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 I sent to Michael on August 28.

Michael:

That e-mail is gold. You’re telling the real story in those words. This is the stuff that people in the field need to be reflecting on as we chart a path taking us from where we are to a place where I believe we all in our hearts very much want to find the way to.

You are absolutely right that EMT/Passive Investing will hang around until a new model is put forward that challenges it. I have done a good bit of work developing a new model (“Rational Investing”). The key features are: (1) it acknowledges the need to adjust allocations in response to big valuation changes; and (2) it stresses the emotional side of the investing project (this feature is responsive to your concern about
the appeal of Passive Investing being “hardwired human neuropsychology.”

I’ll offer two illustrations of how the new model works.

Here is an article entitled “Market Timing — What Works and What Doesn’t”:

http://www.passionsaving.com/market-timing.html

The article points to the sorts of strategic questions that people should be examining today. One of the good things that Passive Investing advocates have done is to point out the futility of short-term timing. Unfortunately, they jumped to an unwarranted conclusion that long-term timing does not work either. There is no legitimate argument that long-term timing cannot work (all of the research showing that timing does not work focuses on short-term timing). So we should have lots of people looking at how to go about long-term timing.

I certainly do not say that my particular take is the controlling authority. I’d like to see hundreds of people join the discussion and offer hundreds of different takes. Again, that is how humankind advances in its understanding on an issue. The problem today is that few will even accept the elementary point that long-term timing can work; too many accept the Passive Investing dogma that “timing doesn’t work” as if if had universal application. So the dominant model is no longer serving to inform. It is serving to hold back the development of important insights. At a bare minimum, we need to get the word out that any claims of Passive Investing advocates that long-term timing does not work are rooted in subjective opinion, not scientific investigation.

Here is a podcast called “The Case Against Valuation-Informed Indexing”:

http://www.passionsaving.com/personal-finance-podcasts-page-two.html

This is an example of how I handle the emotional side of the question. I advocate Valuation-Informed Indexing at my site. I believe that it is a great approach. But I think it is important to let people know of the arguments against this approach so that they will possess a confidence in it that Passive Indexers can never possess in their choice. You don’t need to be on an investing discussion board long to see that most Passive Investors are losing confidence in their approach. Most of these investors are following buy-and-hold strategies and buy-and-hold strategies cannot work without confidence.

I don’t think it is overstating things to say that most following a buy-and-hold strategy today are doomed. That’s not because buy-and-hold cannot work. It’s because confidence is essential to the long-term success of such a strategy and it is not possible for anyone to have confidence (bravado is not the same thing as confidence) in a model that argues that prices do not matter. All investors know from experience buying and selling other types of assets that prices matter. Trying to deny that this is so in the investing realm can work for the length of a wild bull market but not much beyond that.

I much appreciate the problem that people in the field have with the idea of recommending what makes intellectual sense. I went from being one of the most popular posters in the history of the Motley Fool site to being the most hated in the history of that site as the result of my decision to report accurately what the historical data says about safe withdrawal rates. There’s another side to the story however, a much more encouraging and uplifting side.

Here is an article setting forth comments from Motley Fool posters in the early days
of our discussions:

http://www.passionsaving.com/The-Great-Safe-Withdrawal-Rate-Debate.html

Note the enthusiasm with which people take to discussions of the realities of investing. People are thirsting for this stuff. Yes, it is so that people are wary and become upset when the Passive Investing dogmas are questioned. That’s because they have so much riding on knowing the answers to these questions and the challenges that the new model makes to the old model are so fundamental. But most of today’s investors already have doubts in their minds and most of today’s investors want to be exposed to new ideas. I have seen strong evidence of this at every board at which I have posted.

The mistake people make is in thinking that change can take place overnight. This cannot be. Humans will not give up believing in something that they have believed for 20 years because someone points to some historical data showing that the belief does not hold up to scrutiny. It is going to take years to put the Passive Investing model behind us. It may be that we will never put it entirely behind us. As you note, we are hardwired to place our trust in such models. Such it has always been and such it will probably to at least some extent always be.

That doesn’t mean that huge advances are not possible. What we need to do is to open up discussions enough so that people can at least entertain the idea that the Passive Investing model does not report reality at all well. The key is getting people to see that the conclusions of Passive Investing are OPINIONS, not scientifically established facts. I say that the Old School SWR claims are demonstrably false. I do not say that the opinion of a particular researcher that a 4 percent withdrawal will work even for retirements that were initiated at the top of the price bubble is demonstrably false. There is a chance that those retirements will survive. It is acceptable and at times even helpful for people to say that. It never can be helpful for someone to say that the historical data says that taking a 4 percent withdrawal in a retirement beginning at such price levels is safe. It COULD work. That is not at all the same thing as saying that there is scientific evidence that one can count on showing it will work.

The old model served a purpose. The old SWR methodology served a purpose. But the wild bull market is over. We need to transition away from it. To continue to encourage people to follow this model without thought is madness. People are going to get hurt and people are going to blame the planners who led them down this false path for their hurts when they experience them. We don’t need to end advocacy of Passive Investing (and we couldn’t if we tried). We do need to change the terms of debate so that alternatives to Passive Investing come to be accepted as being perfectly respectable and reasonable alternatives.

