What economists consider an optimal portfolio combination is better split into two separate pieces
No doubt you’ve come across the expression “homo sapiens.” That’s Latin for “wise man,” and it’s the name given to our human species. I’d guess, though, that you probably haven’t come across “homo economicus.” That too is Latin, and it simply means “economic man” – a name given to the concept of people who are entirely rational, totally self-interested and pursue their goals in optimal fashion.
Yeah, right! Such people (often called “econs,” for short) don’t exist, of course. But it’s necessary to make these extreme assumptions before mathematics can be used to generate unique optimal solutions to economic problems. We don’t act that way. Our behavior exhibits emotional, cultural, social and other departures from pure rationality. In fact, “behavioral economics” has developed to study how we behave, in practice.
Dr Daniel Kahneman is often cited as the first behavioral economist to win (in 2002) the Economics Nobel Prize (interesting: he wasn’t an economist), followed by Dr Richard Thaler in 2017. But to me the first was really Dr Herbert Simon in 1978 for his notion of satisficing, the idea that we don’t seek optimal solutions: we search instead for a solution that is good enough to meet a number of sensible criteria, and that’s what we use, without continuing to the extreme of searching for the single best possible solution. In other words “Good enough … is good enough.”
I mention all of this because I’ve been thinking recently of Dr Meir Statman and his book Finance for Normal People [https://www.amazon.com/Finance-Normal-People-Investors-Markets-dp-019062647X/dp/019062647X/ref=mt_other?_encoding=UTF8&me=&qid=], in which he makes a clear distinction between economic man and the way human beings operate in practice. And I’m going to use his notions to explain why it’s sensible to have separate growth and safety goals in retirement, rather than a single combined goal.
By the way, a side anecdote. A few years ago I was describing to a British prof how I set up my retirement finances and the reasoning behind it, and he grinned and said, “You’re the first econ I’ve ever come across.” Given his grin, I took it as a compliment. Mind you, it’s not how my family thinks of me. A relative once said, some years ago, “You know, for a smart person you can be very stupid sometimes,” to the delighted guffaws of the other relatives around. And this is a view now totally shared by the next generation too. And believe me, my family really knows me! So I’m very far from being an econ, even if I really have given retirement finance a lot of thought.
I’ve referred to Dr Statman and his book before (https://donezra.com/28-what-does-spending-money-do-for-you/). There I mentioned that he identified three kinds of benefits that justify spending money. Utilitarian benefits are practical; expressive benefits say something about us to the world; and emotional benefits make us feel good. Econs only deal with the first kind; normal people pursue the two other kinds of benefits too.
I like that! Of course, it doesn’t mean that everything we do as normal people is sensible. We can be normal-knowledgeable, but we can also be normal-ignorant and normal-wrong. So this isn’t a way to excuse all behavior. The three motivations make sense. Our actions may not.
***
All of which finally gets me to my point. And it has to do with risk-taking in your retirement finances.
Econs are assumed to have precise, measurable goals and equally precise constraints, as well as a thought process that quantifies the trade-off between seeking better outcomes and taking more risk (which of course can lead to worse outcomes). Out of this mathematical formulation comes an asset allocation that is expected to optimize the “utility” of the outcome. The utility is itself equal to the achieved return, less some multiple of the risk taken to achieve it (often called the risk-adjusted return). That multiple is related to the econ’s risk tolerance: the higher the tolerance for risk, the lower is the multiple.
Are you struggling with all of this? It wouldn’t surprise me.
The thing is, that’s a wonderful theoretical econ concept, permitting a mathematical proof that the solution is truly optimal, but it’s nonsense in practice, for at least a couple of reasons.
One is that frankly we don’t give a damn about utility. In my career I used this approach with virtually every pension committee I worked with, simply because it was an approach that permitted discussion, and the real value came from the discussion. But every quarter, what do you think their first question was? They always asked: “What was our return?” They would probably have considered me insane if I had responded, “Never mind your return, just look how high your utility was!” Even though everything was based on getting utility as high as possible, not one committee ever asked for their utility to be reported. As I said earlier: yeah, right!
