average investors. Experts too suffer from imperfect hard-wiring. The problem is actually worse with the experts. Experts have more of an emotional investment in the advice they offer than do the average investors who make use of it. Experts who have advocated Passive Investing really, really, really do not want to see it abandoned. It is hard to accept that the advice you have given for 20 or 30 years is in many important ways just flat-out wrong.
Still, it is wrong. Valuations DO affect long-term returns. The SWR is NOT a constant number. Investors cannot afford to stick with stock allocations that made sense at times of reasonable valuations when valuations get to the levels we have seen for the past 13 years or so. For us to get out of the mess we are in today, the experts need to reevaluate. They need to learn how to say those three magic words “I” and “Was” and “Wrong.”
Bull markets are about being wrong, Michael. That’s the essential point. The sorts of price levels that we saw from 1995 through the first half of 2008 are simply not possible in a world where most investors are following rational strategies. Investors following rational strategies sell stocks when prices go to insane levels and the selling brings the prices back to reasonable levels. Market prices are self-correcting when investors are armed with a realistic understanding of how stock investing works in the long run.
We talked earlier about the need to replace the Passive Investing model and you made what I viewed as a important point — you said that most financial planners will not give up on the Passive model until a new model comes along to replace it. We have been working on the new model in the Retire Early and Indexing communities for some time now — we call it Rational Investing. Do you know what our biggest problem is in helping people learn about the new model? Abusive posting by those who continue to cling to the old one!
If we were starting with a clean slate today, there is no one who would recommend that SWRs be calculated in the way in which they are calculated in the Old School studies. Here’s what a fellow posting at the Bogleheads.org board said about this methodology in words posted just a few days ago: “SWR calculations don’t really take into consideration conditional probability (so this is somewhat similar [but not identical]to the Gambler’s fallacy). It escapes me as to how this glaring flaw exists: surely the authors could notbe so ignorant about basic principles of statistics? On the other hand, it is not out of the ordinary. Everyfew months I get to review manuscripts from Nobel-calibre scientists, with glaring flaws (the manuscripts, that is).”I can point you to scores of equally harsh comments re the studies that millions have used to plan their retirements if you think that would help make the point. It shouldn’t be possible for people postingon discussion boards to identify glaring logic flaws in work done by the people responsible for our retirementplanning advice. But it is, it is.
The experts are human. That’s what it comes to. They have emotions like everyone else. Their emotionscause them to believe in silly and dangerous things like everyone else. We need to let them off the hook.We need to begin challenging them more forcefully when we discover their mistakes. That helps not onlythe investors placing their faith in the findings of the experts. It also helps the experts themselves. It forcesthem to overcome their human inclination to respond to questioning with defensiveness. By forcing themto fix the things they get wrong, we help the experts make much more productive use of their time in the days that follow.
That’s Rational Investing. That’s the new model you have been looking for, Michael!
You’re waiting for a new model to come along that is better in every way than Passive Investing.We’ve already got it! We have mined some amazing insights over the past six years. All that is holdingus back is this crazy Old School stuff that makes it impossible for humans of good intent to engage incivil and reasoned discussion about what works in the real world. There was a day when both the OldSchool SWR studies and the Passive Investing model of understanding how stocks work served good purposes. That day is long past. As soon as the academic research came in showing that valuations really DO affect long-term returns (a finding contrary to the core premise of the Passive Investing model),all of this nonsense should have been ditched so that we could all move forward with the discovery ofmuch better stuff.
It was a mistake, Michael. That’s all. There is no other area of life endeavor in which people would conclude that because something barely SURVIVED on two occasions that it is safe to try it yet a third time. Takinga 4 percent withdrawal from a high-stock-allocation portfolio at a time of sky-high valuations has ALWAYSbeen a risky thing to do. It survived twice. It may survive a third time or it may not. But there is zero reasonto believe that all of the old realities will be stood on their heads and that this risky idea will become a safe one.What’s always been risky is likely to remain risky in the future.
We need to get about the business of telling people that, in my view. It’s important. Telling people the realitiesis the way to help them overcome the negative effects of their hard-wiring. Most middle-class investors want to do better. Most want to learn. The “experts” need to start doing their part. It is only when we work up whatit takes to admit the mistakes of the past that we become able to make a better future. It’s a win/win/win/win/win. I see no potential downside whatsoever.
Valuations matter. Which is another way of saying that emotions matter. Which is another way of saying thatpeople matter.
The Efficient Market Theory ignores all that. The Efficient Market Theory presume that we are all rational actorsdespite a long historical record showing that we are not. The Efficient Market Theory has failed us. We need to move on.
Rob
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