There have been dozens of times in our discussions when people have compared the Passive Investing claims to religious dogmas. This is not good. These claims are being put forward as science when the reality is that it requires a rejection of the scientific method to maintain confidence in them. People need to take the intensity level down about 17 notches. People need to learn how to engage in respectful back-and-forth conversations about investing topics. Most Passive Investing advocates are today incapable of this. That’s a very, very bad sign. It’s a sign that this model has been oversold dramatically.

Passive Investors should be able to be friends with non-Passive Investors. That’s the bottom line. If people following the old and new models can interact as friends, the rest will take care of itself. Different people will come to different conclusions and the earth will continue turning. This doesn’t happen today. Honest posting on SWRs has been banned at half a dozen discussion boards, including ones at which big-name
experts (ever heard of John Bogle?) participate. This is an astounding and frightening reality. This never should be. This verifiable fact shows that big changes need to be made in how information about how to invest effectively is communicated to people.

The title of the book that I am working on is “Investing for Humans.” That says it. We don’t need to force everyone to believe in Rational Investing any more than we ever needed to force everyone to believe in Passive Investing. What we need to do is to follow the same practices that are followed in all other areas of human endeavor. Political experts don’t act as if one political party has been “proven” to be right on every issue. Housing experts don’t act as if there is one type of house that everyone should live in. Baseball experts don’t act as if every team should focus on accumulating home-run hitters and that stealing has been scientifically proven to be a bad idea. There are some who believe that stealing is not a good strategic move. But they don’t feel a need to repeat a mantra that “stealing never works” in the way that Passive Investing enthusiasts repeat the mantra that timing never works.

Defensiveness is the problem. Defensiveness reveals a lack of confidence. If people lack confidence in Passive Investing today, how do you think they are going to respond when prices drop dramatically and the wealth accumulation of a lifetime is wiped out? The financial planning community has painted itself into a corner. It must find a way out. The encouraging reality is that there is a highly appealing way out that presents itself to us.

The way out is to permit discussions to take place. People need to stop thinking that they need to be gurus who know the One Right Answer to every possible question. Planners need to learn how to say “I don’t know” and “I was wrong” and “some think this but there are others who think that.” People can deal with that. Those sorts of phrases are used successfully in lots of other fields. Learning experiences take place when those sorts of phrases are employed. Using those sorts of phrases lets the financial planners off the hook. People will not stop looking to them for guidance. What will happen is that people will begin feeling more respect for the guidance obtained. People will feel more confidence in the strategies they follow, they will obtain more positive investment results, and the planners will be admired for having set this benevolent circle of events into motion.

The problem is the old one of who is going to be the one to bell the cat. I presume that all can see the great things that would follow from heading in this direction. But what sort of competitive hit will one particular individual or one particular firm experience for being the thought leader? I have come to believe that we need to see a group effort in the financial planning community. We need a statement that is broad enough that just about everyone can sign on to it (perhaps a statement that “Passive Investing has not been scientifically  proven and no responsible planner or advisor should suggest that it has been” or something along those lines) and then we need a big speech by a big-name figure (Bogle would be best, in my assessment) that is covered extensively by the major papers. That would start a national debate among investors. That would take us to all sorts of wonderful places. That would permit researchers to put a lot more work into productive areas of inquiry.

All of this can happen, Michael. We just need a few people of influence to get the ball rolling. I can present documentation of just about anything that anyone needs to see by pointing to the Post Archives of The Great Safe Withdrawal Rate Debate.

Will there be arguments that long-term timing does not pay after taking costs into account? To be sure! But there will also be arguments otherwise. The Scenario Surfer shows that the typical middle-class investor can retire perhaps five years sooner just by electing to engage in long-term timing rather than rebalancing:

http://www.passionsaving.com/portfolio-allocation.html

That’s going to be exciting news to the investors who find out about it. And this can be done with little in the way of transaction costs. Investors can get those sorts of results by only engaging in one allocation shift every 10 years or so. There are millions of middle-class investors who would love to be told how  to retire five years sooner just for being willing to make one allocation shift every 10 years or so.

And the Scenario Surfer is of course just the beginning. There are thousands of insights that none of us know about today that we will be able to unearth once it becomes possible to engage in discussions without having to pretend to believe in the dogmas of the failed (in my view!) Passive Investing model.

The change needed is not primarily a change in substance (although changes in substance will obviously come about as a consequence of it). The change needed is a change in tone. We need people speaking up in clear and firm and unambiguous terms against the idea that Passive Investing is the product of science. It is one strategic approach, that’s all. There should be room for lots of other strategic approaches. Planners made a mistake by leading lots of people to believe that there is only one approach and they need to fix that mistake before it causes more damage. The longer the job is put off, the harder it is to pull off.

As an aside, I wanted to let you know that I will be going on vacation on Sunday and will be away from the computer until the following Monday (September 8). You can be sure, however, that even at the beach I will be devoting a good bit of my mental energies to the safe-withdrawal-rate matter. Perhaps getting hit by a big wave will cause an entirely fresh perspective on the problem!

Rob

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