Another reason is that the return is only a means to an end, as far as your retirement is concerned. The goal is to make you happy, which in turn is achieved by enabling you to live the lifestyle you desire. It’s not investment risk that matters. It’s lifestyle risk. What if you can’t do the things you’d like to do? That’s disappointing, even if your return is high. What if you can indeed do the things you want, even if the return is low? That’s good. So it’s lifestyle ups and downs that are important, not investment return ups and downs.
In thinking about our lifestyle, there are some things we feel we can’t do without: those are the essentials. Other things are in the nice-to-have category, but we know that in bad times we can contemplate living without them. What’s essential and what’s nice to have will vary from one person (or couple) to another; but the concept is simple and applies to everyone. And there isn’t really a trade-off between the categories.
In fact, we typically have different attitudes to the categories. Because essentials are fundamental, we hugely value security for that sort of spending. And because nice-to-haves aren’t essential (by definition), we’re more tolerant (though still disappointed) if we have to forsake some of them from time to time.
What’s more, our relative attitudes to the two categories can change over time. By this I mean that the relative intensity of feeling towards essentials and nice-to-haves can change, particularly as our fortunes change.
So it makes much more emotional sense to set up separate buckets for the two categories, rather than (as mathematical economic theory does) set up a single artificial utility function for the combination and come up with an overall allocation of your assets. Traditional mathematical economists, and some financial professionals, tell you that using a safety bucket and a growth bucket is really an optical illusion. They say you really have a single portfolio, and they’ll measure the investment return on your total (single) portfolio.
It makes mathematical sense, but it fails the test of common sense. The purpose of the safety portfolio isn’t to generate a return. It’s simply to be there for you, in bad times, so that you don’t have to cash in assets that have fallen in value. The safety bucket isn’t meant to produce an investment return. It’s simply a form of insurance.
It’s like telling you that your term insurance policy produced an investment return of minus 100%, because you lost it completely. You paid it, and it’s gone, with nothing in return.
Actually, that’s your preferred outcome! You really prefer NOT to collect on the policy – you’d much rather be alive!
So, just as a term insurance policy has an investment return (preferably minus 100%), so too your safety bucket has an investment return. But it’s irrelevant. The purpose is NOT to generate a return; it’s to be there when it’s needed. If it does that, it has fulfilled its purpose. If it also generates some small investment return, that’s a bonus, not a negative feature.
Dr Statman gave a terrific interview to Morningstar (https://www.morningstar.com/articles/951638/meir-statman-we-are-all-normal), in which he says that there are two things we want. “One is not to be poor, and the other is to be rich. And so, if you think of your money as being one blob, you’re missing something because we don’t really have an attitude towards risk, and we don’t have this blob goal … That is really going to be a very useful way to think about your money, to have them as two buckets, one bucket for not being poor and another bucket for being rich.”
Exactly.
***
Takeaway
Having separate safety and growth components in your retirement portfolio is simpler, more flexible and superior to the concept of a combined do-it-all portfolio.
2 Comments
I have written about retirement planning before and some of that material also relates to topics or issues that are being discussed here. Where relevant I draw on material from three sources: The Retirement Plan Solution (co-authored with Bob Collie and Matt Smith, published by John Wiley & Sons, Inc., 2009), my foreword to Someday Rich (by Timothy Noonan and Matt Smith, also published by Wiley, 2012), and my occasional column The Art of Investment in the FT Money supplement of The Financial Times, published in the UK. I am grateful to the other authors and to The Financial Times for permission to use the material here.
I agree, and in an earlier blog there was discussion of a third component. Whereas the safety component could be a major backup for serious damage to the growth component, the third component functions as a short term backup to the growth component. This was described as a few years’ income replacement which may enable one to maintain a lifestyle during a market decline in the growth component.
Thanks, Ted. My apologies, I may not have been clear. The investment safety and investment growth components are the only two investment components I intended to mention, with the few years of income being the insurance (safety) component, rather than a diversifier of the growth component. The third component is then the longevity safety component, which is some form of longevity pool, perhaps an immediate or deferred annuity.